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FORM 10-K
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1997
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ________ to ___________
Commission file number: 000-22327
PSW TECHNOLOGIES, INC.
(Exact name of Registrant as specified in its charter)
Delaware 74-2796054
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6300 Bridgepoint Parkway, Building 3, Suite 200, Austin Texas 78730 (Address of
principal executive offices) (Zip code)
(512) 343-6666
(Registrant's telephone number including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Securities Exchanges on which Registered
None. None.
Securities registered pursuant to section 12(g) of the Act:
Common Stock, $.01 par value
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ____
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. |_|
The aggregate market value of the voting stock held by non-affiliates
of the Registrant, based upon the closing sale price of Common Stock on March 2,
1998 as reported on the Nasdaq National Market, was approximately $28 million.
As of March 2, 1998, the Registrant had outstanding 8,987,874 shares
Common Stock.
Documents Incorporated By Reference
Portions of the Proxy Statement for Registrant's 1998 Annual Meeting
of Stockholders are incorporated by reference into Part III of this Form 10-K.
PART I
Item 1. Business
This Business section and other parts of this Form 10-K contain
forward-looking statements that involve risk and uncertainties including
statements regarding customer and industry concentration. The Company's actual
results may differ significantly from the results discussed in the
forward-looking statements. Factors that might cause such a difference include,
but are not limited to, those discussed below and in "Management's Discussion
and Analysis of Operations" in Item 7 of this Form 10-K.
PSW Technologies, Inc. ("PSW" or the "Company") provides systems
integration and software development services to information technology ("IT")
vendors and IT users. IT vendors primarily consist of software companies who
utilize the Company's services to help bring their products to market faster. IT
users generally utilize the Company's services to help define, develop and
complete high value, mission critical enterprise software systems for internal
use. Services are typically provided on a project or mission basis. In
project-based engagements, PSW is retained to complete a specifically defined
set of tasks, such as porting a specific version of client software to a new
release of an operating system. In mission-based engagements, PSW is retained to
manage, on an ongoing basis, a specific mission within the client organization,
such as responsibility for all testing functions for a client organization.
Mission engagements involve multiple projects and releases which generally come
up for renewal on an annual or other periodic basis.
The Company is flexible in structuring the terms of its client
engagements, often using a time-and-materials pricing model with set project
milestones, but employing a fixed-price model per phase in certain
circumstances. The Company works in partnership with its clients at the client
site or at PSW's facilities, as appropriate. This flexible, joint development
approach, together with the Company's utilization of proprietary methodologies,
is designed to reduce risks to PSW and its clients, maximize client satisfaction
and allow PSW to transfer expertise to its clients.
The Company was founded in 1989 as a separate division of Pencom
Systems Incorporated, ("Pencom"), a privately held corporation, to take
advantage of the large numbers of subcontractors placed by Pencom with IBM's AIX
organization in Austin, Texas. PSW was incorporated in Delaware in August 1996.
In October 1996, Pencom contributed certain assets and associated liabilities of
its software division and a portion of a software contract that had previously
been allocated to other operations of Pencom to the Company in exchange for all
of the outstanding Common Stock of the Company and certain warrants issued to
Pencom and certain of its employees to purchase shares of Common Stock of the
Company. The Company completed an initial public offering of 3,277,500 shares of
Common Stock in June and July of 1997 in which the Company received $25.7
million in net proceeds. The Company maintains its principal executive offices
at 6300 Bridgepoint Parkway, Building 3, Suite 200, Austin, Texas 78730, and its
telephone number at such location is (512) 343-6666.
Industry Background
The growing worldwide demand for IT services has been driven by the
increasing reliance on IT as a strategic tool for addressing critical business
issues. Deregulation, globalization and technological innovation are
accelerating the rate of change in business, resulting in a more complex and
intensely competitive business environment. Organizations face constant
pressures to improve the quality of products and services, reduce cost and time
to market, improve operating efficiencies and strengthen customer relationships.
These pressures are increasingly causing business managers to utilize IT to
integrate and streamline business processes with customers and suppliers thereby
decreasing response time, lowering costs and improving information flow. These
trends, together with rapid advances in technology, are primarily driving the
move from traditional host-based legacy computing systems to more flexible and
functional technologies, including the Internet, Web based user interfaces,
client/server architectures, object-oriented programming languages and tools,
distributed database management systems and the latest networking and
communications technologies.
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In order to compete in this business environment, IT departments of
Fortune 1000 companies often must deploy custom designed software applications
composed of multiple operating systems, databases, programming languages and
networking protocols throughout the enterprise. At the same time, competitive
conditions and cost pressures are increasingly forcing such companies to focus
on core competencies and reduce or limit the growth of their IT workforce.
In addition to the increasing demand for more responsive technologies
to address these business challenges, technology as a whole is becoming more
complex and individual technology life-cycles are shortening at a faster rate.
The foregoing has placed increasing pressure on IT vendors to bring new products
and new versions of proven products to market faster and simultaneously to
ensure that those products operate with an increasing number of platforms and
middleware.
The convergence of these trends is resulting in (i) an increasing
movement of Fortune 1000 companies toward joint projects with software service
firms that have a high level of expertise in critical emerging technologies,
rather than relying on their internal resources for the design and
implementation of enterprise business systems and (ii) an increasing need within
the research and development departments of key vendors of critical emerging
technologies to outsource to software service firms a portion of the
development, porting and testing of their existing and new products.
Accordingly, a growing number of IT users and IT vendors are seeking the help of
software services firms with strong technical expertise in critical emerging
technologies and the ability to implement high value solutions on a prompt and
cost-effective basis.
The PSW Strategy
PSW provides high value solutions to IT vendors and IT users by
mastering and applying critical emerging technologies, including Web based
distributed computing, object-oriented development, advanced operating systems
and systems management technologies. PSW targets companies that are developing
technologies which it believes will be important to, and likely to be widely
deployed by, its current and potential IT user clients. Through these
engagements, PSW often gains an early and comprehensive understanding of
critical emerging technologies and is therefore well positioned to service the
continued needs of these and other IT vendors, as well as the needs of the IT
user community. The Company incorporates the knowledge and expertise derived
from each of its client projects into its proprietary Genova methodologies,
enabling PSW to retain and distribute its institutional knowledge throughout the
Company and to achieve improvements in cost, quality and speed on client
projects.
Services
IT Vendor Clients
The Company provides software research and development services that
enable its IT vendor clients to improve the quality and speed to market of their
products and, PSW believes, to achieve an earlier flow of revenue and increased
revenues over the long term. PSW's services also enable these clients to focus
on their core competencies, limit their permanent headcount and relieve
temporary workload spikes.
The Company's experience with, and knowledge of, IT vendors' products
often leads to significant follow-on work in related projects with these
vendors, other IT vendors and IT users. At the same time, PSW's experience with
IT users allows it to assist its IT vendor clients as they seek to achieve
wide-spread adoption of their technologies and enables PSW to give valuable
feedback to such IT vendors regarding the most appropriate business use for
their respective technologies.
The Company offers the following suite of services to its IT vendor clients:
Development Services
The Company assists clients in the development of products, the addition of new
capabilities to existing products and the development of specialized software
for clients' customers. PSW's experience in computer architecture, system
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performance, operating systems, device drivers and middleware, as well as its
software development methodology, position the Company to enable its clients to
deliver critical software to the marketplace in a timely fashion.
Porting Services
The Company assists clients in the porting of their software products
to other computing platforms. PSW has extensive operating system experience with
Windows NT, Windows 95, Solaris, AIX, HP/UX and NEXTSTEP, as well as with the
compilers and development tools required to port software. The Company performs
the porting, testing and documentation of the client product to the specified
operating environments. The Company utilizes its Genova porting methodology to
efficiently assess the portability of software to Windows NT and other operating
environments, to determine the best approach for completing ports in a timely
manner and for improving future software portability.
Testing Services
The Company assists clients in test planning, test suite development
and test execution. System verification testing involves the design of tests to
ensure that products adhere to the specifications and standards demanded by the
client. Compatibility testing verifies that specific programs and devices work
with new operating system software. Standards compliance testing involves the
development of test suites to verify binary or source code compatibility with
published standards.
Advisory Services
The Company provides advisory services to assess development, porting,
testing or support projects from a technical, process and project management
viewpoint. The Company utilizes its Genova methodology and prior experience to
identify areas of improvement and make recommendations. In addition, assessment
services are often used to allow for the necessary research and evaluation to
develop a more extensive proposal for a client.
Support Services
The Company provides customized technical support for complex systems
to software developers or users. Support is provided on-site, on-line and by
telephone. The Company's services include help desk, defect correction and
critical situation support.
IT User Clients
The Company also develops high value, mission critical enterprise
business systems designed to enable its IT user clients to improve the quality
of the services they provide to their customers through enhanced information
capture and control, increased accuracy and efficiency and decreased costs and
response times. The Company offers services ranging from consulting, to custom
system development, to the development of systems management solutions. The
Company provides enterprise solutions in a wide variety of computing
environments utilizing leading technologies, including Web/Internet, client/
server architectures, object-oriented programming languages and tools,
distributed database management systems and the latest networking and
communications technologies.
The Company focuses on long-term, strategic enterprise solutions due to
their greater value to the client than departmental systems, and the
corresponding potential for longer-term relationships. In addition, enterprise
system projects are typically larger and more technically complex than
departmental system projects, thereby creating a barrier to entry for smaller
services firms and increasing the importance of the breadth and depth of PSW's
technical expertise when competing with other firms regardless of their size.
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The Company offers the following suite of services to its IT user
clients:
Custom Application Development Services
PSW provides services to design, construct and deploy custom enterprise
business systems utilizing Web, Internet, client/server and object oriented
technologies. The Genova Business Systems Development Methodology is used to
define business objectives, gather requirements and perform analysis, and then
design, implement, test and deploy the system. The project team for a typical
engagement consists of PSW personnel and client personnel, with PSW providing
project management and overall technical leadership. Engagement durations
may last several years and involve deployment of multiple versions of the
business system.
Systems Management Implementation Services
The Company provides planning, design and implementation services for
systems management. These services determine the availability, performance,
capacity and servicing requirements of the clients' computing infrastructure and
applications. Then using industry products primarily associated with the Tivoli
Management Environment, PSW offers serivces to design, install, configure and
test a specific system management solution for the client.
Enterprise Consulting Services
The Company offers enterprise consulting services to assist clients
with the assessment, monitoring and management of projects. PSW utilizes its
Genova Assessment Methodology, which involves a seven step process to define the
focus of the assessment, conduct the required research, analyze the findings and
provide specific actions and recommendations to the client. The Genova Business
Systems Development Methodology is also used as a benchmark to determine missing
components or deliverables in the client's project or process. The deliverable
in an enterprise consulting engagement consists of a report identifying a
project's strengths and weaknesses, assessing schedule and resource plans and
recommending specific actions. A summary report is typically presented to the
client's management.
Genova Methodologies
Software development, testing, delivery and deployment is a complex
process. Consequently, PSW employs its Genova methodologies to lower the risk of
project overruns or client dissatisfaction.
The Company believes that successful software projects require a well
designed approach, development process and underlying procedures to organize the
project team to efficiently accomplish numerous interrelated tasks. PSW's Genova
methodologies achieve this by defining the specific deliverables required at
each phase of the development process, the tasks required to develop them,
examples and templates. In addition, because the methodologies provide a common
structure between projects, PSW team members can tap the experience, ideas,
measurements and estimates of other teams who have worked on similar
engagements. Technical staff members can often get the latest information about
technologies being used on the project from PSW professionals who are working on
projects with the IT vendors who develop and support that technology.
Genova methodologies have several common elements that help align
client expectations with the project objectives. All the methodologies consist
of a thorough definition phase where client objectives and user or marketplace
requirements are defined. The definition phase of a project emphasizes
specifications which can be positively verified during the testing phase. Genova
methodologies also emphasize proper up front design prior to implementation to
minimize the risk of design flaws. The implementation phase of each methodology
includes a complete testing plan, one of the frequently underestimated parts of
a project.
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Marketing and Sales
Marketing
Strategic market planning is performed by the executive staff of the
Company, which actively seeks guidance from a number of sources to make
strategic decisions. These sources include PSW clients, senior technical staff
members, sales personnel and numerous executive contacts throughout the
industry. The executive staff meets off-site quarterly to discuss strategic
issues and actions. Action items are identified and tracked between meetings.
Senior technical staff members meet twice a year at the PSW Technology Forum to
share their views and produce a set of strategic actions for themselves and for
the executive staff to pursue business opportunities resulting from changes in
the technology landscape.
The marketing department controls and promotes key corporate messages,
consistent marketing programs and materials and ongoing public relations. This
is accomplished by working in coordination with Company initiatives and through
a program of regular communication of newsworthy items to key press and industry
analysts. Public relations is the primary vehicle used to promote corporate
image through the use of client case studies and placement of technical articles
by senior technical staff.
Service marketing supports the sales process by producing qualified
leads. The Company focuses on implementing a "value chain" that seeks to align
the communication and delivery of the highest value services possible to the
client. This includes marketing, sales, project management, methodologies,
recruiting, training and any other initiatives required to deliver consistent,
high quality service. The marketing emphasis is on communicating the value of
the service to the client and demonstrating PSW's capabilities to deliver the
service effectively.
The Company's marketing programs emphasize relationships with IT
vendors, clients and other key partners to shorten the sales cycle and increase
the productivity of PSW's sales resources. PSW works closely with these
companies during the sales process to present a unified proposal to the client.
At the same time, PSW does not resell hardware or software products of any other
IT vendor, maintaining its independence to recommend the appropriate solution to
each of its clients.
Sales
PSW's sales force consists of Business Development Managers and Senior
Account Managers. Business Development Managers identify appropriate business
opportunities and client needs. Senior members of the technical staff provide
high level technical consulting early in the client relationship to thoroughly
explore the client's needs and to propose solutions. These solutions often
result in PSW projects involving project managers and technical professionals,
in which case a Senior Account Manager will be assigned to oversee the project
and serve as the primary account manager.
Senior Account Managers are experienced professionals in both
relationship management and in understanding the business needs of either IT
vendors or IT users. They are responsible for achieving high client satisfaction
and growing additional business in their assigned accounts. Business Development
Managers are paid a commission based on the gross margin of business they
obtain. Commissions are also structured to incent finding new clients and to
incent the sale of larger engagements. Senior Account Managers are also
commissioned but have a higher base salary and lower commission leverage
than a Business Development Manager.
The sales and marketing organization utilizes a formal proposal
process to identify engagements in which the Company's technical skills and
project management capabilities are well suited to meet the needs of prospective
clients. The proposal process also involves reviews with the client, which
are designed to ensure that the engagement is based upon a jointly developed
proposal. In some cases, the client pays for an assessment to analyze the
project and make a detailed proposal. Time schedules and cost estimates are
prepared by the technical staff. A pricing model is used to determine whether
the engagement will meet or exceed Company margin targets for new business.
Pricing for fixed price projects must be approved by a Senior Vice President.
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PSW serves clients throughout the United States. The Company seeks to
establish sites in those areas that have a high concentration of IT vendors.
Current sites include Austin, Boston, and Seattle. Each site has a site manager
and sales resources to grow the Company's business and base of clients. In
addition, the Company has established a sales office in Chicago, Illinois in
order to focus on IT user opportunities. Once an engagement is started, key
personnel travel or relocate to the project site and new personnel are added by
both local and national recruiting efforts.
Employees
PSW's workforce has grown significantly over the past three years,
increasing from 167 full-time employees at December 31, 1994 to 461 full-time
employees at December 31, 1997. PSW believes that attracting and retaining
superior and innovative technical professionals, project managers and executive
management is a critical element in its ability to deliver high quality services
to its clients. Accordingly, PSW focuses on identifying and recruiting highly
qualified technical professionals at all levels within the Company. In order to
retain these professionals, the Company maintains a culture and implements
numerous programs that emphasize the importance of its employees, including
training, career development and incentive programs.
None of the Company's employees is covered by a collective bargaining
agreement. Substantially all of the Company's employees have executed an
invention assignment and confidentiality agreement. In addition, the Company
requires that all new employees execute such agreements as a condition of
employment by the Company.
Management considers its relations with its employees to be good.
Selection and Recruiting
Prior to October 1995, the Company relied significantly upon the
recruiting services of Pencom for its technical staff hires. Since that time,
the Company has decreased its reliance on Pencom by building its internal
recruiting infrastructure for technical staff hires, with Pencom accounting for
less than 15% and 4% of the Company's hires in 1996 and 1997, respectively.
Currently, the Company is a party to recruiting agency agreements with Pencom
and several other outside recruiting firms.
The Company utilizes dedicated recruiters to support management in
identifying, staffing and building pipelines for the skill types required to
meet the Company's sales efforts. PSW has a comprehensive interview and
evaluation process, which typically includes a full day of technical interviews.
The Company utilizes a sophisticated on-line recruiting system from Resumix to
quickly capture candidate resumes, allow for specific skill searches and manage
the work flow associated with a specific search.
In addition, PSW has established an employee referral program pursuant
to which existing employees receive a cash incentive for each person they refer
who becomes a PSW employee. This referral program has provided the Company with
a cost-effective means of identifying and recruiting high quality employees. In
addition to agencies and employee referals, the Company utilizes advertising,
job fairs and its Website to identify potential employees.
Career Development and Training
The Company has developed a separate Professional Development
department within Human Resources which is designed, among other things, to
ensure that project assignments and training are consistent with each employee's
career aspirations and that each employee receives meaningful quarterly and
annual performance reviews. In addition, the Company's "technical career ladder"
enables highly qualified technical professionals to reach the level of
Architect, a position which entails substantial professional authority. Finally,
the Company typically offers redeployment and/or relocation to employees upon
business changes, such as the expiration of an engagement.
The Company has developed strong internal training programs for its
technical employees, including its Windows NT certification program for
technical professionals working with the Windows NT operating environment, and
the Genova Business Systems Development Academy coursework, which trains
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employees in object-oriented business systems development using the Genova
methodology. In addition, the Company offers several management training
programs to its senior employees, including Communications & Leadership,
Overview of Management, Interviewing Effectively and Legally, Performance
Reviews, and Progressive Discipline and Termination. Finally, PSW conducts
semi-annual Technology Forums and Business Forums to increase communications and
sharing among both business units and across all locations and disciplines
within the Company.
Incentives
The Company implements a number of compensation and other incentive
programs designed to promote employee retention. Technical professionals are
compensated in accordance with the Company's merit pay program, which is based
on competitive salary ranges and is designed to reward employees based on their
individual job level and their performance in that job level. In addition, the
Company implements a "battle pay" program to compensate employees for extended
on-site work away from home. The Company also issues Common Stock options to all
PSW employees, with senior management and technical personnel receiving options
at levels intended to build a significant and long-term commitment to the
Company. Finally, the Company provides a competitive and comprehensive benefits
program which includes health care, escalating vacation time and life insurance.
Executives and other key employees participate in an annual bonus program. Other
employees receive discretionary bonuses upon recommendation and approval by
management.
Competition
The markets for the Company's services are highly competitive. The
Company believes that it currently competes principally with consulting and
software integration firms and the professional service organizations of certain
hardware and application software vendors. In addition, there are a number of
systems integrators who serve similar markets or provide similar services with
whom the Company competes or may compete in the future. Many of these companies
have significantly greater financial, technical and marketing resources than the
Company, generate greater revenues and have greater name recognition than the
Company. There are relatively low barriers to entry into the Company's markets
and the Company has faced and expects to continue to face additional competition
from new entrants into its markets.
The Company believes that the principal competitive factors in its
markets include reputation, project management expertise, industry expertise,
speed of development and implementation, technical expertise and ability to
deliver on a fixed-price as well as a time and materials basis. The Company
believes that its ability to compete also depends in part on a number of
competitive factors outside its control, including the ability of its clients or
competitors to hire, retain and motivate project managers and other senior
technical staff; the ownership by competitors of software used by potential
clients; the development by others of products and services that are competitive
with the Company's services; the price at which others offer comparable
services; the ability of its clients to perform the services themselves; and the
extent of its competitors' responsiveness to client needs. There can be no
assurance that the Company will be able to compete effectively on pricing or
other requirements with current and future competitors or that competitive
pressures faced by the Company will not cause the Company's revenue or income to
decline or otherwise materially adversely affect its business, financial
condition and results of operations. The Company has entered into employment
agreements with each of its executive officers. These agreements contain
provisions which, among others, prohibit the employee from disclosing or
otherwise using certain confidential information, assign to the Company
inventions or ideas conceived by the employee during his employment, prohibit
solicitation by the employee of clients and other employees of the Company and
prohibit the employee from accepting any opportunity (whether by contract or
full-time employment) with the Company's clients. Furthermore, the Company's
employment agreement with Dr. W. Frank King, the Company's President and Chief
Executive Officer, contains provisions, which for a period of two years,
restrict Dr. King's ability to provide services to, or solicit the business of,
the Company's clients and prospective clients. There can be no assurance that
any of the foregoing measures will prevent a former employee of the Company from
enhancing the prospects of one of the Company's competitors.
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Customers
The Company has derived a significant portion of its revenue from a
limited number of large clients. The Company's five largest clients in each of
1994, 1995, 1996 and 1997, accounted for approximately 77%, 88%, 82% and 63%,
respectively, of its revenues in each such period. The Company's largest client,
International Business Machines Corp., together with its subsidiaries
(collectively, "IBM"), accounted for approximately 52% and 39% of its revenue in
1996 and 1997, respectively. The Company expects a decline in the level of IBM
business in 1998 due to the completion of several projects for IBM nd the growth
in non-IBM business. The volume of work performed for specific clients is likely
to vary from year to year, and a major client in one year may not use the
Company's services in a subsequent year. The loss of, or reduction in PSW
services required by, any large client could have a material adverse effect
on the Company's business, financial condition and results of operations.
Most of the Company's contracts are terminable by the client following
limited notice and without penalty to the client. Further, the level of
investment by the Company's clients in IT projects can be adversely affected by
a number of factors, including changes or developments in the general technology
landscape and the internal budget cycles of such clients. The cancellation of a
large project or a significant reduction in the scope of any such project could
have a material adverse effect on the Company's business, financial condition
and results of operations, and in the past the cancellation of large projects
has adversely impacted the Company's earnings.
Intellectual Property Rights
The Company's future success is dependent in part upon the maintenance
and protection of its intellectual property rights and, to a lesser extent, upon
its ability to license technology from its clients. The Company relies on a
combination of copyrights, trade secrets and trademarks to protect its
intellectual property. There can be no assurance that the steps taken by the
Company to protect its intellectual property rights will be adequate, that
competitors will not be able to develop similar or functionally equivalent
methodologies or products or that the Company will be able to license technology
from its clients in the future. Furthermore, effective copyright and trade
secret protection may be unavailable or limited in certain foreign countries,
and no assurance can be given that foreign copyright and trade secret laws will
adequately protect the Company's intellectual property rights. Litigation may be
necessary to enforce the Company's intellectual property rights, to protect the
Company's trade secrets, to determine the validity and scope of the intellectual
property rights of others, including the Company's clients, or to defend against
claims of infringement. Such litigation could result in substantial costs and
diversion of resources and could have a material adverse effect on the Company's
business, financial condition and results of operations. No assurance can be
given that infringement or invalidity claims (or claims for indemnification
resulting from infringement claims against third parties, such as clients) will
not be asserted against the Company or that any such assertions would not have a
material adverse effect on the Company's business, financial condition or
results of operations. If infringement or invalidity claims are asserted against
the Company or any of its licensees, litigation may be necessary to defend the
Company or such licensees against such claims, and in certain circumstances the
Company may choose to seek to obtain a license under the third party's
intellectual property rights. There can be no assurance that such licenses will
be available on terms acceptable to the Company, if at all.
Additional Factors That Affect Future Results
In addition to the other information in this Form 10-K, the following
factors should be considered in evaluating the Company and its business.
Industry Concentration; Dependence on Large Projects. The Company has
derived and believes it will continue to derive a significant portion of its
revenue from the technology vendor industry. As a result, the Company's
business, financial condition and results of operations are influenced by
economic and other conditions affecting such industry, such as economic
downturns which could lead to a reduction in spending on IT projects, which in
turn could lead to fewer new research and development outsourcing projects being
undertaken. Further, several of the Company's client contracts limit its ability
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to provide services to competitors of such clients, thereby restricting the
field of potential future clients. In addition, as a result of the dynamic
nature of the IT vendor industry, the Company may lose clients due to the
acquisition, merger or consolidation of existing clients with entities which are
not current clients of the Company. The occurrence of any of the foregoing could
have a material adverse effect on the Company's business, financial condition
and results of operations.
Fixed-Price Contracts and Other Project Risks. During 1996 and 1997,
approximately 12% and 20%, respectively, of the Company's revenue was generated
on a fixed price, fixed-delivery-schedule ("fixed price") basis, rather than on
a time-and-materials basis. The Company's failure to accurately estimate the
resources required for a fixed price project or its failure to complete its
contractual obligations in a timely manner consistent with the project plan upon
which its fixed price contract is based could have a material adverse effect on
the Company's business, financial condition and results of operations. In the
past, the Company has found it necessary to revise project plans after
commencement of the project and commit unanticipated additional resources to
complete certain projects, which have negatively affected the profitability of
such projects. The Company may experience similar situations in the future,
which could have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, the Company may establish
contract prices before the project design specifications are finalized, which
could result in a fixed price that proves to be too low and therefore adversely
affects the Company's business, financial condition and results of operations.
Many of the Company's engagements involve projects which are critical
to the operations of its clients' businesses and which provide benefits that may
be difficult to quantify. The Company's failure to meet a client's expectations
in the performance of its services could damage the Company's reputation and
adversely affect its ability to attract new business, and may have a material
adverse effect upon its business, financial condition and results of operations.
The Company has undertaken, and may in the future undertake, projects in which
the Company guarantees performance based upon defined operating specifications
or guaranteed delivery dates. Unsatisfactory performance or unanticipated
difficulties or delays in completing such projects may result in client
dissatisfaction and a reduction in payment to, or payment of damages by, PSW,
any of which could have a material adverse effect on the Company's business,
financial condition and results of operations. There can be no assurance that
the Company will be able to limit its liability to clients, including liability
arising from the Company's failure to meet clients' expectations in the
performance of services, through contractual provisions, insurance or otherwise.
Management of Growth. The Company's growth has placed significant
demands on its management and other resources. For example, the Company's staff
increased from 167 full-time employees at December 31, 1994 to 461 full-time
employees at December 31, 1997. The Company's ability to manage its growth
effectively will require it to continue to develop and improve its operational,
financial and other internal systems, as well as its business development
capabilities, and to continue to attract, train, retain, motivate and manage its
employees. In addition, the Company's future success will depend in large part
on its ability to continue to maintain high rates of employee utilization, set
fixed price fees accurately, maintain project quality and meet delivery dates,
all as the Company seeks to increase the number of projects in which it is
engaged. If the Company is unable to manage its growth and projects effectively,
such inability would have a material adverse effect on the quality of the
Company's services, its ability to retain key personnel and its business,
financial condition and results of operations. No assurance can be given that
the Company's growth will continue to be achieved, or if achieved, will be
maintained or that the Company will be successful in managing any such growth.
Recent Organization; Absence of Operating History as an Independent
Business; Limited Relevance of Historical Financial Information. Prior to
October 1996, the Company conducted its business and operations as the software
division of Pencom. Accordingly, the Company has only a limited independent
operating history upon which an evaluation of the Company and its prospects can
be based. Prior to October 1996, the Company also had limited accounting
capability and depended upon Pencom for most accounting functions. By October 1,
1996, the Company had assumed responsibility for most internal accounting
functions, but continued to depend upon Pencom for limited accounting support in
connection with the Company's 1996 year-end audit. There can be no assurance
that the Company will be successful in taking control of these functions from
Pencom. The Company has also relied upon, and will continue to rely upon, Pencom
10
for certain legal services and recruiting functions. The Company's management
has only limited experience operating the Company as a stand-alone company,
separate and apart from Pencom. Pencom has no obligation to provide financial or
management assistance to the Company and has no plans to do so. The inability of
the Company to operate successfully as an entity independent from Pencom would
have a material adverse effect on the Company's business, financial condition
and results of operations.
The information presented for 1996 and prior periods herein reflects
the financial position, results of operations and cash flows of the Company
and its predecessor, the software division of Pencom, and such information does
not necessarily reflect what the financial position, results of operations and
cash flows of the Company would have been had the Company been operated as
a separate, stand-alone business for the periods presented prior to October 1,
1996.
Variability of Quarterly Operating Results. The Company's revenue and
operating results may fluctuate from quarter to quarter based on a number of
factors, including the number, size and scope of projects in which the Company
is engaged, the contractual terms and degree of completion of such projects, any
delays incurred in connection with a project, the Company's success in earning
bonuses or other contingent payments, employee hiring and utilization rates, the
adequacy of provisions for losses, the accuracy of estimates of resources
required to complete ongoing projects and general economic conditions. Other
factors may affect operating results includes customer budget cycles and
customer spending priorities such as the Year 2000 issue. A high percentage of
the Company's operating expenses, particularly personnel and rent, are fixed in
advance of any particular quarter. For example, while the number of professional
staff the Company employs may be adjusted to reflect active projects, such
adjustments take time and the Company must maintain a sufficient number of
senior professionals to oversee existing client engagements and to focus on
securing new client engagements. As a result, unanticipated variations in the
number or progress toward completion of the Company's projects or in employee
utilization rates may cause significant variations in operating results in any
particular quarter and could result in adverse changes to the Company's
business, financial condition and results of operations. In the first quarter
of 1998, revenues may be adversely impacted by the Company's lenghy sales cycle,
among other matters, which may cause the Company's revenues and earnings to be
below the expectations of securitites analysts. Any shortfall in revenue or
earnings from expected levels or other failures to meet expectations of
securities analysts or the market in general regarding results of operations
could have an immediate and material adverse effect on the market price of the
Company's Common Stock. Given the possibility of such quarterly fluctuations in
revenue or earnings, the Company believes that comparisons of its quarterly
results of operations are not necessarily meaningful and that such results for
one quarter should not be relied upon as an indication of future performance.
Need to Attract and Retain Professional Staff. The Company's success
will depend in large part upon its ability to attract, train, retain, motivate
and manage highly skilled employees, particularly project managers and other
senior technical personnel. Significant competition exists for employees with
the skills required to perform the services offered by the Company, and the
Company requires that a significant number of such employees travel to client
sites to perform services on its behalf, which may make a position with the
Company less attractive to potential employees. Qualified project managers,
software architects and senior technical and professional staff are in great
demand worldwide and are likely to remain a limited resource for the foreseeable
future. Furthermore, there is a high rate of attrition among such personnel.
There can be no assurance that a sufficient number of highly skilled employees
will continue to be available to the Company, that potential employees will be
willing to travel to client sites, or that the Company will be successful in
training, retaining and motivating current or future employees. The Company's
inability to attract, train and retain skilled employees or the Company's
employees' inability to achieve expected levels of performance could impair the
Company's ability to adequately manage and staff its existing projects and to
bid for or obtain new projects, which in turn would have a material adverse
effect on the Company's business, financial condition and results of operations.
Rapid Technological Advances; Risk of Targeting Emerging Technologies. The
Company has derived, and will continue to derive, a substantial portion of its
revenue from projects based on client/server systems.The client/server systems
market is continuing to develop and is subject to rapid technological change.
The Company's future success will also depend in part on its ability to develop
11
IT solutions which keep pace with continuing changes in information processing
technology, evolving industry standards and changing client preferences. There
can be no assurance that the Company will be successful in addressing these
developments in a timely manner or that, if addressed, the Company will be
successful in the marketplace. The Company's delay or failure to address these
developments could have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, there can be no
assurance that products or technologies developed, or services offered, by third
parties will not render the Company's services noncompetitive or obsolete. The
Company's Software Technology Unit also seeks to identify emerging technologies
which it believes will develop into critical technologies with broad application
and longevity. Once identified, the Company may commit substantial resources to
provide services to the developers of such technologies. No assurance can be
given that the technologies identified by the Company will develop into critical
technologies with broad application and longevity. The failure of the Company to
align itself with such critical emerging technologies would have a material
adverse affect on its business, financial condition and results of operations.
Dependence on Key Personnel. The Company's future success will depend
in part upon the continued services of a number of key management employees,
particularly Dr. W. Frank King, Patrick D. Motola, Brian E. Baisley, Dennis P.
Thompson and William C. Cason, and a number of key technical employees. The loss
of the services of any of the Company's key personnel could have a material
adverse effect on the Company's business, financial condition and results of
operations. In addition, the Company's credit facility prohibits material
changes in management. The Company does not maintain key-person life insurance
on any of its employees. In addition, if one or more of the Company's key
employees resigns from the Company to join a competitor or to form a competing
company, any resulting loss of existing or potential clients to any such
competitor could have a material adverse effect on the Company's business,
financial condition and results of operations. In the event of the loss of any
such personnel, there can be no assurance that the Company would be able to
prevent the unauthorized disclosure or use of its technical knowledge, practices
or procedures by such personnel.
System Interruption and Security Risks. The Company's operations are
dependent on its ability to protect its intranet from interruption by damage
from telecommunications failure, fire, earthquake, power loss, unauthorized
entry or other events beyond the Company's control. Most of the Company's
computer equipment, including its processing equipment, is currently located at
a single site. There can be no assurance that unanticipated problems will not
cause any significant system outage or data loss. Despite the implementation of
security measures, the Company's infrastructure may also be vulnerable to
computer viruses, hackers or similar disruptive problems caused by Internet
users. Persistent problems continue to affect public and private data networks.
For example, it is common for Internet service providers to experience system
interruptions which cause the Company to lose access to the Internet, the means
by which the Company posts internal information and provides e-mail and time
sheet query and entry. Any damage or failure that causes interruptions in the
Company's operations could have a material adverse effect on the Company's
business, financial condition or results of operations.
Potential Volatility of Stock Price. The market for securities of
early-stage companies has been highly volatile in recent years as a result of
factors often unrelated to a company's operations. In addition, the Company
believes factors such as quarterly variations in operating results,
announcements of technological innovations or new products or services by the
Company or its competitors, general conditions in the IT industry or the
industries in which PSW's clients compete and changes in earnings estimates by
securities analysts, could contribute to the volatility of the price of the
Company's Common Stock. These factors, as well as general economic conditions
such as recessions or changes in interest rates, could adversely affect the
market price of the Company's Common Stock. Furthermore, in the past, following
periods of volatility in the market price of a company's securities, securities
class action claims have been brought against the issuing company. There can be
no assurance that such litigation will not occur in the future with respect to
the Company. Such litigation could result in substantial costs and a diversion
of management's attention and resources, and any adverse determination in such
litigation could also subject the Company to significant liabilities, all of
which could have a material adverse effect on the Company's business, financial
condition and results of operations.
12
Effect of Certain Antitakeover Provisions. The Company's Board of
Directors has the authority to issue shares of Preferred Stock and to determine
the designations, preferences and rights and the qualifications or restrictions
of those shares without any further vote or action by the stockholders. The
rights of the holders of Common Stock will be subject to, and may be adversely
affected by, the rights of the holders of any Preferred Stock that may be issued
in the future. The issuance of Preferred Stock could have the effect of making
it more difficult for a third party to acquire a majority of the outstanding
voting stock of the Company. In addition, the Company is subject to the
antitakeover provisions of Section 203 of the Delaware General Corporation Law
(the "DGCL"). In general, this statute prohibits a publicly held Delaware
corporation from engaging in a "business combination" with an "interested
stockholder" for a period of three years after the date of the transaction in
which the person became an interested stockholder, unless the business
combination is approved in a prescribed manner. Furthermore, certain other
provisions of the Company's Amended and Restated Certificate of Incorporation
and Amended and Restated Bylaws may have the effect of discouraging, delaying or
preventing a merger, tender offer or proxy contest, which could adversely affect
the market price of the Company's Common Stock.
13
Item 2. Properties
The Company's executive offices and primary facility are located in
Austin, Texas, in a leased facility of 36,319 square feet. The lease for the
Austin facility includes an additional 11,072 square feet of space in an
adjoining building which the Company assumed in February 1998. This lease
expires on December 31, 2003 with respect to both premises and is renewable at
the option of the Company for an additional five-year term. The Company also has
a right of first refusal on additional space in such facilities exercisable
during the primary term of the lease. The Austin facility is located in the high
tech center of Austin near other leading technology firms, and includes
sophisticated laboratory, network and server facilities to support PSW's
operations and project work on a variety of computing platforms.
PSW has 8,957 square feet of additional office space in Bellevue,
Washington, strategically located near Microsoft and the IBM Kirkland
Programming Center. This facility primarily provides office and laboratory space
for the Company's Windows NT porting center, and also supports sales. PSW also
has space in Jersey City, New Jersey, Boston, Massachusetts and Chicago,
Illinois.
PSW employees are also located at client sites throughout the United
States, including Chicago, Raleigh, Atlanta, Costa Mesa, Dallas and Stamford.
Additional office expansion is anticipated in 1998. The Company believes that
its existing facilities are adequate to meet its current needs and that suitable
additional or alternative space will be available in the future on commercially
reasonable terms, if and as needed.
Item 3. Legal Proceedings
None.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted during the fourth quarter of the fiscal year
covered by this report to a vote of security holders, through the solicitation
of proxies or otherwise.
14
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
The Company's Common Stock has traded on the Nasdaq National Market
under the symbol "PSWT" since its initial public offering on June 5, 1997. Prior
to the initial public offering, there had been no public market for the Common
Stock. The following table lists the high and low sales by quarter subsequent to
the initial public offering:
High Low
Fourth quarter of 1997 $19.63 $10.31
Third quarter of 1997 $15.63 $11.38
As of March 2, 1998, there were 8,987,874 shares of the Company's
Common Stock outstanding held by 53 stockholders of record. The Company paid a
cash dividend to its stockholders of record immediately prior to the completion
of the initial public offering in an amount estimated to approximate the 1997
income tax that such stockholders are required to pay on the 1997 taxable income
allocated to them as a result of the Company's prior S Corporation status. The
Company currently intends to retain any earnings for the operations and
expansion of the Company's business and does not anticipate paying any cash
dividends in the foreseeable future. Future dividends, if any, will be
determined by the Company's Board of Directors and will depend upon the
Company's earnings, financial condition, cash requirements, future prospects,
contractual restrictions and other factors deemed relevant by the Board of
Directors.
Use of Proceeds From Registered Securities
On June 5, 1997 (the "Effective Date"), the Company's Registration
Statement on Form S-1 (Registration No. 333-21565) relating to its initial
public offering (the "IPO") was declared effective by the Securities and
Exchange Commission and the offering of up to 3,277,500 shares of the Company's
Common Stock covered by such Registration Statement commenced. The IPO, which
has been completed, was managed by Alex, Brown & Sons Incorporated and J.P.
Morgan & Co., as the representatives of the several underwriters (the
"Underwriters") of the IPO. All of the securities registered were sold for the
account of the Company at an aggregate offering price of $29.5 million. Of the
shares of Common Stock sold by the Company, 2,850,000 shares were sold on June
5, 1997, and 427,500 shares (which were subject to an overallotment option
granted by the Company to the Underwriters) were sold on July 2, 1997.
In connection with the IPO, total expenses of approximately $3.8
million were incurred by the Company, which expenses consisted of: (i) $2.1
million representing underwriting discounts and commissions paid to the
Underwriters; and (ii) other offering expenses, including without limitation,
attorney's fees, accountants' fees, printing costs and filing fees of
approximately $1.7 million. Of the other offering expenses, $101,000 were direct
or indirect payments to directors or officers of the Company or their associates
or to persons owning ten percent (10%) or more of any class of equity securities
of the Company or to affiliates of the Company. The net offering proceeds of
such shares, after deducting such total expenses, was approximately $25.7
million, of which $3.0 million was used to repay indebtedness of the Company,
$654,000 was used to satisfy certain federal income tax obligations of the
Company, $1.4 million was used to pay a dividend to the Company's stockholders
of record just prior to the IPO in respect of the estimated tax that such
stockholders are required to pay on the estimated 1997 taxable income allocated
to them, and the remaining $20.7 million was invested in short-term, interest
bearing accounts pending application of such proceeds by the Company. Other than
the amounts paid as a dividend to the stockholders of record just prior to the
IPO, no other net proceeds were paid directly or indirectly to any directors or
officers of the Company or their associates or to persons owning ten percent
(10%) or more of any class of equity securities of the Company or to affiliates
of the Company.
15
Item 6. Selected Financial Data
PSW commenced operations as a corporation effective October 1, 1996.
Prior to that date, the Company conducted its business and operations as the
software division of Pencom. The selected financial data presented below have
been derived from the audited financial statements of the Company and its
predecessor and include the portion of a software contract that had previously
been allocated to Pencom. The statements of income data for the years ended
December 31, 1995, 1996 and 1997 and the balance sheet data as of December 31,
1996 and 1997 are derived from financial statements, appearing herein. The
statements of income data for the years ended December 31, 1993 and 1994 and the
balance sheet data as of December 31, 1993, 1994 and 1995 are derived from
audited financial statements not included herein. The information presented
below reflects the financial condition and results of operations of the Company
and its predecessor, and does not necessarily reflect what the financial
position and results of operations of the Company would have been had the
Company been operated as a separate, stand-alone company for the periods
presented prior to October 1, 1996, nor is it necessarily indicative of future
results. The following should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the financial statements and notes thereto appearing elsewhere in this Form
10-K.
Year ended December 31,
1993 1994 1995 1996 1997
-------- -------- -------- -------- --------
(in thousands, except per share data)
......................................................................
Statements of Income Data:
Revenue .................................................................. $ 8,725 $ 12,318 $ 21,147 $ 31,274 $ 44,118
Operating expenses:
Technical staff ....................................................... 6,167 7,385 11,193 16,444 22,479
Selling and administrative staff ...................................... 1,873 2,320 3,755 5,622 8,405
Other expenses ........................................................ 1,899 2,317 3,976 5,684 7,979
Special compensation expense(1) ....................................... -- -- -- 2,193 268
-------- -------- -------- -------- -------
Total operating expenses ........................................... 9,939 12,022 18,924 29,943 39,131
-------- -------- -------- -------- -------
Income (loss) from operations ............................................ (1,214) 296 2,223 1,331 4,987
Interest income (expense), net ........................................... (329) (74) (84) (170) 431
-------- -------- -------- -------- -------
Income (loss) before provision
for income taxes ....................................................... (1,543) 222 2,139 1,161 5,418
-------- -------- -------- -------- -------
Provision for income taxes:
Nonrecurring charge for termi-
nation of Subchapter S election ...................................... -- -- -- -- 1,200
C Corporation taxes................................................... -- -- -- -- 1,000
-------- -------- -------- -------- -------
Net income (loss) ........................................................ $ (1,543) $ 222 $ 2,139 $ 1,161 $ 3,218
======== ======== ======== ======== =======
Unaudited pro forma information:
Historical income (loss) before
provision for income taxes .......................................... $ (1,543) $ 222 $ 2,139 $ 1,161 $ 5,418
Pro forma provision (benefit)
for income taxes(2) ................................................. (586) 84 813 441 1,900
======== ======== ======== ======== =======
Pro forma net income (loss) .............................................. $ (957) $ 138 $ 1,326 $ 720 $ 3,518
======== ======== ======== ======== =======
Pro forma diluted earnings
(loss) per share(3) ................................................. $ (0.14) $ 0.02 $ 0.20 $ 0.11 $ 0.41
======== ======== ======== ======== =======
Shares used in pro forma diluted
earnings (loss) per share
calculation(3) ........................................................ 6,635 6,635 6,635 6,689 8,517
======== ======== ======== ======== =======
16
Item 6. Selected Financial Data (continued)
December 31,
1993 1994 1995 1996 1997
------- ------- ------- ------- -------
(in thousands)
Balance Sheet Data:
Working capital ........................................................... $ 1,526 $ 1,933 $ 2,756 $ 1,648 $28,074
Total assets .............................................................. 2,533 3,538 4,982 11,943 35,420
Total stockholders' equity ................................................ 2,302 2,675 3,684 3,444 31,859
(1) See Note 13 of Notes to Financial Statements for an explanation of special
compensation expense.
(2) Computed on the basis described in Notes 2 and 12 of Notes to Financial
Statements.
(3) Computed on the basis described in Note 2 of Notes to Financial Statements.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The discussion and analysis below contains forward-looking statements
that involve risks and uncertainties. These forward-looking statements and other
statements made elsewhere in this document are made in reliance upon safe harbor
provisions of the Private Securities Litigation Reform Act of 1995. The section
below entitled "Certain Factors That May Affect Future Results, Financial
Condition and Market Price of Securities" sets forth and incorporates by
reference certain factors that could cause actual future results of the Company
to differ materially from those statements.
Overview
PSW Technologies, Inc. is a software services firm that provides high
value solutions to IT vendors and IT users by mastering and applying critical
emerging technologies. These critical technologies include Web/Internet
distributed computing, object-oriented development, advanced operating systems
and systems management technologies. IT vendors primarily consist of software
companies that utilize the Company's services to help bring their products to
market faster. IT users generally utilize the Company's services to help
define, develop and complete high value, mission critical enterprise software
systems for internal use.
The Company was founded as a separate division of Pencom in 1989 to
take advantage of the large number of subcontractors placed by Pencom with IBM's
AIX organization in Austin, Texas. As these subcontractors completed their
assignments, the most talented were recruited to become part of the permanent
technical staff of the Company. The Company's mission was to seek
project-oriented assignments to complement Pencom's existing recruiting and
staff supplementation business.
Dr. W. Frank King was hired in 1992 as the President of the Company to
continue its growth, establish profitability and develop the infrastructure that
would eventually enable it to operate as a separate company. In addition, in
1993, Dr. King focused resources to provide application development services to
address the needs of IT users. The Company established a formal sales function
in 1994, and began the Genova initiative with an emphasis on the business
development methodology. The Company first became profitable in 1994. In 1995,
the Company initiated its own recruiting function independent of Pencom.
In 1996, the Company formalized the Genova initiative, completed the
licensing of the Genova Object Libraries and established the Genova Academy
training. On October 1, 1996, the Company was formed as PSW Technologies, Inc.,
at which time the Company assumed responsibility for its own accounting and
finance operations but continued to depend upon Pencom for limited accounting
support in connection with the Company's year-end audit.
The Company completed an initial public offering of its Common Stock in
1997. Including the underwriters exercise of their over-allotment option, the
Company sold 3,277,500 shares of its Common Stock and raised $25.7 million in
17
net proceeds from the offering. In 1997, the Company completed business systems
projects for major IT users including U.S. Bancorp, MCC Behavior Care/ Cigna
Health Care Systems and a multi-year engagement with Canon Computer Systems,
Inc. Major IT vendor projects completed during 1997 included projects for
Novell, Inc., Cadence Design Systems, Inc. and Tivoli Systems. The Company was
also named a Lotus Notes Qualified Business partner and a member of Tivoli's
10/Plus Association Business Partner in 1997.
To date, revenue has been generated principally from time-and-materials
contracts for the Company's software services. Revenue from time-and-materials
contracts is recognized during the period in which the services are provided.
The Company also enters into fixed price contracts for its software services.
Revenue from fixed price contracts is recognized using the
percentage-of-completion method over the term of the client contract, measured
by the labor incurred as a percentage of the estimated total labor used at
completion. Fixed price contract revenue represented approximately 12% and 20%
of the Company's revenue in 1996 and 1997, respectively. The cumulative impact
of revisions in percentage of completion estimates is reflected in the period in
which the revisions are made. Provisions for estimated losses on uncompleted
contracts are made on a contract-by-contract basis and are recognized in the
period in which such losses are determined. There can be no assurance of the
accuracy of the Company's future work completion estimates, and operating
results may be adversely affected by inaccurate estimates of contract related
labor.
The Company has derived a significant portion of its revenue from a
limited number of large clients. One client, IBM, accounted for 52% and 39% of
revenue in 1996 and 1997, respectively. The Company expects a decline in the
level of IBM business in 1998. The Company's relationship with IBM includes
engagements with IBM Kirkland, IBM Austin, Tivoli Systems, Inc. ("Tivoli"),
Lotus Development Corporation ("Lotus") and Transarc. The technologies involved
in these engagements include Windows 95, Windows NT, AIX, system management
software and Lotus Notes workgroup software. None of these individual
engagements accounted for more than 20% of the Company's revenue in 1996 or
1997. The Company believes that future revenue growth and profitability will
principally depend on its ability to further diversify its client base away from
IBM. During 1997, the Company's non-IBM revenue grew approximately 80% compared
to 1996.
The information presented herein reflects the financial position,
results of operations and cash flows of the Company and its predecessor, the
software division of Pencom, and such information does not necessarily reflect
what the financial position, results of operations and cash flows of the Company
would have been had the Company been operated as a separate, stand-alone
business for the periods presented prior to October 1, 1996, nor is it
necessarily indicative of future operations.
Year 2000 Compliance
Many currently installed computer systems and software products are
coded to accept only two-digit entries in the date code field. Beginning in the
Year 2000, these date code fields will need to accept four digit entries to
distinguish 21st century dates from 20th century dates. As a result, computer
systems and software used by many companies may need to be updated to comply
with such "Year 2000" requirements. Significant uncertainty exists in the
consulting and software development services industry concerning the potential
effects associated with such compliance. Although all of the services currently
offered by the Company are designed to be Year 2000 compliant, there can be no
assurance that the Company's services will be compatible with third-party
software that may be integrated or used in conjunction with the Company's
services. The Company believes that its internal and financial reporting systems
will be operational through and beyond the year 2000 without significant
additional expense to the Company.
Net Charge Resulting from S Corporation Termination
From commencement through the completion of the Company's initial
public offering on June 5, 1997, the Company had elected to be treated as an S
Corporation under Subchapter S of the Internal Revenue Code of 1986, as amended.
As such, federal income taxes attributable through June 5, 1997 were the
responsibility of the individual stockholders. As a result of the initial public
18
offering, the Company's Subchapter S status was terminated and the Company
recorded a deferred tax charge against income of approximately $1.2 million for
the cumulative differences between the financial reporting and income tax basis
of certain assets and liabilities existing at that date. Additionally, the
Company was required to change its method of accounting from the cash basis to
the accrual basis for income tax reporting purposes. The Company's stockholders
are obligated to pay the 1997 income taxes related to the period prior to the
completion of the offering. The Company declared and paid a dividend of $1.4
million to the S Corporation stockholders of record immediate prior to the
completion of the offering for the amount estimated to approximate the 1997
income taxes payable by the stockholders. (See Note 12 of Notes to Financial
Statements.)
Special Compensation Expense
Special compensation expense in 1996 consisted of stock-based
compensation in connection with the grants of replacement options to the
Company's employees who participated in the Pencom stock option plan and
compensation related to the cancellation of a note issued by an officer of the
Company to Pencom, which, in the aggregate, totaled $2.2 million. Special
compensation expense in 1997 consisted of stock-based compensation in connection
with grants of replacement options to the Company's employees who participated
in the Pencom stock option plan, which, in the aggregate, totaled $268,000. (See
Notes 9, 12 and 13 of Notes to Financial Statements.)
Pro Forma Income Taxes
Pro forma income taxes reflect the estimated corporate income tax
expense that the Company would have recognized had it not elected S corporation
status prior to the completion of its IPO (see Notes 2 and 12 of Notes to
Financial Statements).
Results of Operations
The following table sets forth the percentage of revenue of certain
items included in the Company's statements of income for the periods indicated:
Year ended December 31,
1995 1996 1997
---- ---- ----
.........................................................................................
Revenue ..................................................................................... 100% 100% 100%
Operating Expenses:
Technical staff ........................................................................ 53 53 51
Selling and administrative staff ....................................................... 18 18 19
Other expenses ......................................................................... 19 18 18
Special compensation expense ........................................................... -- 7 1
---- ---- ----
Total operating expenses .................................................................... 90 96 89
---- ---- ----
Income from operations ...................................................................... 10 4 11
Interest income (expense), net .............................................................. -- (1) 1
Pro forma provision for income taxes ........................................................ 4 1 4
---- ---- ----
Pro forma net income ........................................................................ 6% 2% 8%
---- ---- ----
Results of Operations for 1997 Compared with 1996
Revenue
Revenue consists primarily of fees for software services provided.
Revenue was $44.1 million in 1997, an increase of 41% over 1996 revenue of $31.3
million, principally due to increases in the scope and number of client
19
projects. Revenue attributable to software services rendered to IT vendors was
$27.3 million and $20.4 million in 1997 and 1996, respectively, an increase of
34% in 1997 compared to 1996. Revenue attributable to software services rendered
to IT users was $16.8 million and $10.9 million in 1997 and 1996, respectively,
an increase of 54% in 1997 compared to 1996.
One customer, including its wholly owned subsidiaries, accounted for
52% and 39% of revenue in 1997 and 1996, respectively. The Company expects a
decline in the level of business from this customer in 1998. Another customer
accounted for approximately 14% of total revenue for 1996. No other customer
accounted for more than 10% of revenue in 1997 or 1996.
Technical Staff
Technical staff expenses consist of the cost of salaries, payroll
taxes, health insurance and workers' compensation for technical staff personnel
assigned to client projects and unassigned technical staff personnel, and fees
paid to any subcontractors for work performed in connection with a client
project. Technical staff expenses were $22.5 million in 1997, an increase of 37%
over 1996 technical staff expenses of $16.4 million. The increase in technical
staff expenses was primarily due to the addition of personnel necessary to
service growth in the number and scope of customer projects. Technical staff
expenses declined to 51% of revenue in 1997 from 53% in 1996 primarily as a
result of improved pricing and productivity of the technical staff.
Selling and Administrative Staff
Selling and administrative staff expenses consist of the cost of
salaries, payroll taxes, health insurance and workers' compensation for selling
and administrative personnel, all commissions and bonuses, and the cost of
technical staff salaries for technical staff personnel assigned to methodology
development projects or performing selling or training related tasks. Selling
and administrative staff expenses were $8.4 million in 1997, an increase of 50%
from $5.6 million in 1996. The increase in selling and administrative staff
expenses was primarily due to the addition of sales and administrative
personnel, and technical staff training necessary to support the Company's
growth. Selling and administrative staff expenses increased to 19% of revenue in
1997 from 18% of revenue in 1996. The increase in selling and administrative
staff expenses as a percentage of revenue is due primarily as a result of
increases in the costs and number of sales and marketing staff.
Other Expenses
Other expenses consist of all non-staff related costs, such as
occupancy costs, travel, business insurance, business development, recruiting,
training and depreciation. Other expenses were $8.0 million in 1997, an increase
of 40% over other expenses of $5.7 million in 1996. Other expenses were 18% of
revenue in both 1997 and 1996.
Special Compensation Expense
Special compensation expense in 1997 consisted of amortization of
stock-based compensation originating in 1996, which, in the aggregate, totaled
$268,000 or less than 1% of revenue. Special compensation expense in 1996
consisted of stock-based compensation and compensation related to the
cancellation of a note payable, which, in the aggregate, totaled $2.2 million,
or 7% of revenue. See Notes 9, 12 and 13 of Notes to Financial Statements.
Income from Operations
Income from operations increased to $5.0 million in 1997 from $1.3
million in 1996. If income from operations was adjusted to exclude special
compensation expense, referred to above, income from operations would have
increased to $5.3 million in 1997, up 49% from $3.5 million in 1996. Excluding
special compensation expense, income from operations was 12% of revenue in 1997
and 11% of revenue in 1996.
20
Results of Operations for 1996 Compared with 1995
Revenue
Revenue was $31.3 million in 1996, an increase of 48% over 1995 revenue
of $21.1 million, principally due to increases in the scope and number of client
projects. Revenue attributable to software services rendered to IT vendors was
$20.4 million and $14.0 million in 1996 and 1995, respectively, an increase of
45% in 1996 compared to 1995. Revenue attributable to software services rendered
to IT users was $10.9 million and $7.1 million in 1996 and 1995, respectively,
an increase of 54% in 1996 compared to 1995.
Two clients, including their subsidiaries, accounted for 66% and 76% of
revenue in 1996 and 1995, respectively. No other client accounted for more than
10% of revenue in 1996 or 1995.
Technical Staff
Technical staff expenses were $16.4 million in 1996, an increase of 47%
over 1995 technical staff expenses of $11.2 million. The increase in technical
staff expenses was primarily due to the addition of personnel necessary to
service growth in the number and scope of client projects. Technical staff
expenses were 53% of revenue in both 1996 and 1995.
Selling and Administrative Staff
Selling and administrative staff expenses were $5.6 million in 1996, up
50% from $3.8 million in 1995. The increase in selling and administrative staff
expenses was primarily due to the addition of personnel necessary to support the
Company's growth, including increases in sales and recruiting personnel, and
increases in personnel working on the Company's Genova initiative. Selling and
administrative staff expenses were 18% of revenue in both 1996 and 1995.
Other Expenses
Other expenses were $5.7 million in 1996, an increase of 43% over other
expenses of $4.0 million in 1995. Other expenses declined to 18% of revenue in
1996 from 19% in 1995, primarily as a result of the significant increase in
revenue in 1996.
Special Compensation Expense
Special compensation expense in 1996 consisted of stock-based
compensation and compensation related to the cancellation of a note payable,
which, in the aggregate, totaled $2.2 million, or 7% of revenue. See Notes 9, 12
and 13 of Notes to Financial Statements. There was no special compensation
expense in 1995.
Income from Operations
Income from operations decreased $892,000 to $1.3 million in 1996 from
$2.2 million in 1995. If income from operations was adjusted to exclude special
compensation expense, referred to above, income from operations would have grown
59% in 1996 compared with 1995. Income from operations declined to 4% of revenue
in 1996 from 10% in 1995 primarily as a result of special compensation expense
in 1996. If income from operations was adjusted to exclude special compensation
expense, income from operations would have been 11% of revenue in 1995 and 1996.
Liquidity and Capital Resources
Since commencement of its operations as a separate company on October
1, 1996, the Company has maintained its own cash accounts. Before the IPO in
June 1997, available cash balances were used to reduce bank borrowings and
amounts due to Pencom. Prior to its incorporation, the Company participated in
Pencom's centralized cash management system while it conducted its business and
21
operations as the software division of Pencom. In 1995, cash was used to repay
$1.1 million of contributions by Pencom. In 1996, the Company repaid $2.9
million of contributions from Pencom.
Cash flows from operations were $3.0 million, $2.1 million and $1.6
million in 1997, 1996 and 1995, respectively. Total repayments of borrowings
were $5.1 million in 1997. The Company purchased approximately $2.7 million,
$1.2 million and $450,000 of computer and office equipment in 1997, 1996 and
1995, respectively. At December 31, 1997, the Company did not have any material
commitments for capital expenditures.
At December 31, 1997, the Company had cash and cash equivalents and
investments totaling $23.3 million, an increase from $3.2 million at December
31, 1996, primarily as a result of the completion of the IPO, pursuant to which
the Comp6any issued and sold 3,277,500 shares of its Common Stock at a price to
the public of $9.00 per share. Of the $25.7 million of net proceeds from the
IPO, approximately $3.0 million was used to repay the principal amount and
accrued interest outstanding under the Company's credit facility, as amended
(the "Credit Facility"). In connection with the completion of its IPO, the
Company also recorded liabilities for the payment of an estimated $1.8 million
income tax obligation payable over two years resultant from the conversion
from a cash basis to accrual basis method of tax accounting upon the termination
of its Subchapter S election and the payment of a $1.4 million dividend to
stockholders of the Company prior to the offering in respect of the estimated
tax that such stockholders are required to pay on the estimated 1997 taxable
income allocated to them.
The Company's revolving credit agreement with a bank which was amended
and extended until May 1, 1999, is unsecured and contains customary restrictive
covenants, including covenants requiring the Company to maintain a minimum net
worth and certain financial ratios. The revolving credit agreement is subject to
a borrowing base requirement and bears interest at the greater of (a) the bank's
prime rate or (b) the federal funds rate plus 0.25 percent. At the Company's
election, borrowings can be converted to loans which bear interest at a rate
computed based on the London Interbank Offered Rate ("LIBOR") . The weighted
average borrowing rate on the line of credit was 8.4% for 1997. At December 31,
1997, there was no amount outstanding and the available borrowing amount was
$7.5 million.
The Company anticipates that its existing capital resources described
above, including cash provided by operating activities and available bank
borrowings will be adequate to fund the Company's operations for at least the
next 12 months. There can be no assurance that changes will not occur that would
consume available capital resources before such time. The Company's capital
requirements depend on numerous factors, including potential acquisitions, the
timing of the receipt of accounts receivable, employee growth, and the
percentage of projects performed at PSW facilities. There can be no assurance
that additional funding, if necessary, will be available on favorable terms, if
at all.
Certain Factors That May Affect Future Results, Financial Condition and Market
Price of Securities
Numerous factors may affect the Company's business and its results of
operations. These factors include the client and industry concentrations;
management's ability to accurately estimate resources required for fixed-price
contracts; the Company's ability to meet client expectations and deliverable
dates, the Company's ability to manage the substantial growth of the Company;
potential for significant fluctuations in quarterly results; management's
ability to attract and retain professional staff; the Company's ability to
develop IT solutions with rapid technological advances; and general economic
and business conditions. For a discussion of these and other factors that may
affect the Company's future results, see "Business" in Item 1 of this Form 10-K.
22
Item 8. Financial Statements and Supplementary Data
PSW TECHNOLOGIES, INC.
INDEX TO FINANCIAL STATEMENTS
Page
Report of Independent Auditors............................................. F-2
Balance Sheets as of December 31, 1996 and 1997............................ F-3
Statements of Income for the years ended December 31, 1995, 1996 and 1997.. F-4
Statements of Stockholders' Equity for the years ended December 31, 1995, 1996
and 1997 ...................................................................F-5
Statements of Cash Flows for the years ended December 31, 1995, 1996
and 1997................................................................... F-6
Notes to Financial Statements.............................................. F-7
Report of Independent Auditors
The Stockholders and Board of Directors
of PSW Technologies, Inc.
We have audited the accompanying balance sheets of PSW Technologies, Inc. as
of December 31, 1996 and 1997 and the related statements of income,
stockholders' equity, and cash flows for each of the three years in the
period ended December 31, 1997. These statements are the responsibility of
the Company's management. Our responsiblility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with generallly 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
finanacial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of PSW Technologies, Inc. at
December 31, 1996 and 1997, and the results of its operations and its cash
flows for each of the three years in the period ended December 31, 1997, in
conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Austin, Texas
January 19, 1998
F-2
PSW Technologies, Inc.
Balance Sheets
(in thousands, except share and per share data)
December 31,
1996 1997
-------- --------
Assets
Current assets:
Cash ......................................................... $ 3,182 $ 835
Short-term investments ....................................... -- 22,470
Accounts receivable, net of allowance for doubtful
accounts of $120 and $165 in 1996 and 1997,
respectively ............................................... 6,118 7,429
Due from related party ....................................... 323 --
Unbilled revenue under customer contracts .................... 244 418
Prepaid expenses and other current assets .................... 280 483
-------- --------
Total current assets ............................................ 10,147 31,635
Property and equipment, net ..................................... 1,796 3,551
Deferred income taxes ........................................... -- 234
Total assets .................................................... $ 11,943 $ 35,420
======== ========
Liabilities and stockholders' equity
Current liabilities:
Note payable to bank ......................................... $ 5,125 $ --
Due to related party ......................................... 581 --
Accounts payable and accrued expenses ........................ 2,566 2,834
Deferred revenue ............................................. 227 --
Deferred income taxes ........................................ -- 727
-------- --------
Total current liabilities ....................................... 8,499 3,561
Commitments
Stockholders' equity:
Preferred stock, par value $.01 per share, 1,000,000 shares
authorized and none issued and outstanding ................. -- --
Common stock, par value $.01 per share, 34,000,000 shares
authorized, 5,538,463 and 8,960,935 shares issued and
oustanding at December 31, 1996 and 1997, respectively ..... 55 90
Additional paid-in capital ................................... 4,187 29,484
Deferred compensation ........................................ (641) (243)
Unrealized loss on investments ............................... -- (27)
Retained earnings (accumulated deficit) ...................... (157) 2,555
-------- --------
Total stockholders' equity ...................................... 3,444 31,859
-------- --------
Total liabilities and stockholders' equity ...................... $ 11,943 $ 35,420
======== ========
See accompanying notes.
F-3
PSW Technologies, Inc.
Statements of Income
(in thousands, except per share data)
Year ended December 31,
1995 1996 1997
-------- ---------- ----------
Revenue ....................................................................................... $ 21,147 $ 31,274 $ 44,118
Operating expenses:
Technical staff ............................................................................ 11,193 16,444 22,479
Selling and administrative staff ........................................................... 3,755 5,622 8,405
Other expenses ............................................................................. 3,976 5,684 7,979
Special compensation expense ............................................................... -- 2,193 268
Total operating expenses ...................................................................... 18,924 29,943 39,131
Income from operations ........................................................................ 2,223 1,331 4,987
Interest income (expense), net ................................................................ (84) (170) 431
-------- -------- --------
Income before provision for income taxes ...................................................... 2,139 1,161 5,418
-------- -------- --------
Provision for income taxes:
Nonrecurring charge for termination
of Subchapter S election ................................................................ -- -- 1,200
C Corporation taxes......................................................................... -- -- 1,000
-------- -------- --------
Total provision for income taxes .............................................................. -- -- 2,200
-------- -------- --------
Net income .................................................................................... $ 2,139 $ 1,161 $ 3,218
======== ======== ========
Unaudited pro forma information:
Historical income before provision for
income taxes ............................................................................... $ 2,139 $ 1,161 $ 5,418
Pro forma provision for income taxes .......................................................... 813 441 1,900
-------- -------- --------
Pro forma net income .......................................................................... $ 1,326 $ 720 $ 3,518
======== ======== ========
Pro forma basic earnings per share ............................................................ $ 0.24 $ 0.13 $ 0.48
======== ========= =========
Pro forma diluted earnings per share .......................................................... $ 0.20 $ 0.11 $ 0.41
======== ========= =========
Shares used in pro forma basic earnings
per share calculation ..................................................................... 5,538 5,538 7,384
======== ======== ========
Shares used in pro forma diluted earnings
per share calculation ..................................................................... 6,635 6,689 8,517
======== ======== ========
See accompanying notes.
F-4
PSW Technologies, Inc.
Statements of Stockholders' Equity
(in thousands, except shares)
Retained
Common Stock Additional Unrealized Earnings Total
$.01 Par Value Paid-in Deferred Loss on (Accumulated Stockholders'
Shares Amounts Capital Compensation Investments Deficit) Equity
--------- --------- --------- --------- ------------- ---------- ------------
......................................
Balance at December 31, 1994 ............5,538,463 $ 55 $ 6,077 $ -- $ -- $ (3,457) $ 2,675
Distributions, net ...................... -- -- (1,130) -- -- -- (1,130)
Net income .............................. -- -- -- -- -- 2,139 2,139
--------- --------- --------- --------- ------------- --------- ---------
Balance at December 31, 1995 ........... 5,538,463 55 4,947 -- -- (1,318) 3,684
Distributions, net ..................... -- -- (2,939) -- -- -- (2,939)
Deferred compensation related
to stock options .................... -- -- 2,179 (2,179) -- -- --
Amortization of deferred
compensation ........................ -- -- -- 1,538 -- -- 1,538
Net income ............................. -- -- -- -- -- 1,161 1,161
--------- --------- --------- --------- ------------- --------- ---------
Balance at December 31, 1996 ........... 5,538,463 55 4,187 (641) -- (157) 3,444
Issuance of common stock, net
of issuance costs of $3,816 ......... 3,285,500 33 25,698 -- -- -- 25,731
Employee stock purchase plan
issuance of stock ................... 53,732 1 410 -- -- -- 411
Exercise of stock options .............. 83,240 1 31 -- -- -- 32
Reclassification upon termi-
nation of S Corporation status ...... -- -- (894) -- -- 894 --
Tax benefit related to stock
option exercises .................... -- -- 182 -- -- -- 182
Forfeiture of stock options ............ -- -- (130) 130 -- -- --
Dividend ............................... -- -- -- -- -- (1,400) (1,400)
Amortization of deferred
compensation ........................ -- -- -- 268 -- -- 268
Net unrealized loss on investments ..... -- -- -- -- (27) -- (27)
investments
Net income ............................. -- -- -- -- -- 3,218 3,218
========= ========= ========= ========= ============= ========= =========
Balance at December 31, 1997 ........... 8,960,935 $ 90 $ 29,484 $ (243) $ (27) $ 2,555 $ 31,859
========= ========= ========= ========= ============= ========= =========
See accompanying notes.
F-5
PSW Technologies, Inc.
Statements of Cash Flows
(in thousands)
1995 1996 1997
-------- -------- --------
.......................................................
Operating activities
Net income ........................................... $ 2,139 $ 1,161 $ 3,218
Adjustments to reconcile net income to net
cash provided by operating
activities:
Special compensation ............................... -- 2,193 268
Depreciation and amortization ...................... 288 424 825
Bad debt expense ................................... 52 75 45
Changes in operating assets and liabilities:
Accounts receivable .............................. (1,181) (2,344) (1,367)
Due from related party ........................... -- (323) (258)
Unbilled revenue under customer contracts ........ (100) (144) (174)
Prepaid expenses and other current assets ........ (45) (864) (203)
Due to related party ............................. -- 581 --
Accounts payable and accrued expenses ............ 648 1,154 299
Deferred revenue ................................. (214) 227 (227)
Deferred taxes ................................... -- -- 675
-------- -------- --------
Net cash provided by operating activities 1,587 2,140 3,101
-------- -------- --------
Investing activities
Purchase of short-term investments ................... -- -- (22,497)
Acquisition of property and equipment ................ (444) (1,247) (2,646)
-------- -------- --------
Net cash used in investing activities ... (444) (1,247) (25,143)
-------- -------- --------
Financing activities
Proceeds from (repayments on) line of credit, net .... -- 5,125 (5,125)
Capital distributions, net ........................... (1,130) (2,870) --
Proceeds from issuance of common stock, net of
issuance costs .................................... -- -- 26,220
Dividend paid to S corporation stockholders .......... -- -- (1,400)
-------- -------- --------
Net cash provided by (used in) financing
activities .............................. (1,130) 2,255 19,695
-------- -------- --------
Net increase (decrease) in cash ........................... 13 3,148 (2,347)
Cash, beginning of year ................................... 21 34 3,182
======== ======== ========
Cash, end of year ......................................... $ 34 $ 3,182 $ 835
======== ======== ========
Supplemental disclosure of cash flow information
Interest paid ........................................ $ 84 $ 154 $ 137
Income taxes paid .................................... $ -- $ -- $ 1,571
Supplemental schedule of non-cash activities
Unrealized loss on investments ....................... $ -- $ -- $ 27
Reduction of income taxes payable associated
with the exercise of stock options ................ $ -- $ -- $ 182
See accompanying notes.
F-6
PSW Technologies, Inc.
Notes to the Financial Statements
1. Nature of Business
PSW Technologies, Inc. ("PSW" or the "Company") is a software services firm,
operating in one industry segment, that provides high value solutions to IT
vendors and IT users by mastering and applying critical emerging technologies.
These critical technologies include distributed computing, object-oriented
development, advanced operating systems and systems management technologies. PSW
provides joint project-based development, porting and testing services to
selected IT vendor clients and applies the technical expertise learned to the
design and development of high value, mission critical enterprise business
systems for its Fortune 1000 end-user clients.
2. Summary of Significant Accounting Policies
Basis of Presentation
Pencom Systems Incorporated ("Pencom") provided software services via a separate
division (the "Software Division") that commenced operations in October 1989. In
addition, a portion of a software services contract was allocated between the
other operations of Pencom and the Software Division. Effective October 1, 1996,
Pencom contributed to PSW the business of the Software Division, including the
portion of the software contract that had previously been allocated to the other
operations of Pencom (see Note 3). In exchange for the net assets contributed,
Pencom received all of the then issued and outstanding shares of PSW and PSW
issued warrants to Pencom and to certain Pencom employees to purchase an
aggregate of 507,654 shares of PSW's common stock at $.04 per share. The shares
and warrants issued to Pencom were immediately thereafter distributed to Pencom
shareholders. This exchange has been accounted for in a manner similar to a
pooling of interests and accordingly, the accompanying financial statements
include the operations of the Software Division and the aforementioned portion
of the software services contract allocated to other operations of Pencom for
all periods presented.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions,
including estimates to complete contracts, that affect the reported amounts in
the financial statements and accompanying notes. Actual results could differ
from those estimates.
New Accounting Pronouncements
In June 1997, the Financial Accounting Standards Board issued Statement No. 130,
Reporting Comprehensive Income ("SFAS No. 130"). This statement establishes
standards for reporting and display of comprehensive income and its components
in a full set of general-purpose financial statements. Comprehensive income
includes all revenues, expenses, gains, and losses recognized during the period
regardless of whether they are considered to be results of operations of the
period. This statement is effective for fiscal years beginning after December
15, 1997. The Company does not expect SFAS No. 130 to have a material impact on
the financial statements.
In June 1997, the Financial Accounting Standards Board issued Statement No. 131,
("SFAS No. 131"), Disclosures about Segments of an Enterprise and Related
Information. SFAS No. 131 establishes standards to address the way in which
public business enterprises report information about operating segments in
annual financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports issued to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. SFAS No. 131 is
effective for financial statements for fiscal years beginning after December 15,
1997. The Company does not expect SFAS No. 131 to have a material impact on its
financial statements.
F-7
PSW Technologies, Inc.
Notes to the Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
Share Information
All outstanding share amounts included in the accompanying financial statements
have been adjusted to reflect an 11,250-for-1 forward stock split on December
18, 1996 and the 8-for-13 reverse stock split effected described in Note 3.
Revenue Recognition
Revenue from time and materials contracts is recognized during the period for
which the services are provided.
Revenue from fixed price contracts is recognized using the
percentage-of-completion method, measured by the percentage of units of labor
incurred to the date of measurement relative to the estimated total units of
labor at completion. The cumulative impact of revisions in estimates of the
percentage to complete is reflected in the period in which the revisions are
made. Provisions for estimated losses on uncompleted contracts are made on a
contract-by-contract basis and are recognized in the period in which such losses
are determined. Revenue earned in excess of billings is classified as unbilled
revenue under customer contracts. Billings in excess of earned revenue are
classified as deferred revenue. Revenue excludes reimbursable expenses.
Costs and Expenses
Technical staff expense consists of the cost of (i) salaries, payroll taxes,
health insurance and workers' compensation for technical staff personnel
assigned to client projects, (ii) unassigned technical staff personnel and (iii)
fees paid to subcontractors for work performed in connection with client
projects.
Selling and administrative staff expense consists of (i) the cost of salaries,
payroll taxes, health insurance and workers' compensation for selling and
administrative personnel, (ii) all commissions and bonuses and (iii) technical
staff personnel assigned to development projects or performing selling,
recruiting or training related tasks.
Pencom allocated certain expenses to the Software Division, including corporate
and officers' salaries, interest and rent. Corporate and officers' salaries were
allocated based upon the percentage of time expended by certain individuals on
Software Division matters. Interest was allocated based upon interest incurred
by Pencom on its secured debt (see Note 7). Rent was allocated based on square
footage and/or employee head count. It is management's opinion that the
estimated cost of the allocated expenses on a stand alone basis would not
produce materially different results than those reflected in the 1995 and 1996
financial statements.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentration of
credit risk consist principally of cash balances, short term investments and
trade accounts receivable. The Company invests its excess cash in highly liquid
investments (short-term bank deposits) and places its investments in high
quality securities with financial institutions of high credit standing. The
Company does not require collateral from its customers. The Company maintains
allowances for potential credit losses and such losses were not material for any
of the periods presented. The Company's customers are headquartered primarily in
North America.
Cash and Cash Equivalents
The Company considers all highly liquid investments with original maturities of
three months or less to be cash equivalents.
F-8
2. Summary of Significant Accounting Policies (continued)
Depreciation and Amortization
Depreciation and amortization are computed based on the cost of the related
assets, using the straight-line method over the estimated useful lives of the
assets which range from five to seven years. Leasehold improvements are
amortized over the term of the related lease or estimated life of the leasehold
improvements, whichever is shorter.
Advertising Expense
The Company expenses advertising costs when the advertisement occurs. Total
advertising expense amounted to approximately $175,000 in 1997. Advertising
costs were not material for 1995 and 1996.
Stock Based Compensation
The Company has adopted the disclosure provisions accounts for stock-based
compensation in accordance with Statement of Financial Accounting Standards No.
123, "Accounting for Stock-Based Compensation" ("SFAS 123"). SFAS 123 prescribes
accounting and reporting standards for all stock-based compensation plans,
including employee stock options, restricted stock, employee stock purchase
plans and stock appreciation rights. SFAS 123 requires compensation expense to
be recorded (i) using the new fair value method or (ii) using existing
accounting rules prescribed by Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" ("APB 25") and related
interpretations with pro forma disclosure of what net income and earnings per
share would have been had the Company adopted the new fair value method. The
Company intends to continue to account for its stock based compensation plans in
accordance with the provisions of APB 25 as permitted by SFAS 123.
Income Taxes
Upon formation in August 1996, the Company elected to be treated as a Subchapter
S corporation, under the Internal Revenue Code of 1986 as amended, whereby
federal income taxes are the responsibility of the individual stockholders.
Accordingly, the Company did not provide for federal income taxes. With the
closing of the Company's initial public offering, the Company's Subchapter S
status was terminated and the Company became subject to federal corporate income
taxes.
In accordance with Statement of Financial Accounting Standards, ("SFAS No.
109"), Accounting for Income Taxes, deferred income taxes were provided for all
temporary differences existing at the date of the Company's termination of its
Subchapter S status. This statement prescribes the use of the liability method
whereby deferred tax asset and liability account balances are determined based
on differences between financial reporting and tax bases of assets and
liabilities and are measured using the enacted tax rates and laws that will be
in effect when the differences are expected to reverse.
Pro Forma Earnings Per Share
The unaudited pro forma adjustments on the statements of income reflect an
adjustment to record a provision for income taxes as if the Company had not been
an S corporation.
In 1997, the Financial Accounting Standards Board issued Statement No. 128,
Earnings per Share ("SFAS 128"). SFAS 128 replaced the calculation of primary
and fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share excludes any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to the previously reported fully diluted
earnings per share. All earnings per share amounts for all periods have been
presented, and where appropriate, restated to conform to the requirements of
SFAS 128 and Securities and Exchange Commission Staff Accounting Bulletin 98.
F-9
3. Stockholders' Equity
Effective October 1, 1996, in connection with the contribution of the business
of the Software Division, the Company issued 5,538,463 shares of common stock
and warrants to purchase an aggregate of 507,654 shares of common stock at $.04
per share. All warrants were exercisable upon issuance and expire in October,
2006. In exchange for the shares and warrants issued, PSW received an assignment
of a 26.67% interest in the proceeds to be received from the accounts receivable
as of September 30, 1996 and substantially all the other assets and liabilities
of the Software Division. The net assets contributed amounted to approximately
$2,100,000 (see also note 2).
On February 3, 1997, the Company's Board of Directors approved 1.) an 8-for-13
reverse stock split, which was effected on April 2, 1997, 2.) an increase in the
Company's authorized common stock from 11,250,000 to 34,000,000 shares and 3.)
an authorization of 1,000,000 shares of preferred stock of $.01 par value, which
was effected prior to the completion of the Company's initial public offering.
In June 1997, the Company completed an initial public offering of 2,850,000
shares of its authorized but unissued Common Stock at a price to the public of
$9.00 per share. In connection with the initial public offering, the Company
granted the underwriters of the offering an option to purchase up to 427,500
shares of Common Stock to cover over-allotments. On July 2, 1997, the
underwriters exercised their option, purchasing 427,500 shares of the Company's
Common Stock. The above transactions resulted in total net proceeds from the
initial public offering of $25.7 million (after deducting offering expenses and
the underwriters discount of approximately $3.8 million). The proceeds of the
offering were used to repay indebtedness, to pay certain corporate income tax
obligations of the Company and to pay dividends to existing stockholders of the
Company in amounts estimated to approximate certain of their 1997 income tax
obligations, and for working capital and other general corporate purposes. A
portion of the remaining funds may be used to fund acquisitions of complementary
businesses or technologies.
As discussed in Note 12, the Company's S corporation status was terminated
immediately upon completion of its initial public offering. Additionally, the
Company was required to change its method of tax accounting from the cash to
accrual method. The stockholders of the Company prior to the termination of the
S corporation status are obligated to pay the income taxes for the 1997 taxable
earnings of the Company allocated to them. During 1997, the Company declared and
paid a dividend of $1.4 million to these stockholders. The dividend payment was
an estimate based upon numerous assumptions, including taxable income
attributable to the conversion from the cash to the accrual method of accounting
upon the termination of the Company's S corporation status.
At December 31, 1997, the Company has reserved 507,654 shares of Common Stock
for issuance in connection with warrants outstanding and 1,978,000 shares of
Common Stock for issuance under the Company's stock purchase and stock option
plans.
4. Property and Equipment
Property and equipment consist of the following (in thousands):
1996 1997
------ ------
..........................................
Furniture and fixtures ....................... $ 521 $1,192
Computer equipment ........................... 2,251 3,480
Computer software ............................ 266 603
Leasehold improvements ....................... 59 379
------ ------
3,097 5,654
Less accumulated depreciation and amortization 1,301 2,103
====== ======
$1,796 $3,551
====== ======
F-10
5. Short-Term Investments
The Company determines the appropriate classification of investments at the time
of purchase and re-evaluates such designation at each balance sheet date. The
short-term investments have been classified as available-for-sale and are
carried at fair value (quoted market prices), with unrealized holding gains and
losses reported as a separate component of stockholders' equity. The cost of
debt securities is adjusted for amortization of premiums and accretion of
discounts to maturity. Such amortization, interest income, realized gains and
losses and declines in value judged to be other than temporary are included in
net interest and other income.
Information related to the Company's investments at December 31, 1997 is as
follows (in thousands):
Amortized Unrealized Unrealized Market
Cost Gains Losses Value
--------------- -------------- ------------ -------
.........................................
Money market funds .......................... $ 1,801 $ -- $ -- $ 1,801
Municipal obligations ....................... 16,391 17 29 16,379
Corporate securities ........................ 4,305 20 35 4,290
=============== ============== ============ =======
$ 22,497 $ 37 $ 64 $22,470
=============== ============== ============ =======
Gross gains and gross losses on the sale of investments were not significant in
1997. Short-term investments are generally comprised of variable rate securities
that provide for optional or early redemption within twelve months and the
contractual maturities are generally greater than twelve months.
6. Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses consist of the following (in thousands):
1996 1997
------ ------
.......................................
Trade payables ............................ $ 945 $ 532
Accrued vacation .......................... 307 442
Accrued bonuses ........................... 600 455
Payroll and other taxes payable ........... 216 437
Other accounts payable and accrued expenses 498 968
====== ======
$2,566 $2,834
====== ======
7. Note Payable to Bank
In November 1996, the Company obtained a revolving line of credit from a bank,
providing for borrowings of up to $6.5 million. In November 1997, the line of
credit expired and was replaced with a revolving line of credit which provides
for borrowings of up to $10 million, subject to a borrowing base requirement.
Borrowings under the line of credit bear interest at the greater of (a) the
bank's prime rate or (b) the federal Funds Rate plus 0.25 percent. At the
Company's election, borrowings can be converted to loans which bear interest at
a rate computed based on the London Interbank Offered Rate ("LIBOR"). The
weighted average borrowing rate on the line of credit was 8.4% for 1997. The
line of credit contains certain restrictive convenants which, among other
things, require the Company to maintain a minimum net worth and to meet certain
financial ratios. At December 31, 1997, there was no amount outstanding and the
available borrowing amount was $7.5 million.
Interest expense includes interest allocated by Pencom through September 30,
1996. The allocation represented the Software Division's share of interest
payments paid by Pencom under its line of credit and was based on the ratio of
the monthly balance of the Software Division's accounts receivable to total
accounts receivable of the Software Division and Pencom. This line of credit was
collateralized by all accounts receivable and fixed assets for Pencom and bore
interest at a rate based on the bank's prime rate or alternative LIBOR pricing,
based on LIBOR plus 2.5%.
F-11
8. Significant Customers
One customer and two of its wholly-owned subsidiaries accounted for
approximately 56%, 52% and 39% of total revenue for the years ended December 31,
1995, 1996 and 1997, respectively. This customer accounted for approximately 26%
of accounts receivable at December 31, 1997. Another customer accounted for
approximately 17% and 14% of total revenue for the years ended December 31, 1995
and 1996, respectively. No other customer accounted for more than 10% of revenue
in 1995, 1996 or 1997.
9. Employee Benefit Plans
Stock Option Plan
Effective October 1, 1996, the Company's Board of Directors and stockholders
approved and adopted the PSW Technologies, Inc. 1996 Stock Option/ Stock
Issuance Plan (the "1996 Plan"). The aggregate number of shares issuable under
the 1996 Plan has been increased to 1,715,000 shares of the Company's common
stock for issuance to employees, directors and consultants of the Company.
Incentive stock options as defined in Section 422A of the Internal Revenue Code
of 1986 and nonqualified stock options may be issued under the 1996 Plan. The
exercise price for incentive stock options may not be less than fair market
value on the date of grant, or such greater amount necessary to qualify as an
incentive stock option. The options outstanding under the 1996 Plan generally
vest in four equal annual installments commencing on the first anniversary of
the grant and expire 10 years after the date of grant. Certain of these options
are subject to acceleration clauses.
Pursuant to the organization of the Company and the contribution of net assets
of the Software Division, the Company granted replacement options for shares of
its common stock under the 1996 Plan to its employees who participated in the
Pencom Option Plan and the Pencom Option Plan was terminated. The replacement
options were granted for the same number of shares and at the same exercise
price as those options granted to the employees under the Pencom Option Plan.
The grant date determining vesting was the original grant date under the Pencom
Option Plan. Under APB 25, the difference between the estimated fair market
value of the Company's common stock and the options' exercise prices on the date
of issuance was determined to be approximately $2,179,000. This charge is being
amortized for financial reporting purposes over the vesting period of the
options and the amount recognized as expense during the years ended December 31,
1996 and 1997 amounting to approximately $1,538,000 and $268,000, respectively,
is included in special compensation expense. A deferred tax benefit is recorded
for the amortized compensation expense.
F-12
PSW Technologies, Inc.
Notes to the Financial Statements (continued)
9. Employee Benefit Plans (continued)
The following table summarizes stock option activity under the 1996 Plan:
Range of Exercise Prices
------------------------------------------------------------------
$0.04 - $2.60 $3.90 - $9.00 $11.50 - $15.25 Total
-------------------- --------------------- ---------------------- ----------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
Number Exercise Number Exercise Number Exercise Number Exercise
of shares Price of shares Price of shares Price of shares Price
--------- -------- --------- -------- -------- ---------- ----------- --------
Balance at December 31, 1995 ..... -- $ -- -- $ -- -- $ -- -- $ --
Granted during the year .......... 632,907 0.42 452,804 4.23 -- -- 1,085,711 2.00
Exercised during the year ........ -- -- -- -- -- -- -- --
Forfeited during the year ........ (6,957) 0.72 (1,846) 4.12 -- -- (8,803) 1.44
-------- ----- -------- ----- -------- ----- ---------- ------
Balance at December 31, 1996 ..... 625,950 0.41 450,958 4.23 -- -- 1,076,908 2.00
Granted during the year .......... -- -- 306,784 8.87 177,826 12.36 484,610 10.15
Exercised during the year ........ (77,391) 0.12 (5,849) 3.92 -- -- (83,240) 0.39
Forfeited during the year ........ (41,987) 0.77 (34,136) 5.38 (2,025) 13.22 (78,148) 3.10
======== ===== ======== ===== ======= ===== ========== ======
Balance at December 31, 1997 ..... 506,572 $ 0.43 717,757 $ 6.16 175,801 $ 12.35 1,400,130 4.86
======== ===== ======== ===== ======= ===== ========== ======
Exercisable at December 31, 1996 . 360,464 $ 0.09 3,076 $ 3.90 -- $ -- 363,540 $ 0.12
======== ===== ======== ===== ======= ===== ========== ======
Exercisable at December 31, 1997 . 380,883 $ 0.20 130,693 $ 4.19 4,723 $ 13.08 516,299 $ 1.33
======== ===== ======== ===== ======= ===== ========== ======
Weighted average fair value of
options granted during 1997 .. $ -- $ 5.10 $ 7.00 $ 5.79
===== ===== ===== ======
Weighted average remaining
contractual life in years,
at December 31, 1997 ......... 5.49 7.38 8.38 6.82
===== ===== ===== =====
F-13
PSW Technologies, Inc.
Notes to the Financial Statements (continued)
9. Employee Benefit Plans (continued)
Employee Stock Purchase Plan
On February 3, 1997, the Board of Directors adopted the Company's Employee Stock
Purchase Plan (the "Purchase Plan") that allows eligible employees to purchase
shares of Common Stock, at semi-annual intervals, through periodic payroll
deductions under the Purchase Plan; a reserve of 400,000 shares of common stock
has been established for this purpose. The stockholders of the Company approved
the Purchase Plan on March 17, 1997.
The Purchase Plan incorporates a series of successive offering periods, each
generally with a duration of six months. The initial purchase period began on
the date of the initial public offering (see Note 3) and ended on October 31,
1997. Thereafter, purchase periods begin on the first business day in November
and May of each year and end on the last business day of April and October,
respectively. Shares of Common Stock are purchased for each participant at the
end of each purchase period. On October 31, 1997, the Company sold 53,732 shares
of Common Stock to employees through the Purchase Plan.
Payroll deductions may not exceed 15% of base salary for each purchase period
and each employee's purchases are limited to 500 shares per purchase period. The
purchase price per share is eighty-five percent of the lower of (i) the fair
market value of the Common Stock on the start date of the purchase period or
(ii) the fair market value at the end of the semi-annual purchase period. The
Purchase Plan will terminate on the last business day of April, 2007.
As specified in APB No. 25, the sale of Common Stock under the Purchase Plan
does not result in compensation expense to the Company. Under SFAS 123, however,
expense would be recognized, and accordingly, approximately $408,000 of pro
forma compensation expense relating to the sale of Common Stock under the
Purchase Plan is included in the calculation of pro forma net income and pro
forma basic earnings per share and pro forma diluted earnings per share
resulting from the grant of stock options during 1997, below. The assumptions
used to value the compensation expense resulting from the issuance of shares
under the Purchase Plan do not differ materially from the assumptions used to
value the 1997 stock options.
Employee Retirement Plan
The Company maintains a defined contribution plan (the "Plan") pursuant to
Section 401(k) of the Internal Revenue Code for employees who are at least 21
years of age. Eligible employees can elect to reduce their current compensation
up to the statutory prescribed limit and have the amount of such reduction
contributed to the Plan. The Plan also allows for the Company to make
contributions on behalf of eligible employees. A similar plan in which employees
of the Software Division were eligible to participate was maintained by Pencom.
No contributions were made to the plan in 1995, 1996 or 1997 by the Software
Division or PSW.
Pro forma Information
Pro forma information regarding net income and earnings per share is required by
SFAS 123, and has been determined as if the Company had accounted for option
grants under the 1996 Plan and purchases of Common Stock under the Purchase Plan
using the fair value method of that Statement. The fair value of the options was
estimated at the date of grant using a Black-Scholes option pricing model with
the following weighted average assumptions:
1996 Option Grants
----------------------------
Vested at Non-vested at 1997
Assumption Grant Date Grant Date Option Grants
- ---------- ------------- ------------- -------------
Risk-free interest rate .................................... 5.93% 6.23% 6.34%
Dividend yield ............................................. 0% 0% 0%
Volatility factor of the expected
market price of the Company's
common stock ............................................. 0.374 0.374 0.521
Average life ............................................... 3 years 6 years 6 years
F-14
The Black-Scholes option valuation model was developed for use in estimating the
fair value of traded options which have no vesting restrictions and are fully
transferable. In addition, option valuation models require the input of highly
subjective assumptions including the expected stock price volatility. Because
the Company's employee stock options have characteristics significantly
different from those of traded options, and because changes in the subjective
input assumptions can materially affect the fair value estimate, in management's
opinion, the existing models do not necessarily provide a reliable single
measure of the fair value of its employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the options
under SFAS 123 is amortized to expense over the options' vesting period. For the
years ended December 31, 1996 and 1997, pro forma net income under SFAS 123
amounted to approximately $658,000 and $2.7 million, respectively and pro forma
basic earnings per share and pro forma diluted earnings per share under SFAS 123
amounted to approximately $.012 and $0.09 in 1996 and $0.36 and $0.32 in 1997,
respectively.
10. Related Party Transactions
The Company utilizes non-exclusive recruiting services provided by Pencom.
Management believes that the terms and fees paid in connection with such
recruiting services are comparable to agreements maintained by the Company with
other unrelated recruiting firms and will continue to use these recruiting
services on a non-exclusive basis pursuant to an agreement entered into with
Pencom. In addition, certain expenses were allocated by Pencom to the Software
Division. Management believes that the allocations were reasonable. Services
provided and expenses allocated to PSW were as follows (in thousands):
Year ended December 31,
1995 1996 1997
------ ------ ------
...........................................
Services performed by related party:
Recruiting services ........................ $ 447 $ 316 $ 60
Contracted technical services .............. -- -- 9
Legal and accounting ....................... -- 21 28
Allocated expenses:
Rent ....................................... 329 448 37
Corporate and officers' salaries ........... 242 125 --
------ ------ ------
Total expenses included in other expenses 1,018 910 134
Interest ................................... 84 104 --
------ ------ ------
Total related party expenses .................. $1,102 $1,014 $ 134
====== ====== ======
The Company also entered into an agreement with Pencom for certain accounting
and legal services for the period October 1, 1996 through April 30, 1997 at a
fee of $7,000 per month.
In recognition of establishing an independent profitable company, in 1996, the
Software Division cancelled a note receivable, including unpaid interest, due
from an officer and shareholder of the Company that resulted in a charge against
income of $655,000 which has been included in special compensation expense.
Assets contributed by Pencom on October 1, 1996 included an assignment of a
26.67% interest in the proceeds to be received from the accounts receivable of
the Software Division as of September 30, 1996. At December 31, 1996, "Due from
related party" includes approximately $309,000 that relates to a payment
received on behalf of Pencom which was transferred to Pencom subsequent to
December 31, 1996. Other amounts denoted "due to related party" represent
expenses that were paid on the Company's behalf by Pencom.
F-15
11. Commitments
The Company leases its office space through noncancellable operating lease
arrangements including a lease for its office in Texas which was entered into on
October 31, 1996. Other than the lease related to the Texas office, the other
leases are held by Pencom and will be assigned to PSW. Future minimum rental
commitments (including amounts payable under leases held by Pencom) are as
follows:
Years ending December 31 (in thousands):
....................................
1998 ................................... $1,264
1999 ................................... 1,244
2000 ................................... 1,143
2001 ................................... 1,078
2002 ................................... 1,077
Thereafter ............................. 1,077
------
Total .................................. $6,883
======
The premises previously occupied by the Company in Texas were leased by Pencom.
In connection with the office relocation, the Company transferred leasehold
improvements with a net book value of approximately $69,000 to Pencom. Pencom
has sub-leased these premises. However, the Company entered into an agreement
with Pencom to guarantee Pencom's sublease income. Future minimum sub-lease
rental income that the Company has guaranteed is as follows:
Years ending December 31 (in thousands):
....................................
1998 ................................... $ 376
1999 ................................... 380
2000 ................................... 285
------
Total .................................. $1,041
======
Rent expense, including rent allocated by Pencom, for the years ended December
31, 1995, 1996 and 1997 was approximately $329,000, $601,000 and $1,258,000,
respectively.
12. Income Taxes
From commencement through June 5, 1997, the Company had elected to be treated as
an S Corporation under subchapter S of the Internal Revenue Code of 1986, as
amended. As such, federal income taxes attributable to income through June 5,
1997, were the responsibility of the individual stockholders.
As a result of the initial public offering in June of 1997, the Company's
Subchapter S status was terminated for federal and state tax purposes and the
Company recorded a deferred tax charge against income of approximately
$1,200,000 for the cumulative differences between the financial reporting and
income tax basis of certain assets and liabilities existing at that date.
Additionally, the Company was required to change its method of accounting from
the cash basis to the accrual basis for income tax reporting purposes.
The Company's stockholders are obligated to pay the 1997 income taxes related to
the period up to the completion of the offering. The Company declared and paid a
dividend of $1,400,000 to its stockholders of record immediately prior to the
completion of the public offering for the amount estimated to approximate the
1997 income taxes payable by the stockholders.
The pro forma disclosures on the statements of income reflect adjustments to
record provisions for income taxes as if the Company had not been an S
Corporation. The pro forma provisions for income taxes for the years ended
December 31, 1995 and 1996, of $813,000 and $441,000, respectively, are computed
using an effective tax rate of 38%, which differs from the federal statutory
rate of 34% primarily due to state taxes. The pro forma provision for income
taxes of $1,900,000 attributable to December 31, 1997, is computed using an
effective tax rate of 35%, which differs from the federal statutory rate of 34%
as a result of state taxes and tax-exempt income.
F-16
12. Income Taxes (continued)
Significant components of the provision for income taxes are as follows:
1997
------
Current:
...........................................
Federal ....................................... $1,526
State ......................................... 180
------
Total Current ................................. 1,706
Deferred:
Federal ....................................... 442
State ......................................... 52
------
Total Deferred ................................ 494
======
$2,200
======
The Company's effective tax rate from continuing operations differs from the
U.S. statutory income tax rate as set forth below:
Pro forma Pro forma Pro forma Historical
1995 1996 1997 1997
--------- ---------- --------- ----------
..................................................
U.S. statutory income tax rate ....................... 34.0% 34.0% 34.0% 34.0%
State taxes, net of federal income tax
benefit ........................................... 4.0% 4.0% 4.0% 3.8%
Permanent differences, primarily
tax-exempt income ................................. -- -- (3.0%) (0.7%)
Nonrecurring charge due to
Subchapter S termination .......................... -- -- -- 22.1%
S Corporation income not subject to
tax ............................................... -- -- -- (20.7%)
Other ................................................ -- -- -- 2.1%
========= ========= ====== =========
Effective tax rate ................................... 38.0% 38.0% 35.0% 40.6%
========= ========= ========= =========
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred taxes as of December 31 are as follows:
1997
-------
Deferred tax assets:
Allowances and reserves ......... $ 183
Accrued expenses ................ 246
Stock option compensation expense 575
-------
Total deferred tax assets .......... 1,004
Deferred tax liabilities:
Fixed assets .................... (84)
Cash to accrual adjustment ...... (1,151)
Other ........................... (262)
-------
Total deferred tax liabilities ..... (1,497)
=======
Net deferred tax liabilities ....... $ (493)
=======
The exercise of certain stock options which have been granted under the
Company's stock option plan give rise to compensation which is includable in the
taxable income of the applicable option holder and deductible by the Company for
federal and state income tax purposes. Any realized tax benefit arising from
exercised options in excess of the benefit previously recorded, as discussed in
Notes 9 and 13, is credited to additional paid-in capital.
F-17
13. Special Compensation Expense
As described in Notes 9 and 12, charges to income were made related to the
replacement options issued to employees and the cancellation of a note from an
officer and stockholder of the Company which totaled $2,193,000 for the year
ended December 31, 1996. Amortization of deferred compensation of $268,000 was
recognized for the year ended December 31, 1997. These transactions reduced
income from operations, pro forma net income and pro forma diluted earnings per
share for the years ended December 31, 1996 and 1997 as follows (in thousands,
except per share data):
1996 1997
------ ------
................................
Operating income ................... $2,193 $ 268
Pro forma net income ............... 1,360 169
Pro forma diluted earnings per share 0.19 0.02
Deferred compensation as of December 31, 1997 of approximately $243,000 will be
amortized over the remaining vesting periods in 1998, 1999 and 2000.
14. Earnings per Share
The following table sets forth the computation of basic and diluted earnings per
share (in thousands, except per share data):
1995 1996 1997
------ ------ ------
Numerator:
Pro forma net income ................ $1,326 $ 720 $3,518
====== ====== ======
Denominator:
Shares used in pro forma basic
earnings per share calculation(1) . 5,538 5,538 7,384
Effect of dilutive securities:
Employee stock options ............ 592 646 627
Warrants .......................... 505 505 506
------ ------ ------
Shares used in pro forma diluted
earnings per share calculation(1) . 6,635 6,689 8,517
====== ====== ======
Pro forma basic earnings per share(1) . $ 0.24 $ 0.13 $ 0.48
====== ====== ======
Pro forma diluted earnings per share(1) $ 0.20 $ 0.11 $ 0.41
====== ====== ======
(1) The pro forma basic and pro forma diluted earnings per share amounts
prior to the Company's initial public offering, which occurred during
the second quarter of 1997, have been restated as required to comply
with SFAS No. 128 and the Securities and Exchange Commission Staff
Accounting Bulletin 98 ("SAB 98"). The adoption of SFAS 128 and SAB 98
resulted in an increase to pro forma diluted earnings per share for
1995 and 1996 of $.01 per share.
F-18
15. Quarterly Information (Unaudited)
Summarized quarterly financial information for 1996 and 1997 is as follows (in
thousands, except per share amounts):
Quarter ended
---------------------------------------------------------------------
March 31 June 30 September 30 December 31
------------- -------------- --------------- --------------
1996
Total revenues $ 6,537 $ 6,950 $ 7,737 $ 10,050
Operating income 633 712 79 (93)
Pro forma net income 376 431 12 (99)
Pro forma diluted earnings
per share(1) $ .06 $ .06 $ - $ (.02)
Shares used in diluted earnings
per share calculation(1) 6,635 6,635 6,635 5,538
1997
Total revenues $ 10,307 $ 10,702 $ 11,258 $ 11,851
Operating income 1,057 1,177 1,417 1,336
Pro forma net income 600 721 1,111 1,086
Pro forma diluted earnings
per share(1) $ .09 $ .10 $ .11 $ .11
Shares used in diluted earnings
per share calculation(1) 6,740 7,290 9,973 10,063
(1) The pro forma diluted earnings per share amounts prior to the Company's
initial public offering, which occurred during the second quarter of
1997, have been restated as required to comply with SFAS No. 128 and
the Securities and Exchange Commission Staff Accounting Bulletin 98
("SAB 98"). The adoption of SFAS 128 and SAB 98 resulted in an
increase to pro forma diluted earnings per share for 1995 and 1996
of $.01 per share.
F-19
Item 9. Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure
None.
PART III
Certain information required by Part III is omitted from this Form 10-K because
the Company will file a definitive Proxy Statement pursuant to Regulation 14A
(the "Proxy Statement") not later than 120 days after the end of the fiscal year
covered by this Form 10-K, and certain information to be included therein is
incorporated herein by reference.
Item 10. Directors and Executive Officers of the Registrant
The information required by this Item is incorporated by reference to the Proxy
Statement under the headings "Proposal 1 - Election of Directors," and Executive
Compensation - Executive Officers" and "Compliance with Section 16(a) of the
Exchange Act".
Item 11. Executive Compensation
The information required by this Item is incorporated by reference to the Proxy
Statement under the heading "Executive Compensation".
Item 12. Security Ownership of Certain Beneficial Owners and Management
The information required by this Item is incorporated by reference to the Proxy
Statement under the heading "Principal Stockholders".
Item 13. Certain Relationships and Related Transactions
The information required by this Item is incorporated by reference to the Proxy
Statement under the heading "Executive Compensation - Certain Transactions with
Management".
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) 1. Financial Statements:
The financial statements listed in ITEM 8: Financial Statements and
Supplementary Data, above are filed as part of this Annual Report on Form 10-K.
2. Financial Statement Schedules:
All schedules are omitted because they are not applicable or the required
information is shown in the financial statements or notes thereto.
3. Exhibits
Number Description
**3.1 Amended and Restated Certificate of Incorporation of the Registrant.
**3.2 Amended and Restated Bylaws of the Registrant.
**4.1 Specimen Common Stock Certificate.
**4.2 See Exhibits 3.1 and 3.2 for provisions of the Certificate of
Incorporation and Bylaws of the Registrant defining rights of holders
of Common Stock of the Registrant.
**10.1 Bridgepoint Lease Agreement dated October 31, 1996 between the
Registrant and Investors Life Insurance Company of North America.
**10.2 Lease Guarantee effective January 31, 1997 between the Registrant and
Pencom Systems Incorporated.
**10.3 Office Lease dated April 25, 1996 between G&W Investment Partners and
Pencom Systems Incorporated, as amended.
**10.4 Agreement of Lease dated May 13, 1996 between Newport L.G.-I, Inc. and
Pencom Systems Incorporated.
#**10.5 Software Development Agreement having an effective date of March 9,
1994 between the Registrant and Canon Computer Systems, Inc., as
amended.
#**10.6 Software Licensing Agreement having an effective date of June 13, 1996
between the Registrant and Canon Computer systems Incorporated.
**10.7 Service Agreement No. 200.504 dated November 26, 1990 between the
Registrant and International Business Machines Corporation, as amended
to date.
10.8 Software Task Order Agreement dated November 20, 1995 between the
Registrant and Tivoli Systems, Inc., as amended.
10.9 Credit Agreement dated November 8, 1997 between the Registrant and
Texas Commerce Bank National Association.
10.10 Promissory Note dated November 8, 1997 from the Registrant to Texas
Commerce Bank National Association.
**10.11 Accounts Receivable Agreement dated October 1, 1996 between the
Registrant and Pencom Systems Incorporated.
**10.12 Letter Agreement dated October 2, 1996 between the Registrant and
Pencom Systems Incorporated.
**10.13 Recruiting Services Agreement dated January 20, 1997 between the
Registrant and Pencom Systems Incorporated.
**10.14 Stockholders Agreement dated October 1, 1996 between the Registrant and
certain stockholders of the Registrant.
**10.15 Registration Rights Agreement dated October 1, 1996 between the
Registrant and certain stockholders and warrantholders of the
Registrant.
**10.16 Employment Agreement dated October 19, 1992 between Dr. William Frank
King and Pencom Systems Incorporated.
**10.17 Employment Agreement dated October 1, 1996 between Dr. W. Frank King
and the Registrant.
**10.18 Employment Agreement dated July 1, 1993 between the Registrant and
Patrick Motola.
**10.19 Employment Agreement dated September 27, 1993 between the Registrant
and William Cason. **10.20 Employment Agreement dated October 19,
1993 between the Registrant and Brian Baisley.
10.21 Employment Agreement dated September 15, 1994 between the Registrant
and Dennis Thompson.
**10.22 1996 Stock Option/Stock Issuance Plan.
**10.23 Employee Stock Purchase Plan.
**10.24 PSW Profit Sharing Plan.
**10.25 Description of Executive Bonus Plan.
**10.26 Stock Purchase Agreement dated as of January 1, 1997 between Michael J.
Maples and the Registrant.
**10.27 Stock Subscription dated October 1, 1996 between Pencom Systems
Incorporated and the Registrant.
**10.28 Asset Contribution Agreement dated October 1, 1996 between Pencom
Systems Incorporated and the Registrant.
**10.29 Assignment and Assumption Agreement dated October 1, 1996 between the
Registrant and Pencom Systems Incorporated.
**10.30 Warrant dated October 1, 1996 issued by the Registrant to Pencom
Systems Incorporated.
**10.31 Warrant dated October 1, 1996 issued by the Registrant to Stephen
Markman.
**10.32 Warrant dated October 1, 1996 issued by the Registrant to
Thomas Pallister.
**10.33 Warrant dated October 1, 1996 issued by the Registrant
to Joy Venegas.
23.1 Consent of Ernst & Young L.L.P.
27.1 Financial Data Schedule
- ---------
** Incorporated herein by reference to the Company's Registration
Statement on Form S-1 (File No. 333-21565).
# The Company has been granted confidential treatment with respect to
certain portions of these documents. The portions of these documents
which have been omitted are denoted by an asterisk[*]. The omitted
portions of these documents have been filed with the Securities and
Exchange Commission pursuant to Rule 406 under the Securities Act of
1933.
Reports on Form 8-K:
During the quarter ended December 31, 1997, no current reports on Form 8-K
were filed.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
PSW TECHNOLOGIES, INC.
March 27, 1998 By: /s/ W. Frank King
- -------------- -------------------------------------------
Date Dr. W. Frank King, President, Chief
Executive Officer and Director
(Principal Executive Officer)
March 27, 1998 By: /s/ Patrick D. Motola
- -------------- -------------------------------------------
Date Patrick D. Motola, Senior Vice President of
Operations, Chief Financial Officer and
Secretary (Principal Financial Officer)
March 27, 1998 By: /s/ Keith D. Thatcher
- -------------- -------------------------------------------
Date Keith D. Thatcher, Vice President of
Finance and Treasurer
(Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934,
this report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
March 27, 1998 By: /s/ Wade E. Saadi
- -------------- -------------------------------------------
Date Wade E. Saadi,
Chairman of the Board of Directors
March 27, 1998 By: /s/ Edward C. Ateyeh, Jr.
- -------------- -------------------------------------------
Date Edward C. Ateyeh, Jr., Director
March 27, 1998 By: /s/ Thomas A. Herring
- -------------- -------------------------------------------
Date Thomas A. Herring, Director
March 27, 1998 By: /s/ Kevin B. Kurtzman
- -------------- -------------------------------------------
Date Kevin B. Kurtzman, Director
March 27, 1998 By: /s/ Michael J. Maples
- -------------- -------------------------------------------
Date Michael J. Maples, Director
March 27, 1998 By: /s/ Jonathan D. Wallace, Esq.
- -------------- -------------------------------------------
Date Jonathan D. Wallace, Esq., Director