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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 [Fee Required]
For the Fiscal year ended September 30, 1996
or
[ ]Transition Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934 [No Fee Required]
For the Transition period from_______ to _______
Commission file number 1-11921
E*TRADE GROUP, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-2844166
(State or other jurisdiction (I.R.S. Employer Identification Number)
of incorporation or organization)
Four Embarcadero Place, 2400 Geng Rd. Palo Alto, CA 94303
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (415) 842-2500
Securities registered pursuant to Section 12(b) of the Act:
Title of each class
- -------------------
Common Stock - $0.01 par value
Securities registered pursuant to Section 12(g) of the Act: None
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.[ ]
As of December 13, 1996, the aggregate market value of the voting stock held
by non-affiliates of the registrant was approximately $174,400,000.
The number of shares of Common Stock outstanding as of December 13, 1996 was
29,539,147 shares.
DOCUMENTS INCORPORATED BY REFERENCE
Definitive Proxy Statement relating to the Company's 1997 Annual Meeting to
be filed hereafter (incorporated into Part III hereof).
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E*TRADE GROUP, INC.
FORM 10-K ANNUAL REPORT
FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1996
TABLE OF CONTENTS
Part I
- ------
Item 1. Business-------------------------------------------------------- 3
Item 2. Properties------------------------------------------------------24
Item 3. Legal Proceedings-----------------------------------------------25
Item 4. Submission of Matters to a Vote of Security Holders-------------25
Part II
- -------
Item 5. Market for Registrant's Common Equity and Related
Shareholder Matters-------------------------------------------26
Item 6. Selected Financial Data---------------------------------------27
Item 7. Management's Discussion and Analysis of
Financial Condition and Results of Operations-----------------28
Item 8. Financial Statements and Supplementary Data-------------------36
Item 9. Changes in and Disagreements with Accountants
on Accounting and Financial Disclosure------------------------52
Part III
- --------
Item 10. Directors and Executive Officers of the Registrant------------52
Item 11. Executive Compensation----------------------------------------52
Item 12. Security Ownership of Certain Beneficial Owners
and Management------------------------------------------------52
Item 13. Certain Relationships and Related Transactions----------------52
Part IV
- -------
Item 14. Exhibits, Financial Statement Schedules and Reports
on Form 8-K---------------------------------------------------53
Exhibit Index--------------------------------------------53
Signatures-----------------------------------------------56
The page numbers in this Table of Contents reflect EDGAR page tag numbers.
UNLESS OTHERWISE INDICATED, REFERENCES TO "COMPANY" MEAN E*TRADE GROUP, INC.
AND ITS SUBSIDIARIES AND REFERENCES TO "FISCAL" MEAN THE COMPANY'S YEAR ENDED
SEPTEMBER 30 (E.G. FISCAL 1996 REPRESENTS THE PERIOD OCTOBER 1, 1995 TO
SEPTEMBER 30, 1996).
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Item 1. BUSINESS
Except for historical information contained herein, the matters discussed in
this report contain certain forward-looking statements that involve risks and
uncertainties that could cause actual results to differ materially from those
anticipated in such forward looking statements.
E*TRADE Group, Inc. ("E*TRADE or the "Company") is a leading provider of
cost-effective, secure online investing services. The Company offers
automated order placement, portfolio tracking and related market information,
news and other information services 24 hours a day, seven days a week by
means of the Internet, online service providers CompuServe, Inc. and America
Online, Inc., direct modem access, touch-tone telephone, and to a lesser
extent, interactive television. E*TRADE's proprietary transaction processing
technology enables it to offer highly automated, easy-to-use and cost-
effective services that empower customers to take control of their own
financial transactions.
Advancements in telecommunications and information technology have
fundamentally altered the way individuals conduct business. Just as the
microprocessor dramatically changed the way individuals use computers, the
emergence of the Internet as a tool for communications and commerce is
bringing about a revolution in the world of financial transactions and
information services. This development provides individual investors with
direct access to information and transaction processing capabilities once
available only through full-commission securities brokerage firms. As a
result, consumers are increasingly taking direct control over their personal
investment transactions, not simply because they are able to, but because
they find it more convenient and cost-effective than relying on full-
commission or even traditional discount brokers.
E*TRADE provides customers with the ability to place orders for stocks and
options at a lower, more predictable transaction cost than traditional full-
commission or discount brokerage firms. The Company's services feature an
easy-to-use graphical user interface, the ability to create "personalized
environments" reflecting users' individual needs and interests, accessibility
from virtually anywhere at any time via multiple gateways, unbundled services
for cost-effective pricing and highly secure services through the use of
encryption and authentication technology.
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The Company had over 91,000 accounts as of September 30, 1996, with an
average monthly growth in accounts of over 9% since October 1, 1995 and had
an average daily transaction volume of approximately 8,400 in September 1996,
as compared to approximately 3,600 transactions in September 1995,
representing an average monthly growth of over 7% during that period.
The Company began offering Internet investing services in February 1996 to
supplement its then existing online services.
The Company was incorporated in California in 1982 and was reincorporated in
Delaware in July 1996. Its principal corporate offices are located at Four
Embarcadero Place, 2400 Geng Road, Palo Alto, California 94303, and its
telephone number is (415) 842-2500. Unless otherwise indicated, all
references in this Form 10-K to "E*TRADE" or the "Company" refer to E*TRADE
Group, Inc., a Delaware corporation, E*TRADE Securities, Inc., its principal
broker-dealer subsidiary ("E*TRADE Securities"), its other subsidiaries and
its predecessor California corporation. The Company's World Wide Web ("Web")
site is located at http://www.etrade.com. Information contained in the
Company's website shall not be deemed to be part of this Form 10-K. In
August, 1996 the Company completed an initial public offering of 5,702,000
shares of its common stock, 5,026,550 shares of which were sold by the
Company generating net proceeds to the Company of $46.4 million.
The Company operates in a single industry segment: securities brokerage and
related investment services. No material part of the Company's consolidated
revenue is received from a single customer or group of customers, or from
foreign operations.
THE E*TRADE SOLUTION
E*TRADE uses its proprietary processing technology to provide consumers with
easy-to-use and cost-effective online securities investing services. The
Company offers equity and option order placement services 24 hours a day,
seven days a week, thereby shifting the financial transactions paradigm from
a business hours only, intermediary-based model to one in which consumers
have the ultimate control over where and when they initiate securities
transactions.
The Company's services are highly automated, with most customer orders being
entered, processed and confirmed electronically and without human
intervention. By avoiding the inefficiencies, personnel requirements and
associated costs of non-automated order entry and processing, the Company is
able to provide its services at a lower cost than traditional full-commission
or discount brokerage firms. The Company's technology is based on a modular
architecture which is scaleable to handle increasing transaction volumes.
Modular architecture allows for application programs to be quickly modified
in response to changing business requirements. In addition, a modular
architecture which utilizes multiple components and tiers is designed to
scale quickly without requiring fundamental changes to the application
programs.
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E*TRADE empowers customers to take control of their own financial
transactions through the following features:
User-Friendly Web Investing Interface. Through its easy-to-use graphical
interface, E*TRADE has made online investing simple, fast and fun. Consumers
accessing E*TRADE for the first time are able to understand quickly the wide
variety of services available and how to access those services. The barriers
to first-time trading online have been reduced, enabling new users to feel
just as comfortable trading online as technologically savvy early adopters.
The look and feel of the graphical user interface on the Web has been
replicated on CompuServe and is expected to be replicated on America Online.
Personalized Environments. Customers are able to create "personalized
environments," including personalized watch lists and portfolios for tracking
securities. A customer's trading experience is enhanced with portfolio,
account and market information readily available prior to initiating a trade.
The Company plans to enable customers to further customize their user
interfaces by allowing them to select the market indicators, portfolio views
and value-added information services, including news, charts and market
analysis, that are most valuable to them.
Anywhere/Any Time Access. By maintaining multiple gateways through which
customers may access E*TRADE virtually anywhere at any time, the Company can
increase the number of customers served and transactions processed. Customers
are able to trade securities through the Internet, direct modem access,
online service providers CompuServe and America Online, touch-tone telephone
and, to a lesser extent, interactive television.
Cost-effective Services. By unbundling the services that many full-commission
and discount brokerage firms include in their high transaction costs, the
Company is able to offer customers just the services they want at a lower
price, yet provide value-added products and services.
Secure Operations. The Company believes that customer confidence in account
security is one of the key factors for success in the online investing
industry. By offering highly secure services through the use of encryption
and authentication technology, the Company has achieved a leadership position
in the secure provision of online investing services.
MARKETING
The Company's marketing strategy is based on an integrated marketing model
which employs a mix of communications media. The goals of the Company's
marketing programs are to increase E*TRADE's brand name recognition and to
attract new customers. The Company pursues these goals through direct-
response advertising, marketing through its own Web site, an aggressive
public relations program and co-marketing with various alliances. All
communications by E*TRADE Securities with the public are regulated by the
National Association of Securities Dealers, Inc. (the "NASD"). See
"Government Regulation; Net Capital Requirements."
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Direct Response Advertising; Web Site Marketing
The Company's advertising focuses on building awareness of E*TRADE's products
and services and on marketing online investing as a better way of handling
their securities transactions, accessing financial and market data, and
managing portfolios. Advertising is increasingly directing interested
prospects to the Company's Web site for additional information, as opposed to
generating primarily telephone-based inquiries. Print advertisements are
placed in a broad range of business, technology and financial publications,
including the Wall Street Journal, Investor's Business Daily, Forbes, Forbes
ASAP, Barron's, Money, SmartMoney and Wired. E*TRADE also advertises
regularly on CNBC, CNN and on national business radio networks. At the Web
site, prospective customers can get detailed information on the Company's
services, use an interactive demonstration system, request additional
information and/or complete an account application online. Since May 1, 1996,
a majority of the Company's new accounts have been generated through the
Internet. E*TRADE's increasing Internet focus is resulting in decreased
customer acquisition costs, since providing information through its Web
site can substitute for paper-based information packages.
Public Relations Program
The Company aggressively pursues public relations opportunities to build
brand awareness. This campaign has resulted in appearances on The Today Show,
CNN and CNBC, in addition to profiles in Business Week, Time, Money, the
Financial Times, Investor's Business Daily and the Wall Street Journal among
others. There are links to E*TRADE's home page from approximately 1,200 sites
on the Web, which the Company believes is a significant factor in increasing
brand awareness and generating leads, as consumers increasingly look to the
Internet as a key source of information and commercial activity. The Company
also actively seeks speaking opportunities at industry conferences and
events.
Co-marketing/Promotion
The Company has established a number of significant co-marketing
relationships to promote its products. These include participation in
Netscape's in-box promotional offer for the Netscape Navigator browser
available through retail outlets, distribution of new account kits with
Window on Wallstreet's Investor software products, inclusion in Apple
Computer's in-store interactive demonstrations and links with a number of
Web-based information providers. The Company intends to enter into additional
co-marketing relationships as a component of its marketing strategy.
E*TRADE is also developing a virtual shopping mall of software, services and
products that will help individuals make informed investment decisions.
Through E*TRADE's Web site, customers would be able to purchase or subscribe
to products available from this mall at special discount prices. Goods and
services offered would be reviewed and selected for inclusion by E*TRADE
based on overall perceived "best value" within specified product categories.
Companies selected for inclusion in return would promote E*TRADE's services
through their Web sites and/or marketing materials. There can be no assurance
that the Company will succeed in developing a virtual shopping mall or that,
if developed, it will be successful or profitable.
7
International Customer Base
The Company's customers are able to place trades online from anywhere in the
world. The Internet, America Online and CompuServe permit the Company's
customers to access its system without regard to geographic location.
Although E*TRADE currently has no marketing program directed specifically at
consumers outside the United States, over 1,000 of its accounts are for
customers with addresses in over 60 countries. The Company expects its
international customer base to grow with the continued proliferation of the
Internet and increasing free trade, although there can be no assurance in
that regard.
A component of the Company's strategy is its planned aggressive increase in
marketing efforts to attract more international customers. The Company plans
to create "localized" user interfaces using local languages and offering
services tailored to regional requirements and customs. The Company has been
discussing possible alliances with local institutions such as brokers and
banks to make the portfolio tracking, purchase and sale and funds transfer
processes easier for non-U.S. investors, to facilitate the handling of
foreign securities, and to ensure the Company is in compliance with local
laws and regulations.
To date, the Company has limited experience in providing investing services
internationally. There are certain risks inherent to doing business in
international markets, particularly in the heavily regulated brokerage
industry. There can be no assurance that the Company will be able to market
successfully its services and products in international markets.
BROKERAGE AND INFORMATION SERVICES AND PRODUCTS
The Company's services are based on proprietary processing technology and are
designed to meet the needs of individuals who make their own investment
decisions. The Company's services include fully automated stock and option
order processing via personal computer or touch-tone telephone, online
investment portfolio tracking and financial market news and information. The
Company offers its services to consumers through a broad range of electronic
access points, including the Internet, direct modem access, online service
providers CompuServe and America Online, touch-tone telephone and, to a
lesser extent, interactive television. All records are maintained on one
centralized system, so that customers have access to current account
information regardless of which gateways they are using.
The Company continually strives to increase the functionality of its
services, as well as to offer new services that enhance customers' online
trading experiences. The Company's services give consumers increased control
of their personal investments by providing a direct link to the financial
markets and to financial information through a customized user interface. The
Company's existing services and product offerings are described below:
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Stock and Option Trading
Customers can directly place orders to buy and sell Nasdaq and exchange-
listed securities, as well as equity and index options, through the E*TRADE
automated order processing system. E*TRADE supports a range of order types,
including market orders, limit orders (good-till-cancelled or day), stop
orders and short sales. System intelligence automatically checks the
parameters of an order, together with the customer's buying power and
positions held, prior to executing an order. All listed market orders
(subject to certain size limitations) are executed at the National Best
Bid/Offer ("NBBO") or better at the time of receipt by the third market firm
or exchange. The NBBO is a dynamically updated representation of the combined
highest bid and lowest offer quoted across all United States stock exchanges
and market makers registered in a specific stock. Eligible orders are exposed
to the marketplace for possible price improvement, but in no case are orders
executed at a price inferior to the NBBO. Limit orders are executed based on
an indicated price and time priority. All Nasdaq market orders (subject to
certain size limitations) are executed at the Best Bid/Offer (Inside Market)
or better at the time of receipt by the market-maker. All transaction
and portfolio records are automatically updated to reflect trading activity.
Buy and sell orders placed when the markets are closed are automatically
submitted prior to the next day's market opening. Account holders receive
electronic notification of order executions, printed trade confirmations and
detailed monthly statements. The Company also arranges for the transmittal of
proxy, annual report and tender offer materials to customers.
Market Data
During trading hours, E*TRADE continually receives a direct feed of detailed
quote data, market information and news. Customers can create their own
personal lists of stocks and options for quick access to current pricing
information. E*TRADE provides its customers free access 20-minute delayed
quotes, including stocks, options, major market indices, most active issues,
and largest gainers and losers for the major exchanges. Users are alerted
when there is current news on an identified stock or when a stock has reached
a user-defined price threshold.
Upon placing an order, the customer is provided with a real-time bid and ask
quote, at no extra charge. For $30 per month, individual investors can obtain
unlimited real-time quotes and market data. The Company's Web site provides
links to other business and financial Web sites, including the CNN Financial
Network and the EDGAR database of the Securities and Exchange Commission (the
"SEC"), which provides access to SEC filings of public companies. The Company
has expanded its existing services to include immediate access to breaking
news, charts, market analysis and company financial information.
Portfolio Tracking and Records Management
Customers have online access to a listing of all their portfolio assets held
at E*TRADE, including data on the date of purchase, cost basis, current price
and current market value. The system automatically calculates unrealized
profits and losses for each asset held. Detailed account balance and
transaction information includes cash and money fund balances, buying power,
net market portfolio value, dividends paid, interest earned, deposits and
withdrawals. Brokerage history includes all orders, changes and
cancellations. Tax records include total short-term or long-term gain/loss
and commissions paid. Customers can also create "shadow" portfolios to
include any number of financial instruments a customer is interested in
tracking --for example, assets held at another brokerage firm. These shadow
portfolios can include stocks, options, bonds and mutual funds.
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Cash Management Services
Customer payments are received through the mail or federal wire system and
are credited to customer accounts upon receipt. The Company also provides
other cash management services to its customers. For example, uninvested
funds earn interest in a credit interest program or can be invested in one of
five money market funds. In addition, the Company provides free checking
services through a commercial bank and is exploring the expansion of these
services. The Company plans to expand its cash management offerings to
include electronic funds transfer via the Internet and an automatic deposit
program to allow scheduled periodic transfers of funds into customers'
accounts.
Account Security
The Company uses a combination of proprietary and industry standard security
measures to protect customers' assets. Customers are assigned unique account
numbers, user identifications and passwords that must be used each time they
log on to the system. The Company relies on encryption and authentication
technology, including public key cryptography technology licensed from RSA
Data Security, Inc. ("RSA"), to provide the security and authentication
necessary to effect the secure exchange of information. Telephone
transactions are secured through a personal identification number (PIN)--the
same technology used in ATMs. A second level of password protection is used
prior to order placement.
Access and Delivery of Services
The Company's services are widely accessible through multiple gateways, with
automated order placement available 24 hours a day, seven days a week by
personal computer. In addition, customers can access E*TRADE by touch-tone
telephone and, in a limited number of markets, through interactive
television.
Personal Computer. Customers using personal computers can access the E*TRADE
system through the Internet, online service providers CompuServe and America
Online, or direct modem access. Accessing the E*TRADE Web site via the
Internet offers the customer platform independence. The Company's Web site
combines an easy-to-use graphical user interface with the trading
capabilities that experienced investors demand. The Web-based system also
includes direct links to many investment-related resources on the Web.
Alternatively, accessing E*TRADE by dialing directly through a modem offers a
method for connecting to the trading system independent of either the
Internet or a proprietary online service.
Touch-tone Telephone. TELE*MASTER, E*TRADE's interactive voice response
system, provides a convenient way for customers to access quote information,
place stock and option orders, review account balances and check messages
from any touch-tone telephone.
Interactive Television. GTE MainStreet, an interactive television system
operated by GTE Corporation, is available as a gateway to the Company's
investing services. GTE MainStreet has been on the air over certain cable
television franchises on a pilot basis for approximately four years and is
now operational in three test markets. Revenues and transaction volume through
GTE MainStreet represent an immaterial portion of the Company's business.
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Substantially all of the Company's revenues in recent years have been from
online investing services, and the Company expects its online investing
services to continue to account for substantially all of its revenues for the
foreseeable future. E*TRADE, like other securities firms, is directly
affected by national and international economic and political conditions,
broad trends in business and finance and substantial fluctuations in volume
and price levels of securities and futures transactions. Severe market
fluctuations in the future could have a material adverse effect on the
Company's business, financial condition and operating results. Certain of the
Company's competitors with more diverse product and service offerings may be
better positioned to withstand such a downturn in the securities industry.
The market for online investing services, particularly over the Internet, is
at an early stage of development and is rapidly evolving. As is typical for
new and rapidly evolving industries, demand and market acceptance for
recently introduced services and products are subject to a high level of
uncertainty.
Sales of many of the Company's services and products will depend upon the
adoption of the Internet by consumers as a widely used medium for commerce
and communication. The Internet may not prove to be a viable commercial
marketplace because of inadequate development of the necessary
infrastructure. Moreover, the security and privacy concerns of existing and
potential users of the Company's services may inhibit the growth of online
commerce. If the necessary infrastructure is not developed, if security and
privacy concerns inhibit the growth of online commerce, or if the Internet
does not otherwise become a viable commercial marketplace, there would be a
material adverse effect on the Company's business, financial condition and
operating results.
CUSTOMER SERVICE
The Company believes that providing an effective customer service team to
handle customer needs is critical to its success. The Company's customer
service organization helps customers get online, handles product and service
inquiries and addresses all brokerage and technical questions. The customer
service team also makes welcome calls to verify the satisfaction of its
customers. The Company's customers have access to a toll-free number from
6:00 a.m. to 5:00 p.m. Pacific time, Monday through Friday. In January 1997
the Company plans to expand the toll free number's hours of operation so that
it operates from 5:00 a.m. to 9:00 p.m. Pacific time. The Company's current
policy specifies that customer service associates have or obtain a securities
broker's license.
The Company's customer service capacity has been and may continue to be
strained at times. The Company frequently has fallen short of its target
response time for customer service inquiries. The Company has been making
and is continuing to make significant investments in technology and
personnel to improve response times. The Company's continued focus on
customer independence and technology has successfully resulted in fewer
inquiries to E*TRADE personnel per transaction than in the past. The impact of
these efforts can already be seen in the service levels reached. Wait times
and average speed of answer have dropped significantly since the
implementation of the new investments in technology, people, training and
out-sourcing.
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However, there can be no assurance that the Company will be able to
consistently provide enough service capacity, and the failure to do so could
have a material adverse effect on the Company's business, financial condition
and operating results.
E*TRADE PROCESSING TECHNOLOGY
The E*TRADE engine is a proprietary transaction processor that automates
traditionally labor-intensive transactions. Because it was custom-tailored
for electronic marketplace use, the E*TRADE engine provides customers with
efficient service and has the added advantage of being scalable and adaptable
as usage increases and service offerings are expanded. Beyond these features,
the design of the E*TRADE engine and related software allows for rapid
expansion of network and computing capacity without interrupting service or
requiring replacement of existing hardware or software.
The E*TRADE Engine
The E*TRADE transaction processing engine includes a wide variety of
functions and services that allow customers to open and monitor brokerage
accounts and to place orders for equity and option transactions. The engine
also has been structured so that it can be adapted for use by other service
providers, enabling them to integrate E*TRADE's transaction processor into
their own front-end applications to create or expand their electronic
services.
E*TRADE's core technology, developed over a period of several years, is
comprised of three parts: the graphical user interface that the customer
sees; the interface server that connects the customer to the processor; and
the automated processor that processes the transactions.
Graphical User Interface ("GUI"). E*TRADE's GUI environment is based on
Netscape's Secure Commerce Server and today can be accessed by individuals
utilizing Netscape Navigator or Microsoft Internet Explorer. E*TRADE's GUI
connects to the interface server through a bank of Sun servers. These
"gateway servers" provide for load balancing and offer immediate scalability.
Access is restricted through the use of secured network servers and routers
and by requiring two applications of passwords--one for access to the secured
Web site, and a second before an order is placed.
The Interface Server. The interface server's primary function is to provide
access to an efficient, standard transaction processor from all gateways. The
server technology enables communications through multiple platforms and
allows different platforms to communicate with each other. Beyond these
features, the interface server also has been designed to be scalable and
portable and runs in an environment that is both redundant and secure.
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The Automated Processor. The core of the E*TRADE engine is the automated
processor, designed to provide the highest degree of automation for all
E*TRADE transactions. The automated processor was designed to rapidly read
data, process transactions and transmit information to multiple locations.
Because of this, the Company is able to process over 80% of its transactions
without any manual intervention. Dual facilities that run independently share
load balancing and provide redundancy, as well as scalability. The
proprietary nature of the system, along with user ID and password protection
at the application level, provide security for the automated processor.
Internet access to the processor is through the Company's Web site, which
restricts access through the use of secured network servers and routers.
The Company maintains an internal development staff to continually enhance
its software and develop new services and transactions. The Company's
software is designed to be versatile and adaptable, so that the E*TRADE
engine can be configured to meet the differing demands of strategic
relationships or customer requests.
The Company established a secondary data center in Rancho Cordova,
California. This facility replaced the previous back-up facility in Palo
Alto, California, in July 1996. This new facility supports systems, network
and transaction redundancy between the Company's Palo Alto and Rancho Cordova
data centers, thereby providing an operational system in the event of a
service interruption at either facility. To provide for system continuity
during short outages, the Company also has equipped its computer facilities
with uninterruptible power supply units as well as back-up generators.
The information and financial services and communications industries are
characterized by rapid technological change, changes in customer
requirements, frequent new service and product introductions and
enhancements, and emerging industry standards. The introduction of services
or products embodying new technologies and the emergence of new industry
standards and practices can render existing services or products obsolete and
unmarketable. The Company's future success will depend, in part, on its
ability to develop leading technologies, enhance its existing services and
products, develop new services and products that address the increasingly
sophisticated and varied needs of its prospective customers, and respond to
technological advances and emerging industry standards and practices on a
timely and cost-effective basis. There can be no assurance that the Company
will be able, for technical or other reasons, to develop and introduce new
services and products or enhance existing services and products in a timely
manner in response to changing market conditions or customer requirements, or
that new services and products will achieve market acceptance, the failure of
any of which could result in a material adverse effect on the Company's
business, financial condition and operating results.
A significant risk to online commerce and communication is the insecure
transmission of confidential information over public networks. The Company
relies on encryption and authentication technology, including public key
cryptography technology licensed from RSA, to provide the security and
authentication necessary to effect secure transmission of confidential
information. There can be no assurance that advances in computer
capabilities, new discoveries in the field of cryptography or other events or
developments will not result in a compromise or breach of the RSA or other
algorithms used by the Company to protect customer transaction data. If any
such compromise of the Company's security were to occur, it could have a
material adverse effect on the Company's business, financial condition and
operating results.
13
STRATEGIC RELATIONSHIPS AND BUSINESS DEVELOPMENT
The Company pursues strategic relationships to increase its access to online
consumers, to build brand name recognition and to expand the products and
services the Company can provide to its online customers.
Core Business Expansion
E*TRADE has secured or is actively pursuing alliances with (i) Internet
access and service providers, (ii) Internet content providers, (iii)
providers of home and online banking services, and (iv) electronic commerce
companies. These alliances are intended to increase the Company's core
customer base, transaction volume and operational efficiency and will further
enhance its brand name recognition.
To date, the Company has concentrated principally on securing alliances with
online service providers. While a majority of the Company's customers access
its services directly through the Internet, direct modem access or touch-tone
telephone, many use online service providers CompuServe and America Online.
Strategic relationships with such service providers allow the Company to
access a greater number of potential customers and allow the online service
providers to offer their subscribers a broader range of service options.
America Online. America Online and the Company have had a business
relationship for over nine years. In October 1996, the Company signed a non-
exclusive agreement with America Online to place E*TRADE in America Online's
new online Brokerage Area, where E*TRADE will receive a more prominent
presence, accessible through an icon to an upgraded graphical user interface.
Currently, E*TRADE's non-graphical, ASCII interface is accessible through the
America Online service only through a key word search.
CompuServe. CompuServe and the Company have had a non-exclusive contractual
relationship for over ten years. Initially, CompuServe served as an access
point for the Company's service bureau business. The Company's current
agreement with CompuServe permits CompuServe customers to open brokerage
accounts with E*TRADE and access those accounts either through CompuServe or
via the Company's TELE*MASTER service. The economics of this relationship
were recently restructured in a three-year contract to provide for the
Company to pay CompuServe a fee for these transactions. The Company has also
entered into a three-year network agreement with CompuServe Network Services
for the provision of network access for the Company's customers who wish to
access E*TRADE using direct modem software.
Data Broadcasting Corporation. Data Broadcasting Corporation ("DBC"), a
provider of financial information to individual investors, has entered into
an agreement with the Company whereby DBC provides a direct link to E*TRADE's
services from its own Internet Web site and that of the brand labeled quote
sites it provides to others.
14
GTE Corporation. The Company entered into an agreement with GTE Corporation
("GTE") in 1989 to develop an online interactive television brokerage service
that would be made available through GTE MainStreet, an interactive
television system operated by GTE over certain cable television franchises.
GTE MainStreet has been on the air on a pilot basis for approximately four
years and is now operational in three test markets. The volume of transactions
through GTE MainStreet and associated revenues represent an immaterial
portion of the Company's business.
Intuit. The Company has signed a letter of intent for a strategic
relationship with Quicken Investment Services, Inc., a subsidiary of Intuit,
Inc. ("Intuit"), pursuant to which the services of Intuit would permit Intuit
users to download information from E*TRADE to the Intuit software resident on
an Intuit user's personal computer. In addition, it is intended that these
same users will be able to link to E*TRADE for the purpose of entering orders
via their E*TRADE accounts. There can be no assurance that the Company will
reach a definitive agreement with Intuit on terms favorable to the Company, or
at all.
USA Today. The Company has entered into an agreement with USA Today Online
to provide direct access to E*TRADE's services through USA Today Online's
Financial Marketplace, a commercial area that includes personal finance
services and products.
BASELINE Financial Services. BASELINE Financial Services ("BASELINE")
provides customers with access to a wide array of investment fundamentals,
First Call earnings estimates and historical prices on over 6,500 company
stocks. Available to customers free of charge from the "Information
Resources" area of the E*TRADE web site, BASELINE information can be used to
examine a company's statistics prior to making investment decisions.
Quote.com. Quote.com provides current news and charting capabilities that are
directly linked to E*TRADE customers' stock watch and quote lookup features.
News provided includes Reuters News, PR Newswire and BusinessWire. Charts
provided include intra-day, daily and weekly price graphs. These services
were integrated into E*TRADE's Web site and are free to E*TRADE customers.
Quote.com also has entered into an agreement with the Company to provide a
direct link to E*TRADE's services from its trading menu on its own Internet
Web site.
Briefing.com. Briefing.com, a service of Charter Media, provides market
commentary and analysis free to E*TRADE customers. Updates are posted
throughout the day to keep investors informed of important developments
affecting the markets.
New Products and Services
E*TRADE is also pursuing opportunities to increase the number of products and
services offered electronically to E*TRADE customers. These include (i) other
investment products, including mutual funds, fixed income securities and non-
U.S. securities, (ii) electronic funds transfer, and, subject to regulatory
approval,(iii) equity offerings over the Internet. There can be no assurance
that the Company will be successful in its pursuit of these opportunities or
that such pursuit will not divert management attention or inefficiently
utilize Company resources.
15
Significant relationships formed to date are as follows:
CyberCash. The Company has signed a memorandum of understanding for a
strategic relationship with CyberCash, Inc. ("CyberCash"), pursuant to which
E*TRADE would use the software and services of CyberCash to permit E*TRADE
customers to perform direct deposits into their E*TRADE accounts via the
Internet from accounts at third-party institutions. There can be no assurance
that the Company will reach a definitive agreement with CyberCash on terms
favorable to the Company, or at all.
National Processing Company. The Company has signed a letter of intent with
National Processing Company ("NPC") to provide the ability for E*TRADE's
Internet customers to initiate, over the Web, funds transfers from checking
accounts at third-party institutions into their E*TRADE accounts. This
service would be made available to E*TRADE customers free of charge. There
can be no assurance that the Company will reach a definitive agreement with
NPC on terms favorable to the Company, or at all.
InterVoice. The Company has signed an agreement with InterVoice, Inc.
whereby the Company will purchase a number of intelligent software agent
platforms which will expand its TELE*MASTER telephone trading system through
advanced touchtone, fax-back, Internet and ADSI based applications, among
others. There can be no assurance that the Company will successfully
implement InterVoice software on terms favorable to the Company, or at all.
The Company has established a number of strategic relationships with online
service providers and software and information service providers. A
significant number of such relationships have only recently been entered
into. There can be no assurance that any such relationships will be
maintained, that if such relationships are maintained, they will be
successful or profitable, or that the Company will develop any new such
relationships.
While the Company has no current agreements or negotiations underway with
respect to any potential acquisitions, the Company may make acquisitions of
other companies or technologies in the future, and the Company regularly
evaluates such opportunities. Acquisitions entail numerous risks and the
Company has no experience in assimilating acquired organizations into the
Company's operations. No assurance can be given as to the ability of the
Company to integrate successfully any operations, personnel, services or
products that might be acquired in the future, and the failure of the Company
to do so could have a material adverse effect on the Company's business,
financial condition and operating results.
16
OPERATIONS
Clearing
The Company implemented self-clearing operations in July 1996. Clearing
operations include the confirmation, receipt, settlement, custody and
delivery functions involved in securities transactions. Performing its own
clearing operations allows E*TRADE Securities to retain customer free credit
balances and securities for use in margin lending activities subject to SEC
and NASD rules. Prior to its conversion to self-clearing, the Company cleared
all of its customer transactions as a fully disclosed correspondent of Herzog,
Heine, Geduld, Inc. ("Herzog"). The Company has entered into a seven-year
agreement with BETA Systems for the provision of computer services by BETA
Systems to support order entry, order routing, securities processing,
customer statements, tax reporting, regulatory reporting, and other services
necessary to the management of a brokerage clearing business.
Since the Company's conversion to self-clearing, customers' securities
typically are held by the Company in nominee name on deposit at one or more
of the recognized securities industry depository trust companies, to
facilitate ready transferability. The Company collects dividends and interest
on securities held in nominee name and makes the appropriate credits to
customer accounts. The Company also facilitates exercise of subscription
rights on securities held for its customers. The Company arranges for the
transmittal of proxy, annual report and tender offer materials to customers.
E*TRADE Securities relies upon certificate counts and microfilming procedures
as deterrents to theft of securities and, as required by the NASD and certain
other regulatory authorities, carries fidelity bonds covering loss or theft.
Self-clearing, especially where conducted by firms such as the Company,
without significant prior experience, involves substantial risks. The failure
of the Company to perform self-clearing accurately and cost-effectively could
have a material adverse effect on the Company's business, financial condition
and operating results.
Lending and Borrowing Activities
Margin Lending. The Company makes loans to customers collateralized by
customer securities. Margin lending by the Company is subject to the margin
rules of the Board of Governors of the Federal Reserve System, NASD margin
requirements and the Company's internal policies, which are more stringent
than the Federal Reserve and NASD requirements. In permitting customers to
purchase securities on margin, the Company takes the risk of a market decline
that could reduce the value of the collateral held by the Company to below
the customers' indebtedness before the collateral can be sold, which could
result in losses to the Company. Under applicable NASD rules, in the event of
a decline in the market value of the securities in a margin account, the
Company is obligated to require the customer to deposit additional securities
or cash in the account so that at all times the customer's equity in the
account is at least 25% of the value of the securities in the account.
E*TRADE's current internal requirement, however, is that the customer's
equity not fall below 30%. If it does, the customer will be required to
increase the account's equity to 40%. Margin lending to customers constitutes
the major portion of the basis on which net capital requirements of the
Company are determined under the SEC's Net Capital Rule. To the extent these
activities expand, the Company's net capital requirements will increase.
Securities Lending and Borrowing. The Company borrows securities both to
cover short sales and to complete customer transactions in the event a
customer fails to deliver securities by the required settlement date. The
Company collateralizes such borrowings by depositing cash or securities with
the lender and receives a rebate (in the case of cash collateral) or pays a
fee calculated to yield a negotiated rate of return. When lending securities,
the Company receives cash or securities and generally pays a rebate (in the
case of cash collateral) to the other party in the transaction. Securities
lending and borrowing transactions are executed pursuant to written
agreements with counterparties that require that the securities borrowed be
"marked to market" on a daily basis and that excess collateral be refunded or
that additional collateral be furnished in the event of changes in the market
value of the securities. The securities usually are "marked to market" on a
daily basis through the facilities of the various national clearing
organizations.
17
Order Processing
All listed market orders other than those with special qualifiers (subject to
certain size limitations based on the size in the primary market) are
executed at the National Best Bid/Offer ("NBBO") or better at the time of
receipt by the third market firm or exchange. Eligible orders are exposed to
the marketplace for possible price improvement, but in no case are orders
executed at a price inferior to the NBBO. Limit orders are executed based on
an indicated price and time priority. All Nasdaq market orders (subject to
certain size limitations based on the trading characteristics of the
particular security) are executed at the Best Bid/Offer (Inside Market), or
better at the time of receipt by the market-maker. Eligible orders are
subject to possible price improvement in the marketplace.
The Company receives orders principally through the Internet, online
services and touch-tone telephone. This method of trading is heavily
dependent on the integrity of the electronic systems supporting it. Heavy
stress placed on the Company's systems during peak trading times could
cause the Company's systems to operate at an unacceptably low speed or
fail. Any significant degradation or failure of the Company's systems or
any other systems in the trading process (e.g., online service providers,
record keeping and data processing functions performed by third parties
and third-party software such as Internet browsers), even for a short time,
could cause customers to suffer delays in trading. Such delays could cause
substantial losses for customers and could subject the Company to claims
from customers for such losses, including litigation claiming fraud or
negligence.
The Company has experienced such system failures and degradation in the past
and, most recently, experienced two such failures in May 1996. In order to
promote customer satisfaction and protect the E*TRADE brand name, the Company
compensated customers for verifiable losses arising in connection with such
systems failures. The Company sustained losses in excess of $1.7 million for
such systems failures in May 1996. Any systems failure that causes
interruptions in the Company's operations could have a material adverse
effect on the Company's business, financial condition and operating results.
The Company relies on a number of third parties to process its transactions,
including online access providers, back office processing organizations,
service providers and market makers, all of which may need to expand the
scope of the operations they perform for the Company. Any backlog caused by a
third party's inability to expand at the rate necessary to meet the Company's
needs or a loss in the availability of these services and the inability of
the Company to make alternative arrangements in a timely manner, if at all,
could have a material adverse effect on the Company's business, financial
condition and operating results.
18
COMPETITION
The market for online investing services, particularly over the Internet, is
new, rapidly evolving and intensely competitive, and the Company expects
competition to continue to intensify in the future. E*TRADE encounters direct
competition from discount brokerage firms providing either touch-tone
telephone or online investing services, or both. These competitors include
Charles Schwab & Co., Inc. ("Charles Schwab") and Fidelity Brokerage
Services, Inc., among others. The Company also encounters competition from
established full-commission brokerage firms, such as Merrill Lynch, Pierce,
Fenner & Smith Incorporated ("Merrill Lynch") and Paine Webber Incorporated,
among others. In addition, the Company competes with financial institutions,
mutual fund sponsors and other organizations, some of which provide online
investing services.
The Company believes that the principal competitive factors affecting the
market for its electronic commercial transaction processing services are
cost, service, quality, execution, delivery platform capabilities, ease of
use, graphical user interface look and feel, depth and breadth of services,
financial strength and innovativeness. Based on research conducted with both
customer and non-customer focus groups and the success the Company has
enjoyed, the Company believes that it presently competes favorably with
respect to each of these factors.
There are virtually no barriers to entry in the market in which the Company
operates. Many of the Company's competitors have longer operating histories
and significantly greater financial, technical, marketing and other resources
than the Company. Many current and potential competitors also have greater
name recognition and more extensive customer bases that could be leveraged,
thereby gaining market share to the Company's detriment. Additionally, it is
possible that new competitors or alliances among competitors may emerge and
rapidly acquire significant market share.
The general financial success of companies within the securities industry
over the past several years has strengthened existing competitors. Management
believes that such success will continue to attract new competitors to the
securities industry such as banks, software development companies, insurance
companies, providers of online financial and information services and others,
as such companies expand their product lines. The current trend toward
consolidation in the commercial banking industry could further increase
competition in all aspects of the Company's business. While it is not
possible to predict the type and extent of competitive services that
commercial banks and other financial institutions ultimately may offer or
whether administrative or legislative barriers will be repealed or modified,
firms such as the Company may be adversely affected by such competition or
legislation. In addition, competition among financial services firms exists
for experienced technical and other personnel.
There can be no assurance that the Company will be able to compete
effectively with current or future competitors or that the competitive
pressures faced by the Company will not have a material adverse effect on the
Company's business, financial condition and operating results.
19
GOVERNMENT REGULATION; NET CAPITAL REQUIREMENTS
Securities Industry
The securities industry in the United States is subject to extensive
regulation under both federal and state laws. The SEC is the federal agency
responsible for the administration of the federal securities laws. E*TRADE
Securities is registered as a broker-dealer with the SEC. Much of the
regulation of broker-dealers has been delegated to self-regulatory
organizations, principally the NASD, which has been designated by the SEC as
E*TRADE Securities' primary regulator. These self-regulatory organizations
adopt rules (subject to approval by the SEC) that govern the industry and
conduct periodic examinations of E*TRADE Securities' operations. Securities
firms are also subject to regulation by state securities administrators in
those states in which they conduct business. E*TRADE Securities is registered
as a broker-dealer in all 50 states, and the District of Columbia.
Broker-dealers are subject to regulations covering all aspects of the
securities business, including sales methods, trade practices among broker-
dealers, use and safekeeping of customers' funds and securities, capital
structure, record keeping and the conduct of directors, officers and
employees. The Company is required to comply with many complex laws and
rules, including rules relating to possession and control of customer funds
and securities, margin lending and execution and settlement of transactions.
Additional legislation, changes in rules promulgated by the SEC, the NASD,
the Board of Governors of the Federal Reserve System, the various stock
exchanges, and other self-regulatory organizations, or changes in the
interpretation or enforcement of existing laws and rules, may directly affect
the mode of operation and profitability of broker-dealers. The SEC, the NASD
or other self-regulatory organizations and state securities commissions may
conduct administrative proceedings, which can result in censure, fine, the
issuance of cease-and-desist orders or the suspension or expulsion of a
broker-dealer or any of its officers or employees. The Company's ability to
comply with all applicable laws and rules is dependent in large part upon the
maintenance of a compliance system reasonably designed to ensure such
compliance. The principal purpose of regulation and discipline of broker-
dealers is the protection of customers and the securities markets, rather
than protection of creditors and shareholders of broker-dealers.
E*TRADE Securities is a member of Securities Investor Protection Corporation
("SIPC"), which provides, in the event of the liquidation of a broker-dealer,
protection for customers' accounts held by E*TRADE Securities of up to
$500,000 for each customer account, subject to a limitation of $100,000 for
claims for cash balances. In addition, E*TRADE Securities has obtained
protection, in excess of SIPC coverage, of $9.5 million for each account in
the form of an excess securities bond from National Union Fire Insurance
Company of Pittsburgh, Pennsylvania, a member company of American
International Group.
The Company has initiated an aggressive marketing campaign designed to bring
brand name recognition to E*TRADE. All marketing activities by E*TRADE
Securities are regulated by the NASD, and all such marketing materials are
required by the NASD to be reviewed by E*TRADE Securities' compliance officer
prior to release. The Company does not currently solicit orders from its
customers or make investment recommendations. However, if the Company were to
engage in such activities, it would become subject to additional rules and
regulations governing, among other things, the suitability of recommendations
to customers and sales practices.
20
It is the Company's intent to expand its business in United States securities
to other countries through the Internet and other gateways. For the fiscal
year ended September 30, 1996, the Company's revenues from accounts with
foreign addresses has not been a material part of its operating revenues. In
order to expand its services globally, E*TRADE Securities must comply with
the regulatory controls of each specific country in which it conducts
business. E*TRADE Securities is regulated in the United States primarily by
the NASD and the SEC. The varying compliance requirements of other national
regulatory jurisdictions may impose a limit to the Company's rate of
international expansion.
Net Capital Requirements
As registered broker-dealers and members of the NASD, E*TRADE Securities and
E*TRADE Capital (a non-operational broker-dealer subsidiary of the Company)
are subject to the Net Capital Rule. The Net Capital Rule, which specifies
minimum net capital requirements for registered broker-dealers, is designed
to measure the general financial integrity and liquidity of a broker-dealer
and requires that at least a minimum part of its assets be kept in relatively
liquid form.
E*TRADE Securities has elected to compute net capital under the alternative
method of calculation permitted by the Net Capital Rule. Under the
alternative method, E*TRADE Securities is required to maintain minimum net
capital, as defined in the Net Capital Rule, equal to the greater of $250,000
or 2% of the amount of its "aggregate debit items" computed in accordance
with the Formula for Determination of Reserve Requirements for Brokers and
Dealers. The "aggregate debit items" are assets that have, as their source,
transactions with customers, primarily margin loans. Failure to maintain the
required net capital may subject a firm to suspension or revocation of
registration by the SEC and suspension or expulsion by the NASD and other
regulatory bodies and ultimately could require a firm's liquidation. The Net
Capital Rule prohibits payments of dividends, redemption of stock, the
prepayment of subordinated indebtedness, and the making of any unsecured
advance or loan to a shareholder, employee or affiliate, if aggregate debit
items rise beyond 5% of net capital. The Net Capital Rule also provides that
the SEC may restrict, for up to 20 business days, any withdrawal of equity
capital, or unsecured loans or advances to shareholders, employees or
affiliates ("capital withdrawal") if such capital withdrawal, together with
all other net capital withdrawals during a 30-day period, exceeds 30% of
excess net capital and the SEC concludes that the capital withdrawal may be
detrimental to the financial integrity of the broker-dealer.
Net capital is essentially defined as net worth (assets minus liabilities),
plus qualifying subordinated borrowings and certain discretionary
liabilities, less certain mandatory deductions that result from excluding
assets that are not readily convertible into cash and from valuing
conservatively certain other assets. Among these deductions are adjustments
(called "haircuts") which reflect the possibility of a decline in the market
value of an asset prior to its disposition.
21
A change in the Net Capital Rule, the imposition of new rules or any
unusually large charge against net capital could limit those operations of
the Company that require the intensive use of capital, such as trading
activities and the financing of customer account balances, and also could
restrict the Company's ability to withdraw capital from its brokerage
subsidiaries, which in turn could limit the Company's ability to pay
dividends, repay debt and redeem or purchase shares of its outstanding stock.
As of September 30, 1996, E*TRADE Securities was required to maintain minimum
net capital of $3.7 million and had total net capital of approximately $17.1
million, or approximately $13.4 million in excess of the minimum amount
required. In February 1996, E*TRADE Capital, then doing business as ET
Execution Services, undertook to act as guarantor pursuant to an agreement
between the Company and Merrill Lynch Business Financial Services, Inc. As a
result of a breakdown of internal controls for the monitoring of such
proposed contracts, this undertaking inadvertently caused E*TRADE Capital to
fall short of its minimum net capital requirement and thus be in violation of
the Net Capital Rule through May 30, 1996 when E*TRADE Capital was released
from the guarantee. The Company has reported the violation of E*TRADE Capital
to the SEC and the NASD. The Company believes that any penalty imposed by the
NASD will not be substantial, as the subsidiary in violation is non-
operational and no customer assets are now, nor ever have been, in jeopardy
as a result of this occurrence. However, there can be no assurance that
either or both the SEC or the NASD will not impose a penalty upon E*TRADE
Capital, including fines, restrictions on business activities or suspension
of trading activities, or that the imposition of any such penalty will not
have a material adverse effect on the Company's business, financial condition
and operating results. The Company has implemented internal controls intended
to prevent such violations in the future, including the review of proposed
contracts by finance personnel of the Company. There can be no assurance that
a violation of the Net Capital Rule will not occur in the future.
Electronic Commerce
The Company anticipates that it may be required to comply with record
keeping, data processing and other regulatory requirements as a result of
proposed federal legislation or otherwise, and the Company may be subject to
additional regulation as the market for online commerce evolves. Because of
the growth in the electronic commerce market, Congress has held hearings on
whether to regulate providers of services and transactions in the electronic
commerce market, and federal or state authorities could enact laws, rules or
regulations affecting the Company's business or operations. The Company also
may be subject to federal, state and foreign money transmitter laws and state
and foreign sales and use tax laws. If enacted or deemed applicable to the
Company, such laws, rules or regulations could be imposed on the Company's
activities or its business.
Due to the increasing popularity of the Internet, it is possible that laws
and regulations may be enacted with respect to the Internet, covering issues
such as user privacy, pricing, content and quality of products and services.
The Telecommunications Act of 1996, which was enacted in January 1996,
prohibits the transmission over the Internet of certain types of information
and content. Although certain of these prohibitions have been held
unconstitutional by a federal trial court, that ruling is expected to be
appealed, and, in any event, the increased attention focused upon these
liability issues as a result of the Telecommunications Act could adversely
affect the growth of Internet and private network use.
22
INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS
The Company's success and ability to compete are dependent to a significant
degree on its proprietary technology. The Company relies primarily on
copyright, trade secret and trademark law to protect its technology. The
Company has no patents. Effective trademark protection may not be available
for the Company's trademarks. The Company has registered the trademark
"E*TRADE" in the United States and certain other countries, and has certain
other registered trademarks. The inability of the Company to adequately
protect the name "E*TRADE" would have a material adverse effect on the
Company's business, financial condition and operating results.
The source code for the Company's proprietary software is protected both as a
trade secret and as a copyrighted work. The Company's policy is to enter into
confidentiality and assignment agreements with its associates, consultants
and vendors and generally to control access to, and distribution of, its
software, documentation and other proprietary information. Notwithstanding
the precautions taken by the Company, it may be possible for a third party to
copy or otherwise obtain and use the Company's software or other proprietary
information without authorization or to develop similar software
independently. The laws of other countries may afford the Company little or
no effective protection of its intellectual property. The inability of the
Company to protect its intellectual property rights could have a material
adverse effect on the Company's business, financial condition and operating
results.
The Company may in the future receive notices of claims of infringement of
other parties' proprietary rights. Any such claims, with or without merit,
could be time consuming to defend, result in costly litigation, divert
management's attention and resources or require the Company to enter into
royalty or licensing agreements. There can be no assurance that such licenses
would be available on reasonable terms, if at all, and the assertion or
prosecution of any such claims could have a material adverse effect on the
Company's business, financial condition and operating results.
ASSOCIATES
At September 30, 1996, the Company had 327 full-time associates. The
Company's success has been, and will be, dependent to a large degree on its
ability to retain the services of its existing executive officers and to
attract and retain qualified additional senior and middle managers and key
personnel in the future. There can be no assurance that the Company will be
able to attract, assimilate or retain qualified technical and managerial
personnel in the future, and the failure of the Company to do so would have a
material adverse effect on the Company's business, financial condition and
operating results. None of the Company's associates is subject to collective
bargaining agreements or is represented by a union. The Company considers its
relations with its associates to be good.
23
EXECUTIVE OFFICERS OF THE REGISTRANT
In addition to executive officers who are also directors of the Company, the
following executive officers are not directors and are elected by and serve
at the discretion of the Board of Directors:
NAME AGE POSITION
David R. Ewing................ 40 Senior Vice President, E*TRADE
Technologies and Chief Information Officer
Wayne H. Heldt................ 56 Vice President and Managing
Director, International Affairs
Kathy Levinson................ 41 Executive Vice President, Operations;
President and Chief Operating Officer,
E*TRADE Securities, Inc.
Rebecca L. Patton............. 41 Senior Vice President, Marketing and
Communications
Stephen C. Richards........... 42 Senior Vice President, Finance and
Administration, Chief Financial Officer
and Treasurer; Chief Financial Officer
of E*TRADE Securities, Inc.
David R. Ewing has served as Senior Vice President, E*TRADE Technologies
since August 1996, Senior Vice President of Systems from May 1996 to August
1996, Chief Information Officer of E*TRADE Group, Inc., since May 1996 and
Vice President since September 1995. From 1994 to September 1995, Mr. Ewing
served as President of Vital Business Solutions, Inc., a company that
provides information systems consulting services. From September 1990 to
September 1994, Mr. Ewing served as Director of Information Systems at
Nellcor Puritan Bennett, Inc., a manufacturer of critical care monitoring
components. Prior to that, Mr. Ewing served as a Manager in the Information
Technology practice at Price Waterhouse and as a Manager in the Information
Systems Division at Charles Schwab.
Wayne H. Heldt has been Vice President and Managing Director, International
Affairs for E*TRADE Group, Inc. since May 1996 and has served as a director
of E*TRADE Securities, Inc. since January 1995. Mr. Heldt joined the Company
in June 1993 as Vice President of Operations of E*TRADE Group, Inc., served
as President and Chief Operating Officer from October 1993 to July 1995, and
served on the Board of Directors from November 1993 to April 1996. Mr. Heldt
has also served in various positions with E*TRADE Securities, Inc. and
E*TRADE Capital, including Chairman of the Board and Chief Executive Officer,
from May 1993 to June 1996. From 1986 to April 1993, Mr. Heldt served as
Executive Vice President and Chief Operating Officer of Reynolds, Kendrick,
Stratton, Inc., a brokerage firm specializing in clearing securities
transactions. He also served as President of PHASE3 Systems, Inc. from
January 1983 to December 1984. Previously, he was a founding Partner of
Robertson, Colman & Siebel (now Robertson, Stephens & Company) where he was
Chief Financial Officer and Chief Operating Officer. Mr. Heldt received a BA
in Philosophy from Westminster College.
24
Kathy Levinson has served as Executive Vice President of Operations for the
Company since November 1996, Senior Vice President of the Company from May
1996 to November 1996 and President and Chief Operating Officer of E*TRADE
Securities, Inc., since January 1996, and a director of E*TRADE Securities,
Inc. since June 1996. From January 1995 to December 1995, Ms. Levinson worked
as a consultant for the Company. Prior to that, Ms. Levinson worked for
Charles Schwab from 1981 to October 1994, most recently serving as Senior
Vice President of Custody Services and prior to that was Senior Vice
President of Credit Service from 1989 to October 1994. She received a BA in
Economics from Stanford University.
Rebecca L. Patton has served as Senior Vice President, Marketing and
Communications of E*TRADE Group, Inc. since October 1996, and Vice President,
Marketing since September 1995. From 1988 to September 1995, Ms. Patton
served in a variety of management positions at Apple Computer, including
Worldwide Marketing Manager of the Personal Interactive Electronics Division
and Manager of Apple's PowerBook marketing group. Ms. Patton received a BA in
Economics, summa cum laude, from Duke University and an MBA from Stanford
University.
Stephen C. Richards joined the Company in April 1996 as Chief Financial
Officer and Treasurer and, as of June 1996, Senior Vice President, Finance
and Administration, and Chief Financial Officer of E*TRADE Securities, Inc.
From 1984 to April 1996, Mr. Richards served in various positions at Bear
Stearns & Co., Inc., an investment bank, including Managing Director and
Chief Financial Officer of Correspondent Clearing. Prior to 1984, Mr.
Richards served as Vice President/Deputy Controller of Becker Paribas and
First Vice President/Controller of Jefferies & Company, Inc. He received a BA
in Statistics and Economics from the University of California at Davis and an
MBA in Finance from the University of California at Los Angeles. Mr. Richards
is a certified public accountant.
The Company's present directors (including the director emeritus) and
executive officers and their respective affiliates own approximately 51% of
the outstanding Common Stock. As a result, these shareholders, if they act
together, will be able to exercise significant influence over all matters
requiring shareholder approval, including the election of directors and
approval of significant corporate transactions, and will have veto power with
respect to any shareholder action or approval requiring a majority vote. Such
concentration of ownership also may have the effect of delaying, preventing
or deterring a change in control of the Company.
Item 2. PROPERTIES
The Company currently leases two spaces for its corporate offices in Palo
Alto, California. The leases comprise an aggregate of 59,000 square feet and
expire in December 2001. The Company established a secondary data center in
Rancho Cordova, California which became fully operational in July 1996,
replacing a back-up facility in Palo Alto. The Company leases an aggregate
70,000 square feet at the Rancho Cordova facility. The lease expires in July
2006. The Company believes that it has adequate space for its current needs.
25
Item 3. LEGAL PROCEEDINGS
The Company is not currently a party to any litigation that it believes could
have a material adverse effect on the Company's business, financial condition
or operating results. However, from time to time the Company has been
threatened with, or named as a defendant in, lawsuits and administrative
claims. Compliance and trading problems that are reported to the NASD or the
SEC by dissatisfied customers are investigated by the NASD or the SEC, and,
if pursued by such customers, may rise to the level of arbitration or
disciplinary action. One or more of such lawsuits, claims or disciplinary
actions decided adversely to the Company could have a material adverse effect
on the Company's business, financial condition and results of operations. The
Company is also subject to periodic regulatory audits and inspections.
The Company maintains insurance in such amounts and with such coverages,
deductibles and policy limits as management believes are reasonable and
prudent. The principal risks that the Company insures against are
comprehensive general liability, commercial property, hardware/software
damage, and directors and officers liability. The Company believes that such
insurance coverages are adequate for the purpose of its business.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On July 1, 1996, the following matters were submitted to E*TRADE Group, Inc.
security holders for written consent:
(i) Reincorporation in Delaware:
(a) votes cast for: 21,662,256 shares;
(b) votes cast against: 0 shares; and
(c) abstentions/votes withheld: 2,300,640 shares.
(ii) Adoption of the 1996 Stock Incentive Plan and the 1996 Stock Purchase
Plan:
(a) votes cast for: 21,974,676 shares;
(b) votes cast against: 100,020 shares; and
(c) abstentions/votes withheld: 1,888,200 shares.
26
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER
MATTERS
Price range of Common Stock
The Company's common stock has been quoted on the Nasdaq National Market
under the symbol "EGRP" since August 16, 1996. The following table shows the
high and low closing sales prices for the Common Stock of the Company for the
period indicated, as reported by the Nasdaq National Market. The prices do
not include retail markups, markdowns or commissions.
1996 High Low
Quarter ended September 30, 1996 $13.1875 $8.3750
The closing sale price of the Company's Common Stock as reported on the
Nasdaq National Market on December 13, 1996 was $11.75 per share. As of
that date there were 255 holders of record of the Company's Common Stock.
The market price of the Company's Common Stock is likely to be highly
volatile and could be subject to wide fluctuations in response to quarterly
variations in operating results, announcements of technological innovations
or new software, services or products by the Company or its competitors,
changes in financial estimates by securities analysts or other events or
factors, many of which are beyond the Company's control. In addition, the
stock market has experienced significant price and volume fluctuations that
have particularly affected the market prices of equity securities of many
technology and services companies and that often have been unrelated to the
operating performance of such companies. These broad market fluctuations may
adversely affect the market price of the Company's Common Stock. In the past,
following periods of volatility in the market price for a company's
securities, securities class action litigation often has been instituted.
Such litigation could result in substantial costs and a diversion of
management attention and resources, which could have a material adverse
effect on the Company's business, financial condition and operating results.
Dividends
The Company has never declared or paid cash dividends on its capital stock.
The Company currently intends to retain all of its earnings, if any, for use
in its business and does not anticipate paying any cash dividends in the
foreseeable future. The payment of any future dividends will be at the
discretion of the Company's Board of Directors and will depend upon a number
of factors, including future earnings, the success of the Company's business
activities, capital requirements, the general financial condition and future
prospects of the Company, general business conditions and such other factors
as the Board of Directors may deem relevant.
27
Item 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL DATA
YEARS ENDED SEPTEMBER 30,
--------- --------- --------- --------- ---------
1996 1995 1994 1993 1992
--------- --------- --------- --------- ---------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
(in thousands, except per share data)
Revenues:
Transaction revenues $44,178 $20,835 $ 9,548 $ 2,158 $ 327
Net interest 4,813 1,004 302 17 -
Computer services
and other. 2,604 1,501 1,055 799 521
--------- --------- --------- --------- ---------
Net revenues 51,595 23,340 10,905 2,974 848
--------- --------- --------- --------- ---------
Cost of services:
Cost of services 30,688 12,678 6,796 1,973 579
Self-clearing
start-up costs 2,240 141 -- -- --
--------- --------- --------- --------- ---------
Total cost of services 32,928 12,819 6,796 1,973 579
--------- --------- --------- --------- ---------
Operating expenses:
Selling and marketing 7,600 2,466 998 282 116
Technology development 2,792 943 335 216 176
General and administrative 9,658 2,803 2,532 400 260
--------- --------- --------- --------- ---------
Total operating
expenses 20,050 6,212 3,865 898 552
--------- --------- --------- --------- ---------
Total cost of services
and operating expenses 52,978 19,031 10,661 2,871 1,131
--------- --------- --------- --------- ---------
Pre-tax income (loss) (1,383) 4,309 244 103 (283)
Income tax expense (benefit) (555) 1,728 (541) 4 2
--------- --------- --------- --------- ---------
Net income (loss) $ (828) $ 2,581 $ 785 $ 99 $ (285)
========= ========= ========= ========= =========
Net income (loss)
per share $ (0.03) $ 0.10 $ 0.03 $ -- $ (0.01)
========= ========= ========= ========= =========
Shares used to compute per
share data 28,564 26,481 26,186 26,677 24,828
========= ========= ========= ========= =========
SEPTEMBER 30,
--------- --------- --------- --------- ---------
1996 1995 1994 1993 1992
--------- --------- --------- --------- ---------
CONSOLIDATED BALANCE SHEET DATA (in thousands):
Cash and equivalents $14,641 $ 9,624 $ 692 $ 36 $ 48
Total assets 294,881 14,164 2,163 728 226
Long-term obligations 22 45 64 1,310 1,165
Shareholders'
equity (deficiency) 69,304 11,148 (92) (788) (1,107)
========= ========= ========= ========= =========
28
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of operations
of the Company should be read in conjunction with the consolidated financial
statements and notes thereto included elsewhere in this Form 10-K. This
discussion contains forward-looking statements that involve risks and
uncertainties. The Company's actual results may differ materially from those
anticipated as a result of certain factors, including, but not limited to,
those set forth elsewhere in this Form 10-K.
OVERVIEW
E*TRADE is a leading provider of cost-effective, secure online investing
services. Founded in 1982, the Company operated initially as a service
bureau, providing automated online securities transaction services to
various brokerage firms, including Fidelity Brokerage Services, Inc., Quick &
Reilly and, through an agreement with Bank of America, Charles Schwab. In
1992, the Company formed E*TRADE Securities and began to offer retail
investing services and account information 24 hours a day, seven days a
week.
The Company's revenues consist principally of transaction revenues, which
include securities brokerage commissions and payments based on order flow
(described below), interest and certain other fees related to the Company's
product offerings. The Company has experienced substantial growth in its
revenues since the inception of E*TRADE Securities. At the end of fiscal
1992, the Company was processing slightly over 100 transactions per day. By
the fourth quarter of fiscal 1996, the Company's average daily transaction
volume had grown to 7,500. Although increases in the overall activity in the
securities markets have contributed to the Company's growth, the Company
believes that its growth has also been due to the success of its advertising
campaigns in bringing brand name recognition to the E*TRADE name, the launch
of Internet access to E*TRADE and the continuing successful integration
of new product developments.
The Company uses other broker-dealers to execute its customers' orders and,
in recent years, has derived a significant portion of its revenues from these
broker-dealers for such order flow. This practice of receiving payments for
order flow is widespread in the securities industry. Under applicable SEC
regulations, receipt of these payments requires disclosure of such payments
by the Company to its customers. The revenues received by the Company under
these arrangements for fiscal years 1996 and 1995 amounted to 22% and 20% of
total revenues, respectively. There can be no assurance that these revenues
will continue at their present levels or that the Company will be able to
continue its present relationships and terms for such payments for order
flow. In addition, there can be no assurance that payments for order flow
will continue to be permitted by the SEC, the NASD or other regulatory
agencies, courts or governmental units. Loss of any or all of these revenues
could have a material adverse effect on the Company's business, financial
condition and operating results.
29
The Company is making significant investments in systems technology and has
established a secondary site in Rancho Cordova, California, which became
fully functional in July 1996. This new facility supports systems, network
and transaction redundancy between the Company's Palo Alto and Rancho Cordova
locations, thereby providing an operational system in the event of a service
interruption at either facility. The Company also is making significant
investments in its customer service department. The Company's customer
service capacity has been strained at times. Through significant investments
in technology and personnel, the Company continues to address its growing
customer service needs.
The Company implemented self-clearing operations in July 1996. Prior to this
time, the Company cleared all of its customer transactions as a
fully-disclosed correspondent of Herzog. Clearing services include the
confirmation, receipt, settlement, custody and delivery functions involved in
securities transactions. In the first quarter of fiscal 1996, the Company
began hiring associates to perform these functions. As a consequence, the
Company incurred significant non-recurring costs associated with the hiring
and training of its associates, as well as systems integration costs. The
Company continued to incur expenses for clearing operations performed by
Herzog through June 1996. The Company believes that its conversion to
self-clearing was a strategic investment in the Company's future that will
allow the Company to realize significant future savings, although there
can be no assurance in that regard.
The Company now assumes direct responsibility for the possession and control
of customer securities and other customer assets and the clearance of
customers' securities transactions. Having this responsibility requires the
Company to record on its balance sheet the customer receivables and customer
payables to the Company that are a result of customer margin loans (i.e.,
loans made to customers that are collateralized by securities held in the
customers' margin accounts at the Company) and customer free credit balances
(i.e., customer cash balances maintained by the Company), respectively. In
addition, to the extent that the Company's customer debit balances exceed
customer free credit balances, the Company must obtain financing for any
excess debit balance. As a result, effective upon its conversion to self-
clearing, the Company recorded receivables from customers, payables to
customers and collateralized bank loans, which has had a significant effect
on the Company's total assets and total liabilities. The Company recorded
receivables from customers, brokers, dealers and clearing organizations of
$193 million and payables to customers, brokers, dealers and clearing
organizations of $219 million as of September 30, 1996. In connection with
the transition to self-clearing, the Company obtained bank financing to
finance its customer balances. The Company also contracted with a third-party
service bureau, BETA Systems, for its customer record keeping and data
processing services, having previously relied on Herzog for these services.
30
The Company's transaction revenues have grown from $9.5 million in fiscal
1994 to $44.2 million in fiscal 1996. Transaction revenues include securities
brokerage transactions and, since late fiscal 1994, payments for order flow.
Interest revenues, net of interest expense, have grown from $302,000 in
fiscal 1994 to $4.8 million in fiscal 1996. The Company previously
participated in the interest spread on its customer debit and credit balances
through its clearing agreement with Herzog but is no longer subject to that
agreement as a result of the change to self-clearing. Consequently, the
Company now has greater control over interest rates charged to customers for
debit balances and interest rates paid for credit balances. The Company began
receiving fees on its customers' assets invested in money market funds in
September 1994, which were shared with Herzog until the change to self-
clearing. Computer service and other revenues have grown from $1.1 million in
fiscal 1994 to $2.6 million in fiscal 1996. Computer service revenues are
comprised primarily of fees for the time customers are connected to the
Company online. Other revenues represent the Company's return on its
investment in Roundtable Partners LLC, a consortium of broker-dealers that
provides the Company with alternative broker-dealers through which to route
its customers' orders for execution. The Company also participates in the
operating results of Roundtable Partners LLC as an equity owner.
The Company's cost of services has grown from $6.8 million in fiscal 1994 to
$32.9 million in fiscal 1996. Cost of services includes clearing fees paid to
the Company's former clearing broker, system maintenance and communication
expenses and expenses related to the Company's operations and customer
service activities.
Selling and marketing expenses have grown from $1.0 million in fiscal 1994 to
$7.6 million in fiscal 1996 and consist primarily of the costs associated
with the actual advertising placement expenses as well as the creative
development of advertising.
Technology development expenses have grown from $335,000 in fiscal 1994 to
$2.8 million in fiscal 1996 and consist of payroll and consulting costs
associated with the development and enhancement of the Company's product
offerings.
General and administrative expenses have grown from $2.5 million in fiscal
1994 to $9.7 million in fiscal 1996 and consist primarily of facilities
costs, equipment and maintenance expenses, as well as corporate management
costs, including accounting, human resources, compliance and other
administrative expenses.
The Company has experienced substantial changes in and expansion of its
business and operations since it began offering online investing services in
1992 and Internet investing services in February 1996 and expects to
continue to experience periods of rapid change. The Company's past expansion
has placed, and any future expansion would place, significant demands on the
Company's administrative, operational, financial and other resources.
Competition for highly qualified senior managers and technical personnel is
intense. If the Company fails to attract, assimilate and retain such
personnel, there would be a material adverse effect on the Company's
business, financial condition and operating results.
31
RESULTS OF OPERATIONS
The following table sets forth the percentage of net revenues represented by
certain items on the Company's consolidated statements of operations for the
following years ended September 30:
1996 1995 1994
----- ----- -----
Revenues:
Transaction revenues 85.6% 89.3% 87.6%
Net interest 9.3 4.3 2.7
Computer services and other 5.1 6.4 9.7
----- ----- -----
Net revenues 100.0 100.0 100.0
----- ----- -----
Cost of services:
Cost of services 59.5 54.3 62.3
Self-clearing start-up costs 4.3 0.6 --
----- ----- -----
Total cost of services 63.8 54.9 62.3
----- ----- -----
Operating expenses:
Selling and marketing 14.8 10.6 9.2
Technology development 5.4 4.0 3.1
General and administrative 18.7 12.0 23.2
----- ----- -----
Total operating expenses 38.9 26.6 35.5
----- ----- -----
Total cost of services and operating
expenses 102.7 81.5 97.8
----- ----- -----
Pre-tax income (loss) (2.7) 18.5 2.2
Income tax expense (benefit) (1.1) 7.4 (5.0)
----- ----- -----
Net income (loss) (1.6)% 11.1% 7.2%
===== ===== =====
32
Fiscal Years Ended September 30, 1996, 1995 and 1994
Revenues
Transaction revenues were $44.2 million in fiscal 1996, an increase of 112%
compared to $20.8 million in fiscal 1995 and $9.5 million in fiscal 1994. Of
these amounts, payments for order flow were $11.4 million in fiscal 1996, an
increase of 148% compared to $4.6 million in fiscal 1995. The increases in
transaction revenues were primarily the result of higher security transaction
volumes over both periods and the initiation of order flow rebates in early
fiscal 1995, offset in part by reductions in the commission rates charged for
certain transactions. The average revenue per securities transaction was
$27.81 in fiscal 1996, $31.61 in fiscal 1995 and $29.68 in fiscal 1994.
Net interest revenue was $4.8 million in fiscal 1996, an increase of 379%
compared to $1.0 million in fiscal 1995 and $302,000 in fiscal 1994. These
increases were primarily due to average customer margin debt of $124.4
million in fiscal 1996, an increase of 164% compared to $47.1 million
in fiscal 1995 and $25.3 million in fiscal 1994; average customer free
credit balances of $85.2 million in fiscal 1996, an increase of 492%
compared to $14.4 million in fiscal 1995 and $10.1 million in fiscal 1994;
and average customer money market fund balances of $290.7 million in fiscal
1996, an increase of 100% compared to $145.0 million in fiscal 1995 and $80.0
million in fiscal 1994.
Computer services and other revenues were $2.6 million in fiscal 1996, an
increase of 73% compared to $1.5 million in fiscal 1995 and $1.1 million in
fiscal 1994. The increase in computer services and other revenues is
primarily due to the increase in the amount of connect time used by customers
over both periods.
Cost of Services
Total cost of services was $32.9 million in fiscal 1996, an increase of 157%
compared to $12.8 million in fiscal 1995 and $6.8 million in fiscal 1994.
These increases were largely attributable to the increase in the number of
transactions processed by the Company and an increase in customer service
inquiries.
Self-clearing start-up costs were $2.2 million in fiscal 1996 compared to
$141,000 in fiscal 1995. The Company incurred these expenses as it continued
to hire associates and utilize consultants in preparation for the conversion
to self-clearing, which occurred in July 1996. The Company does not
anticipate incurring additional conversion costs in fiscal 1997.
Operating Expenses
Selling and marketing expenses were $7.6 million in fiscal 1996, an increase
of 208% compared to $2.5 million in fiscal 1995 and $1.0 million in fiscal
1994. These increases reflect the increased expenditures for advertising
placements, creative development and collateral materials. In fiscal 1996
there were additional costs attributed to the launch of the Company's Web
site and associated advertising campaign.
33
Technology development expenses were $2.8 million in fiscal 1996, an
increase of 196% compared to $943,000 in fiscal 1995 and $335,000 in fiscal
1994. These increases are attributable to the costs associated with enhancing
the Company's existing product offerings. In fiscal 1996 there were
additional costs associated with the Company's development efforts for the
launch of the Web site and the design and implementation of the Company's
secondary data center in Rancho Cordova, California.
General and administrative expenses were $9.7 million in fiscal 1996, an
increase of 240% compared to $2.8 million in fiscal 1995 and $2.5 million in
fiscal 1994. The increase in fiscal 1996 was the result of increased costs
associated with personnel additions, a $3.1 million increase in customer
claims and bad debt reserves, a relocation to larger facilities and an
increased use of consultants by the Company. The increase in fiscal 1995 was
the result of additional expenses incurred for customer bad debts, claims
resulting from a systems failure in the third quarter of fiscal 1995 and
increases in the number of corporate associates needed to accommodate the
growth experienced by the Company during the year. These increases were
partially offset by claims the Company settled in the amount of $850,000 made
by its former clearing broker in fiscal 1994.
Income Tax Expense (Benefit)
Income tax expense (benefit) represents federal and state income taxes at an
effective rate of 40.1% for both fiscal 1996 and 1995. The Company recorded
a net income tax benefit of $541,000 in fiscal 1994, due to full recognition
of net operating loss carryforwards generated in prior years.
VARIABILITY OF RESULTS
The Company expects to experience significant fluctuations in future
quarterly operating results that may be caused by many factors, including the
following: the timing of introductions of enhancements to online financial
services and products by the Company or its competitors; market acceptance of
online financial services and products; the pace of development of the market
for online commerce; changes in transaction volume on the securities markets;
trends in the securities markets; changes in pricing policies by the Company
or its competitors; changes in strategy; the success of or costs associated
with acquisitions, joint ventures or other strategic relationships; changes
in key personnel; seasonal trends; the extent of international expansion; the
mix of international and domestic sales; changes in the level of operating
expenses to support projected growth; and general economic conditions.
Due to the foregoing factors, quarterly revenues and operating results are
difficult to forecast, and the Company believes that period-to-period
comparisons of its operating results will not necessarily be meaningful and
should not be relied upon as an indication of future performance. It is
likely that the Company's future quarterly operating results from time to
time will not meet the expectations of securities analysts or investors,
which may have an adverse effect on the market price of the Company's Common
Stock.
34
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its activities through cash provided by operations,
the private placement of Preferred Stock and, to a lesser extent, equipment
financing. In August 1996, the Company completed an initial public offering
of its Common Stock resulting in net proceeds to the Company of approximately
$46.4 million. In September 1995, the Company privately placed $12.3 million
of convertible Preferred Stock, of which $3.8 million was used to repurchase
and retire outstanding Common Stock from existing shareholders. In April
1996, the Company sold an additional 20,336 shares of convertible Preferred
Stock for $2.8 million. In June 1996, the Company sold an additional 11,180
shares of convertible Preferred Stock for $9.0 million. All of the Company's
Preferred Stock converted to Common Stock upon completion of the Company's
initial public offering.
In May 1996, the Company obtained $100 million in authorized financing, to be
collateralized by customer securities, which became available in July 1996
upon completion of its conversion to self-clearing. There were no borrowings
outstanding under these lines at September 30, 1996. In addition, the
Company has entered into numerous agreements with other broker-dealers to
provide financing for the Company's stock loan activities.
The Company currently anticipates that its available cash resources and
credit facilities will be sufficient to meet its presently anticipated
working capital and capital expenditure requirements for at least the next 12
months. However, the Company may need to raise additional funds in order to
support more rapid expansion, develop new or enhanced services and products,
respond to competitive pressures, acquire complementary businesses or
technologies or respond to unanticipated requirements. If additional funds
are raised through the issuance of equity securities, the percentage
ownership of the shareholders of the Company will be reduced, shareholders
may experience additional dilution in net book value per share or such equity
securities may have rights, preferences or privileges senior to those of the
holders of the Company's Common Stock. There can be no assurance that
additional financing will be available when needed on terms favorable to the
Company, if at all. If adequate funds are not available on acceptable terms,
the Company may be unable to develop or enhance its services and products,
take advantage of future opportunities or respond to competitive pressures or
unanticipated requirements, any of which could have a material adverse effect
on the Company's business, financial condition and operating results.
Cash used in operating activities was $7.9 million for fiscal 1996 primarily
as a result of the recording of $7.3 million in customer accounts and
statutorily required segregated balances subsequent to the operational change
of conversion to self-clearing of security transactions in July 1996.
Cash used in investing activities was $45.7 million for fiscal 1996 primarily
as a result of the investment of the proceeds from the initial public
offering and the Company's continued investment in technological
infrastructure and the new backup facility in Rancho Cordova.
Cash provided by financing activities was $58.6 million for fiscal 1996 due
to proceeds from the initial public offering and private offerings offset by
the repayment of long-term debt.
The Company expects that it will have $20.0 million of capital expenditures
during the fiscal year ending September 30, 1997.
35
RECENTLY ISSUED ACCOUNTING STANDARDS
The Company is required to adopt SFAS No. 121, Accounting for Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, in fiscal
1997. SFAS No. 121 establishes the accounting and reporting requirements for
recognizing and measuring impairment of long-lived assets to be either held
and used or held for disposal. The Company does not expect SFAS No. 121 to
have a material effect on its consolidated financial statements.
The Company is also required to adopt SFAS No. 123, Accounting for Stock-
Based Compensation, in fiscal 1997. SFAS No. 123 establishes accounting and
disclosure requirements using a fair-value based method of accounting for
stock based employee compensation plans. Under SFAS No. 123, the Company may
either adopt the new fair-value based accounting method or continue the
intrinsic value based method and provide pro forma disclosures of net income
and earnings per share as if the accounting provisions of SFAS No. 123 had
been adopted. The Company plans to adopt only the disclosure requirements of
SFAS No. 123; therefore, such adoption will have no effect on the Company's
consolidated net income or cash flows.
On June 28, 1996, the Financial Accounting Standards Board issued SFAS No.
125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, effective for transfers of financial assets
made after December 31, 1996. This new statement provides accounting and
reporting standards for transfers and servicing of financial assets and
extinguishments of liabilities. The Company does not expect SFAS No. 125 to
have a material effect on its consolidated financial statements.
36
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements
Independent Auditors' Report......................................... 37
Consolidated Balance Sheets, September 30, 1996 and 1995............. 38
Consolidated Statements of Operations for years ended
September 30, 1996, 1995 and 1994.............................. 39
Consolidated Statements of Shareholders' Equity for years
ended September 30, 1996, 1995 and 1994........................ 40
Consolidated Statements of Cash Flows for years ended
September 30, 1996, 1995 and 1994.............................. 41
Notes to Consolidated Financial Statements........................... 42
Schedules
All schedules have been omitted as the required information is inapplicable
or the information is presented in the consolidated financial statements or
related notes.
37
Independent Auditors' Report
To the Board of Directors and Shareholders of
E*TRADE Group, Inc.:
We have audited the accompanying consolidated balance sheets of E*TRADE
Group, Inc. and subsidiaries (the "Company") as of September 30, 1996 and
1995, and the related consolidated statements of operations, shareholders'
equity and cash flows for each of the three years in the period ended
September 30, 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 audits.
We conducted our audits 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 audits provide a
reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly,
in all material respects, the financial position of E*TRADE Group, Inc. and
subsidiaries at September 30, 1996 and 1995, and the results of their
operations and their cash flows for each of the three years in the period
ended September 30, 1996 in conformity with generally accepted accounting
principles.
DELOITTE & TOUCHE LLP
San Jose, California
November 22, 1996
38
E*TRADE GROUP, INC. AND SUBSIDIARIES
Consolidated Balance Sheets
September 30,
1996 1995
------------- -------------
ASSETS
Current assets:
Cash and equivalents $ 14,641,000 $ 9,624,000
Cash and investments required to
be segregated under Federal or
other regulations 35,500,000 -
Investment securities 35,003,000 -
Brokerage receivables - net 193,228,000 1,936,000
Other assets 2,203,000 470,000
------------ ------------
Total current assets 280,575,000 12,030,000
Property and equipment--net 9,228,000 1,458,000
Equity investment 2,860,000 676,000
Other assets 2,218,000 -
------------ ------------
TOTAL $294,881,000 $ 14,164,000
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Brokerage payables $219,483,000 $ -
Income taxes payable - 602,000
Accounts payable,
accrued liabilities and other 6,072,000 2,369,000
------------ ------------
Total current liabilities 225,555,000 2,971,000
Long-term portion of capital leases 22,000 45,000
------------ ------------
Total liabilities 225,577,000 3,016,000
------------ ------------
COMMITMENTS AND CONTINGENCIES
(NOTES 8 AND 9)
SHAREHOLDERS' EQUITY:
Preferred stock, $.01 par: shares
authorized, 1,000,000; Series A: 800,000
shares designated; shares issued and
outstanding: 1996, none; 1995, 100,000 - 1,000
Common stock, $.01 par: shares authorized,
50,000,000; shares issued and
outstanding: 1996, 29,539,147;
1995, 14,890,980 295,000 149,000
Additional paid-in capital 68,738,000 9,899,000
Retained earnings 271,000 1,099,000
Total shareholders' equity 69,304,000 11,148,000
------------ ------------
TOTAL $294,881,000 $14,164,000
============ ============
See Notes to Consolidated Financial Statements
39
E*TRADE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Operations
Years Ended
September 30,
1996 1995 1994
----------- ----------- -----------
REVENUES:
Transaction revenues $44,178,000 $20,835,000 $9,548,000
Interest, net of interest expense
of $2,224,000; $83,000;
and $106,000 in 1996, 1995,
and 1994, respectively 4,813,000 1,004,000 302,000
Computer services and other 2,604,000 1,501,000 1,055,000
----------- ----------- -----------
Net revenues 51,595,000 23,340,000 10,905,000
----------- ----------- -----------
COST OF SERVICES:
Cost of services 30,688,000 12,678,000 6,796,000
Self-clearing start-up costs 2,240,000 141,000 -
----------- ----------- -----------
Total cost of services 32,928,000 12,819,000 6,796,000
----------- ----------- -----------
OPERATING EXPENSES:
Selling and marketing 7,600,000 2,466,000 998,000
Technology development 2,792,000 943,000 335,000
General and administrative 9,658,000 2,803,000 2,532,000
Total operating expenses 20,050,000 6,212,000 3,865,000
----------- ----------- -----------
Total cost of services and
operating expenses 52,978,000 19,031,000 10,661,000
----------- ----------- -----------
PRE-TAX INCOME (LOSS) (1,383,000) 4,309,000 244,000
INCOME TAX EXPENSE (BENEFIT) (555,000) 1,728,000 (541,000)
----------- ----------- -----------
NET INCOME (LOSS) $ (828,000) $ 2,581,000 $ 785,000
----------- ----------- -----------
Net income (loss) per share $ (0.03) $ 0.10 $ 0.03
----------- ----------- -----------
Weighted average number of common and
common equivalent shares outstanding 28,564,000 26,481,000 26,186,000
See Notes to Consolidated Financial Statements
40
E*TRADE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Total
Preferred Stock Common Stock Additional Retained Shareholders'
Paid-In Earnings Equity
Shares Amount Shares Amount Capital (Deficit) (Deficiency)
--------- ------- ----------- -------- ------------ ------------ -------------
BALANCE,
OCTOBER 1, 1993 15,498,180 $155,000 $ 1,325,000 $(2,267,000) $ (787,000)
Net income 785,000 785,000
Issuance of common
stock 380,520 4,000 159,000 163,000
Exercise of stock
warrants 1,235,940 12,000 (12,000) -
Repurchase of
common stock (2,160,240) (22,000) (231,000) (253,000)
--------- ------- ----------- -------- ------------ ------------ -------------
BALANCE,
SEPTEMBER 30, 1994 14,954,400 149,000 1,241,000 (1,482,000) (92,000)
Net income 2,581,000 2,581,000
Issuance of Series A
preferred stock 100,000 $1,000 12,299,000 12,300,000
Exercise of stock
warrants 1,293,120 13,000 - 13,000
Exercise of stock
options 497,100 5,000 141,000 146,000
Repurchase of
common stock (1,853,640) (18,000) (3,782,000) (3,800,000)
--------- ------- ----------- -------- ------------ ------------ -------------
BALANCE,
SEPTEMBER 30, 1995 100,000 1,000 14,890,980 149,000 9,899,000 1,099,000 11,148,000
Net loss (828,000) (828,000)
Issuance of Series B
preferred stock,
net of issuance
costs 20,336 - 2,837,000 2,837,000
Issuance of Series C
preferred stock,
net of issuance
costs 11,180 - 8,950,000 8,950,000
Initial public
offering 5,026,550 50,000 46,352,000 46,402,000
Conversion of
preferred stock (131,516) (1,000) 7,890,960 79,000 (78,000) -
Exercise of stock
warrants, including
tax benefit 403,080 4,000 286,000 290,000
Exercise of stock options,
including tax benefit 1,320,060 13,000 472,000 485,000
Issuance of common
stock for services 7,517 - 20,000 20,000
--------- ------- ----------- -------- ------------ ------------ -------------
BALANCE,
SEPTEMBER 30, 1996 - - 29,539,147 $295,000 $68,738,000 $ 271,000 $69,304,000
========= ======= =========== ======== ============ ============ =============
See Notes to Consolidated Financial Statements
41
E*TRADE GROUP, INC. AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years Ended
September 30,
1996 1995 1994
------------ ------------ ------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ (828,000) $2,581,000 $ 785,000
Noncash items included in net
income (loss):
Deferred income taxes (487,000) 303,000 (589,000)
Issuance of common stock for
services 20,000 - -
Depreciation and amortization 876,000 230,000 65,000
Equity income from investment (228,000) (353,000) -
Interest converted to
long-term notes payable - 67,000 87,000
Loss on the disposal of
office equipment 87,000 - -
Net effect of changes in:
Brokerage receivables (191,292,000) (1,437,000) (203,000)
Cash and investments required
to be segregated under Federal
or other regulations (35,500,000) - -
Other assets (3,112,000) (113,000) 97,000
Brokerage payables 219,483,000 - -
Accounts payable, accrued
liabilities and other 3,101,000 2,095,000 649,000
------------ ------------ ------------
Net cash provided by (used in)
operating activities (7,880,000) 3,373,000 891,000
------------ ------------ ------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (8,733,000) (1,375,000) (124,000)
Purchase of equity investment (2,000,000) - -
Purchase of investment securities (337,073,000) (504,000) -
Sale/maturity of investment
securities 302,070,000 - -
Distributions received from
equity investment 44,000 181,000 -
------------ ------------ ------------
Net cash used in
investing activities (45,692,000) (1,698,000) (124,000)
------------ ------------ ------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of
Series A preferred stock - 12,300,000 -
Proceeds from issuance of
Series B preferred stock 2,837,000 - -
Proceeds from issuance of
Series C preferred stock 8,950,000 - -
Proceeds from issuance of
common stock 46,402,000 - 163,000
Proceeds from exercise of
stock options 310,000 146,000 -
Proceeds from exercise of
stock warrants 113,000 13,000 -
Proceeds from long-term
note payable 2,500,000 - -
Repurchase of common stock - (3,800,000) (253,000)
Repayment of long-term note
payable (2,500,000) (1,381,000) -
Repayment of capital leases (23,000) (21,000) (21,000)
------------ ------------ ------------
Net cash provided by (used in)
financing activities 58,589,000 7,257,000 (111,000)
------------ ------------ ------------
INCREASE IN CASH AND EQUIVALENTS 5,017,000 8,932,000 656,000
CASH AND EQUIVALENTS--Beginning of year 9,624,000 692,000 36,000
------------ ------------ ------------
CASH AND EQUIVALENTS--End of year $14,641,000 $9,624,000 $ 692,000
------------ ------------ ------------
SUPPLEMENTAL DISCLOSURES:
Cash paid for interest $ 2,013,000 $ 399,000 $ 18,000
Cash paid for income taxes $ 1,025,000 $ 830,000 $ 41,000
Noncash investing and
financing activities:
Capital expenditures financed
with capital leases - - $ 26,000
Tax benefit on exercise of
non-qualified stock warrants $ 177,000 - -
Tax benefit on exercise of
stock options $ 175,000 - -
In August 1996, each share of
preferred stock was converted
into 60 shares of common stock
automatically after the closing
of the initial public offering
See Notes to Consolidated Financial Statements
42
E*TRADE GROUP, INC. AND SUBSIDIARIES
Notes to Consolidated Financial Statements
1. SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation--The consolidated financial statements include
E*TRADE Group, Inc. and its subsidiaries (collectively, the "Company"),
E*TRADE Securities, Inc. ("E*TRADE Securities") and E*TRADE Capital, Inc.
(formerly, ET Execution Services, Inc.), securities broker-dealers. The
Company has two offices in California, and as of September 30, 1996,
approximately 25% of E*TRADE Securities' total customer accounts were located
in California. All intercompany balances and transactions have been
eliminated.
Effective January 18, 1996, the shareholders of the Company approved a
change in its name from Trade*Plus, Inc. to E*TRADE Group, Inc.
Transaction Revenues--The Company derives revenues from commissions and
payments from other broker-dealers for order flow related to customer
transactions in equity and debt securities and options. Securities
transactions are recorded on a trade date basis and are executed by
independent broker-dealers. Through June 1996 the Company did not receive or
hold customers' securities or funds. The Company implemented self-clearing
operations and took custody of securities and funds in customer accounts in
July 1996.
Interest, Net of Interest Expense--Prior to July 1996, these amounts
represent the Company's participation in the interest differential on its
customer debit and credit balances through a contractual agreement with its
former clearing broker, and fees on its customer assets invested in money
market accounts. Subsequent to the implementation of self-clearing in July
1996, these amounts primarily represent interest earned by the Company on
credit extended to its customers to finance their purchases of securities on
margin, fees on its customer assets invested in money market accounts and
interest earned on investment securities, offset by interest paid to
customers on certain credit balances at a rate that approximates the
prevailing money market rate.
Computer services revenue represents connect time charges for direct
modem access and touch-tone telephone customers. Such revenues are recorded
as earned.
Depreciation and Amortization--Furniture, fixtures and equipment are
stated at cost and are depreciated on a straight-line basis over their
estimated useful lives, generally three to seven years. Leasehold
improvements are amortized over the lesser of their useful lives or the life
of the lease.
Technology development costs are charged to operations as incurred.
Technology development costs include costs incurred in the development and
enhancement of software used in connection with services provided by the
Company that do not otherwise qualify as internally developed software costs.
Cash Equivalents--For purposes of reporting cash flows, the Company
considers all highly liquid investments with original maturities of three
months or less (except for amounts required to be segregated under Federal or
other regulations or amounts designated as trading securities) to be cash
equivalents.
Cash and investments required to be segregated under Federal or other
regulations consist primarily of money market funds.
Investment securities represent a portfolio of commercial paper, cash
and money market funds. The cost of these investments approximates fair
market value, and management has designated them as trading securities.
43
Equity investment represents the Company's investment in a limited
liability company, Roundtable Partners LLC ("Roundtable"), which is accounted
for using the equity method. The Company's return on its investment in
Roundtable is included in other revenues. Roundtable is a consortium of
broker-dealers.
Internally Developed Software Costs--The cost of internally developed
software is capitalized and included in other assets. The costs to develop
such software are capitalized when management authorizes and commits to
funding a project it believes will be completed and used to perform the
functions intended and the conceptual formulation, design and testing of
possible software project alternatives have been completed. Internally
developed software costs include payroll and consulting costs, and are
amortized on a straight line basis over their estimated useful lives,
generally two to three years.
Estimated Fair-Value of Financial Instruments--The Company believes the
amounts presented for financial instruments on the consolidated balance sheet
consisting of cash equivalents, money market funds, commercial paper, and
brokerage receivables and payables to be reasonable estimates of fair-value.
The Company uses available market information as of the balance sheet date
and appropriate valuation methodologies in deriving amounts reported for
financial instruments.
Use of Estimates--The preparation of the Company's consolidated
financial statements in conformity with generally accepted accounting
principles necessarily 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 consolidated balance sheet dates and
the reported amounts of revenues and expenses for the periods presented.
Income Taxes--The Company accounts for income taxes in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 109, Accounting for
Income Taxes. SFAS No. 109 requires the recognition of deferred tax
liabilities and assets at tax rates expected to be in effect when these
balances reverse. Future tax benefits attributable to temporary differences
are recognized to the extent that realization of such benefits is more likely
than not.
Earnings Per Share--Earnings per share is based on the fully diluted
weighted average number of common and common equivalent shares outstanding
during the period. Pursuant to rules of the Securities and Exchange
Commission, all common and common equivalent shares issued and options,
warrants and other rights to acquire shares of common stock at a price less
than the initial public offering price granted by the Company during the 12
months preceding the offering date (using the treasury stock method until
shares are issued) have been included in the computation of common and common
equivalent shares outstanding for all periods prior to the initial public
offering (see Note 6).
Recently Issued Accounting Standards--The Company is required to adopt
SFAS No. 121, Accounting for Impairment of Long-Lived Assets and for Long-
Lived Assets to Be Disposed Of, in fiscal 1997. SFAS No. 121 establishes the
accounting and reporting requirements for recognizing and measuring
impairment of long-lived assets to be either held and used or held for
disposal. The Company does not expect SFAS No. 121 to have a material effect
on its consolidated financial statements.
44
The Company is also required to adopt SFAS No. 123, Accounting for
Stock-Based Compensation, in fiscal 1997. SFAS No. 123 establishes accounting
and disclosure requirements using a fair-value based method of accounting for
stock based employee compensation plans. Under SFAS No. 123, the Company may
either adopt the new fair-value based accounting method or continue the
intrinsic value based method and provide pro forma disclosures of net income
and earnings per share as if the accounting provisions of SFAS No. 123 had
been adopted. The Company plans to adopt only the disclosure requirements of
SFAS No. 123; therefore, such adoption will have no effect on the Company's
consolidated net income or cash flows.
On June 28, 1996, the Financial Accounting Standards Board issued SFAS
No. 125, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities, effective for transfers of financial assets
made after December 31, 1996. This new statement provides accounting and
reporting standards for transfers and servicing of financial assets and
extinguishments of liabilities. The Company does not expect SFAS No. 125 to
have a material effect on its consolidated financial statements.
Reclassifications--Certain items in prior years' financial statements
have been reclassified to conform to the fiscal 1996 presentation.
2. BROKERAGE RECEIVABLES AND PAYABLES--NET
Brokerage receivables and payables--net consists of the following:
September 30,
1996 1995
------------ ------------
Receivable from brokers, dealers
and clearing organizations $ 24,451,000 $ 1,936,000
Receivable from customers (less
allowance for doubtful
accounts of $129,000 in 1996) 168,777,000 -
------------ ------------
Total brokerage receivables - net $193,228,000 $ 1,936,000
============ ============
Payable to brokers, dealers and
clearing organizations $ 35,922,000 $ -
Payable to customers 183,561,000 -
------------ ------------
Total brokerage payables $219,483,000 $ -
============ ============
Receivable from and payable to brokers, dealers and clearing organizations
result from the Company's trading activities on behalf of its customers.
Receivable from customers represents credit extended to customers to finance
their purchases of securities on margin. At September 30, 1996, credit
extended to customers with respect to margin accounts was $171.3 million.
Securities owned by customers are held as collateral for amounts due on
margin balances (the value of which is not reflected on the accompanying
balance sheets). Payable to customers represents free credit balances and
other customer funds pending completion of security transactions. The Company
pays interest on certain customer credit balances (see Note 4).
45
3. PROPERTY AND EQUIPMENT--NET
Property and equipment--net consists of the following:
SEPTEMBER 30,
----------- -----------
1996 1995
----------- -----------
Furniture and fixtures $ 706,000 $ 206,000
Equipment 6,221,000 2,199,000
Leasehold improvements 4,164,000 52,000
----------- -----------
11,091,000 2,457,000
Less: Accumulated depreciation
and amortization 1,863,000 999,000
----------- -----------
Total $9,228,000 $1,458,000
=========== ===========
4. LONG-TERM NOTES PAYABLE AND SHORT-TERM FUNDING
The Company used $2.5 million of the proceeds from the initial public
offering (see Note 6) to repay a term loan with Merrill Lynch Business
Financial Services, Inc. The term loan was obtained in February 1996 and was
used to finance the purchase of equipment and leasehold improvements.
Interest was accrued at the per annum rate equal to the sum of 2.70% over the
30-Day Commercial Paper Rate as defined. The original terms of such financing
provided for the repayment of the term loan in 60 consecutive monthly
installments. The term loan was collateralized by a first lien on all
business assets of the Company. There was no prepayment penalty.
The principal source of financing for E*TRADE Securities' margin lending is
cash balances in customers' accounts. At September 30, 1996, E*TRADE
Securities was paying interest at 4.9% on $151.4 million of cash balances in
customers' accounts, which were included in brokerage payables. For use in
its brokerage operations, E*TRADE Securities maintains committed lines of
financing totaling $100 million to provide collateral financing of customer
securities. There were no borrowings outstanding under these lines at
September 30, 1996.
46
5. INCOME TAXES
The components of income tax expense (benefit) for the years ended September
30 are as follows:
1996 1995 1994
---------- ---------- ----------
Current:
Federal $ (66,000) $1,030,000 $ 11,000
State (2,000) 395,000 37,000
---------- ---------- ----------
Total current (68,000) 1,425,000 48,000
---------- ---------- ----------
Deferred:
Federal (441,000) 302,000 (563,000)
State (46,000) 1,000 (26,000)
---------- ---------- ----------
Total deferred (487,000) 303,000 (589,000)
---------- ---------- ----------
Total tax expense (benefit) $ (555,000) $1,728,000 $ (541,000)
========== ========== ==========
Deferred income taxes are recorded when revenues and expenses are recognized
in different periods for financial statement and tax return purposes. The
temporary differences and tax carryforwards that created deferred tax assets
at September 30 are as follows:
1996 1995
---------- ----------
Deferred tax assets:
Reserves and allowances $ 215,000 $ 156,000
Net operating loss carryforwards 804,000 --
Other 226,000 141,000
---------- ----------
Total deferred tax assets 1,245,000 297,000
---------- ----------
Deferred tax liabilities:
Depreciation and amortization 284,000 3,000
Roundtable Partners LLC investment 180,000 --
Other 8,000 8,000
---------- ----------
Total deferred tax liabilities 472,000 11,000
---------- ----------
Net deferred tax asset $ 773,000 $ 286,000
========== ==========
There were no valuation allowances associated with the deferred tax assets at
September 30, 1996 and 1995.
47
The effective tax rates differed from the federal statutory rates as follows:
1996 1995 1994
------ ------ ------
Tax expense at federal statutory rate 35.0 % 35.0 % 34.0 %
State income taxes, net of federal tax benefit 2.3 6.1 2.8
Decrease in federal income tax asset valuation
allowance -- -- (260.4)
Other 2.8 (1.0) 1.5
------ ------ ------
Effective tax rate 40.1 % 40.1 % (222.1)%
====== ====== ======
6. SHAREHOLDERS' EQUITY
On September 28, 1995, the Company sold 100,000 shares of Series A Preferred
Stock ("Series A") to General Atlantic Partners for $12,300,000. The Company
used approximately $3,800,000 of the proceeds to repurchase and retire
outstanding common stock from existing shareholders.
On April 10, 1996, the Company sold 20,336 shares of Series B Preferred Stock
("Series B") to Christos Cotsakos and affiliates, Richard Braddock, and
General Atlantic Partners and affiliates for $2,847,000 and incurred
issuance costs of $10,000. The Company used the proceeds to provide
additional working capital.
On June 6, 1996, the Company sold 11,180 shares of Series C Preferred Stock
("Series C") to SOFTBANK Holdings Inc. for $9,000,000 and incurred issuance
costs of $50,000. The Company used the proceeds to provide additional
regulatory net capital to ETRADE Securities.
In July 1996, the shareholders of the Company approved the re-incorporation
of the Company in Delaware, an increase in the number of authorized shares of
common stock to 50,000,000 and the related exchange of each share of common
stock of the Company into 60 shares of common stock of the Delaware
corporation. All references in the consolidated financial statements to
number of shares, per share amounts and share prices of the Company's common
stock were retroactively restated to reflect the increased number of common
shares outstanding.
The Company executed an initial public offering under the Securities Act of
1933 resulting in the issuance by the Company of 5,026,550 shares of common
stock on August 16, 1996, at a price to the public of $52.8 million. In
connection with this offering, the Company incurred issuance costs of $6.4
million, including underwriting discounts and commissions.
Each share of Series A, Series B and Series C Preferred Stock was converted
into 60 shares of common stock automatically upon the closing of the initial
public offering under the Securities Act of 1933.
The Company's stock option plans provide for granting of nonqualified or
incentive stock options to officers, directors, key employees and consultants
for the purchase of shares of the Company's common stock at a price
determined by the Board of Directors at the date the option is granted. The
options are generally exercisable ratably over a five-year period from the
date the option is granted and expire within ten years from the date of
grant.
48
In April 1993, the shareholders of the Company approved the 1993 Stock Option
Plan (the "1993 Plan"), which authorized 1,800,000 shares of the Company's
common stock as available for the granting of options. In 1994, the number
of authorized shares under the 1993 Plan was increased to 3,000,000. In
January 1996, the authorized number of shares under the 1993 Plan was
increased to 4,200,000, and in April 1996, the authorized number of shares
was increased to 5,400,000.
In July 1996, the shareholders of the Company approved the 1996 Stock
Incentive Plan (the "1996 Plan") and reserved 4,000,000 shares of common
stock for future grants. The 1996 Plan is divided into three components: the
Discretionary Option Grant Program, the Stock Issuance Program and the
Automatic Option Grant Program. Under the Discretionary Option Grant Program,
options may be granted to purchase shares of common stock at an exercise
price not less than the fair market value of those shares on the grant date
to eligible employees. The Stock Issuance Program allows for individuals to
be issued shares of common stock directly through the purchase of such shares
at a price not less than the fair market value of those shares at the time of
issuance or as a bonus tied to the performance of services. Under the
Automatic Option Grant Program, options are automatically granted at periodic
intervals to eligible non-employee members of the Board of Directors to
purchase shares of common stock at an exercise price equal to the fair market
value of those shares on the grant date.
In July 1996, the shareholders of the Company approved the 1996 Stock
Purchase Plan ("Stock Purchase Plan") and reserved 650,000 shares of common
stock for sale to employees at a price no less than 85% of the lower of the
fair market value at the beginning of the two-year offering period or the end
of each of the six-month purchase periods. The first purchase date under the
Stock Purchase Plan will be January 31, 1997.
During 1994 and 1995, warrants that had been issued to the Company's
creditors in September 1990 in connection with a restructuring agreement (the
"Restructuring Warrants") to purchase 1,235,940 and 1,263,240 shares of
common stock, respectively, were exercised for $210 and $206, respectively.
The remaining Restructuring Warrants expired in September 1995. In January
1995, a consultant was granted a warrant to purchase 300,000 shares of the
Company's common stock at $.42 per share, of which 29,880 were exercised in
fiscal 1995 and the remainder in fiscal 1996.
49
A summary of stock option activity follows:
NUMBER OPTION PRICE
OF SHARES PER SHARE
---------- ------------
Outstanding at September 30, 1993 3,210,000 $.13-$.28
Granted 90,000 $0.28
---------- ------------
Outstanding at September 30, 1994 3,300,000 $.13-$.28
Granted 1,776,000 $.28-$.50
Canceled (876,000) $.28-$.42
Exercised (497,100) $.13-$.50
---------- ------------
Outstanding at September 30, 1995 3,702,900 $.13-$.50
Granted 4,045,000 $2.05-$13.42
Canceled (157,200) $.28-$10.50
Exercised (1,320,060) $.13-$.50
---------- ------------
Outstanding at September 30, 1996 6,270,640 $.13-$13.42
========== ============
SEPTEMBER 30,
---------- ---------- ----------
1996 1995 1994
---------- ---------- ----------
Options available for grant 3,184,100 900,000 1,800,000
Options exercisable 959,040 1,490,000 1,230,000
In the opinion of management, exercise prices of stock options, warrants and
common stock issued to employees and consultants were not less than the fair
market value of the common stock at the time of grant or issuance. In
accordance with Accounting Principles Board Opinion No. 25, Accounting for
Stock Issued to Employees, no compensation expense has been recognized.
Estimates of the fair value of the common stock at the grant or issuance date
are based solely on management's opinion. Independent appraisals of the
Company's common stock were not obtained.
The Company has a 401(k) salary deferral program, which became effective on
January 1, 1995, for eligible employees who have met certain service
requirements. The Company matches certain employee contributions; additional
contributions to this plan are at the discretion of the Company. Total
Company contribution expense for the years ended September 30, 1996, 1995 and
1994 was $52,000, $6,000 and $0, respectively.
50
7. REGULATORY REQUIREMENTS
E*TRADE Securities is subject to the Uniform Net Capital Rule (the "Rule")
under the Securities Exchange Act of 1934 administered by the Securities and
Exchange Commission and the National Association of Securities Dealers, Inc.,
which requires the maintenance of minimum net capital. E*TRADE Securities has
elected to use the alternative method permitted by the Rule, which requires
that the Company maintain minimum net capital equal to the greater of
$250,000 or 2 percent of aggregate debit balances arising from customer
transactions, as defined. At September 30, 1996, E*TRADE Securities had net
capital of $17,117,000 (9.2% of aggregate debit balances), which was
$13,414,000 in excess of its required net capital of $3,703,000. Under the
alternative method, a broker-dealer may not repay subordinated borrowings,
pay cash dividends or make any unsecured advances or loans to its parent or
employees if such payment would result in net capital of less than 5% of
aggregate debit balances or less than 120% of its minimum dollar amount
requirement.
8. LEASE ARRANGEMENTS
The Company leases equipment under capital leases expiring through fiscal
1999. Future minimum lease payments under capital leases as of September 30,
1996, are as follows:
Year ending September 30:
1997 $27,000
1998 20,000
1999 2,000
--------
Total minimum lease payments 49,000
Less: Amount representing interest 5,000
--------
Present value of minimum lease payments $44,000
========
The Company has three non-cancelable operating leases for office facilities
through 2006 and operating leases for equipment through 2001. Future minimum
rental commitments under these leases at September 30, 1996, are as follows:
Year ending September 30:
1997 $ 6,462,000
1998 6,534,000
1999 5,502,000
2000 2,158,000
2001 2,043,000
Thereafter 2,912,000
Certain leases contain provisions for renewal options and rent escalations
based on increases in certain costs incurred by the lessor. Rent expense for
the years ended September 30, 1996, 1995 and 1994 was approximately
$2,441,000, $344,000 and $169,000, respectively.
51
9. COMMITMENTS, CONTINGENT LIABILITIES AND OTHER INFORMATION
The Company is a defendant in civil actions arising from the normal course of
business. In the opinion of management, these actions are expected to be
resolved with no material effect on the Company's consolidated financial
position or results of operations. During the year ended September 30, 1994,
the Company settled claims made by its former clearing broker. The total
amount of this settlement was $850,000 and is included in general and
administrative expenses. In connection with the settlement agreement, the
Company repurchased all shares of its common stock owned by its former
clearing broker at the date of the settlement for $253,000, which represented
their estimated fair market value.
In March 1996, the Company entered into a five-year employment agreement with
a key executive officer. The employment agreement provides for, among other
things, an annual base salary which is subject to adjustment based on the
Company's performance and a severance payment up to $1,250,000 in the event
of termination of employment under certain defined circumstances.
10. FINANCIAL INSTRUMENTS WITH OFF-BALANCE-SHEET CREDIT RISK AND
CONCENTRATIONS OF CREDIT RISK
The Company's customer securities activities are transacted on either a cash
or margin basis. In margin transactions, the Company extends credit to the
customer, subject to various regulatory and internal margin requirements,
collateralized by cash and securities in the customer's account. As
customers write option contracts or sell securities short, the Company may
incur losses if the customers do not fulfill their obligations and the
collateral in customer accounts is not sufficient to fully cover losses which
customers may incur from these strategies. To control this risk, the Company
monitors required margin levels daily, and customers are required to deposit
additional collateral, or reduce positions, when necessary.
Through its broker-dealer subsidiaries, the Company loans securities
temporarily to other brokers in connection with its securities lending
activities. The Company receives cash as collateral for the securities
loaned. Increases in security prices may cause the market value of the
securities loaned to exceed the amount of cash received as collateral. In
the event the counterparty to these transactions does not return the loaned
securities, the Company may be exposed to the risk of acquiring the
securities at prevailing market prices in order to satisfy its customer
obligations. The Company controls this risk by requiring credit approvals
for counterparties, by monitoring the market value of securities loaned on a
daily basis and by requiring deposits of additional cash as collateral when
necessary.
The Company is obligated to settle transactions with brokers and/or other
financial institutions even if its customers fail to meet their obligations
to the Company. Customers are required to complete their transactions on
settlement date, generally three business days after trade date. If
customers do not fulfill their contractual obligations, the Company may incur
losses. The Company has established procedures to reduce this risk by
requiring that customers deposit cash and/or securities into their account
prior to placing an order.
52
The Company may at times maintain inventories in equity securities on both a
long and short basis. While long inventory positions represent the Company's
ownership of securities, short inventory positions represent obligations of
the Company to deliver specified securities at a contracted price, which may
differ from market prices prevailing at the time of completion of the
transaction. Accordingly, both long and short inventory positions may result
in losses or gains to the Company as market values of securities fluctuate.
To mitigate the risk of losses, long and short positions are marked to market
daily and are continuously monitored by the Company.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None
PART III
The Company's Proxy Statement for its 1997 Annual Meeting of Shareholders,
which, when filed pursuant to Regulation 14A under the Securities Exchange
Act of 1934, will be incorporated by reference in this Annual Report on Form
10-K pursuant to General Instruction G(3) of Form 10-K, provides the
information required under Part III (Items 10, 11, 12 and 13), except for the
information with respect to the Company's executive officers who are not
directors, which is included in "Item 1. Business-Executive Officers of the
Registrant."
53
PART IV
Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Consolidated Financial Statements and Financial Statement Schedules.
See "Item 8. Financial Statements and Supplementary Data."
(b) Reports on Form 8-K.
None
(c) Exhibits.
Exhibit
Number Document Description
3.1 Restated Certificate of Incorporation. (Incorporated by reference to
Exhibit 3.3 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
3.2 Restated Bylaws of the Registrant. (Incorporated by reference to
Exhibit 3.4 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
4.1 Specimen of Common Stock Certificate. (Incorporated by reference to
Exhibit 4.1 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
4.2 Reference is hereby made to Exhibits 3.1 and 3.2.
*10.1 Underwriting Agreement dated August 15, 1996, by and among the
Company, Robertson, Stephens & Company LLC, Hambrecht & Quist LLC,
Deutsche Morgan Grenfell/C. J. Lawrence Inc., and the Selling
Stockholders named therein.
#10.2 Form of Indemnification Agreement entered into between the Registrant
and its directors and certain officers. (Incorporated by reference
to Exhibit 10.1 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
#10.3 1983 Employee Incentive Stock Option Plan. (Incorporated by
reference to Exhibit 10.2 of the Company's Registration Statement on
Form S-1, Registration Statement No. 333-05525.)
#10.4 1993 Stock Option Plan. (Incorporated by reference to Exhibit 10.3
of the Company's Registration Statement on Form S-1, Registration
Statement No. 333-05525.)
#10.5 1996 Stock Incentive Plan. (Incorporated by reference to
Exhibit 99.1 of the Company's Registration Statement on Form S-8,
Registration Statement No. 333-12503.)
54
#10.6 401(k) Plan. (Incorporated by reference to Exhibit 10.8 of the
Company's Registration Statement on Form S-1, Registration Statement
No. 333-05525.)
#10.7 1996 Stock Purchase Plan. (Incorporated by reference to
Exhibit 99.13 of the Company's Registration Statement on Form S-8,
Registration Statement No. 333-12503.)
#10.8 Employee Bonus Plan. (Incorporated by reference to Exhibit 10.10 of
the Company's Registration Statement on Form S-1, Registration
Statement No. 333-05525.)
10.9 Lease of premises at Four Embarcadero Place, 2400 Geng Road, Palo
Alto, California. (Incorporated by reference to Exhibit 10.11 of the
Company's Registration Statement on Form S-1, Registration Statement
No. 333-05525.)
10.10 Lease of premises at 10951 White Rock Road, Rancho Cordova,
California. (Incorporated by reference to Exhibit 10.12 of the
Company's Registration Statement on Form S-1, Registration Statement
No. 333-05525.)
#10.11 Employment Agreement dated March 15, 1996, by and between Christos M.
Cotsakos and the Registrant. (Incorporated by reference to
Exhibit 10.13 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
10.12 Clearing Agreement between E*TRADE Securities, Inc. and Herzog,
Heine, Geduld, Inc. dated May 11, 1994. (Incorporated by reference
to Exhibit 10.14 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
10.13 Guarantee by the Registrant to Herzog, Heine, Geduld, Inc.
(Incorporated by reference to Exhibit 10.15 of the Company's
Registration Statement on Form S-1, Registration Statement No. 333-
05525.)
+10.14 BETAHOST Master Subscription Agreement between E*TRADE Securities,
Inc. and BETA Systems Inc. dated June 27, 1996. (Incorporated by
reference to Exhibit 10.13 of the Company's Registration Statement on
Form S-1, Registration Statement No. 333-05525.)
10.15 Stock Purchase Agreement among the Registrant, General Atlantic
Partners II, L.P. and GAP Coinvestment Partners, L.P. dated
September 28, 1995. (Incorporated by reference to Exhibit 10.17 of
the Company's Registration Statement on Form S-1, Registration
Statement No. 333-05525.)
10.16 Stock Purchase Agreement among the Registrant, General Atlantic
Partners II, L.P., and GAP Coinvestment Partners, L.P., Richard S.
Braddock and the Cotsakos Group dated April 10, 1996. (Incorporated
by reference to Exhibit 10.18 of the Company's Registration Statement
on Form S-1, Registration Statement No. 333-05525.)
55
10.17 Stock Purchase Agreement between the Registrant and SOFTBANK Holdings
Inc. dated June 6, 1996. (Incorporated by reference to Exhibit 10.19
of the Company's Registration Statement on Form S-1, Registration
Statement No. 333-05525.)
10.18 Stockholders Agreement among the Registrant, General Atlantic
Partners II, L.P., GAP Coinvestment Partners, L.P. and the
Stockholders named therein dated September 28, 1995 (the
"Stockholders Agreement"). (Incorporated by reference to
Exhibit 10.20 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
10.19 Supplement No. 1 to Stockholders Agreement dated as of April 10, 1996
(Incorporated by reference to Exhibit 10.21 of the Company's
Registration Statement on Form S-1, Registration Statement No. 333-
05525.)
10.20 Stockholders Agreement Supplement and Amendment dated as of June 6,
(Incorporated by reference to Exhibit 10.22 of the Company's
Registration Statement on Form S-1, Registration Statement No. 333-
05525.)
#10.21 Consulting Agreement between the Registrant and George Hayter dated
as of June 7, 1996. (Incorporated by reference to Exhibit 10.23 of
the Company's Registration Statement on Form S-1, Registration
Statement No. 333-05525.)
*11.1 Statement regarding computation of per share earnings.
21.1 Subsidiaries of the Registrant. (Incorporated by reference to
Exhibit 21.1 of the Company's Registration Statement on Form S-1,
Registration Statement No. 333-05525.)
*23.1 Consent of Independent Auditors.
*27.1 Financial Data Schedule as of and for the year ended September 30,
1996.
*Filed herewith
#Management Contract, Compensatory Plan or Arrangement
+Confidential treatment has been requested with respect to certain portions
of this exhibit.
56
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.
E*TRADE Group, Inc.
By /s/ CHRISTOS M. COTSAKOS
-----------------------------
Christos M. Cotsakos
President, Chief Executive
Officer and Director
Dated: December 23, 1996
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/ CHRISTOS M. COTSAKOS President, Chief Executive December 23, 1996
--------------------- Officer and Director
Christos M. Cotsakos (principal executive officer)
/s/ STEPHEN C. RICHARDS Senior Vice President, December 23, 1996
--------------------- Finance and Administration, Chief
Stephen C. Richards Financial Officer and Treasurer;
Chief Financial Officer of E*TRADE
Securities, Inc. (principal financial
and accounting officer)
/s/ WILLIAM A. PORTER Chairman of the Board December 23, 1996
- ----------------------
William A. Porter
/s/ RICHARD S. BRADDOCK Director December 23, 1996
- ------------------------
Richard S. Braddock
/s/ WILLIAM E. FORD Director December 23, 1996
- ------------------------
William E. Ford
/s/ GEORGE HAYTER Director December 23, 1996
- ------------------------
George Hayter
/s/ KEITH PETTY Director December 23, 1996
- ------------------------
Keith Petty
/s/ LEWIS E. RANDALL Director December 23, 1996
- ------------------------
Lewis E. Randall
/s/ LESTER C. THUROW Director December 23, 1996
- ------------------------
Lester C. Thurow