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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
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934
For the fiscal year ended December 31, 1998
Commission File No. 1-11859
PEGASYSTEMS INC.
(Exact name of Registrant as specified in its charter)
Massachusetts 04-2787865
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
101 Main Street
Cambridge, MA 02142-1590
(Address of principal executive offices) (zip code)
(617) 374-9600
(Registrant's telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: None
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Common Stock, $.01 par value per share
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 the 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. [X]
As of March 16, 1999, the aggregate market value of the Registrant's voting
stock held by non-affiliates of the Registrant was approximately $34.6 million
(without admitting that any person whose shares are not included in determining
such value is an affiliate).
There were 28,714,700 shares of the Registrant's common stock, $.01 par value
per share, outstanding on March 16, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Definitive Proxy Statement for its 1998 Annual
Meeting of Stockholders scheduled to be held on June 21, 1999 (the "1999 Proxy
Statement") are incorporated by reference into Part III of this Form 10-K and
portions of the Registrant's Annual Report to Stockholders for the Registrant's
fiscal year ended December 31, 1998 (the "1998 Annual Report") are incorporated
by reference into Part II and Part IV of this Form 10-K. With the exception of
the portions of the 1999 Proxy Statement and the 1998 Annual Report expressly
incorporated into this Form 10-K by reference, such documents shall not be
deemed filed as part of this Form 10-K.
TABLE OF CONTENTS
PART 1
Item Page
- ---- ----
1 Business............................................................... 1
2 Properties............................................................. 9
3 Legal Proceedings...................................................... 9
4 Submission of Matters to a Vote of Security Holders
Executive Officers of the Registrant .................................. 10
PART II
5 Market for Registrant's Common Stock and Related
Stockholder Matter..................................................... 15
6 Comparison of Selected Consolidated Financial Data .................... 16
7 Management's Discussion and Analysis of Financial Condition
and Results of Operations.............................................. 17
7A Quantitative and Qualitative Disclosure About Market Risk ............. 24
8 Financial Statements and Supplementary Data............................ 24
9 Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure ............................................. 24
PART III
10 Directors and Executive Officers of the Registrant..................... 25
11 Executive Compensation................................................. 25
12 Security Ownership of Certain Beneficial Owners and
Management ............................................................ 29
13 Certain Relationships and Related Transactions......................... 30
PART IV
14 Exhibits, Financial Statement Schedules, and Reports on Form
8-K.................................................................... 30
PART I
Item 1
BUSINESS
Pegasystems develops customer relationship management software to automate
customer interactions across transaction-intensive enterprises. Many of the
world's largest organizations in the banking, mutual funds and securities,
mortgage services, credit card services, insurance, healthcare management, and
telecommunications sectors use the Company's solutions to integrate, automate,
standardize, and manage a broad array of mission-critical customer interactions
(including account set-up, record retrieval, correspondence, disputes,
investigations, adjustments, and sales). The Company's solutions can be used by
thousands of concurrent users to manage customer interactions, and to generate
billions of dollars a day in resulting transactions. Work processes initiated by
the Company's solutions are driven by a highly adaptable "rule base" defined by
the user-organization for its specific needs. The rule base facilitates a high
level of consistency in customer interactions in call centers, over the
Internet, and other delivery channels, yet drives different processes depending
on the customer profile or the nature of the request. The Company's open,
multi-tiered, client/server solutions operate on a broad variety of platforms,
including UNIX, Windows/NT, and IBM/MVS. The Company offers consulting,
training, and support services to facilitate the use of its solutions.
Industry Background
Intensifying competition is forcing businesses to reduce costs while focusing on
customer relationship management as an important means of differentiation. Many
businesses increasingly recognize customer interactions as a critical
opportunity to solidify and expand customer relationships. Due to the volume and
precise nature of customer transactions, it is especially critical for
organizations to implement cost-effective systems that manage customer
interactions accurately and efficiently and capitalize on that interaction to
cross sell additional products and services.
Providing high-quality, cost-effective customer relationship management is
complex. Organizations with global operations must manage customer interactions
in different languages, time zones, currencies, and regulatory environments. The
challenge is magnified as the product offerings of an organization increase and
when organizations are combined. Work processes occasioned by a single customer
interaction often involve multiple departments within an organization; these
departments may have different priorities and service standards, and involve a
variety of different computer systems. Customers may contact an organization
through various means, including telephone, facsimile, the Internet, or in
person. The organization must be able to respond in a timely, accurate, and
consistent fashion or risk customer defection.
Historically, in attempting to meet demand for new customer management software
systems, organizations have faced a choice between building custom systems or
purchasing third-party systems. Building custom systems or modifying third-party
systems can be slow and costly, and has often led to isolated, departmentalized
solutions. Traditional third-party systems are often inflexible, requiring
organizations to conform their work processes to the system, rather than vice
versa. Neither custom nor third-party solutions have generally accommodated an
organization's need to evolve or expand operations without significant
programming effort. Moreover, neither has had the high-volume transaction
processing or integration capabilities necessary to support the comprehensive
customer interaction requirements of large organizations. Today, organizations
need flexible, scalable customer relationship management solutions that can be
implemented on an enterprise-wide basis to facilitate consistent, cost-effective
customer relationship management.
The Pegasystems Solution
The Company's solutions integrate, automate, standardize, and manage on an
enterprise-wide basis a broad array of mission-critical customer interactions
for organizations, including account set-up, record retrieval, correspondence,
disputes, investigations, adjustments, and sales. Pegasystems' solutions provide
an architecture that drives intelligent processing and seamlessly integrates an
organization's geographically dispersed and product specific service operations
and isolated computer systems. By bridging these "islands of automation" within
large organizations, the Company's solutions increase the efficiency of sales
and service representatives, and enable organizations to address multiple
customer needs during a single contact.
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Advantages
The Company's customer service management solutions offer the following
advantages:
Flexibility and Consistency. The Company's solutions are based on rules defined
by the user-organization. The user-defined rules drive various types of
processing depending on such factors as the content of the customer request, the
profile of the customer, the organization's policies and procedures, and the
authority or qualifications of the customer sales and service representatives.
By modifying its rule base, an organization can evolve its processing to address
the competitive requirements of its business without costly and time consuming
reprogramming. Significantly, the rule base feature of the Company's systems
permits an organization to establish consistent standards yet interact
differently with different segments of its customer base, and thereby "mass
personalize" its services.
Scalability and Robust Functionality. The scalability of the Company's
multi-tiered client/server architecture allows an organization to add
departments to new or existing servers to build enterprise solutions.
Organizations currently entrust the Company's systems with the storage and
management of data relating to hundreds of millions of financial transactions.
The Company's systems can be used by several thousand concurrent users to manage
customer interactions and to process accurately and securely transactions
involving billions of dollars a day that result from those interactions.
Ease-of-Use. The Company's client software applications increase the
effectiveness and productivity of customer sales and service representatives by
providing them with a flexible graphical user interface and processing
capabilities that leverage the power of client/server desktop computers or the
Internet/intranet. The Company's solutions allow customer sales and service
representatives to focus on delivering superior customer management, rather than
on mastering the protocols and procedures of multiple applications.
Integration Capabilities. The Company's open architecture permits its solutions
to be integrated with a wide variety of other applications and technologies,
including industry-standard relational database management systems, advanced
telephony equipment, and diverse storage media (including magnetic, optical,
tape, and microfilm). The Company's solutions also support the message formats
of major financial transaction networks such as the SWIFT international funds
network, the Federal Reserve's Fedwire system, and the VISA and MasterCard
networks.
Multi-Platform Server Support. The Company's solutions feature a common software
code base which, in addition to facilitating maintenance and enhancement
development efforts, simplifies the support of multiple platforms. The Company's
solutions are designed to run on a broad range of computer operating systems
including IBM's MVS/CICS and AIX/UNIX systems, Digital Equipment Corporation's
VMS system, Microsoft's Windows/NT system, Sun Microsystems' Solaris UNIX
system, and Hewlett-Packard Corporation's HP-UX UNIX system.
Improved Efficiency of Customer Management. Pegasystems' solutions actually
perform work, rather than simply track a customer service representative's
tasks. Variable data elements (e.g., date, amount, customer, account)
automatically route service requests and invoke system processes, depending on
an organization's rule base. This feature allows customer sales and service
representatives to focus on revenue enhancing opportunities, such as cross
selling, and other matters requiring personal attention. During a customer
interaction, the Company's solutions provide pertinent, consolidated information
to guide the service representative. Savings are realized through reduced talk
time, fewer manual processes, and less rework.
Business Strategy
Pegasystems' objective is to become the leading provider of mission-critical
client/server customer relationship management software to organizations
performing a high volume of complex interactions with demanding customers. To
achieve this objective, the Company is pursuing the following strategies:
Leverage Strength in Financial Services Market. Pegasystems provides customer
relationship management solutions to many of the largest financial services
organizations in the world. The Company is seeking to expand its business with
these organizations through sales efforts focused on marketing the Company's
products and services to other business operations of these organizations.
Penetrate Other Markets. In 1998, Pegasystems continued to deliver its products
to the insurance, telecommunications, and healthcare management markets. Like
the financial services industry, these markets have customer relationship
management needs, and the Company's core technology is adaptable to these
markets. During 1998, the Company hired employees with experience in these other
markets.
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Develop Standard Product Templates. The Company plans to continue developing and
marketing standard product templates that give organizations an advanced
starting point for configuring their work processes. The Company believes that
these templates facilitate more rapid implementation of the Company's solutions,
and will be a cost-effective way to address the needs of smaller organizations.
Reduce Implementation Time. The Company is continuing to refine its consulting
methodology in order to facilitate quicker implementation of the Company's
customer relationship management systems and continued evolution of such systems
by an organization's personnel after initial implementation. This methodology
complements the Company's standard product templates to reduce the time required
to implement the Company's systems.
Build Strategic Relationships. The Company has actively developed a partner
strategy to increase market penetration at several levels. It has developed a
PegaCSP (Pegasystems' Certified Solutions Provider) program to recruit systems
integrators and enable them to develop active Pegasystems practices. The Company
is continuing with its strategy of leveraging dominant players in certain
markets to sell and support its products. Financial transaction processors such
as First Data Resources, for example, provide access to key customers and
significant insight into the product requirements of the credit card market. The
Company also continues to leverage relationships with technology companies to
jointly develop and market customer relationship management products.
Maintain Technological Leadership Position. Pegasystems is continuing to develop
and invest in its product offerings. Current development efforts include the
development of tools to facilitate the use of its customer management system,
interoperability with Internet and intranet systems, and the support of emerging
technical and workflow standards.
Technology
The Company's technology automates an organization's sales and service processes
over a variety of delivery channels, including call centers, branch offices, and
the Internet. Pegasystems' solutions have the following key technological
attributes:
Information Management. Effective customer response, management, and retention
requires up-to-date information about the customer relationship, regardless of
how, why, when, or where the customer contacts the organization. Pegasystems'
customer relationship management solutions organize core customer information to
facilitate global access.
Multi-tiered, Dynamic Distributed Processing. The Company's systems are designed
to run in an advanced, highly scalable multi-tiered environment. In traditional
three-tiered client/server environments, the user interface, the application
code, and the data are segregated onto separate tiers. In the Pegasystems
multi-tiered client/server environment, the application code, the rule base, and
selected data may be replicated on both the central and satellite tiers so that
processing may occur on either the central server or the distributed satellite
servers to minimize network traffic and enhance performance. The Pegasystems
rule base determines the optimal location for processing to occur based on the
nature of the work required and the data involved.
Inherited Workflow. Pegasystems solutions maintain organizational consistency
while providing the flexibility needed for mass personalization. The rule base
of the Company's systems may be defined so that certain processes are
standardized across an organization while others may be superseded or
supplemented by "local" rules tailored to the specific requirements of groups
within the organization.
Platform Independence. Recognizing that organizations often use a variety of
computer platforms, Pegasystems provides technology alternatives by supporting a
range of mainframes, minicomputers, PC networks, and interface devices. While
the Company offers an advanced 32-bit Windows-PegaREACH application for the
desktop, the Company's server applications can also drive "dumb terminals,"
allowing organizations to preserve their investments in legacy networks.
Internet and Intranet Access. Pegasystems' solution PegaREACH uses the
Internet-based HTML (Hypertext Markup Language) to define display attributes for
its graphical user interface, leveraging logic and presentation rules between
PegaReach and Internet/intranet workflows. With PegaWEB, these workflows can be
accessed over the Internet or an intranet using standard World Wide Web
browsers. Pegasystems' rules dynamically create HTML forms, menus, and displays,
thereby facilitating interaction with the Internet.
Interfacing With Other Systems. Pegasystems' open architecture permits
integration with a wide variety of other applications and networks, including
relational databases, legacy systems accessed through IBM 3270 emulation, and
messaging protocols. The Company offers a Universal Application Programming
Interface (API) that allows an organization's custom software to be integrated
with the Company's applications without the need to modify the Company's core
application code. Pegasystems' PegaCONNECT components also support interfaces to
IBM's MQSeries, CORBA, 3270-based mainframe applications, and
3
major relational database systems. Pegasystems' solutions also integrate with
other applications, accounting systems, and imaging products.
Storage Options. Data storage flexibility is important to the Company's
customers, and the Company's software uses an innovative object-oriented
approach that dynamically maps data according to the type of workflow. Versions
of the Company's systems can store customer service request data in the
Microsoft SQL Server, Oracle, Informix, and Sybase relational databases.
Functionality
The Company's solutions employ a consistent architecture and support the
following "5 Rs" of customer relationship management functions across call
centers, the World Wide Web, and other service delivery operations:
Receiving. An organization's customer contact center receives requests by
telephone, mail, facsimile, the Internet, or personal contact. Customer service
representatives and agents may enter details of incoming requests into
PegaREACH, the Company's easy-to-use, 32-bit graphical user interface.
Alternatively, electronic service requests are received from various networks or
messaging interfaces such as MQSeries, the SWIFT network, the Internet, or the
VISA/MasterCard network. The Company's systems also support direct electronic
access by customers through PCs and the Internet browsers, and voice response
units. In all cases, the service request automatically initiates appropriate
processing based on the user-defined rule base.
Routing. As processing steps are completed, the Company's systems categorize and
queue the request for appropriate automatic or manual processing.
Productivity-based load leveling and dynamic prioritization ensure high
performance and responsiveness. As work is processed, each customer
representative's "work list" is automatically updated in real time. The systems
monitor each customer request for conformance to the organization's timeliness
standards, automatically increasing priority and generating warnings based on
the service standards of the organization.
Retrieving. The Company's systems determine when more information is needed and
how to retrieve it from databases or other repositories. Pegasystems'
rule-driven processing automatically extracts relevant data, directs it to the
customer service representative or customer, links it to the work, and keeps it
readily accessible. The Company's systems can access information from multiple
data sources, whether maintained by the Company's systems or third-party
systems.
Responding. The Company's systems facilitate communications by an organization
with its customers by combining user-defined templates and specific customer
information to create personalized correspondence. When appropriate, service
representatives may further refine message content before forwarding, and
attaching images of statements, checks, and other data. Follow-up communications
are automatically generated. Sensitive correspondence can be queued for online
review before release, and the systems create a permanent audit trail of
customer communications.
Reporting. Data collected by a Pegasystem enables an organization to analyze
service representative efficiency and determine needs for service representative
training or changes to work processes. The systems produce reports, graphical
output, and feeds to spreadsheets illustrating the volume and status of customer
requests, the productivity of customer service representatives, and service
levels with specific customers.
The Company offers a number of different products with components and features
designed to address particular business areas while sharing core technology and
adaptable rule-driven processing. The Company intends to continue to develop and
market standard packaged solutions targeted at traditional and new markets. The
Company offers product sets and brand identities associated with each market.
4
Industries
The Company offers industry specific solutions for the following industries:
Banking. The Company provides banking solutions that automate customer
sales and service initiatives across varied delivery channels (such as, Internet
self-service, call centers, and branch networks). These solutions improve the
quality, accuracy, and efficiency of customer interactions, supporting a banking
organization's product and service offerings. Pegasystems' solutions automate
targeted functions within banking, including customer-contact management,
sales-campaign management, call center service, check research and adjustments,
funds transfer investigations, and correspondence.
Mutual Funds. The Company services the mutual funds industry through an
agreement with First Data Investor Services Group, Inc. (FDI), a subsidiary of
First Data Corporation. The integrated product -- marketed by FDI under the name
IMPRESS Plus -- offers mutual fund institutions a comprehensive service
solution. The Company also has direct sales to customers in this market.
Securities and Investments. The Company's solutions automate service and sales
efforts associated with corporate actions, payments and securities settlement
investigations, retail brokerage, and wholesale clearing services.
Credit Card Processing. The Company's products are offered to the credit card
processing market through a relicensing agreement with First Data Resources
(FDR) -- the largest credit card processor in the world. A jointly developed
solution combines Pegasystems' workflow and service delivery technology with
FDR's servicing functionality and on-line interfaces. The resulting product
gives clients a flexible, user-friendly solution that can be quickly and easily
adapted to meet evolving business needs without costly programming. The Company
also has direct customers in this market.
Insurance. The Company's insurance solutions integrate disparate back-end
systems to ensure that when calls, letters, or faxes reach representatives and
agents, they have easy access to information they need to handle policyholder
requests. The Company's solutions position insurance organizations to provide
highly personalized customer service and enhance cross-selling.
Healthcare. The Company's healthcare solutions enable healthcare organizations
to more efficiently coordinate care and integrate administrative operations.
This allows health maintenance organizations, healthcare providers, pharmacists,
laboratory clinicians, and health insurers to access integrated patient
information over a network of previously disconnected systems. Personalized data
presentation gives users easy access to just the information they need to
quickly respond to requests including referrals, benefits verification, and
claim status.
Telecommunications. The Company's flexible rule-base solutions can be configured
to automate a telecommunications service provider's interactions with its
customers and other providers. The Company provides workflow management
solutions that integrate disparate information systems -- a capability of
importance to telecommunications providers facing increased competition due to
deregulation.
Product Pricing
The Company's systems have historically been licensed to organizations under
agreements requiring the monthly payment of fees over the term of the agreement.
The amount of the monthly license fee is related to various factors, including
the number of concurrent users, the functionality of the system, the number of
servers on which the product is installed, and the scope of business usage.
Typical recent individual system licenses have provided for the payment of
monthly fees of between $10,000 and $100,000 for an initial implementation. Some
organizations receive discounts for licensing multiple systems. The monthly
license payments generally begin once a system is installed and is accepted.
Historically, the term of such licenses is typically five years, subject to
renewal at the organization's option.
In the future, the Company may allow some sales prospects to license the
Company's software for an extended, prepaid term for a one-time license fee, and
may also provide existing customers the option to convert to an extended,
prepaid license term. The conversion of existing term licenses to extended,
prepaid term licenses may reduce the predictability of license revenue.
Consulting Services. The Company supports its customers' reengineering efforts
during and after system installation with the PegaSTAR (the Pegasystems
Structured Technique for Analysis and Reengineering) installation methodology.
The Company encourages team building and transfer of knowledge from its
consultants to an organization's staff through an interactive co-production
methodology. Pegasystems and its customers work together to customize the
system's rule base for the customer. Pegasystems' goal is to empower its
customers' staffs with the knowledge and confidence to operate, refine, and
continuously
5
evolve their systems. The Company's new PegaCSP program provides customers with
the option of using third-party Systems Integrators' analytical, technical, and
managerial expertise to assist in Pegasystems' implementation projects.
Training. The Company offers training programs for its customers' operations
staff and "Workflow Architects," who are responsible for evolving the rules that
drive the various processes related to customer interactions. Pegasystems has
training centers in Cambridge, MA; San Francisco, CA; and Reading, U.K.
Continuous Feedback. Pegasystems organizes an annual PegaVISION Customer
Conference and periodic Advisory Board meetings, which enable its clients to
exchange ideas, learn about product directions, and influence Pegasystems'
development direction.
Maintenance and Support. Pegasystems provides comprehensive maintenance and
support services, which may include 24 hours a day, 7 days a week customer
service, periodic preventative maintenance, documentation updates, and new
software releases.
Organizations that license the Company's systems may enter into a maintenance
contract providing for the payment to the Company of a monthly maintenance fee
over the term of the related license agreement equal to approximately 18% of the
monthly license fee. Organizations seeking consulting and support services are
generally charged for services at an hourly rate or under a fixed-price
arrangement.
Pegasystems Client Services Group, which as of December 31, 1998 consisted of
approximately 200 people located in the Company's 14 offices, provides
consulting, training, and customer support.
Customers
Pegasystems provides robust and scalable customer relationship management
solutions that can support thousands of concurrent users based in multiple
countries, speaking different languages, and working with different currencies.
A list of the Company's major customers and the uses to which they apply the
Company's products follows:
American Home Assurance (AIG) - Insurance customer service, policy renewal, new
business applications.
Banco Popular de Puerto Rico -- Retail service center automation, check
research, and consumer loan inquiry and service.
Bank of America -- Retail/check customer service and research, automation of
branch support centers. Institutional funds transfer and foreign exchange
customer service for U.S. and European operations. Credit and debit card
correspondence, and dispute and chargeback service processing.
Bank of Ireland -- Retail/check clearings and research, automation of branch
support centers, and exception/credit item review and verification.
Banque Nationale de Paris -- Institutional funds transfer service, research, and
archive.
Barclays Bank PLC -- Institutional funds transfer and foreign exchange customer
service for international operations. Merchant credit card service including
telephony center, correspondence, and dispute and chargeback processing.
Cedel Bank -- Global custody and securities movement customer service.
Central Vermont Public Services Corp. -- Customer service management, providing
call center representatives with access to consolidated customer information.
Citibank -- Global funds transfer and foreign exchange customer service.
Check-related customer service and research. Domestic MasterCard and Visa
service including image integration, correspondence, and dispute and chargeback
processing.
Colonial Group -- Mutual fund customer service supporting telephony center and
correspondence.
Federal Reserve Banks -- Check processing customer service, suspense ledger
management, research, adjustment, and archive.
Fidelity Investments -- Mutual fund customer service supporting telephony center
and correspondence.
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First Chicago NBD -- Retail/check customer service and research. Wholesale
banking, funds transfer, check, corporate lockbox, and interbank compensation
service for global operations.
First Data Corporation - Relicenses the Pegasystems solution to provide customer
service, collections, and credit application processing for card issuers.
Franklin Templeton Group -- Mutual fund customer service supporting telephony
center, correspondence, and research.
Homeside Lending -- Escrow analysis and payment processing.
Household Credit Services -- Credit card service including telephony center,
correspondence, dispute, and chargeback processing. Private label customer
service for major retailers.
Kaiser Permanente -- Automating healthcare member, patient, provider, and payer
interactions.
Marine Midland Bank -- Institutional funds transfer customer service.
Mellon Bank Corporation -- Retail/check customer service, research, and archive.
Wholesale, institutional, cash management, and corporate lockbox customer
service.
Sears Roebuck-- Customer service and authorizations at the Regional Credit Card
Operations Centers of Sears Credit, the consumer credit division.
Trans Union Corporation -- Credit bureau data-management customer service for
institutional customers and real estate property appraisal processing.
In 1998, First Data Resources Corporation accounted for 17.7% of the Company's
consolidated revenue. In 1997, Kaiser Permanente and First Data Resources
Corporation accounted for 13.7% and 10.0%, respectively, of the Company's
consolidated revenue. In 1996, Bank of America, Chase Manhattan Bank, and Fleet
Bank accounted for 14.5%, 11.4% and 10.5%, respectively, of the Company's
consolidated revenue.
Sales and Marketing
The Company markets its software and services primarily through a direct sales
force. As of December 31, 1998, the Company's sales force consisted of
approximately 61 salespersons in the Company's U.S. and foreign offices. To
achieve significant revenue growth in the future, it will be necessary for the
Company to increase the productivity of its direct sales force.
In 1997, Pegasystems entered into a strategic relationship with First Data
Corporation, which includes an agreement with First Data Resources (FDR) that
gives FDR -- the largest credit card processor in the world -- world wide rights
to use and re-license Pegasystems' solutions in the credit card issuing market.
The Company has evolved its indirect distribution channel by entering into an
agreement with First Data Investor Services Group, Inc., under which the
Company's PegaSHARES product is distributed. In addition, the Company has
established joint marketing relationships with GeoTel, Genesys Laboratories, Sun
Microsystems, Hewlett-Packard Company, and Management Data. In the future, the
Company may also market and sell its products through other value added
resellers (VARs) and systems integrators. There can be no assurance, however,
that the Company will be able to attract and retain VARs, systems integrators,
and other third parties that will be able to market and sell the Company's
products effectively.
To support its sales force, the Company conducts marketing programs, such as
PegaVISION (annual customer conference), trade shows, industry seminars,
meetings with industry analysts, direct mail, and telemarketing. Sales leads are
also generated by the Company's consulting staff, business partners, and other
third parties.
In 1998, 1997, and 1996, sales to customers based outside of the United States
represented 22.6%, 16.5%, and 17.7%, respectively, of the Company's total
consolidated revenue.
The Company's export sales from the United States for 1998, 1997, and 1996 were
as follows:
(in thousands $) 1998 1997 1996
United Kingdom 6,311 3,642 3,698
Europe 4,434 1,715 2,017
Other 2,890 1,973 232
------ ------ ------
13,635 7,330 5,947
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See "Management's Discussion and Analysis of Financial Condition and Results of
Operations -- Results of Operations" incorporated herein by reference from the
1998 Annual Report. See Note 1(l) of Notes to Consolidated Financial Statements
contained in the 1998 Annual Report.
Product Development
Since its inception, the Company has made substantial investments in product
development. The Company believes that its future performance depends on its
ability to maintain and enhance its current products and develop new products.
The Company's product development priorities include (1) creating tools to
enable organizations to configure more easily their customer service management
systems; (2) integrating the Company's products with the Internet for customer
self-service and with intranet systems for departmental service; (3) developing
standard application programming interfaces that allow other client workstation
and server applications to interoperate with the Company's systems; and (4)
enhancing product quality, platform stability, ease of use, and ease of
installation.
In 1998, 1997, and 1996 the Company's research and development expenses were
approximately $23.4 million, $15.1 million, and $8.2 million, respectively.
Competition
The customer service management software market is intensely competitive and
subject to rapid change. Competitors vary in size and in the scope and breadth
of the products and services offered. The Company encounters competition from
internal information systems departments of potential or current customers that
develop custom software. The Company also competes with: (1) software companies
that target the customer interaction or workflow markets such as Siebel Systems
and Vantive; (2) companies that target specific service areas (such as DST
Systems and Shared Medical Systems); and (3) professional services organizations
such as Andersen Consulting that develop custom software in conjunction with
rendering consulting services. In addition, the Company expects additional
competition from other established and emerging companies, such as Oracle and
SAP AG, as the market continues to develop and expand. Increased competition may
result in price reductions, less beneficial contract terms, reduced gross
margins and loss of market share, any of which could materially and adversely
affect the Company's business, operating results, and financial condition.
The Company believes that the principal competitive factors affecting its market
include product features such as adaptability, scalability, ability to integrate
with other products and technologies, functionality and ease-of-use, the timely
development and introduction of new products and product enhancements, as well
as product reputation, quality, performance, price, customer service and
support, and the vendor's reputation. Although the Company believes that its
products currently compete favorably with regard to such factors, there can be
no assurance that the Company can maintain its competitive position against
current and potential competitors.
Many of the Company's competitors have greater resources than the Company, and
may be able to respond more quickly and efficiently to new or emerging
technologies, programming languages or standards, or to changes in customer
requirements or preferences. Many of the Company's competitors can devote
greater managerial or financial resources than the Company can to develop,
promote and distribute customer service management software products and provide
related consulting, training, and support services. There can be no assurance
that the Company's current or future competitors will not develop products or
services which may be superior in one or more respects to the Company's or which
may gain greater market acceptance. Some of the Company's competitors have
established or may establish cooperative arrangements or strategic alliances
among themselves or with third parties, thus enhancing their abilities to
compete with the Company. It is likely that new competitors will emerge. There
can be no assurance that the Company will be able to compete successfully
against current or future competitors or that the competitive pressures faced by
the Company will not materially and adversely affect its business, operating
results, and financial condition.
Employees
As of December 31, 1998, the Company had approximately 616 employees, of whom
approximately 509 were based in the United States, 6 were based in Canada, 89
were based in Europe, and 12 were based in Australia. Of the total,
approximately 175 perform research and development, 322 perform consulting and
customer support, 61 were in sales and marketing, and 58 were in administration
and finance. The Company's future performance depends in significant part upon
the continued
8
service of its key technical, sales and marketing, and senior management
personnel and its continuing ability to attract and retain highly qualified
technical, sales and marketing and managerial personnel. Competition for such
personnel is intense and there can be no assurance that the Company will be
successful in attracting or retaining such personnel in the future. None of the
Company's employees is represented by a labor union or is subject to a
collective bargaining agreement. In January 1999, Ira Vishner resigned as Vice
President of Corporate Services, Treasurer and a Director of the Company. In
April 1999, Thomas E. Swithenbank resigned as Executive Vice President of the
Company, and Richard B. Goldman, the Company's Vice President, Treasurer, and
Chief Financial Officer, has indicated his intention to resign from the Company
within the next several months.
Backlog of License and Maintenance Revenues
As of December 31, 1998, the Company had software license and maintenance
agreements with customers expected to result in approximately $35 million of
revenue in 1999, $22 million of which is currently recorded as deferred revenue.
Under such agreements, the Company must fulfill certain conditions prior to
recognizing revenue thereunder, and there can be no assurances that the Company
will be able to satisfy all such conditions in each instance or that the timing
of when such conditions may be satisfied is predictable. As of December 31,
1997, the Company estimated its software license and maintenance backlog as
being approximately $26 million in revenue for 1998.
Item 2
PROPERTIES
Pegasystems' principal administrative, sales, marketing, support, and research
and development operations are located in a 92,762 square foot leased facility
in Cambridge, Massachusetts. The lease for this facility expires in 2003,
subject to the Company's option to extend the term for up to eight additional
years. The Company also leases space for its other offices in the United States,
Canada, Australia, France, and the United Kingdom. These leases expire at
various dates through 2006. The Company believes that additional or alternative
space will be available in the future on commercially reasonable terms as
needed.
Item 3
LEGAL PROCEEDINGS
Chelverus Case. In April 1998, a complaint purporting to be a class action was
filed with the United States District Court for the District of Massachusetts
(the "Court") alleging that the Company and several of its officers violated
section 10(b) of the Securities Exchange Act of 1934, as amended (the "Exchange
Act"), Rule 10b-5 promulgated by the Commission thereunder, and section 20(a) of
the Exchange Act. In December 1998, the plaintiffs filed their First Amended
Consolidated Complaint which names the Company, the Company's President (Alan
Trefler) and a former officer and director (Ira Vishner) as defendants. The
Amended Complaint alleges that the defendants issued false and misleading
financial statements and press releases concerning the Company's publicly
reported earnings. The Amended Complaint seeks certification of a class of
persons who purchased the Company's Common Stock between July 2, 1997 and
October 29, 1997, and does not specify the amount of damages sought. The
defendants have filed a motion to dismiss this litigation to which the
plaintiffs have replied. The Company intends to defend this matter vigorously.
Gelfer Case. In December 1998, a complaint also purporting to be a class action
was filed with the Court alleging that the Company and Alan Trefler violated
section 10(b)of the Exchange Act, Rule 10b-5 promulgated by the Commission
thereunder, and that Mr. Trefler also violated section 20(a) of the Exchange
Act. The litigation was filed recently after the Company's announcement on
November 24, 1998 that it might be recording revenue adjustments, on behalf of a
purported class of persons who purchased the Company's Common Stock between
October 29, 1998 through November 24, 1998. The Complaint does not specify the
amount of damages sought. Plaintiff's have indicated that they intend to file an
amended complaint. The defendants have not yet filed an answer or other
responsive pleading in this action. The Company intends to defend this matter
vigorously.
9
Item 4
SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the fourth quarter of fiscal 1998, there were no matters submitted to a
vote of security holders.
EXECUTIVE OFFICERS OF THE REGISTRANT
The names of the Company's executive officers and certain information about them
are set forth below as of April 15, 1999:
Name Age Position(s) and Office(s) Held
Alan Trefler............................ 43 President, Clerk and Director
Joseph J. Friscia....................... 44 Vice President of Sales and Service
Richard B. Goldman...................... 52 Vice President, Chief Financial Officer and Treasurer (1)
Executive officers of the Company are elected by the Board of Directors on an
annual basis and serve until the next annual meeting of the Board of Directors
and until their successors have been duly elected and qualified. There are no
family relationships among any of the executive officers or directors of the
Company.
Alan Trefler, a founder of the Company, has served as President and Clerk and
has been a director since the Company's organization in 1983. Prior thereto, he
managed an electronic funds transfer product for TMI Systems Corporation, a
software and services company. Mr. Trefler holds a B.A. degree in economics and
computer science from Dartmouth College.
Joseph J. Friscia joined the Company in 1984 to establish its New York office.
Mr. Friscia has served as Vice President of Sales and Service since 1987 and has
recently undertaken responsibility for delivery of consulting and installation
services. Prior to joining the Company, he worked as a money transfer operations
manager with Bankers Trust Company and J. Henry Schroder Bank and Trust Company.
Mr. Friscia holds a B.A. degree from Long Island University and an M.B.A. degree
from Adelphi University.
Richard B. Goldman joined the Company in September 1998 as a Vice President and
its Chief Financial Officer. In January 1999, he was also elected as the
Company's Treasurer. From June 1997 through September 1998, he served as Vice
President, Chief Financial Officer, Chief Accounting Officer, Treasurer, and
Secretary of PictureTel Corp., a developer, manufacturer, marketer and servicer
of visual communications solutions. Prior to joining PictureTel, Mr. Goldman
held the position of Senior Vice President, Chief Financial Officer, Treasurer
and Secretary of Giga Information Group, an Internet-based, third generation
knowledge provider from April 1996 to December 1996. Mr. Goldman also served as
Vice President, Chief Financial Officer and Treasurer for Sequoia Systems, a
manufacturer of fault tolerant computer products from September 1992 to April
1996. Mr. Goldman has a B.S. degree in Finance from Northeastern University and
an M.B.A. degree from Boston University.
(1) Mr. Goldman has indicated his intention to resign from the Company within
the next several months.
10
CERTAIN STATEMENTS FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
The Company, desiring to avail itself of the "safe harbor" provisions of the
Private Securities Litigation Reform Act of 1995, wishes to caution readers that
the following important factors, among others, in some cases have caused and in
the future could cause the Company's actual results to differ materially from
those expressed in forward-looking statements made by or on behalf of the
Company in filings with the Securities and Exchange Commission, press releases
or oral statements. Words such as "expects," "may," "anticipates," "intends,"
"seeks", "would," "will," "plans," "believes," "estimates," "should," and
similar words and expressions are intended to identify such forward-looking
statements. These statements are based on estimates, projections, beliefs, and
assumptions of the Company and its management, and are not guarantees of future
performance.
The Company has suffered losses in prior fiscal periods and faces liquidity and
financing risks. The Company has experienced losses from operations during 1997
and 1998 and a significant reduction in its cash position. The Company intends
to take measures to reduce those losses and cash usage, including implementing
various cost controls. If cost containment is not achieved or revenues are not
increased, the Company may need to further reduce its cost structure or need to
find additional sources of financing. In addition, to improve its liquidity
position, the Company intends to augment its credit/collections efforts, improve
its billing system and offer customers an alternative to the established term
license model.
The Company is also considering the securitization of certain accounts
receivable and may enter into an equipment sale lease-back transaction. There
can be no assurance that the Company will be able to consummate either
transaction. In addition, either or both transactions could cause the Company to
assume debt or other liabilities. The Company believes that its cash balances
and anticipated future cash flows will be sufficient to fund operations for the
immediate term. The Company can make no assurances that measures taken to date
or to be taken in the future will be sufficient to stem losses or that future
financing will be available to the Company on satisfactory terms. A transition
from existing term licenses to prepaid extended term licenses may significantly
reduce the predictability of revenue since historically the Company has
recognized revenue from software license renewals, and the change to a prepaid
extended term license model will obviate such renewals.
The Company faces litigation. Negative publicity resulting from its delayed SEC
filings and its restatement of prior period financial statements has made sales
more difficult to close. The Company is presently a defendant in two private
securities litigation matters. Although the Company intends to defend these
actions vigorously, no assurance can be given as to the outcomes. It is possible
that the Company may be required to pay substantial damages or settlement costs
which could have a material adverse effect on the Company's financial position
or results of operation. In addition, regardless of the outcome of any of these
actions, it is likely that the Company will incur substantial defense costs and
that such actions will cause a diversion of management time and attention. The
Company's delays in SEC filings and adjustments made to previously published
financial statements have resulted in negative publicity for the Company. Such
events and related publicity have adversely affected demand for the Company's
products and services.
The Company's stock price has been volatile. Quarterly results have and are
likely to fluctuate significantly. The market price of Pegasystems' Common Stock
has been and may continue to be highly volatile. Factors that are difficult to
predict, such as quarterly revenues and operating results, statements and
ratings by financial analysts and overall market performance, will have a
significant effect on the price for shares of Pegasystems' Common Stock.
Revenues and operating results have varied considerably in the past from period
to period and are likely to vary considerably in the future. Product development
and other expenses are planned anticipating future revenue. If revenue falls
below expectations, financial performance is likely to be adversely affected
because only a small portion of expenses vary with revenue. As a result,
period-to-period comparisons of operating results are not necessarily meaningful
and should not be relied upon to predict future performance.
The timing of license revenues is related to the completion of implementation
services and product acceptance by the customer, the timing of which has been
difficult to predict accurately. There can be no assurance that Pegasystems will
be profitable on an annual or quarterly basis or that earnings or revenues will
meet analysts' expectations. Fluctuations may be particularly pronounced because
a significant portion of revenues in any quarter is attributable to product
acceptance or license renewal by a relatively small number of customers.
Fluctuations also reflect a policy of recognizing license fee revenue upon
product acceptance or license renewal in an amount equal to the present value of
the total committed license payment due during the term. Customers generally do
not accept products until the end of a lengthy
11
sales cycle and an implementation period, typically ranging from one to six
months but in some cases significantly longer. Risks over which the Company has
little or no control, including customers' budgets, staffing allocation, and
internal authorization reviews, can significantly affect the sales and
acceptance cycles. Changes dictated by customers may delay product
implementation and revenue recognition. The Company's business and financial and
operating results has experienced and may continue to experience significant
seasonality.
The Company will need to develop new products, evolve existing ones, and adapt
to technological change. Technological developments, customer requirements,
programming languages and industry standards change frequently in the Company's
markets. As a result, success in current markets and new markets will depend
upon the Company's ability to enhance current products, to develop and introduce
new products that meet customer needs, keep pace with technological changes,
respond to competitive products, and achieve market acceptance. Product
development requires substantial investments for research, refinement and
testing. There can be no assurance that the Company will have sufficient
resources to make necessary product development investments. Pegasystems may
experience difficulties that will delay or prevent the successful development,
introduction or implementation of new or enhanced products. Inability to
introduce or implement new or enhanced products in a timely manner would
adversely affect future financial performance. The Company's products are
complex and may contain errors. Errors in products will require the Company to
ship corrected products to customers. Errors in products could cause the loss of
or delay in market acceptance or sales and revenue, the diversion of development
resources, injury to the Company's reputation, or increased service and warranty
costs which would have an adverse effect on financial performance.
The Company has historically sold to the financial services market. This market
is consolidating rapidly, and faces uncertainty due to many other factors. The
Company has historically derived a significant portion of its revenue from
customers in the financial services market, and its future growth depends, in
part, upon increased sales to this market. Competitive pressures, industry
consolidation, decreasing operating margins within this industry, currency
fluctuations, geographic expansion and deregulation affect the financial
condition of the Company's customers and their willingness to pay. In addition,
customers' purchasing patterns are somewhat discretionary. As a result, some or
all of the factors listed above may adversely affect the demand by customers.
The financial services market is undergoing intense domestic and international
consolidation. In recent years, several customers have been merged or
consolidated. Future mergers or consolidations may cause a decline in revenues
and adversely affect the Company's future financial performance.
The Company's growth strategy requires expansion into new vertical markets. The
results of this strategy are uncertain. A critical part of the Company's growth
strategy is to continue selling products to markets other than financial
services, such as insurance, telecommunications, and health care. The Company
will need to hire additional personnel with expertise in these other markets and
otherwise invest in people and technologies to facilitate this expansion.
Deterioration in economic or market conditions generally may also adversely
affect the demand by customers in these other markets. There can be no assurance
that the Company will continue to be successful in selling products to these
other markets or in continuing to attract and retain personnel with the
necessary industry expertise. Inability to effectively penetrate these other
markets could have an adverse effect on future financial performance.
If existing customers do not renew, the Company's financial results may suffer.
A significant portion of total revenue has been attributable to license
renewals. While historically a substantial majority have been renewed, there can
be no assurance that a substantial majority of customers will continue to renew
expiring licenses. A decrease in license renewals absent offsetting revenue from
other sources would have a material adverse effect on future financial
performance. In addition, possible transition to a prepaid extended term license
may have a material adverse impact on the amount of license renewal revenues in
future periods.
The Company depends on certain key personnel, and must be able to attract and
retain qualified personnel in the future. The business is dependent on a number
of key, highly skilled technical, managerial, consulting, sales and marketing
personnel, including Mr. Trefler, the Company's President and Chief Executive
Officer. The loss of key personnel could adversely affect financial performance.
No employee is party to an employment contract with Pegasystems, although each
is typically subject to a non-disclosure and non-competition agreement. The
Company does not have any significant key-man life insurance on any officers or
employees and does not plan to put any in place. The Company's success will
depend in large part on the ability to hire and retain qualified personnel. The
number of potential employees who have the extensive knowledge of computer
hardware and operating systems needed to develop, sell and maintain our products
is limited, and competition for their services is intense. Competition for
qualified and effective sales personnel is intense, and there can be no
assurance that the Company will be able to attract and retain such personnel. If
the Company is unable to do so, the Company's business, operating results, and
financial condition could be materially and adversely affected.
The market for the Company's offerings is increasingly and intensely
competitive, rapidly changing, and highly fragmented. The market for customer
relationship management software and related consulting and training services is
intensely competitive and highly fragmented. The Company currently encounters
significant competition from internal information
12
systems departments of potential or existing customers that develop custom
software. It also competes with companies that target the customer interaction
and workflow markets and professional services organizations that develop custom
software in conjunction with rendering consulting services. Competition for
market share and pressure to reduce prices and make sales concessions are likely
to increase. Many competitors have far greater resources and may be able to
respond more quickly and efficiently to new or emerging technologies,
programming languages or standards or to changes in customer requirements or
preferences. Competitors may also be able to devote greater managerial and
financial resources to develop, promote and distribute products and provide
related consulting and training services. There can be no assurance that the
Company will be able to compete successfully against current or future
competitors or that the competitive pressures faced by the Company will not
materially and adversely affect its business, operating results, and financial
condition.
The Company must manage increased business complexity and growth effectively.
The business has grown in size, geographic scope and complexity and product
offerings and the customer base have expanded. This growth and expansion have
placed, and are expected to continue to place, a significant strain on
management, operations and capital needs. Continued growth will require the
Company to hire, train and retrain many employees in the United States and
abroad, particularly additional sales and financial personnel. The Company will
also need to enhance its financial and managerial controls and reporting
systems. There can be no assurance that the Company will attract and retain the
personnel necessary to meet our business challenges. Failure to manage growth
effectively may adversely affect future financial performance.
The Company will have to attract and retain effective sales personnel.
Competition for qualified sales personnel is intense, and there can be no
assurance that the Company will be able to attract and retain such personnel. If
the Company is unable to attract and retain effective sales personnel on a
timely basis, the Company's business, operating results, and financial condition
could be materially and adversely affected.
"Year 2000" issues may affect the Company's operations, demand for its
offerings, and future results. The "Year 2000" problem is pervasive and complex
and is discussed in Management's Discussion and Analysis of Financial Condition
and Results of Operations. Year 2000 issues could have an adverse effect on
Pegasystems in a number of ways. Pegasystems' customers rely on date-sensitive
operations to calculate internal data and to service their customers. There can
be no assurance that the Company's products will not contain errors or defects
affecting Year 2000 problems or that litigation involving Pegasystems will not
arise out of such problems. In addition, the Company also uses other companies'
products as part of market offerings and for internal use; these programs may
also be affected. As a result of efforts to correct or patch their current
systems, customers may have fewer funds available to purchase the Company's
products. Also, the Y2K issue may divert current and potential customers' time,
attention and resources away from those projects which typically lead to
purchases of the Company's products or services.
The Company relies on certain third party relationships. The Company has a
number of relationships with third parties that are significant to sales,
marketing and support activities and product development efforts. The Company
relies on relational database management system applications and development
tool vendors, software and hardware vendors, and consultants to provide
marketing and sales opportunities for the direct sales force and to strengthen
the Company's products through the use of industry-standard tools and utilities.
The Company has also recently begun establishing relationships with third
parties that will distribute its products. In particular, the Company relies on
its relationship with First Data Corporation for the distribution of products to
the credit card and mutual fund markets. There can be no assurance that these
companies, most of which have significantly greater financial and marketing
resources, will not develop or market products that compete with those of the
Company in the future or will not otherwise end their relationships with or
support of the Company.
The Company may face product liability and warranty claims. The Company's
license agreements typically contain provisions intended to limit the nature and
extent of the Company's risk of product liability and warranty claims. There is
a risk that a court might interpret these terms in a limited way or could hold
part or all of these terms to be unenforceable. Also, there is a risk that these
contract terms might not bind a party other than the direct customer.
Furthermore, some of the Company's licenses with its customers are governed by
non-U.S. law, and there is a risk that foreign law might give the Company less
or different protection. Although the Company has not experienced any material
product liability claims to date, a product liability suit or action claiming a
breach of warranty, whether or not meritorious, could result in substantial
costs and a diversion of management's attention and the Company's resources.
The EURO's adoption imposes product and market risks. A new currency, the
"EURO", was introduced in certain Economic and Monetary Union ("EMU") countries
in early 1999. It is expected that by 2002 (at the latest) all participating EMU
countries will use the EURO as their single currency. As a result, software used
by many companies headquartered or maintaining a subsidiary in a participating
EMU country is expected to be EURO-enabled. In less than four years, all
13
companies headquartered or maintaining a subsidiary in an EMU country will need
to be EURO-enabled. These changes will change budgetary, accounting and fiscal
systems in companies and public administration, and require the simultaneous
handling of parallel currencies and conversion of legacy data. These
requirements (and the fact that the final rules and regulations are not yet
available) may curb market demand for the Company's products because the budgets
and priorities of our customers and prospective customers may change. The
Company is monitoring the rules and regulations as they become known in order to
make any changes to its software products that the Company deems necessary to
comply with such rules and regulations. Although the Company believes that its
most recent products address these requirements, there can be no assurance that,
once the final rules and regulations are completed, the Company's software will
contain all of the necessary changes or meet all of the EURO requirements. Any
inability to comply with the EURO requirements could have an adverse effect on
the Company's business, operating results and financial condition.
The Company faces risks from operations and customers based outside of the U.S.
Sales to customers headquartered outside of the United States represented
approximately 22.6%, 16.5%, and 17.7% of the Company's total revenue in 1998,
1997, and 1996, respectively. The Company, in part through its wholly-owned
subsidiaries based in the United Kingdom and in Australia, markets products and
renders consulting and training services to customers based in Canada, the
United Kingdom, France, Switzerland, Ireland, Luxembourg, Mexico, Sweden,
Australia, Austria, and Singapore. The Company has established offices in
continental Europe and in Australia. The Company believes that its continued
growth will necessitate expanded international operations requiring a diversion
of managerial attention and financial resources. The Company anticipates hiring
additional personnel to accommodate international growth, and the Company may
also enter into agreements with local distributors, representatives, or
resellers. If the Company is unable to do one or more of these things in a
timely manner, the Company's growth, if any, in its foreign operations will be
restricted, and the Company's business, operating results, and financial
condition could be materially and adversely affected.
In addition, there can be no assurance that the Company will be able to maintain
or increase international market demand for its products. Most of the Company's
international sales are denominated in U.S. dollars. Accordingly, any
appreciation of the value of the U.S. dollar relative to the currencies of those
countries in which the Company distributes its products may place the Company at
a competitive disadvantage by effectively making its products more expensive as
compared to those of its competitors.
Additional risks inherent in the Company's international business activities
generally include unexpected changes in regulatory requirements, increased
tariffs and other trade barriers, the costs of localizing products for local
markets and complying with local business customs, longer accounts receivable
patterns and difficulties in collecting foreign accounts receivable,
difficulties in enforcing contractual and intellectual property rights,
heightened risks of political and economic instability, the possibility of
nationalization or expropriation of industries or properties, difficulties in
managing international operations, potentially adverse tax consequences
(including restrictions on repatriating earnings and the threat of "double
taxation"), enhanced accounting and internal control expenses, and the burden of
complying with a wide variety of foreign laws. There can be no assurance that
one or more of these factors will not have a material adverse effect on the
Company's foreign operations, and, consequentially, the Company's business,
operating results, and financial condition.
The Company faces risks related to intellectual property claims or appropriation
of its intellectual property rights. The Company relies primarily on a
combination of copyright, trademark and trade secrets laws, as well as
confidentiality agreements to protect its proprietary rights. In October 1998,
the Company was granted a patent by the United States Patent and Trademark
Office relating to the architecture of the Company's systems. There can be no
assurance that such patent will not be invalidated or circumvented or that
rights granted thereunder or the description contained therein will provide
competitive advantages to the Company's competitors or others. Moreover, despite
the Company's efforts to protect its proprietary rights, unauthorized parties
may attempt to copy aspects of the Company's products or to obtain the use of
information that the Company regards as proprietary. In addition, the laws of
some foreign countries do not protect the Company's proprietary rights to as
great an extent as do the laws of the United States. There can be no assurance
that the Company's means of protecting its proprietary rights will be adequate
or that the Company's competitors will not independently develop similar
technology.
The Company is not aware that any of its products infringe the proprietary
rights of third parties. There can be no assurance, however, that third parties
will not claim infringement by the Company with respect to current or future
products. The Company expects that software product developers will increasingly
be subject to infringement claims as the number of products and competitors in
the Company's industry segment grows and the functionality of products in
different industry segments overlaps. Any such claims, with or without merit,
could be time-consuming, result in costly litigation, cause product shipment
delays, or require the Company to enter into royalty or licensing agreements.
Such royalty or licensing agreements, if required, may not be available on terms
acceptable to the Company or at all, which could have a material adverse effect
upon the Company's business, operating results, and financial condition.
14
From time to time, the Company licenses software from third parties for use with
its products. The Company believes that no such license agreement to which it is
presently a party is material and that if any such license agreement were to
terminate for any reason, the Company would be able to obtain a license or
otherwise acquire other comparable technology or software on terms and on a
timetable that would not be materially adverse to the Company.
PART II
Item 5
MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS
The following table sets forth the range of high and low sales prices on the
National Association of Security Dealers Automatic Quotation ("Nasdaq") National
Market System under the Nasdaq symbol PEGA, for 1998 and 1997. As of March 16,
1999, the Company had approximately 72 stockholders of record and approximately
5,200 beneficial owners of the Company's common stock. On March 16, 1999, the
closing sale price of the common stock was $4.63. The Company has never declared
or paid any dividends on its common stock. The Company intends to retain its
earnings to finance future growth, and therefore does not anticipate paying any
dividends in the foreseeable future.
1998 High Low
- --------------------------------------- ------------ --------------
First Quarter $ 26.13 $ 15.38
Second Quarter $ 31.88 $ 16.00
Third Quarter $ 30.63 $ 14.75
Fourth Quarter $ 17.63 $ 3.44
1997 High Low
- --------------------------------------- ------------ --------------
First Quarter $ 39.13 $ 19.38
Second Quarter $ 32.06 $ 16.75
Third Quarter $ 38.50 $ 26.81
Fourth Quarter $ 33.88 $ 15.13
15
Item 6
COMPARISON OF SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data presented below have been derived from
the consolidated financial statements of Pegasystems Inc. ("Pegasystems" or the
"Company"). This data may not be indicative of the Company's future condition or
results of operations and should be read in conjunction with the consolidated
financial statements and related notes included herein.
Years Ended December 31,
----------------------------------------------------------------------------
(in thousands, except per share data) 1998 1997 1996 1995 1994
------------ ------------ ------------ ------------ -----------
Consolidated Statements of Operations Data:
Total revenue $60,406 $44,361 $33,545 $22,247 $16,263
Income (loss) from operations (24,249) (3,388) 10,019 3,257 2,236
Net income (loss) (13,070) 1,085 7,500 2,878 2,193
*Earnings (loss) per share:
Basic $ (0.46) $ 0.04 $ 0.30 $ 0.12 $ 0.09
Diluted $ (0.46) $ 0.04 $ 0.28 $ 0.12 $ 0.09
Weighted average number of common
shares outstanding:
Basic 28,604 28,284 24,802 23,490 23,407
Diluted 28,604 30,268 26,397 23,743 23,472
Years Ended December 31,
(in thousands) 1998 1997 1996 1995 1994
------------ ------------ ------------ ------------ -----------
Consolidated Balance Sheet Data:
Cash and cash equivalents $24,806 $52,005 $24,201 $ 511 $ 456
Working capital 32,870 62,708 34,364 4,393 4,441
Long-term license installments, net 49,000 36,403 23,802 13,399 9,135
Total assets 138,098 127,520 66,855 25,876 20,787
Long-term debt - - - 816 450
Stockholders' equity 100,467 112,721 52,385 14,674 11,872
* Certain of these amounts have been restated in accordance with the adoption of
SFAS No. 128, "Earnings Per Share."
16
Item 7
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
The Company's revenue is derived from two sources: software license fees and
services revenue. License fees are generally payable on a monthly basis under
license agreements, which typically have a five-year term, and may be extended
at the customer's option for an additional fixed period. Such license agreements
are generally non-cancellable, although some may be terminated by the customer
for a fee prior to the expiration of the initial term, but after a minimum
specified period. The Company's license agreements generally provide for annual
license fee increases (the "inflation adjustments") based on recognized
inflation indexes.
License revenue is generally recognized upon the delivery and acceptance of the
licensed software in accordance with the applicable license agreement. The fair
value of all undelivered elements must be deferred at the time of license
revenue recognition. In the case of license agreement renewals or extensions,
revenue is recognized upon execution of the renewal or the extension. The
inflation adjustments are recognized ratably over the periods to which they
apply. The amount of software license revenue recognized is generally equal to
the present value of the license payments due during the minimum initial or
renewal term, plus the present value of any early termination fee.
For the three months ended March 31, 1996, the discount rate for purposes of the
present value calculation was 7%; for the nine months ended December 31, 1996,
such discount rate was 6.75%. Commencing with the three months ended March 31,
1996, the Company established the discount rate quarterly as a function of the
Company's current marginal borrowing rate. In 1997 the discount rate for
purposes of the present value calculation was 7% and for the nine months ended
September 30, 1998, the discount rate for purposes of the present value
calculation was 7%. Commencing with the three months ended December 31, 1998,
the Company established the discount rate monthly as a function of the Company's
current marginal borrowing rate, reduced, with respect to licenses which provide
for inflation adjustments, by 1.5%, reflecting the Company's estimate of future
inflation adjustments during the minimum license term. In the fourth quarter of
1998, the discount rate for purposes of the present value calculation were 6.63%
in October, 6.38% in November and 6.25% in December. The imputed interest
portion of the license fees, which is reported as license interest income in the
Company's consolidated statements of income, is recognized over the term. To
date, a majority of the Company's software licenses have been renewed upon
expiration.
The Company's services revenue is comprised of fees for implementation,
consulting, maintenance and training services. Software license customers are
offered the ability to enter into a maintenance contract requiring the customer
to pay a monthly maintenance fee over the term of the related license agreement
typically equal to approximately 18% of the license fee. Maintenance fees are
recognized ratably over the term of the maintenance agreement. The Company's
software implementation agreements typically require the Company to provide a
specified level of implementation services for a specified fee, typically with
additional implementation services available at an hourly rate. Implementation
fees are often recognized as performed or upon the achievement of specified
milestones. The Company generally recognizes implementation as well as
consulting and training fees as the services are provided.
The Company's international revenues have fluctuated considerably in the past
due to the fact that such revenues have been largely attributable to a small
number of product acceptances during a given period. In 1998, international
revenues increased to 22.6% as a result of renewal of prior agreements and
acceptances of new product for new customers. In 1997, international revenues
increased to $7.3 million as a result of new product acceptances and license
renewals in Europe, Canada and Mexico. In 1996, international revenues increased
to $5.9 million as a result of new customers in Europe.
Most of the Company's contracts are denominated in U.S dollars. The Company
expects that in the future more of its contracts may be denominated in foreign
currencies. The Company has not experienced any significant foreign exchange
gains or losses, and the Company does not expect that foreign currency
fluctuations will significantly affect its financial position or results from
operations. The Company's business has experienced and is expected to continue
to experience significant seasonality and lack of predictable revenues.
Historically, the Company has recognized a greater percentage of its revenue in
its third and fourth quarters than in its first and second quarters due to the
Company's sales commission structure and the impact of that structure on the
timing of product acceptances and license renewals by customers. This pattern is
reinforced by the Company's maintenance contracts, which generally entitle
customers to, among other things, a fixed number of free consulting hours per
calendar year. Once the annual allotment of free consulting hours is exhausted,
customers pay for additional services on a hourly basis. The timing of license
revenues is directly related to the completion of implementation services and
acceptance of the licensed software by the customer, the timing of which has
proven to be difficult to predict accurately.
17
On April 15, 1998, the Company restated its consolidated financial statements
for each of the three unaudited quarters in the nine-month period ended
September 30, 1997. The restatements reflected revenue adjustments as a result
of a change in the timing of revenue recognition on certain contracts. Also
included in the restated consolidated financial statements are operating
expenses, including a provision for bad debts not previously recorded by the
Company and the recording of certain other expenses and reserves.
On October 29, 1998, the Company publicly announced its preliminary, unaudited
results of operations for the three and nine-month periods ended September 30,
1998. Subsequently, based on information that had not previously come to the
attention of the Company or its external auditors, the Company determined that
it may not have accounted properly for certain revenue transactions. As a
result, the Company, with the assistance of its independent auditors, conducted
a comprehensive review of those transactions and others relating to the three
months ended September 30, 1998 and other periods in 1998 and 1997.
Based on such review, the Company concluded that it was necessary to revise its
previously disclosed preliminary, unaudited results of operations for the three
and nine-month periods ended September 30, 1998 and to restate its unaudited
interim financial statements for the first and second quarters of each of 1998
and 1997. The revenue changes are principally reversals of license and service
revenue arising from the inability to estimate fair value of undelivered
elements (implementation services) granted in connection with software license
and implementation service arrangements, issues surrounding the timing of
delivery or acceptance of licensed software, certain project milestones not
being completed and improper or delayed billings. The revenue changes also
reflect an increase in revenue reserves. In the opinion of management, all
material adjustments necessary to correct the consolidated financial statements
have been recorded.
RESULTS OF OPERATIONS
The following table sets forth for the years indicated the percentage of total
revenue represented by certain items reflected in the Statements of Operations
of the Company:
Years Ended December 31,
------------------------------------------------------------
1998 1997 1996
----------- ------------- ----------------
Revenue:
Software license 48.7% 64.6% 66.4%
Services 51.3 35.4 33.6
----- ------- -------
Total revenue 100.0 100.0 100.0
----- ------- -------
Cost of revenue:
Cost of software license 2.6 0.6 1.4
Cost of services 38.9 26.5 20.8
----- ------- -------
Total cost of revenue 41.5 27.1 22.2
----- ------- -------
Gross profit 58.5 72.9 77.8
----- ------- -------
Operating expenses:
Research and development 38.7 34.1 24.5
Selling and marketing 42.7 39.4 17.9
General and administrative 17.3 7.0 5.5
----- ------- -------
Total operating expenses 98.7 80.5 47.9
----- ------- -------
Income (loss) from operations (40.1) (7.6) 29.9
License interest income 4.4 4.0 4.7
Other interest income 3.4 7.5 1.8
Interest expense -- - (0.3)
----- ------- -------
Income (loss) before (benefit) provision
for income taxes (32.3) 3.9 36.1
Benefit provision for income taxes (10.7) 1.5 13.7
===== ======= =======
Net income (loss) (21.6)% 2.4% 22.4%
===== ======= =======
18
YEAR ENDED DECEMBER 31, 1998 COMPARED TO YEAR ENDED DECEMBER 31, 1997
Revenue
Total revenue for 1998 increased 36.2% to $60.4 million from $44.4 million for
1997. The increase was primarily due to an increase in services revenue.
Software license revenue for 1998 increased 2.6% to $29.4 million from $28.7
million for 1997. The increase in software license revenue was primarily
attributable to software license acceptances by new customers and software
license agreement renewals and extensions by existing customers. Significant
deferrals of license revenue occurred to coincide with the timing of customer
acceptance and the completion of implementation services. Total deferred revenue
increased by approximately $20.0 million, a majority of which related to
software license revenues.
Services revenue for 1998 increased 97.4% to $31.0 million from $15.7 million
for 1997. The increase in services revenue was primarily attributable to
additional consulting services provided to existing customers, increased
implementation services for new customers, and to a lesser extent, increased
maintenance revenue from a larger installed product base. Due to the Company's
ability to enter into a larger software license transactions, the size of
corresponding services revenue transactions has increased.
Cost of Revenue
Cost of software license consists of amortization expense related to the stock
warrant and purchased software costs, royalty payments to such third party
software vendors, and costs of product media, duplication and packaging. Cost of
software license for 1998 increased to $1.6 million from $0.3 million for 1997,
and increased as a percentage of total revenue to 2.6% for 1998 from 0.6% for
1997. As a percentage of software license revenue, cost of software license
increased to 5.4% for 1998 from 0.9% for 1997. Increases were primarily due to
licensing third-party software and amortization costs associated with a stock
purchase warrant issued by the Company in June 1997 which cost is being
amortized through December 31, 2002.
Cost of services consists primarily of the costs of providing implementation,
consulting, maintenance, and training services. Cost of services for 1998
increased 99.0% to $23.4 million from $11.8 million for 1997. Cost of services
as a percentage of total revenue increased to 38.9% for 1998 from 26.5% for 1997
due to the lack of growth in license revenues, and remained constant as a
percentage of services revenue at 75.6% for 1998 and 75.0% for 1997. These
increases in cost of services were mainly due to increased staffing in the
Company's Client Services group worldwide.
Operating Expenses
Research and development expenses consist primarily of the cost of personnel and
equipment needed to conduct the Company's research and development efforts.
Research and development expenses for 1998 increased 54.8% to $23.4 million from
$15.1 million for 1997. The increase in research and development expenses was
due to the hiring of additional development personnel in the Company's research
and development group. As a percentage of total revenue, research and
development expenses increased to 38.7% for 1998 from 34.1% for 1997. These
increases were due to the additional investments in integrating the Company's
products with the Internet and intranets, developing standard application
programming interfaces, and enhancing product quality and ease of use.
Selling and marketing expenses for 1998 increased 47.4% to $25.8 million from
$17.5 million for 1997. As a percentage of total revenue, selling and marketing
expenses increased to 42.7% for 1998 from 39.4% for 1997 as the Company invested
in building its sales force. Such increases were attributable to the hiring of
additional direct sales and marketing personnel and increased sales commission
payments attributable to higher sales. During 1998, the Company continued to
build its sales and marketing infrastructure in its domestic and international
offices.
General and administrative expenses for 1998 increased 234.8% to $10.5 million
from $3.1 million for 1997 and increased as a percentage of total revenue to
17.3% for 1998 from 7.0% for 1997. Such increases were due to increased staffing
in the accounting, computer systems and facilities management groups needed to
support the Company's growth; however, a significant portion of the increase was
due to increased professional fees. Such professional fees were incurred as a
result of additional interim audit services performed in association with the
financial restatements, the year end annual audit and legal costs associated
with ongoing class action litigation.
19
License Interest Income
License interest income, which is the portion of all license fees due and
received under software license agreements that was not recognized upon product
acceptance or license renewal, increased 48.8% to $2.7 million for 1998 from
$1.8 million for 1997, reflecting a larger installed product base and customer
payments.
Other Income
Other income, which consists of interest income generated on cash and cash
equivalents, and mark to market gains or losses on foreign denominated accounts
receivable, decreased 36.4% to $2.1 million for 1998 from $3.3 million for 1997.
This decrease was due to lower cash and cash equivalent balances being invested,
partially offset by gains recognized on the mark to market of foreign
denominated accounts receivable.
Provision for Income Taxes
The benefit for federal, state and foreign income taxes was $6.4 million for
1998. The provision for federal, state and foreign taxes was $0.7 million in
1997. The effective tax rates were (32.9)% and 38.0% for 1998 and 1997,
respectively. At December 31, 1998, the Company had $31.0 million in net
operating loss and AMT and research and development tax credit carryforwards
available to offset future federal taxable income. See Note 9 of Notes to
Consolidated Financial Statements.
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
Revenue
Total revenue for 1997 increased 32.2% to $44.4 million from $33.5 million for
1996. The increase was primarily due to an increase in software license revenue.
Software license revenue for 1997 increased 28.7% to $28.7 million from $22.3
million for 1996. The increase in software license revenue was primarily
attributable to software license acceptances by new customers, software license
agreement renewals, expanded software usage by existing customers, the licensing
of standard product templates, and inflation-based increases in monthly license
fees.
Services revenue for 1997 increased 39.1% to $15.7 million from $11.3 million
for 1996. The increase in services revenue was primarily attributable to
increased demand for implementation and consulting services.
Cost of Revenue
Cost of software license consists of amortization expense related to stock
warrant and capitalized software costs, royalty payments to third party software
vendors, and costs of product media, duplication and packaging. Cost of software
license for 1997 decreased 46.4% to $0.3 million from $0.5 million for 1996, and
decreased as a percentage of total revenue to 0.6% for 1997 from 1.4% for 1996.
As a percentage of software license revenue, cost of software license decreased
to 0.9% for 1997 from 2.1% for 1996. Such decreases were due to decreased
amortization of purchased software costs partially offset by the costs
associated with a stock purchase warrant issued by the Company in June 1997,
which cost is being amortized through December 31, 2002.
Cost of services consists primarily of the costs of providing implementation,
consulting, maintenance, and training services. Cost of services for 1997
increased 68.9% to $11.8 million from $7.0 million for 1996. Cost of services as
a percentage of total revenue increased to 26.6% for 1997 from 20.8% for 1996,
and increased as a percentage of services revenue to 75.0% for 1997 from 61.8%
for 1996. These increases in cost of services were mainly due to increased
staffing in the Company's Client Services group worldwide.
Operating Expenses
Research and development expenses consist primarily of the cost of personnel and
equipment needed to conduct the Company's research and development efforts.
Research and development expenses for 1997 increased 83.8% to $15.1 million from
$8.2 million for 1996. The increase in research and development expenses was due
to the hiring of additional development personnel as well as the depreciation of
purchased capitalized software. As a percentage of total revenue, research and
development expenses increased to 34.0% for 1997 from 24.5% for 1996. The
Company has been increasing spending on sales and marketing more rapidly than
spending in development and intends to continue a strategy of leveraging
existing product functionality by balancing its historical focus on research and
development with an increased emphasis on sales and marketing.
20
Selling and marketing expenses for 1997 increased 191.4% to $17.5 million from
$6.0 million for 1996. As a percentage of total revenue, selling and marketing
expenses increased to 39.4% for 1997 from 17.9% for 1996 as the Company invested
in building its sales force. Such increases were attributable to the hiring of
additional direct sales and marketing personnel, increased sales commission
payments attributable to higher sales, and increased investment in marketing
support activities and materials. During 1997, the Company continued to build
its sales and marketing infrastructure in its domestic and international
offices.
General and administrative expenses consist primarily of the salaries of the
Company's executive, administrative and financial personnel, and associated
expenses. General and administrative expenses for 1997 increased 68.2% to $3.1
million from $1.9 million for 1996 due to increased investment in the
infrastructure needed to support the Company's growth. Such expenses increased
as a percentage of total revenue to 7.0% for 1997 from 5.5% for 1996 due to the
Company's investment in infrastructure.
License Interest Income
License interest income represents the portion of all license fees due under
software license agreements which was not recognized upon product acceptance or
license renewal. License interest income for 1997 increased 14.3% to $1.8
million from $1.6 million for 1996, reflecting a larger installed product base.
Provision for Income Taxes
The provisions for federal, state and foreign taxes were $0.7 million and $4.6
million for 1997 and 1996, respectively. The effective tax rates were 38.0% for
1997 and 38.1% for 1996. At December 31, 1997, the Company had $9.1 million in
net operating loss and research and development tax credit carryforwards
available to offset future federal taxable income
LIQUIDITY AND CAPITAL RESOURCES
From inception until the Company's initial public offering of Common Stock, the
Company funded its operations primarily through cash flow from operations and
bank borrowings. In July 1996, the Company issued and sold 2.7 million shares of
Common Stock in connection with its initial public offering. Net proceeds to the
Company from such offering were approximately $29.4 million. In January 1997,
the Company issued and sold 1.8 million shares of Common Stock in connection
with a second public offering. Net proceeds to the Company from such second
public offering were approximately $51.9 million. At December 31, 1998, the
Company had cash and cash equivalents of approximately $24.8 million and working
capital of approximately $32.9 million.
Net cash used by operating activities for the years ended December 31, 1998,
1997 and 1996 was $20.0 million, $10.0 million and $2.9 million, respectively.
The increase in cash used in operating activities was primarily attributable to
a 1998 net loss of $19.4 million and a $36.8 million increase in accounts
receivable, partially offset by increases in deferred revenue, and accounts
payable and accrued expenses. The Company's accounts receivable increased due to
larger sales volume and deterioration in the age of the accounts receivable. The
increase of cash used in operating activities was also attributable to the costs
associated with the significant increase in new employees during the year ended
December 31, 1998, some of whom, especially those in the Company's Sales and
Client Services groups, require months of training and experience before they
are able to generate revenue. Additionally, the Company's method of licensing
its software over a 60 month period with payments made in monthly installments
over the license term results in significant cash utilization during periods of
rapid growth because a substantial portion of the associated expenses are
incurred prior to the commencement of the license term. The Company is currently
taking a number of steps to reduce the amount of cash used in operating
activities, including improving billings practices in order to reduce the time
between when services are performed and when such services are billed,
intensifying collection efforts on past due accounts, exploring the possible
securitization of license receivables, hiring new employees on a more selective
basis and implementing more stringent cost controls, including reducing
unnecessary personnel. The company has incurred severance committments of
approximately $0.3 million in connection with the termination of approximately
60 employees.
Net cash used by investing activities for the years ended December 31, 1998,
1997 and 1996 was $7.5 million, $14.5 million and $2.0 million, respectively.
This cash was used mainly to support the purchase of development software, in
addition to the purchase of property and equipment consisting mainly of computer
hardware and software, and furniture and fixtures to support the expansion of
certain facilities and the Company's growing employee base.
Net cash provided by financing activities for the years ended December 31, 1998,
1997 and 1996 was $0.4 million, $52.6 million and $28.5 million, respectively.
This cash was provided mainly as a result of the Company completing an initial
public stock offering in 1996, a secondary public stock offering in 1997
and, to a lesser extent, the exercise of stock options.
21
In addition to cash used for investing activities, the Company has operating
leases for office space and equipment. At December 31, 1998, the Company's
commitments under non-cancellable operating leases for office space with terms
in excess of one year totaled $4.6 million, $4.2 million and $4.2 million for
1999, 2000 and for 2001, respectively. The Company's total expense under such
leases was $2.6 million, $1.4 million and $1.0 million for 1998, 1997 and 1996,
respectively. See Note 8 of Notes to Consolidated Financial Statements.
As of December 31, 1998, the Company had a working capital line of credit, which
expires on June 30, 1999, with a bank allowing for borrowings up to $5.0 million
at the bank's prime rate (7.25% at December 31, 1998). Borrowings are subject to
various covenants which call for a specified level of working capital and net
worth, maintenance of certain financial ratios and restrictions on the payments
of dividends. As of December 31, 1998, the Company was in compliance with all
covenants, except for the profitability financial covenant, for which the
Company received a non-compliance waiver. The Company intends to renegotiate the
term and the covenant requirements under the existing line of credit with the
same bank. See Note 5 of Notes to Consolidated Financial Statements.
The Company recorded bad debt expense in the amounts of $2.2 million, $1.9
million and $0.3 million in 1998, 1997, and 1996, respectively, to provide for
the risk of non-payment of certain receivables, relating primarily to consulting
and installation services rendered by the Company.
The Company believes that current cash and cash equivalents will be sufficient
to fund the Company's operations for the near term. There can be no assurance
that additional capital which may be required to support further revenue growth
will not be required or that any such required additional capital will be
available on reasonable terms, if at all, at such time as required by the
Company.
Effect of "Year 2000" Issues.
The "Year 2000" problem is pervasive and complex, as virtually every computer
operation will be affected in some way by the rollover of the two-digit year
value to "00." The issue is whether computer systems will properly recognize
date sensitive information when the year changes to 2000. Systems that do not
properly recognize such information (or other date changes) could generate
erroneous data or fail. Pegasystems' customers rely on date-sensitive operations
to calculate internal data and to service their customers. In addition, the
Company also uses other companies' products as part of market offerings and for
internal use; these programs may also be affected by the issue.
Year 2000 readiness issues may negatively affect the purchasing patterns of
existing and potential customers. Many organizations are spending significant
amounts and rededicating personnel to correct or patch their current systems to
achieve Year 2000 readiness. Thus, fewer funds may be available to purchase the
Company's products. Also, the issue may divert customers' and potential
customers' time, attention, and resources away from those projects which
typically lead to purchases of products or services. The Company does not
believe that there is any practical way to ascertain the extent of, and has no
plans to address problems associated with, any such reduction in purchasing
resources of its customers. Any such reduction could, however, result in a
material adverse effect on the Company's business, operating results and
financial condition.
Pegasystems has designed and tested current versions of its products to be
consistent with use after Year 2000. However, some customers are using earlier
product versions. In addition the Company's products are generally integrated
with the systems and products of its customers developed by other vendors. Year
2000 problems in these systems and products might significantly limit the
ability of the Company's customers to realize the intended benefit offered by
the Company's products. The Company may in the future be subject to claims based
on Year 2000 problems in others' products or issues arising from the integration
of multiple products within an overall system. Although the Company has not been
involved in any litigation or proceeding to date involving its products or
services related to Year 2000 issues, there can be no assurance that the Company
will not in the future be required to defend its products or services or to
negotiate resolutions of claims based on Year 2000 issues. The costs of
defending and resolving Year 2000-related disputes, and any liabilities of the
Company for Year 2000-related damages could have a material adverse effect on
the Company business, operating results and financial condition.
The Company also relies on certain computer technology and software that it
licenses form third parties, including software that is integrated with the
Company's products. These programs may also present Year 2000 problems. Although
the Company has not experienced any significant product claims to date, there
can be no assurance that unanticipated errors or defects will not result in
product liability or other claims in the future. Failure of third-party software
comprising any part of the Company's systems to operate properly with regard to
Year 2000 and thereafter could require the Company to incur unanticipated
expenses to address associated problems, which could have a material adverse
effect on the Company's business, operating results and financial condition.
22
The Company has adopted standard industry practices to prepare for the effect of
the upcoming date change on internal data and information technology systems
(such as communications, development, accounting, billing, and other systems).
The Company's Year 2000 internal readiness program primarily covers: taking
inventory of hardware, software and embedded systems, assessing business and
customer satisfaction risks associated with such systems, creating action plans
to address known risks, executing and monitoring action plans, and contingency
planning. Pegasystems expects to substantially complete Year 2000 readiness
preparations by the end of the second quarter of 1999 with respect to core
business systems.
Although the Company does not believe that it will incur any material costs or
experience material disruptions in its business associated with preparing its
internal systems for the year 2000, there can be no assurances that the Company
will not experience serious unanticipated negative consequences and/or material
costs caused by undetected errors or defects in the technology used in its
internal systems. The most reasonably likely worst case scenarios would include:
(i) corruption of data contained in internal information systems, (ii) hardware
failure, and (iii) the failure of infrastructure services provided by government
agencies and other third parties (e.g., electricity, phone service, water
transport, Internet services, etc.). The Company is in the process of completing
contingency planning for high risk areas (such as accounting, payroll, and
invoicing/billing systems) at this time and has commenced contingency planning
relating to other areas. The Company expects contingency plans to include, among
other things, manual "work-arounds" for software and hardware failures, as well
as substitution of systems, if necessary.
INFLATION
Inflation has not had a significant impact on the Company's operating results to
date, and the Company does not expect it to have a significant impact in the
future. The Company's license and maintenance fees are typically subject to
annual increases based on recognized inflation indexes.
SIGNIFICANT CUSTOMERS
In 1998, the Company had one customer that accounted for 17.7% of the Company's
consolidated revenue. In 1997, the Company had two customers that accounted for
13.7% and 10.0%, respectively, of the Company's consolidated revenue. In 1996,
the Company had three customers that accounted for 14.5%, 11.4% and 10.5%,
respectively, of the Company's consolidated revenue.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Annual Report may be construed as
"forward-looking statements" as defined in the Private Securities Litigation
Reform Act of 1995. These statements involve various risks and uncertainties
which could cause the Company's actual results to differ from those expressed in
such forward-looking statements. These risks and uncertainties include the
effect of losses from prior periods, liquidity issues, pending litigation and
regulatory proceedings, recent adverse publicity, seasonal variation of the
Company's operations and fluctuations in the Company's quarterly results, rapid
technological change involving the Company's products and those of competitors,
delays in product development and implementation, the technological
compatibility of the Company's products with its customers' systems, the
Company's dependence on customers in the financial services market, intense
competition in the markets for the Company's products, risk of non-renewal by
current customers, management of the Company's growth, and other risks and
uncertainties. These statements are based on estimates, projections, beliefs,
and assumptions of the Company and its management and are not guarantees of
future performance. Further information regarding those factors that could cause
the Company's actual results to differ materially from any forward-looking
statements contained herein is included in the Company's report on Form 10-K for
the year ended December 31, 1998, which has been filed with the Securities and
Exchange Commission.
23
Item 7A
QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Market risk represents the risk of loss that may affect the consolidated
financial statements of the Company due to adverse changes in financial market
prices and rates. The Company's market risk exposure is primarily the result of
fluctuations in foreign exchange rates. The Company has not entered into
derivative or hedging transactions to manage risk in connection with such
fluctuations.
The Company derived approximately 22.6% of its total revenue in 1998 from sales
to customers based outside of the United States. Certain of the Company's
international sales are denominated in foreign currencies. The price in dollars
of products sold outside the United States in foreign currencies will vary as
the value of the dollar fluctuates against such foreign currencies. Although the
Company's sales denominated in foreign currencies in 1998 were not material,
there can be no assurance that such sales will not be material in the future and
that there will not be increases in the value of the dollar against such
currencies that will reduce the dollar return to the Company on the sale of its
products in such foreign currencies.
Item 8
FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Financial statement schedules are set forth in Item 14, "Exhibits, Financial
Statement Schedules, and Reports on Form 8-K of this Form 10-K and are filed
herewith.
Item 9
CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE
None
24
PART III
Item 10
DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
. Information relating to the executive officers of the Company is set forth in
Part I, immediately following Item 4, of this Report under the caption
"Executive Officers of the Registrant." The following information is furnished
with respect to each Director.
Edward A. Maybury, 59, has been a Director of the Company since its
organization in 1983. Since July 1991, he has served as a Director, and from
July 1991 through May 1993 was the President and Chief Executive Officer, of
Creative Systems, Inc., a software and services company. Prior thereto, Mr.
Maybury was the Chief Executive Officer of Data Architect Systems, Inc., a
software and services company.
Leonard A. Schlesinger, 46, has been a Director of the Company since
June 1996. Professor Schlesinger is Professor of Sociology and Public Policy
and Senior Vice President for Development at Brown University. From 1988 through
1998, he was a Professor of Business Administration at the Harvard Business
School where he was chairman of the Service Management Group, an
interdisciplinary faculty group that focuses on customer service. Professor
Schlesinger is also a Director of The Limited, Inc., a specialty retailer,
Borders Group, Inc., a book, music and video retailer, and GC Companies, Inc., a
movie exhibition and investments company.
Edward B. Roberts, 63, has been a Director of the Company since June
1996. Since 1961, he has been the David Sarnoff Professor of Management of
Technology at the Massachusetts Institute of Technology. He was co-founder and
chairman, from 1963 until June 1995, of Pugh-Roberts Associates, Inc., an
international management consulting firm specializing in strategic planning and
technology management. In addition, Dr. Roberts co-founded and is a Director of
Medical Information Technology, Inc., a provider of hospital information
systems. Dr. Roberts is also a Director of Advanced Magnetics, Inc., a medical
imaging company, Selfcare, Inc., a manufacturer of home medical diagnostic
products, and is a general partner of Zero Stage Capital, a venture capital
firm.
Thomas E. Swithenbank, 54, has been a Director of the Company since
June 1996. From 1990 to 1998, he was President and Chief Executive Officer
of Harte-Hanks Data Technologies, a computer software and servicing company
specializing in database marketing systems. Prior thereto, Mr. Swithenbank was
President of International Data Corporation, a world-wide computer marketing
consulting firm. Mr. Swithenbank has an A.B. from Harvard University and an
M.B.A. from the Harvard Business School.
Alan Trefler, 43, a founder of the Company, has served as President and
Clerk and has been a Director since the Company's organization in 1983. Prior
thereto, he managed an electronic funds transfer product for TMI Systems
Corporation, a software and services company. Mr. Trefler holds a degree in
economics and computer science from Dartmouth College.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 (the "1934 Act")
requires the Company's Directors and executive officers, and persons who own
more than ten percent of the Company's Common Stock, to file reports with the
Securities and Exchange Commission (the "SEC") disclosing their ownership of
stock in the Company and changes in such ownership. Copies of such reports are
also required to be furnished to the Company.
To the Company's knowledge, based solely on review of the copies of the
above-mentioned reports furnished to the Company and written representations
that no other reports were required, during 1998 all such filing requirements
were complied with in a timely fashion.
Item 11
EXECUTIVE COMPENSATION
DIRECTOR COMPENSATION
Each non-employee Director of the Company receives $1,000 for every
Board or committee meeting attended. The Company also reimburses non-employee
Directors for expenses incurred in attending Board meetings. In addition,
non-employee Directors of the Company are eligible to receive stock options
under the 1996 Non-Employee Director Stock Option Plan. No other compensation is
paid to Directors for attending Board or committee meetings. Messrs. Maybury,
Roberts, Schlesinger and Swithenbank are currently the non-employee Directors of
the Company
EXECUTIVE COMPENSATION
The following table sets forth all compensation awarded to, earned by or paid
for services rendered to the Company in all capacities during the years ended
December 31, 1998, 1997 and 1996 by (i) the Company's Chief Executive Officer
and
25
(ii) the four most highly compensated other executive officers (collectively,
the "Named Executive Officers"):
Summary Compensation Table
Annual Compensation (1)
-------------------------------------- All Other
Name and Principal Positions Year Salary ($) Bonus ($) Compensation ($)
- -------------------------------------------------------------------------------------------------------------------------
Alan Trefler 1998 $200,000 - -
President 1997 $200,000 - -
1996 188,333 (2) $ 38,759 (3) $ 15,000 (4)
Joseph J. Friscia 1998 $180,000 70,000 -
Vice President of Sales and Marketing 1997 143,333 47,250 (5) 10,786 (4)
1996 125,000 94,730 (6) -
Eugene A. Bonte 1998 $140,000 25,000 -
Vice President of Market Strategy and Delivery (7) 1997 129,167 21,000 (5) -
1996 86,897 31,149 (6) -
Michael R. Pyle 1998 $140,000 15,000 -
Vice President of Applications Development 1997 120,000 15,750 (5) 8,587 (4)
1996 111,250 41,285 (8) -
Ira Vishner 1998 $125,000 10,000 10,000 (4)
Vice President, Corporate Services, Treasurer, 1997 120,000 10,500 (5) 19,441 (4)
Chief Financial Officer (9) 1996 110,667 30,169 (8) -
- -----------------
(1) In accordance with the rules of the Securities and Exchange Commission,
other compensation in the form of perquisites and other personal benefits
has been omitted because the aggregate amount of such perquisites and other
personal benefits constituted less than the lesser of $50,000 or 10% of the
total of annual salary and bonuses for each of the Named Executive Officers
for 1998, 1997 and 1996.
(2) Includes $8,333 earned between August and December 1996 and paid in
February 1997.
(3) Represents bonus earned between July 1995 and June 1996 and paid in
February 1997.
(4) Represents payments in lieu of paid days off.
(5) Represents bonus earned between July 1996 and December 1997 and paid in
1998.
(6) Represents bonus earned in 1996 and paid in February 1997.
(7) Mr. Bonte has indicated his intention to resign from the Company on
May 21, 1999.
(8) Represents bonus earned between July 1995 and June 1996 and paid in 1996.
(9) Mr. Vishner's employment with the Company terminated in January 1999.
26
Option Grants
The following table provides certain information concerning grants of options to
purchase the Company's Common Stock made during the fiscal year ending December
31, 1998, to each of the Named Executive Officers:
Option Grants in Fiscal 1998
Individual Grants
---------------------------------------------------------------------
Potential Realizable Value
Number of Percent of at Assumed Annual Rates
Shares Total Options of Stock Price Appreciation
Underlying Granted to Exercise or for Option Term (1)
Options Employees In Base Price Expiration --------------------------------
Name Granted (#) (2) Fiscal Year ($/Share) Date 5% ($) 10% ($)
- ----------------------- ----------------- ---------------- --------------- ------------ --------------- ---------------
Alan Trefler - - - - - -
Joseph J. Friscia 60,000 1.0% $7.75 10/15/08 $292,434 $744,090
Eugene A. Bonte 25,000 0.4 7.75 10/15/08 121,848 308,788
Michael R. Pyle 25,000 0.4 7.75 10/15/08 121,848 308,788
Ira Vishner 20,000 0.3 7.75 10/15/08 97,478 247,030
- -----------------
(1) As required by the rules of the Securities and Exchange Commission,
potential values stated are based on the prescribed assumption that the
Company's common stock will appreciate in value from the date of grant to
the end of the option term at rates (compounded annually) of 5% and 10%,
respectively, and therefore are not intended to forecast possible future
appreciation, if any, in the price of the Company's common stock.
(2) These options vest over a five year term, with twenty percent of the total
grant vesting on the first anniversary date of the grant, and quarterly
vests thereafter.
Aggregated Option Exercises and Year-End Option Table
The following table sets forth certain information concerning options exercised
during 1998 and the number and value of unexercised stock options held by each
of the Named Executive Officers as of December 31, 1998.
Aggregated Option Exercises in Last Fiscal Year and Year-End Option Values
Number of Shares Value of Unexercised
Underlying Unexercised In-the-Money Options
Options at Year-End At Year-End ($)
----------------------------------- --------------------------------
Shares Value
Acquired on Realized
Name Exercise (#) ($) Exercisable Unexercisable Exercisable Unexercisable
- ---------------------------------------------------------------------------------------------------------------------------
Alan Trefler - - - - - -
Joseph J. Friscia - - 267,000 238,000 903,715 206,782
Eugene A. Bonte - - 18,000 154,000 - -
Michael R. Pyle 25,000 $620,583 125,900 143,200 482,109 165,426
Ira Vishner - - 5,000 75,000 - -
27
Compensation Committee Interlocks and Insider Participation
Prior to May 1996, decisions concerning compensation of executive
officers were made by the Board of Directors which included Mr. Trefler, the
President of the Company, and Mr. Vishner, a Vice President and the Chief
Financial Officer of the Company. In May 1996, the Company established the
Compensation Committee. No executive officer of the Company has served as a
Director or member of the compensation committee (or other committee serving an
equivalent function) of any other entity, whose executive officers served on the
Company's Board of Directors or Compensation Committee.
28
Item 12
SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
PRINCIPAL AND MANAGEMENT STOCKHOLDERS
The following table sets forth certain information as of February 15,
1999, with respect to the beneficial ownership of Common Stock of the Company by
(i) each person known by the Company to be the beneficial owner of more than 5%
of the outstanding Common Stock of the Company, (ii) each Director of the
Company, (iii) the CEO and the four other most highly compensated executive
officers and (iv) all executive officers and Directors of the Company as a
group. To the knowledge of the Company, based on information provided by such
owners, all persons listed below have sole voting and investment power with
respect to their shares of Common Stock except to the extent authority is shared
by spouses under applicable law.
Name of Number of Shares Percentage of Shares
Beneficial Owner Beneficially Owned (1) Beneficially Owned
Alan Trefler (2) 21,237,100 74.0%
Joseph J. Friscia (3) 298,000 1.0
Eugene A. Bonte (3) 54,000 *
Michael R. Pyle (3) 280,800 *
Ira Vishner 224,700 *
Edward A. Maybury (3) 17,600 *
Edward B. Roberts (4) 17,000 *
Leonard A. Schlesinger (3) 12,000 *
Thomas E. Swithenbank (3) 12,000 *
All executive officers and Directors
as a group (11 persons) (5) 22,388,200 78.0%
- -----------------
* Represents beneficial ownership of less than 1% of the outstanding Common
Stock.
(1) The number of shares of Common Stock deemed outstanding includes (i)
28,683,100 shares of Common Stock outstanding as of February 15, 1999 and
(ii) 18,000 shares issuable pursuant to outstanding options held by the
respective person or group which are exercisable within 60 days of February
15, 1999, as set forth below.
(2) Includes 375,000 shares held in trust with respect to which Mr. Trefler has
voting and dispositive power. Mr. Trefler disclaims beneficial interest.
(3) Consists solely of shares of Common Stock subject to stock options
exercisable within 60 days of February 15, 1999.
(4) Includes 6,000 shares of Common Stock subject to stock options exercisable
within 60 days of February 15, 1999.
(5) Includes 680,400 shares of Common Stock subject to stock options exercisable
within 60 days of February 15, 1999.
29
Item 13
CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
CERTAIN TRANSACTIONS
Since December 31, 1996 there have been no transactions involving more
than $60,000, nor are any proposed, between the Company and any executive
officer, Director, 5% beneficial owner of the Company's Common Stock or
equivalents, or any immediate family member of any of the foregoing, in which
any such persons or entities had or will have a direct or indirect material
interest.
The Company has adopted a policy whereby all future transactions between the
Company and its officers, Directors, principal stockholders and their affiliates
will be on terms no less favorable to the Company than could be obtained from
unrelated third parties and will be approved by a majority of the disinterested
members of the Company's Board of Directors. No such transactions are currently
being considered.
PART IV
Item 14
EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1) Financial Statements
The following consolidated financial statements are required to be filed by Item
8 of this Form 10-K and are filed herewith as noted below.
Item
Consolidated Balance Sheets at December 31, 1998 and 1997
Consolidated Statements of Operations for the years ended December
31, 1998, 1997, and 1996
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1998, 1997, and 1996
Consolidated Statements of Cash Flows for the years ended December
31, 1998, 1997, and 1996
Notes to Consolidated Financial Statements
Reports of Independent Public Accountants
(2) Financial Statement Schedules
All financial statement schedules are omitted because the required
information is not present or not present in sufficient amounts to require
submission of the schedule or because the information is reflected in the
consolidated financial statements or notes thereto.
(3) Exhibits
The exhibits filed as part of this Report are listed in the Exhibit Index
immediately following the financial statement schedule included in this Report.
30
(b) Reports on Form 8-K
On November 25, 1998, the Company filed a report on Form 8-K with the Commission
to announce the delaying of its filing on Form 10-Q for the quarter ended
September 30, 1998.
On January 8, 1999, the Company filed a report on Form 8-K with the Commission
to announce that Ira Vishner had resigned from his positions with the Company,
effective January 4, 1999.
31
SIGNATURES
Pursuant to the requirements to Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this Annual Report on Form 10-K to
be signed on its behalf by the undersigned, thereunto duly authorized.
PEGASYSTEMS INC.
Date: April 15, 1999
By: /s/ Richard B. Goldman
------------------------------------
Richard B. Goldman, Vice President,
Chief Financial Officer and Treasurer
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual
Report on Form 10-K has been signed below on April15, 1999 by the following
persons on behalf of the Registrant and in the capacities indicated.
/s/ Alan Trefler
- -------------------------------- President, Clerk and Director (principal
Alan Trefler executive officer)
/s/ Richard B. Goldman
- -------------------------------- Vice President, Chief Financial Officer
Richard B. Goldman and Treasurer (principal financial
officer and principal accounting officer)
/s/ Edward A. Maybury
- -------------------------------- Director
Edward A. Maybury
/s/ Edward B. Roberts
- -------------------------------- Director
Edward B. Roberts
/s/ Leonard A. Schlesinger
- -------------------------------- Director
Leonard A. Schlesinger
/s/ Thomas E. Swithenbank
- -------------------------------- Director
Thomas E. Swithenbank
32
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS ON SUPPLEMENTARY SCHEDULE
To the Board of Directors of Pegasystems Inc.:
We have audited the accompanying consolidated balance sheets of Pegasystems Inc.
as of December 31, 1998 and 1997 and the related consolidated statements of
operations, stockholders' equity, and cash flows for each of the two years in
the period ended December 31, 1998. These consolidated financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion on these consolidated 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.
As further discussed in Note 10, two class action lawsuits have been filed by
certain stockholders against the Company and certain of its current and former
officers and directors, the outcome of which are uncertain at this time.
Management believes that it is possible that the Company may be required to pay
substantial damages or settlement costs which could have a material adverse
effect on the Company's financial position or results of operations. In
addition, regardless of the outcome of any of these actions, it is likely that
the Company will incur substantial defense costs and that such actions will
cause a diversion of management's time and attention. The Company's delays in
SEC filings and adjustments made to previously published financial statements
have resulted in negative publicity for the Company. Such events and related
publicity have adversely affected demand for the Company's products and services
and may also have an adverse effect on the Company's financial position or
results of operations.
In our opinion. the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Pegasystems Inc. at December 31, 1998 and 1997, and the consolidated results of
its operations and its cash flows for each of the two years in the period ended
December 31, 1998 in conformity with generally accepted accounting principles.
/s/ Arthur Andersen LLP
Boston, Massachusetts
April 15, 1999
33
Report of Independent Auditors
To the Board of Directors of
Pegasystems Inc.:
We have audited the accompanying consolidated statements of operations,
stockholders' equity, and cash flows of Pegasystems Inc. for the year ended
December 31, 1996. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated results of operations and
cash flows of Pegasystems Inc. for the year ended December 31, 1996, in
conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
Boston, Massachusetts
February 24, 1997
PEGASYSTEMS INC.
Exhibit Index
Exhibit No. Description
3.3.* Restated Articles of Organization of the Registrant.
3.4.* Restated By-Laws of the Registrant.
4.1.* Specimen certificate representing the Common Stock.
10.1.* Amended and Restated 1994 Long-Term Incentive Plan.
10.2.* 1996 Non-Employee Director Stock Option Plan.
10.3.* 1996 Employee Stock Purchase Plan.
10.4.* Loan Agreement dated as of December 16, 1993 between the
Registrant and Fleet Bank of Massachusetts, N.A.
10.5.* Loan Modification Agreement dated as of May 5, 1995 between the
Registrant and Fleet Bank of Massachusetts, N.A.
10.6.* Second Loan Modification Agreement dated May 15, 1996 between
the Registrant and Fleet National Bank (successor by merger
to Fleet Bank of Massachusetts, N.A.).
10.11.* Promissory Note dated May 15, 1996 in the amount of $5,000,000
made by the Registrant to the order of Fleet National Bank.
10.13.* Lease Agreement dated February 26, 1993 between the Registrant
and Riverside Office Park Joint Venture.
10.14.* Amendment Number 1 to Lease Agreement dated August 7, 1994
between the Registrant and Riverside Office Park Joint
Venture.
10.15.+ Warrant agreement dated June 27, 1997 by and between the
Registrant and First Data Resources Inc.
21.1 Subsidiaries of the Registrant.
23.1. Consent of Arthur Andersen LLP.
23.2. Consent of Ernst & Young LLP.
27.1. Financial Data Schedule-1998.
* Filed as an exhibit to the Registrant's Registration Statement on Form S-1
(Registration No. 333-03807) or an amendment thereto and incorporated herein
by reference to the same exhibit number.
+ Filed as an exhibit to the Registrant's Form 10-K for 1997.
35
PEGASYSTEMS INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share-related data)
December 31,
-------------------------------
Assets 1998 1997
-------- --------
Current assets:
Cash and cash equivalents $24,806 $52,005
Trade and installment accounts receivable, net of
allowance for doubtful accounts of $2,753 in
1998 and $2,200 in 1997 42,316 20,319
Prepaid expenses and other current assets 2,427 1,514
-------- --------
Total current assets 69,549 73,838
Long-term license installments, net 49,000 36,403
Equipment and improvements, net 10,044 5,578
Purchased software and other, net 9,505 11,701
-------- --------
Total assets $138,098 $127,520
======== ========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses $14,842 $5,398
Deferred revenue 21,714 1,754
Deferred income taxes - 3,978
Current portion of capital lease obligations 123 -
-------- --------
Total current liabilities 36,679 11,130
Commitments and contingencies (Notes 8 and 10)
Deferred income taxes 750 3,669
Capital lease obligations, net of current portion 202 -
Stockholders' equity:
Preferred stock, $.01 par value, 1,000,000 shares
authorized; no shares issued and outstanding - -
Common stock, $.01 par value, 45,000,000 shares authorized; 28,683,100
shares and 28,545,100 shares issued and outstanding in 1998
and 1997, respectively 287 285
Additional paid-in capital 87,757 86,841
Deferred compensation (36) (55)
Stock warrant 2,897 2,897
Retained earnings 10,037 23,107
Cumulative foreign currency translation adjustment (475) (354)
-------- --------
Total stockholders' equity 100,467 112,721
-------- --------
Total liabilities and stockholders' equity $138,098 $127,520
======== ========
The accompanying notes are an integral part of
these consolidated financial statements
37
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
Years Ended December 31, 1998 1997 1996
--------- -------- --------
Revenue:
Software license $29,409 $28,657 $22,258
Services 30,997 15,704 11,287
--------- -------- --------
Total revenue 60,406 44,361 33,545
--------- -------- --------
Cost of revenue:
Cost of software license 1,598 256 477
Cost of services 23,449 11,782 6,975
--------- -------- --------
Total cost of revenue 25,047 12,038 7,452
--------- -------- --------
Gross profit 35,359 32,323 26,093
Operating expenses:
Research and development 23,380 15,104 8,218
Selling and marketing 25,769 17,483 5,999
General and administrative 10,459 3,124 1,857
--------- -------- --------
Total operating expenses 59,608 35,711 16,074
--------- -------- --------
Income (loss) from operations (24,249) (3,388) 10,019
License interest income 2,662 1,789 1,565
Other interest income 2,059 3,348 619
Other income (expense), net 47 - (85)
--------- -------- --------
Income (loss) before provision (benefit) for
income taxes (19,481) 1,749 12,118
Provision (benefit) for income taxes (6,411) 664 4,618
========= ======== ========
Net income (loss) ($13,070) $1,085 $7,500
========= ======== ========
Earnings (loss) per share:
Basic ($0.46) $0.04 $0.30
========= ======== ========
Diluted ($0.46) $0.04 $0.28
========= ======== ========
Weighted average number of common shares outstanding:
Basic 28,604 28,284 24,802
========= ======== ========
Diluted 28,604 30,268 26,397
========= ======== ========
The accompanying notes are an integral part of
these consolidated financial statements
38
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands)
Cumulative
Common Stock Foreign
Number Additional Deferred Currency Total
of Paid-in Deferred Stock Retained Translation Stockholders'
Shares Amount Capital Compensation Warrant Earnings Adjustment Equity
--------- -------- ---------- -------------- --------- -------- ----------- -------------
Balance at December 31, 1995 23,490 $235 $106 $(91) $ - $14,522 $(98) $14,674
Issuance of common stock 2,700 27 29,339 29,366
Exercise of stock options 202 2 64 66
Tax benefit from exercise
of stock options 697 697
Foreign currency
translation adjustment 64 64
Amortization of deferred
compensation 18 18
Net income 7,500 7,500
------ ---- ------- ------ --------- ------- ----- -------
Balance at December 31, 1996 26,392 264 30,206 (73) - 22,022 (34) 52,385
Issuance of common
stock, net of issuance
costs of $485,198 1,837 18 51,925 51,943
Exercise of stock options 316 3 638 641
Tax benefit from exercise
of stock options 4,072 4,072
Foreign currency
translation adjustment (320) (320)
Amortization of deferred
compensation 18 18
Issuance of stock warrant 2,897 2,897
Net income 1,085 1,085
------ ---- ------- ------ --------- ------- ----- -------
Balance at December 31, 1997 28,545 285 86,841 (55) 2,897 23,107 (354) 112,721
Exercise of stock options 138 2 429 431
Tax benefit from exercise
of stock options 487 487
Foreign currency
translation adjustment (121) (121)
Amortization of deferred
compensation 19 19
Net loss (13,070) (13,070)
------ ---- ------- ------ --------- ------- ----- -------
Balance at December 31, 1998 28,683 $287 $87,757 ($36) $2,897 $10,037 ($475) $100,467
====== ==== ======= ====== ========= ======= ===== =======
The accompanying notes are an integral part of
these consolidated financial statements
39
Pegasystems Inc.
Consolidated Statements of Cash Flows
(in thousands)
Years Ended December 31, 1998 1997 1996
-------- ------- -------
Cash flows from operating activities:
Net income (loss) $(13,070) $ 1,085 $ 7,500
Adjustments to reconcile net income (loss) to net cash used in
operating activities:
Provision (benefit) for deferred income taxes (6,596) 722 3,977
Depreciation and amortization 5,595 3,159 1,633
Provision for doubtful accounts 2,165 1,938 300
Change in operating assets and liabilities:
Trade and installment accounts receivable (36,759) (20,276) (16,389)
Prepaid expenses and other current assets (913) (279) (810)
Accounts payable and accrued expenses 9,629 1,978 950
Deferred revenue 19,960 1,701 (61)
-------- ------- -------
Net cash used in operating activities (19,989) (9,972) (2,900)
Cash flows from investing activities:
Purchase of equipment and improvements (7,520) (4,488) (2,005)
Purchased software - (10,000) -
-------- ------- -------
Net cash used in investing activities (7,520) (14,488) (2,005)
Cash flows from financing activities:
Repayments of long-term debt - - (1,598)
Issuance of common stock, net - 51,943 29,366
Exercise of stock options 431 641 66
Tax benefit from exercise of stock options - - 697
-------- ------- -------
Net cash provided by financing activities 431 52,584 28,531
Effect of exchange rate on cash and cash equivalents (121) (320) 64
-------- ------- -------
Net increase (decrease) in cash and cash equivalents (27,199) 27,804 23,690
Cash and cash equivalents, at beginning of year 52,005 24,201 511
-------- ------- -------
Cash and cash equivalents, at end of year $ 24,806 $52,005 $24,201
======== ======= =======
Supplemental disclosures of cash flow information:
Cash paid during period:
Interest $ 9 $ 7 $ 86
-------- ------- -------
Income taxes $ 84 $ 13 $ 90
-------- ------- -------
Non-cash financing activity:
Issuance of stock warrant - $2,897 -
======== ======= =======
Equipment acquired under capital lease $ 325 $ - -
======== ======= =======
The accompanying notes are an integral part of
these consolidated financial statements.
40
PEGASYSTEMS INC.
NOTES TO FINANCIAL STATEMENTS
DECEMBER 31, 1998
1. SIGNIFICANT ACCOUNTING POLICIES
(a) Business
Pegasystems Inc. (the "Company") was incorporated on April 21,
1983 and develops customer service management software used by
large, transaction-intensive organizations to automate and manage
their customer interactions. Customers of the Company include
large banks, credit card processors, mutual fund companies and
major companies in non-financial service industries. The Company
also offers consulting, training, and maintenance and support
services to facilitate the installation and use of its solutions.
The environment of rapid technological change and intense
competition which is characteristic of the software development
industry results in frequent new products and evolving industry
standards. The Company's continued success depends upon its
ability to penetrate vertical markets, enhance current products
and develop new products on a timely basis that keep pace with the
changes in technology and competitors' innovations.
International revenue is subject to various risks, including
imposition of government controls, export license requirements,
political and economic conditions and instability, trade
restrictions, currency fluctuations, changes in taxes,
difficulties in staffing and managing international operations,
and high local wage scales and other operating costs and expenses.
(b) Management Estimates and Reporting, Operating and Control
Environment
The preparation of financial statements in conformity with
generally accepted accounting principles requires management to
make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the periods
presented. Actual results could differ from those estimates.
Significant assets and liabilities with reported amounts based on
estimates include trade and installment accounts receivable, long
term license installments and deferred revenue.
Following the December 31, 1997 audit, the Company received a
management letter from its independent public accountants that
identified material weaknesses in the Company's internal control
environment. The letter included recommendations to hire an
industry competent Chief Financial Officer, reorganize and upgrade
the sales and
41
contract administration process and upgrade the accounts
receivable collection process to ensure proper revenue recognition
and financial reporting. A new chief financial officer was hired
in September 1998. In connection with the preparation of the
Company's financial statements for the quarter ended September 30,
1998, information was discovered that lead to a review of certain
revenue transactions. In January 1999 the Company announced that
it had restated its financial statements for the first and second
quarters of 1997, (which provided for offsetting adjustments), and
each of the first three quarters of 1998 (see Note 2).
The December 31, 1998 audit resulted in material adjustments to
the fourth quarter's revenues and expenses. In connection with the
completion of the December 31, 1998 audit, the independent public
accountants have informed the Company that their management letter
will again communicate material weaknesses similar to many of
those material weaknesses included in the 1997 management letter.
In addition to certain material weaknesses previously included in
the 1997 management letter, the independent public accountants
have noted various other internal control deficiencies. These
include inadequate controls and procedures over the customer
service project implementation process that has resulted in the
Company's inability to reasonably estimate the fair value of
undelivered elements and therefore, its inability to allocate
contract fees to each element of an arrangement based on
vendor-specific objective evidence of fair value. Additionally,
the independent public accountants have noted significant control
deficiencies over the Company's billing and collection process and
software delivery and acceptance process. Additionally, in April
1999, the new chief financial officer indicated his intention to
resign from the Company within the next several months.
(c) Principles of Consolidation
The consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries, Pegasystems Limited (a
United Kingdom Company), Pegasystems Investment Inc. (a
Massachusetts Securities Corporation), Pegasystems Company (a
Canadian Company), Pegasystems Worldwide Inc. (a United States
Corporation), GDOO (a Swedish Company), and Pegasystems Pty Ltd.
(an Australian Company). All intercompany accounts and
transactions have been eliminated in consolidation.
(d) Foreign Currency Translation
The translation of assets and liabilities of the Company's foreign
subsidiaries is made at year-end exchange rates, while revenue and
expense accounts are translated at the average exchange rates for
the respective years ended. The resulting translation adjustments
are excluded from net income (loss) and are charged or credited to
"Cumulative foreign currency translation adjustment" included as
part of stockholders' equity.
Realized and unrealized exchange gains or losses from transaction
adjustments are reflected in other income and are not material.
(e) Revenue Recognition
The Company's revenue is derived from two sources: software
license fees and service fees. Software license fees are payable
on a monthly basis under license agreements, which generally have
a five-year term and may be renewed for additional terms at the
customer's option. Software license fee revenue represents the
present value of future license payments. A portion of the fee
from each arrangement is initially deferred and recognized as
interest income over the term of the license agreement. Service
fees are generally recognized as revenue as the services are
performed or as certain implementation milestones are achieved.
During 1996 and 1997, the Company recognized revenue in accordance
with Statement of Position (SOP) 91-1, "Software Revenue
Recognition", as issued by the American Institute of Certified
Public Accountants. Specifically, revenue from software license
arrangements is generally recognized upon delivery and product
acceptance pursuant to non-cancelable license agreements, and is
based on management's assessment that the collectability of the
long-term license installments is probable. Additionally, upon
acceptance the Company must have had no significant remaining
vendor obligations regarding the licensed software.
Effective January 1, 1998, the Company adopted the provisions of
SOP 97-2, "Software Revenue Recognition", as issued by the
American Institute of Certified Public Accountants. Beginning in
1998, software license fee revenue is recognized upon customer
acceptance of the software when there is persuasive evidence of an
arrangement, delivery has occurred, the fee is fixed or
determinable and collectability of the fee is probable. Service
fee revenue is recognized as the services are performed.
Maintenance revenue is recognized ratably over the term of the
maintenance arrangement. In arrangements that include multiple
elements, SOP 97-2 requires the total fee to be allocated to the
various elements based on vendor-specific objective evidence of
fair value. If sufficient vendor-specific objective
evidence does not exist for allocation of the fee to the various
elements of the arrangement, all revenue from the arrangement is
deferred until such vendor-specific objective evidence exists or
all elements have been delivered and accepted. Deferred revenue at
December 31, 1998 consists primarily of software license and
service fees from arrangements for which acceptance of the
software license has not occurred or acceptance has occurred but
sufficient vendor-specific objective evidence of the fair value of
each element as required by SOP 97-2 does not yet exist for the
allocation of the contract fee to each element of the
arrangement. Deferred revenue also includes the fair value of
free consulting hours committed by the Company that had not been
performed as of December 31, 1998.
In the case of software license agreement renewals, license fee
revenue is recognized upon execution of the renewal or extension
agreement. The Company provides for revenue reserves for the
estimated fair value of warranty obligations or product returns in
the period in which license fee revenue is recognized.
Beginning in the fourth quarter of 1998, the Company began using
discount rates ranging between 6.35% - 7.0%. The discount rate
used for the year ended December 31, 1997 and the nine-months
ended September 30, 1998 was 7.0%. The discount rate used in the
present value calculations was 7.0% for the three months ended
March 31, 1996 and was 6.75% for the remainder of the year ended
December 31, 1996.
(f) Cash and Cash Equivalents
The Company considers all highly liquid investments with original
maturities of three months or less to be cash and cash
equivalents.
(g) Concentration of Credit Risk
Financial instruments that potentially subject the Company to a
concentration of credit risk consist of trade accounts receivable
and long-term license installments receivable. The Company records
long-term license installments in accordance with its revenue
recognition policy, which results in receivables from customers
(primarily large organizations with strong credit ratings).
(h) Equipment and Improvements
Equipment and improvements are recorded at cost. Depreciation is
computed using the straight-line method over the estimated useful
lives of the assets, which are three years for equipment and
purchased software and five years for furniture and fixtures.
Leasehold improvements are amortized over the life of the lease.
(i) Software Costs
In compliance with the Statement of Financial Accounting Standards
("SFAS") No. 86, "Accounting for the Costs of Computer Software to
be Sold, Leased, or Otherwise Marketed", certain software costs
are capitalized by the Company. Capitalization of software costs
begins upon the establishment of technological feasibility,
defined by the Company as a working model or an operative version
of the computer software product that is completed in the same
language and is capable of running on all of the platforms as the
product to be ultimately marketed. No costs were capitalized
during 1998, 1997, or 1996.
Amortization of capitalized software costs is included in cost of
software license revenue. No amortization expense for capitalized
software costs was charged to cost of software license revenue in
1998 and 1997. Total amortization expense charged to cost of
software license was $0.5 million during 1996.
(j) Net Earnings (Loss) Per Share
The Company follows the provisions of SFAS No. 128, "Earnings Per
Share". SFAS No. 128 establishes standards for computing and
presenting (loss) earnings per share and applies to entities with
publicly held common stock or potential common stock. In
accordance with the Securities and Exchange Commission's Staff
Accounting Bulletin ("SAB") No. 98, the Company has determined
that there were no nominal issuances of common stock or potential
common stock in the period prior to the Company's initial public
offering ("IPO"). The Company has applied the provisions of SFAS
No. 128 and SAB No. 98 retroactively to all periods presented.
For the year ended December 31, 1998, diluted weighted average
shares is the same as basic weighted average shares as the
inclusion of stock options and warrants would be anti-
dilutive. Calculations of basic and diluted net earnings (loss)
per share and potential common share are as follows:
Years Ended December 31,
1998 1997 1996
(in thousands, except per share data)
Basic:
Net income (loss) $ (13,070) $ 1,085 $ 7,500
=============== =============== ===============
Weighted average common shares outstanding 28,604 28,284 24,802
=============== =============== ===============
Basic earnings (loss) per share $ (0.46) $ 0.04 $ 0.30
=============== =============== ===============
Diluted:
Net income (loss) $ (13,070) $ 1,085 $ 7,500
=============== =============== ===============
Weighted average common shares outstanding 28,604 28,284 24,802
Effect of assumed exercise of stock options - 1,984 1,595
--------------- --------------- ---------------
Weighted average common shares outstanding, assuming 28,604 30,268 26,397
dilution =============== =============== ===============
Diluted earnings (loss) per share $ (0.46) $ 0.04 $ 0.28
=============== =============== ===============
For the years ended December 31, 1998, 1997 and 1996, 1,987,020
options and warrants, 185,481 options and 7,201 options,
respectively, were excluded from the weighted average common
shares outstanding, assuming dilution, as their effect would be
anti-dilutive.
(k) Comprehensive Income
In June 1997, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 130, "Reporting Comprehensive Income". SFAS No.
130 requires disclosure of all components of comprehensive income
on an annual and interim basis. Comprehensive income is defined as
the change in equity of a business enterprise during a period from
transactions and other events and circumstances from nonowner
sources. The components of the Company's comprehensive income are
as follows:
Year Ended December 31
(in thousands) 1998 1997 1996
Net (loss) income $ (13,070) $ 1,085 $ 7,500
Foreign currency translation, net
of income taxes (81) (198) 39
--------- -------- --------
Comprehensive (loss) income (13,151) 887 7,539
========= ======== ========
(l) Segment Reporting
During 1998, the Company has adopted SFAS No. 131, "Disclosures
About Segments of an Enterprise and Related Information". SFAS No.
131 requires certain financial and supplementary information to be
disclosed on an annual and interim basis for each reportable
operating segment of an enterprise, as defined. Based on the
criteria set forth in SFAS No. 131, the Company currently operates
in one operating segment, customer service software.
SFAS No. 131 also requires that certain enterprise-wide
disclosures be made related to products and services, geographic
areas and major customers. The Company derives substantially all
of its operating revenue from the sale and support of one group of
similar products and services. Substantially all of the Company's
assets are located within the United States. During 1998, 1997 and
1996, the Company derived its operating revenue from the following
countries (as a percentage of total operating revenue):
Year Ended
December 31,
1998 1997 1996
United States 77% 84% 82%
United Kingdom 11% 8% 11%
Other 12% 8% 7%
--- --- ----
100% 100% 100%
=== === ===
In 1998 one customer accounted for approximately 17.7% of the
Company's total revenue. In 1997, two customers accounted for
approximately 13.7% and 10% of the Company's total revenue,
respectively. In 1996, three customers accounted for approximately
14.5%, 11.4% and 10.5% of the Company's total revenue.
(m) New Accounting Standards
In March 1998, the AICPA issued SOP 98-1, "Accounting for Costs of
Computer Software Developed or Obtained for Internal Use". SOP
98-1 requires computer software costs associated with internal use
software to be expensed as incurred until capitalization criteria
are met, as defined. Adoption of this statement will not have a
material impact on the Company's consolidated financial position
or results of operations.
During 1998, the Financial Accounting Standards Board issued SFAS
No. 132, Employers' Disclosures About Pensions and Other
Postretirement Benefits. SFAS No. 132 is effective for years
beginning after December 15, 1998. Management does not expect that
the adoption of this statement will have a material impact on the
Company's consolidated financial statements taken as a whole.
In June 1998, the FASB issued SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities". SFAS 133
establishes accounting and reporting standards for derivatives as
either assets or liabilities in the statement of financial
position and measure those instruments at fair value. This
statement applies to all entities for all fiscal quarters
beginning after June 15, 1999. Initial application of this
statement should be as of the beginning of an entity's fiscal
quarter. As of December 31, 1998 and during
the three year period then ended the Company did not hold any
derivative instruments or have any hedging activities. The Company
does not expect adoption of this statement to have a significant
impact on its financial position or results of operations.
(n) Stock Options
The Company grants stock options for a fixed number of shares to
employees with an exercise price equal to the fair market value
of the shares at the date of the grant. The Company accounts for
stock option grants in accordance with APB Opinion No. 25,
"Accounting for Stock Issued to Employees", and intends to
continue to do so. During 1995, the Company granted stock options
for a fixed number of shares to employees with an exercise price
less than the then fair market value of the shares at the date of
the grant. For the difference between the fair market value and
the exercise price, the Company recorded deferred compensation in
the consolidated statements of stockholders' equity, which is
being expensed over the vesting period.
The Company has adopted only the disclosure provisions of SFAS
No. 123, "Accounting for Stock-Based Compensation," and will
continue to account for its stock option plans in accordance with
the provisions of APB Statement No. 25.
2. RESTATEMENTS
On April 15, 1998, the Company restated its consolidated financial
statements for each of the unaudited first three quarterly periods ended
September 30, 1997. The restatements reflected revenue adjustments as a
result of a change in the timing of revenue recognition on certain
contracts. Also included in the restated consolidated financial
statements are operating expenses, including a provision for bad debts
not previously recorded by the Company and the recording of certain other
expenses and reserves.
On October 29, 1998, the Company publicly announced its preliminary,
unaudited results of operations for the three and nine-month periods
ended September 30, 1998. Subsequently, based on information that had not
previously come to the attention of the Company or its independent
auditors, the Company determined that it may not have accounted properly
for certain revenue transactions. As a result, the Company, with the
assistance of its independent auditors, conducted a comprehensive review
of those transactions and others relating to the three months ended
September 30, 1998 and other periods in 1998 and 1997.
Based on such review, the Company concluded that it was necessary to
revise its previously disclosed preliminary, unaudited results of
operations for the three and nine-month periods ended September 30, 1998
and to restate its unaudited interim financial statements for the first
and
second quarters of each of 1998 and 1997. The revenue changes are
principally reversals of license and services revenues arising from the
inability to reasonably estimate the fair value of undelivered elements
(implementation services) in connection with software license and
implementation service arrangements, issues surrounding the timing and
delivery or acceptance of licensed software, certain project milestones
not being completed and billing errors or delays. The revenue changes
also reflect an increase in revenue reserves. In the opinion of
management, all material adjustments necessary to correct the
consolidated financial statements have been recorded.
A summary of the impact of such restatement on the financial statements
for the unaudited nine-month period ended September 30, 1998 is as
follows:
(unaudited)
Nine Months Ended
September 30, 1998
(in thousands)
As Reported As Restated
----------- -----------
Software license revenue $40,750 $27,224
Services revenue 27,436 22,799
Total revenue 68,186 50,023
Income (loss) from operations 13,806 (5,520)
Net income (loss) 10,917 (1,065)
Earnings (loss) per share: Basic $.38 $(.04)
Earnings (loss) per share: Diluted $.37 $(.04)
Total assets $150,596 $147,955
See Note 11 for disclosure of the restated unaudited selected quarterly
information for the four quarters ended December 31, 1998 and 1997.
3. EQUIPMENT AND IMPROVEMENTS
The cost and accumulated depreciation of equipment and improvements
consist of the following:
December 31,
1998 1997
(in thousands)
Equipment $ 11,987 $ 7,243
Furniture and fixtures 2,721 1,895
Leasehold improvements 2,627 838
Equipment under capital leases 342 -
--------------- ---------------
17,677 9,976
Less: accumulated depreciation and
amortization (7,633) (4,398)
---------------- ---------------
Equipment and improvements, net $ 10,044 $ 5,578
=============== ===============
Depreciation and amortization expense was approximately $3.2 million,
$2.0 million and $1.2 million for the years ended December 31, 1998, 1997
and 1996, respectively.
4. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consist of the following:
December 31,
1998 1997
(in thousands)
Trade accounts payable $ 2,502 $ 863
Employee compensation and benefits 3,317 1,332
Accrued income taxes 161 754
Other accrued expenses 3,792 1,114
Revenue reserve 4,861 961
Accrued consulting costs 209 374
----------- ----------
$ 14,842 $ 5,398
=========== ==========
5. DEBT
The Company had no outstanding long-term debt at December 31, 1998 and
December 31, 1997.
As of December 31, 1998, the Company had a working capital line of
credit, which will expire on June 30, 1999, with a bank allowing for
borrowings up to $5.0 million at the bank's prime rate (7.25% at December
31, 1998). The Company had no borrowings outstanding under the line of
credit at December 31, 1998. Borrowings are subject to various covenants
which call for a specified level of working capital and net worth,
maintenance of certain financial ratios and restrictions on the payments
of dividends. As of December 31, 1998, the Company was in compliance with
all covenants, except for the profitability financial covenant, for which
the Company subsequently received a non-compliance waiver. The Company
intends to renogotiate the terms and covenant requirements under the
existing line of credit with the same bank.
6. STOCKHOLDERS' EQUITY
(a) Recapitalization and Stock Split
On July 10, 1996, the Company increased the number of shares of
common stock authorized from 9.0 million to 45.0 million shares.
The Company's Board of Directors approved a three-for-one stock
split in the form of a stock dividend effective on July 10, 1996.
The financial statements give effect to the stock split for all
periods presented.
The Board of Directors is authorized, subject to certain
limitations prescribed by law, without further stockholder
approval, to issue from time to time up to an aggregate 1.0
million shares of preferred stock in one or more series and to fix
or alter the designations, preferences, rights and any qualifying
limitations or restrictions of the shares of each such series
thereof, including the dividend rights, dividend rates, conversion
rights, voting rights, terms of redemptions (including sinking
fund provisions), redemption price or prices, liquidation
preferences and the number of shares constituting any shares or
designations of such series.
(b) Long-Term Incentive Plan
In 1994, the Company adopted a Long Term Incentive Plan (as
amended, the "1994 Plan") to provide employees, directors and
consultants with opportunities to purchase stock through incentive
stock options and non-qualified stock options.
In addition to options, eligible participants under the 1994 Plan
may be granted stock appreciation rights, restricted stock and
long-term performance awards. As of December 31, 1998, a total of
6.8 million shares of common stock were reserved for issuance
under the 1994 Plan.
The option price per share is determined at the date of grant. For
incentive stock options, the option price may not be less than
100% of the fair market value of the Company's common stock at the
grant date. Incentive stock options granted to a person having
greater than 10% of the voting power of all classes of stock must
have an exercise price of at least 110% of fair market value of
the Company's common stock. Options granted under the 1994 Plan
generally vest over five years and expire no later than ten years
from the date of grant.
(c) 1996 Non-Employee Director Stock Option Plan
The 1996 Non-Employee Director Stock Option Plan (the "Director
Plan") was adopted by the Board of Directors on May 13, 1996 and
approved by the stockholders on June 26, 1996. The Director Plan
provides for the grant of options for the purchase of up to
250,000 shares of common stock of the Company.
The Director Plan is administered by the Compensation Committee
and provides that each person who becomes a director of the
Company after May 13, 1996, and who is not also an employee of the
Company, will receive upon initial election to the Board of
Directors an option to purchase 30,000 shares of common stock
vesting in equal annual installments over five years. The exercise
price for all options granted under the Director Plan is equal to
the market price of the common stock on the date of grant.
(d) 1996 Employee Stock Purchase Plan
The 1996 Employee Stock Purchase Plan (the "Stock Purchase Plan")
was adopted by the Board of Directors on May 13, 1996 and approved
by the stockholders on June 26, 1996. An aggregate of 500,000
shares of common stock are reserved for issuance pursuant to this
plan. To date, there have been no offerings under the Stock
Purchase Plan and no shares of common stock have been issued
thereunder.
The following table presents the combined activity for the 1994
Plan and the Director Plan for the years ended December 31, 1998,
1997 and 1996:
1998 1997 1996
Number of Weighted Number of Weighted Number of Weighted
Options Average Options Average Options Average
Exercise Exercise Exercise
Price Price Price
(in (in (in
thousands) thousands) thousands)
Outstanding options at 3,099 $ 10.40 2,582 $ 5.04 1,924 $ 0.34
beginning of year
Granted 5,955 $ 12.35 1,214 $ 22.79 993 $ 13.19
Exercised (138) $ 3.13 (316) $ 2.03 (202) $ 0.33
Cancelled (3,384) $ 18.69 (381) $ 20.52 (133) $ 4.94
---------- ----------- ----------- ----------- ---------- -----------
Outstanding options 5,532 $ 7.61 3,099 $ 10.40 2,582 $ 5.04
at end of year ========== =========== =========== =========== ========== ===========
Exercisable options 1,065 $ 2.57 822 $ 2.13 679 $ 0.33
at end of year ========== =========== =========== =========== ========== ===========
Weighted average $ 9.34 $ 11.38 $ 8.84
fair value of =========== =========== ===========
options granted
during the year
The following table presents weighted average price and life
information about significant option groups outstanding and
exercisable at December 31, 1998:
Options Outstanding Options Exercisable
Range of Exercise Number Weighted Weighted Number Weighted
Prices Outstanding Average Average Exercisable Average
Remaining Exercise Exercise
Contractual Price Price
Life (years)
(in thousands) (in thousands)
$0.33-0.39 1,179 6.18 $ 0.34 863 $ 0.34
$6.00-$7.75 3,303 9.78 $ 7.74 - $ -
$8.00-$12.50 434 7.39 $ 9.79 145 $ 9.90
$17.06-$20.56 412 9.00 $ 17.51 57 $ 17.67
$22.69-28.09 204 9.41 $ 22.73 - $ -
--------- ---------
5,532 1,065
========= =========
The following are the pro forma net income (loss) and earning s
(loss) per share for 1998, 1997 and 1996, as if the compensation
expense for the option plans had been determined based on the
fair value at the grant date for grants in 1998, 1997 and 1996,
consistent with the provisions of SFAS 123:
1998 1997 1996
As Pro As Pro As Pro
Reported Forma Reported Forma Reported Forma
Net income (loss) (in thousands) $ (13,070) $ (15,235) $ 1,085 $ (774) $ 7,500 $ 7,122
Basic earnings (loss) per share $ (0.46) $ (0.53) $ 0.04 $ (0.03) $ 0.30 $ 0.29
Diluted earnings (loss) per share $ (0.46) $ (0.53) $ 0.04 $ (0.03) $ 0.28 $ 0.26
A range of expected vesting percentages were given to each range
of exercise prices. In 1998, for the range of exercise prices from
$0.33 to $0.39, $6.00 to $7.75, $8.00 to $12.50, $17.06 to $20.56,
and $22.69 to $28.09, it is expected that 95 percent, 90 percent,
80 percent, 75 percent and 50 percent of those options will vest,
respectively. These ranges were based upon the Company's estimates
that a more significant number of lower priced options as compared
to higher priced options will vest.
The fair value of options at the date of grant were estimated
using the Black-Scholes option pricing model with the following
weighted-average assumptions:
1998 1997 1996
Volatility .97 0.5 0.0-9.9
Expected option life (years) 5.0 5.0 5.0
Interest rate (risk free) 4.23-5.65% 6.13-6.57% 5.38-6.69%
Dividend yield 0.0% 0.0% 0.0%
Volatility for 1998 was calculated on a daily basis and was
determined to be .97. Volatility for 1997 was calculated on a
quarterly basis and was determined to be 0.5. Volatility for 1996
was calculated on a monthly basis. For 1996, exclusive of one
month's data where volatility was 9.9, volatility ranged from 0.0
to 1.4. The Company has never declared, nor paid dividends, on any
of its capital stock and does not expect to in the foreseeable
future.
The effects on 1998, 1997, and 1996 pro forma net income (loss)
and earnings (loss) per share of expensing the estimated fair
value of stock options and shares are not necessarily
representative of the effects on reporting the results of
operations for future years as the periods presented include only
two, three, and four years of option grants under the Company's
plan.
7. SOFTWARE LICENSE AND SUPPORT AND WARRANT AGREEMENTS
On June 27, 1997, the Company entered into Software License and Support
and Warrant Agreements with First Data Resources, Inc. ("FDR").
The provisions of the Software License and Support Agreement give FDR
the right to use the Company's software in connection with new
products and also the exclusive right to market, distribute and
sublicense the Company's software and new products to FDR customers
and prospects. In addition to the granting of a license to use its
software, the Company will also provide services to FDR in connection
with the new products. For the right to the license and the services,
FDR is expected to pay the Company a base fee of $49.25 million with
additional fees possible based on successful resale of the products.
FDR paid $8.25 million in 1998 and remaining fees are expected to be
paid on a monthly basis over the term of the agreement. The initial
term of this agreement commenced on June 27, 1997 and runs through
December 31, 2002.
In accordance with the Software License and Support Agreement, the
Company was granted a license for access to and use of the designs,
specifications and code of FDR's ESP product. As consideration for this
right, the Company paid FDR $10.0 million. This amount was recorded as
purchased software on the accompanying balance sheets.
In connection with the Software License and Support Agreement on June 27,
1997, the Company committed to provide a warrant to FDR. Pursuant to the
Warrant Agreement, the Company gave FDR the right to purchase 284,876
shares of the Company's common stock at a purchase price of $28.25 per
share which represented the fair market value of the common stock on the
date of the agreement. The warrant became exercisable on June 27, 1998
and will expire on June 27, 2002. The warrant was valued at $2.9 million
and the corresponding deferred asset was capitalized and included in
"purchased software and other" on the accompanying balance sheets.
The Company will recognize the base fee revenue and also amortize the
value of the purchased software and the warrant on a pro rata basis over
the initial 5 1/2 year term of the agreement. During the year ended
December 31, 1998 and the period from June 27, 1997 through December 31,
1997, the Company recognized revenue of approximately $8.9 million and
$4.6 million, respectively, related to the Software License and Support
Agreement and
recorded amortization expense of approximately $2.3 million and $1.2
million, respectively, related to the ESP software and warrant.
8. LEASES
The Company leases certain equipment and office space under
non-cancelable capital and operating leases. Future minimum rental
payments required under the capital and operating leases with
non-cancelable terms in excess of one year at December 31, 1998 are as
follows:
Year Ended December 31, Capital Leases Operating
Leases
(in thousands) (in thousands)
Future Minimum Payments
1999 $ 123 $ 4,634
2000 123 4,159
2001 115 4,159
2002 - 4,159
2003 - 2,075
Thereafter - 1,322
---------------- ----------------
361 $ 20,508
================
Less--Amounts representing interest 36
----------------
$ 325
================
Total rent expense under operating leases was approximately $5.1 million,
$3.0 million and $1.4 million, for the years ended December 31, 1998,
1997, and 1996, respectively.
9. INCOME TAXES
Income (loss) before provision (benefit) for income taxes consists of the
following:
1998 1997 1996
Domestic $ (15,490) $ 8,599 $ 11,546
Foreign (3,991) (6,850) 572
--------------- --------------- ---------------
Total $ (19,481) $ 1,749 $ 12,118
=============== =============== ===============
The provision (benefit) for income taxes for the years ended December 31,
1998, 1997, and 1996 consists of the following:
1998 1997 1996
(in thousands)
Current:
Federal $ - $ (149) $ 6
State 84 (30) 212
Foreign 101 121 160
----------- ----------- -----------
Total current 185 (58) 378
Deferred:
Federal (6,380) 688 3,662
State (966) 34 578
Foreign 750 - -
----------- ----------- -----------
Total deferred (6,596) 722 4,240
----------- ----------- -----------
$ (6,411) $ 664 $ 4,618
=========== =========== ===========
The effective income tax rate differed from the statutory federal income
tax rate due to the following:
1998 1997 1996
Statutory federal income tax rate (35.0)% 34.0% 35.0%
State income taxes, net of federal benefit (3.0)% 3.9% 4.2%
and tax credits
Permanent differences (0.9)% 6.4% 0.3%
Tax credits (0.9)% (8.6)% (0.6)%
Foreign Taxes 6.9% -% -%
Other -% 2.3% (0.8)%
Effective income tax rate (32.9)% 38.0% 38.1%
Deferred income taxes at December 31, 1998 and 1997 reflect the net tax
effects of net operating loss and tax credit carryforwards and temporary
differences between the carrying amounts of assets and liabilities for
financial statement purposes and the amounts used for tax purposes. The
approximate income tax effect of the Company's net deferred tax liability
as of December 31, 1998 and 1997 are as follows:
December 31,
1998 1997
(in thousands)
Software revenue $ (13,980) $ (18,195)
Depreciation (2,934) (76)
Vacation accrual 1,001 184
Receivable and other reserves 3,260 1,198
Net operating loss carryforwards 11,719 8,195
Tax credits 1,081 864
Foreign Taxes (750) -
Other 185 183
------------ -----------
(418) (7,647)
------------ -----------
Less valuation allowance (332) -
------------ -----------
Net deferred tax liabilities (750) (7,647)
Less current portion - (3,978)
------------ -----------
$ (750) $ (3,669)
============ ===========
A valuation allowance has been provided for a portion of the deferred tax
asset since it is uncertain if the Company will realize the entire
benefit of the deferred tax asset.
At December 31, 1998, the Company had alternative minimum tax ("AMT") and
research and development ("R&D") credit carryforwards of approximately
$1,081, available to offset future federal taxable income. The
carryforward period for the AMT credit is unlimited. The R&D credit
carryforwards generally expire from 2004 to 2018.
As of December 31, 1998 the Company also has available net operating loss
carryforwards of approximately $29,936 expiring through 2018. These
carryforwards may be used to offset future income taxes payable, if any,
and are subject to review by the Internal Revenue Service.
As of December 31, 1998, approximately $14,025 of the net operating
loss carryforward relates to the excess tax benefit of disqualifying
dispositions and the exercise of non-qualified stock options.
Accordingly, approximately $5,256 of the deferred tax asset was
recorded in additional paid in capital.
10. LITIGATION AND CONTINGENCIES
In April 1998, a complaint purporting to be a class action was filed with
the United States District Court for the District of Massachusetts (the
"Court") alleging that the Company and several of its officers violated
section 10(b) of the Securities Exchange Act of 1934, as amended (the
"Exchange Act"), Rule 10b-5 promulgated by the Commission thereunder, and
section 20(a) of the Exchange Act. In December 1998, the plaintiffs filed
their First Amended Consolidated Complaint which names the Company, the
Company's President (Alan Trefler) and a former officer and director (Ira
Vishner) as defendants. The Amended Complaint alleges that the defendants
issued false and misleading financial statements and press releases
concerning the Company's publicly reported earnings. The Amended
Complaint seeks certification of a class of persons who purchased the
Company's Common Stock between July 2, 1997 and October 29, 1997, and
does not specify the amount of damages sought. The defendants have filed
a motion to dismiss this litigation to which the plaintiffs have replied.
In December 1998, a complaint also purporting to be a class action was
filed with the Court alleging that the Company and Alan Trefler violated
section 10(b) of the Exchange Act, Rule 10b-5 promulgated by the
Commission thereunder, and that Mr. Trefler also violated section 20(a)
of the Exchange Act. This litigation was filed after the Company's
announcement on November 24, 1998 that it might be recording revenue
adjustments, on behalf of a purported class of persons who purchased the
Company's Common Stock between October 29, 1998 through November 24,
1998. The Complaint does not specify the amount of damages sought.
Plaintiff's have indicated that they intend to file an amended complaint.
The defendants have not yet filed an answer or other responsive pleading
in this action.
The Company intends to defend these actions vigorously, but no assurance
can be given as to the outcomes. Management believes that is possible
that the Company may be required to pay substantial damages or settlement
costs which could have a material adverse effect on the Company's
financial position or results of operations. In addition, regardless of
the outcome of any of these actions, it is likely that the Company will
incur substantial defense costs and that such actions will cause a
diversion of management time and attention. The Company's delay in filing
its From 10-Q for the quarter ended September 30, 1998 and other regular
reports with the SEC and its announcement that it has adjusted previously
published financial statements have resulted in negative publicity for
the Company. Such events and related publicity have adversely affected
demand for the Company's products and services may also have an adverse
effect on the Company's financial position or results of operations.
11. SELECTED QUARTERLY INFORMATION (UNAUDITED)
1998
(in thousands, except per share data) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Revenue $14,234 $18,157 $17,631 $10,384
Loss from operations (1,743) (395) (3,382) (18,843)
Net income (loss) (350) 500 (1,215) (12,005)
Earnings (loss) per share-Basic $(.01) $.02 $(.04) $(.43)
Earnings (loss) per share- Diluted $(.01) $.02 $(.04) $(.43)
1997
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(in thousands, except per share data) 1st Quarter 2nd Quarter 3rd Quarter 4th Quarter
Revenue $7,958 $5,272 $8,668 $22,462
Income (loss) from operations (86) (5,421) (4,011) 6,128
Net income (loss) 644 (2,482) (1,620) 4,543
Earnings (loss) per share-Basic $.02 $(.09) $(.06) $.16
Earnings (loss) per share- Diluted $.02 $(.09) $(.06) $.15
The information above is inclusive of the effects of quarterly restatements
performed by the Company. See Note 2 for further discussion of these
restatements.
12. VALUATION AND QUALIFYING ACCOUNTS
Balance Additions
at charged to Charged Balance
beginning costs and to other Deductions at end
Description (in thousands) of period expenses account (c) of period
Allowance for doubtful accounts:
Year ended December 31, 1998 $2,200 $2,165 -- ($1,612) $2,753
Year ended December 31, 1997 939 1,938 (a)285 ( 962) 2,200
Year ended December 31, 1996 434 300 (b)205 -- 939
(a) Amount relates to service revenue reversed, which was previously charged
against the allowance for doubtful accounts.
(b) Amount reclassified from liabilities during the year.
(c) Deductions are related to accounts receivable write-offs.