Back to GetFilings.com
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, 1998
OR
o 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 Each Class Name of Each Exchange 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. o
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 February
26, 1999 as reported on the Nasdaq National Market, was approximately $13.4
million (affiliates being, for these purposes only, directors, executive
officers and holders of more than 5% of the Registrant's Common Stock).
As of February 26, 1999, the Registrant had outstanding 9,351,301
shares Common Stock.
Documents Incorporated By Reference
Portions of the Proxy Statement for Registrant's 1999 Annual Meeting
of Stockholders are incorporated by reference into Part III of this Form 10-K.
PART I
Item 1. Business
In addition to the historical information contained herein, the
discussion in this Form 10-K contains certain forward-looking statements, within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, that involve risks and uncertainties, such as
statements concerning: growth and future operating results, developments in the
Company's markets and strategic focus; and future economic and business
conditions. The cautionary statements made in this Form 10-K should be read as
being applicable to all related forward-looking statements whenever they appear
in this Form 10-K. The Company's actual results could differ materially from the
results discussed in the forward-looking statements. Factors that could cause or
contribute to such differences include, but are not limited to, those discussed
under the section captioned "Additional Factors That May Affect Future Results"
in Item 1 of this Form 10-K as well as those cautionary statements and other
factors set forth elsewhere herein.
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 are
subject to 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
and completed an initial public offering in June of 1997. 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.
2
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 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 and (ii) 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. 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.
3
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 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, in the following areas:
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.
4
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.
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 services 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, and
to deliver 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.
5
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.
Marketing and Sales
Marketing
Strategic market planning is performed by the executive staff of the
Company, which actively seeks input and guidance from a number of sources to
make strategic decisions. These sources include PSW clients, senior technical
staff members, marketing and sales personnel and numerous executive contacts
throughout the industry. The executive staff meets regularly to discuss
strategic issues and actions. Senior technical staff members meet once 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 corporate marketing department develops and promotes key corporate
messages, consistent marketing programs and materials and ongoing public
relations. This is accomplished by coordinating the execution of the Company's
strategic marketing 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 developing a "value proposition" for its services
that clearly defines the benefits of engaging PSW and seeks to align the
communication of the value proposition with the delivery of the highest value
services possible to the client. This includes project management,
methodologies, recruiting, training and any other initiatives required to
deliver consistent, high quality service. The marketing emphasis is on
communicating the value proposition to the client and demonstrating PSW's
capabilities to deliver the service effectively.
The Company's marketing programs emphasize its 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 certain key
partners during the sales process to present a unified proposal to the client.
Sales
PSW's sales force consists of Regional Sales Directors and Managers.
The Company's executive management, project managers and senior members of the
technical staff also assist with the sale of the Company's services. The sales
force identifies appropriate business opportunities and client needs. Senior
members of the technical staff provide high level technical review, typically
involving members of the client's staff, early in the client relationship to
thoroughly explore the client's needs and to propose solutions. In some cases,
the client pays for an assessment to analyze the requirements and make a
detailed proposal. Large project proposals typically involve project managers
and other technical professionals.
The sales force is responsible for achieving high client satisfaction
and growing additional business in their assigned accounts. They are assigned
revenue quotas and are paid a commission based on the revenue of business they
obtain. Time schedules and cost estimates are prepared by the technical staff
with input from the responsible salesperson. These schedules and estimates are
used to determine the financial structure and proposed pricing for a project
based on gross margin targets for new business. All pricing is approved by
operating management, whose performance and compensation is not based primarily
on revenue.
6
PSW serves clients throughout the United States. The Company seeks to
establish offices in those areas that have a high concentration of IT vendors.
Current office sites include Austin, Boston, Seattle and Mountain View,
California. Each office has a site manager and salespersons assigned to grow the
Company's base of clients and revenue. Once an engagement is started, work may
be conducted on PSW's premises or the Company's and technical personnel travel
or relocate to the client site.
Employees
PSW's workforce has grown significantly over the past four years,
increasing from 167 full-time employees at December 31, 1994 to 391 full-time
employees at December 31, 1998. 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%, 4% and 1% of the Company's hires in 1996, 1997 and 1998,
respectively. Currently, the Company is a party to recruiting agency agreements
with Pencom as well as 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 extensive telephone and in-person
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 referrals, the Company utilizes advertising,
job fairs, internet recruiting sites, its Website and research and direct
sourcing to identify and attract potential employees.
Career Development and Training
The Company has developed a Resource Management group that is designed,
among other things, to build strong, long-term relationships with the technical
staff. These relationships are critical in ensuring that project assignments and
training are consistent with each employee's career aspirations and that each
employee receives meaningful project and annual performance reviews.
The Company has placed a focus on creating career ladders for the
technical staff that are equivalent to that of the management career ladder.
Career ladders exist for software consultants, software developers, and software
quality specialists as well as for technical management.
7
The Company has developed strong internal training programs for its
employees, including technical training, management training, and knowledge
management. Technical training includes Java and Microsoft Developer and Systems
Engineering certification programs. Employees gain classroom as well as hands-on
experience with Genova methodologies created and refined by each business
practice, including object-oriented business systems, porting, UNIX-to-Windows
NT migration, software quality assurance, and project management.
The Company offers several management training programs to its
employees, including overall management skills, effective and legal
interviewing, effective performance reviews, and progressive discipline and
termination.
To effectively leverage the Company's intellectual assets, PSW embraces
the knowledge management approach to learning. Employees contribute information
to an ever-growing knowledge base that includes technology and products,
methodologies, project web sites, and corporate information. PSW also conducts
annual technology forums and business forums to increase communication 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 stock options to all key
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,
other than the enterprise system projects, 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
8
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 for which the employee has had
direct contact. Furthermore, the Company's employment agreement with Timothy D.
Webb, the Company's President and Chief Executive Officer, contains provisions,
which for a period of two years, restrict Mr. Webb's ability to provide services
to, or solicit the business of, the Company's clients and prospective clients in
a competitive manner. 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.
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
1995, 1996, 1997 and 1998, accounted for approximately 88%, 82%, 63% and 57%,
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 39% and 35% of its revenue in
1997 and 1998, respectively. The Company may experience a decline in the percent
of revenue and level of IBM business in 1999 due to the completion of several
projects for IBM and 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 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.
9
Additional Factors That May 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
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, 1997 and
1998, approximately 12%, 20% and 16%, 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. The Company has also undertaken projects in which
a material portion of total revenue is earned based upon meeting specified
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, the Company, 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.
10
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 391 full-time
employees at December 31, 1998. In order to manage its growth effectively, the
Company will need 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; Limited 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 Systems Incorporated, ("Pencom"). Accordingly, the Company
has only a limited independent operating history upon which an evaluation of the
Company and its prospects can be based. 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.
Variability of Quarterly Operating Results. The Company's quarterly
revenue, expenses and operating results have varied significantly in the past
and are likely to vary significantly from quarter to quarter in the future. Such
quarterly fluctuations are 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 which
may effect operating results include customer budget cycles and customer
spending priorities such as the Year 2000 compliance 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. 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
depends 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.
11
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 and internet systems. The
client/server and internet 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 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.
Changes in Senior Management. The Company has recently announced
several additions and changes in its senior management team. The Company's Chief
Executive Officer, Timothy D. Webb, joined the Company during 1998 and John M.
Velasquez, Vice President of Enterprise Solutions, and Pedro A. Fernandez, Vice
President of Corporate Strategy and Marketing came to the Company in the first
quarter of 1999. With recently named Vice President of Software Research and
Development Solutions, Kenneth L. Drake and the Vice President of Embedded
Systems Solutions, Brent R. Terry, the above team comprises the new operations
senior management. There can be no assurances that such changes in the senior
management of the Company will not adversely affect the Company's results of
operations or financial condition, that the new members of the management team
will succeed in their roles in a timely or efficient manner or that they will be
satisfactorily assimilated, or that new and additional management
responsibilities can be allocated effectively among such executives. Failure by
the Company to assimilate new executives, or the failure of any such executive
to perform effectively, could have a material adverse effect on the Company's
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 Timothy D. Webb, Keith D. Thatcher, Kenneth L. Drake, Pedro A.
Fernandez, John M. Velasquez and Brent R. Terry, 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.
12
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 and results of operations.
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.
Uncertainty Related to the Year 2000 Compliance Issues. Many older
computer systems and software products currently in use are coded to accept only
two digit entries in the date code field. These date code fields will need to
accept four digit entries to distinguish 21st century dates from 20th century
dates. As a result, in less than 12 months, computer systems and/or software
used by many companies will need to be upgraded to comply with such "Year 2000"
requirements. Significant uncertainty still exists as to the global implications
of the Year 2000 issue. The Company believes that the purchasing patterns of
customers and potential customers may be affected by Year 2000 issues in a
variety of ways. Many companies (including customers of the Company, and
customers or potential customers of the Company's customers) are expending
significant resources to correct or patch their current hardware and software
systems for Year 2000 compliance. Such expenditures may result in reduced funds
available for the Company's customers to pursue product development programs or
IT systems enhancements for which the Company's services would otherwise be
utilized. Any of the foregoing, including costs of defending and resolving Year
2000-related disputes, reductions in development programs or IT systems
enhancements by customers and their customers or the failure of the Company to
adequately resolve internal Year 2000 compliance issues could result in a
material adverse effect on the Company's business, operating results and
financial condition.
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.
The Company 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. In 1998,
PSW leased a facility of 10,670 square feet in Mountainview, California adding a
strategic presence for the Company in the silicon valley. PSW also has space in
Boston, Massachusetts.
PSW employees are also located at client sites throughout the United
States, including Chicago, Raleigh, Costa Mesa, Menlo Park and Cupertino.
Additional office expansion is anticipated in 1999. 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 1998 $ 3.13 $ 2.00
Third quarter of 1998 $ 7.13 $ 1.94
Second quarter of 1998 $ 9.63 $ 5.56
First quarter of 1998 $15.00 $ 6.38
Fourth quarter of 1997 $19.63 $10.31
Third quarter of 1997 $15.63 $11.38
As of February 26, 1999, there were 9,351,301 shares of the Company's
Common Stock outstanding held by 66 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. During the year ended December 31, 1998, the Company used $1.8 million
of the proceeds to acquire property and equipment and $2.2 million to fund
working capital requirements. The remaining $17.0 million is invested in
short-term, interest bearing accounts available as working capital for 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
15
owning ten percent (10%) or more of any class of equity securities of the
Company or to affiliates of the Company.
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, 1996, 1997 and 1998 and the balance sheet data as of December 31,
1997 and 1998 are derived from financial statements, appearing herein. The
statements of income data for the years ended December 31, 1994 and 1995 and the
balance sheet data as of December 31, 1994, 1995 and 1996 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,
-------------------------------------------------------------------
1994 1995 1996 1997 1998
---------- --------- --------- --------- -----------
(in thousands, except per share data)
Statements of Income (Loss) Data:
Revenue $12,318 $21,147 $31,274 $44,118 $39,101
Operating expenses:
Technical staff 7,385 11,193 16,444 22,479 23,440
Selling and administrative staff 2,320 3,755 5,622 8,405 10,121
Other expenses 2,317 3,976 5,684 7,979 8,933
Special compensation expense(1) - - 2,193 268 75
---------- ---------- ---------- ---------- ----------
Total operating expenses 12,022 18,924 29,943 39,131 42,569
---------- ---------- ---------- ---------- ----------
Income (loss) from operations 296 2,223 1,331 4,987 (3,468)
Interest income (expense), net (74) (84) (170) 431 946
---------- ---------- ---------- ---------- ----------
Income (loss) before provision
for income taxes 222 2,139 1,161 5,418 (2,522)
---------- ---------- ---------- ---------- ----------
Provision (benefit) for income taxes:
Nonrecurring charge for termi-
nation of Subchapter S election - - - 1,200 -
C Corporation taxes - - - 1,000 (1,060)
---------- ---------- ---------- ---------- ----------
Net income (loss) $ 222 $ 2,139 $ 1,161 $ 3,218 $(1,462)
========== ========== ========== ========== ==========
Diluted loss per share $(0.16)
==========
Unaudited pro forma information:
Historical income before
provision for income taxes $ 222 $ 2,139 $ 1,161 $ 5,418
Pro forma provision
for income taxes(2) 84 813 441 1,900
========== ========== ========== ==========
Pro forma net income $ 138 $ 1,326 $ 720 $ 3,518
========== ========== ========== ==========
Pro forma diluted earnings
per share(3) $ 0.02 $ 0.20 $ 0.11 $ 0.41
========== ========== ========== ==========
Shares used in diluted
earnings (loss) per share
calculation(3) 6,635 6,635 6,689 8,517 9,113
========== ========== ========== ========== ==========
16
Item 6. Selected Financial Data (continued)
December 31,
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
(in thousands)
Balance Sheet Data:
Working capital................................... $1,933 $2,756 $1,648 $28,074 $27,379
Total assets...................................... 3,538 4,982 11,943 35,420 33,351
Total stockholders' equity........................ 2,675 3,684 3,444 31,859 31,068
- ----------
(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 Notes 2 and 14 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, within
the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, that involve risks and uncertainties, such as
statements for the plans, objectives, expectations and intentions of PSW. Such
forward looking statements are generally accompanied by words such as "plan,"
"estimate," "expect," "believe," "could," "would," "anticipate," "may," or other
words that convey uncertainty of future events or outcomes. These
forward-looking statements and other statements made elsewhere in this report
are made in reliance on 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 certain factors
that could cause actual future results of the Company to differ materially from
these statements.
Overview
PSW Technologies, Inc. (the "Company"), is a software services firm
that provides high value solutions to information technology ("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. 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. 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 IT user clients.
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. 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.
17
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.
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
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
were 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 immediately 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 and 1998 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 and $75,000 in 1997 and 1998, respectively. (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).
18
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,
1996 1997 1998
---- ---- ----
Revenue 100% 100% 100%
Operating Expenses:
Technical staff 53 51 60
Selling and administrative staff 18 19 26
Other expenses 18 18 23
Special compensation expense 7 1 -
---------- ---------- ---------
Total operating expenses 96 89 109
---------- ---------- ---------
Income (loss) from operations 4 11 (9)
Interest income (expense), net (1) 1 2
Provision (benefit) for income taxes 1 (a) 4 (a) (3)
---------- ---------- ---------
Net income (loss) 2% (a) 8% (a) (4%)
---------- ---------- ---------
(a) Net income is presented on a pro forma basis as if the Company had been
fully subject to federal and state income taxes.
Results of Operations for 1998 Compared with 1997
Revenue
Revenue consists primarily of fees for software services provided.
Revenue was $39.1 million in 1998, down 11% from 1997 revenue of $44.1 million,
principally due to the decline in the scope and number of IT user projects.
Revenue attributable to software services rendered to IT vendors was $25.8
million and $27.3 million in 1998 and 1997, respectively a decrease of 5% in
1998 compared to 1997. Revenue attributable to software services rendered to IT
users was $13.3 million and $16.8 million in 1998 and 1997, respectively, a
decrease of 21% in 1998 compared to 1997.
IBM, including its wholly owned subsidiaries, accounted for 35% and 39%
of revenue in 1998 and 1997, respectively. The Company may experience a decline
in the level of business from this customer in 1999. No other customer accounted
for more than 10% of revenue in 1998 or 1997.
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 $23.4 million in 1998, an increase of 4%
over 1997 technical staff expenses of $22.5 million. The increase in technical
staff expenses was primarily due to the addition of personnel in 1998 in
anticipation of new engagements. Technical staff expenses increased to 60% of
revenue in 1998 from 51% in 1997 primarily as a result of lower utilization of
technical staff and lower revenues.
19
Selling and Administrative Staff
Selling and administrative staff expenses consist of the cost of
salaries, payroll taxes, health insurance and workers' compensation for selling,
marketing and administrative personnel, and all commissions and bonuses. Selling
and administrative staff expenses were $10.1 million in 1998, an increase of 20%
from $8.4 million in 1997. The increase in selling and administrative staff
expenses was primarily due to the increased focus on sales and marketing
initiatives which resulted in an increase to the sales and marketing staff
during 1998. Selling and administrative staff expenses increased to 26% of
revenue in 1998 from 19% of revenue in 1997. The increase in selling and
administrative staff expenses as a percentage of revenue is due primarily as a
result of increases in the sales staff and lower revenues.
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 $8.9 million in 1998, an increase
of 12% over other expenses of $8.0 million in 1997. The increase is principally
due to higher occupancy, travel, project and bad debt expenses and severance
costs. Other expenses were 23% of revenue in 1998 compared to 18% in 1997.
Special Compensation Expense
Special compensation expense in 1998 and 1997 consisted of amortization
of stock-based compensation originating in 1996, which, in the aggregate,
totaled $75,000 and $268,000 or less than 1% of revenue for 1998 and 1997,
respectively. See Notes 9, 12 and 13 of Notes to Financial Statements.
Income (loss) from Operations
The Company recorded a loss from operations of $3.5 million in 1998,
down from $5.0 million of income from operations in 1997. Loss from operations
was 9% of revenue in 1998, compared to income from operations of 11% of revenue
in 1997.
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
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.
IBM, including its wholly owned subsidiaries, accounted for 52% and 39%
of revenue in 1997 and 1996, respectively. 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.
20
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.
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
operations as the software division of Pencom. In 1996, the Company repaid $2.9
million of contributions from Pencom.
Cash used in operating activities was $1.7 million in 1998 as compared
to cash provided by operations of $3.1 million and $2.1 million in 1997 and
1996, respectively. Total repayments of borrowings were $5.1 million in 1997.
The Company purchased approximately $1.8 million, $2.7 million and $1.2 million
of computer and office equipment in 1998, 1997 and 1996, respectively. At
December 31, 1998, the Company did not have any material commitments for capital
expenditures.
At December 31, 1998, the Company had cash and cash equivalents and
short-term investments totaling $20.3 million, a decrease from $23.3 million at
December 31, 1997. During 1998, the Company used $1.8 million to acquire
property and equipment and $1.2 million to fund working capital requirements.
21
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 Company did
not draw on the line of credit during 1998. At December 31, 1998, there was no
amount outstanding and the available borrowing amount was $7.5 million.
The Company anticipates that its existing capital resources described
above, 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.
Year 2000 Compliance
Many older computer systems and software products currently in use are
coded to accept only two digit entries in the date code field. These date code
fields will need to accept four digit entries to distinguish 21st century dates
from 20th century dates. As a result computer systems and/or software used by
many companies will need to be upgraded to comply with such "Year 2000"
requirements.
All of the services currently offered by the Company are designed to be
Year 2000 compliant. However, the Company's services are often integrated or
used in conjunction with third-party software; such software may not be
compatible with Company's services or Year 2000 compliant. The Company may in
the future be subject to claims based on Year 2000 problems in other's products,
custom scripts created by third parties to interface with the Company's services
or issues arising from the integration of multiple products and systems within
an overall system. The costs of defending and resolving Year 2000-related
disputes, and any liability of the Company for Year 2000-related damages,
including consequential damages, could have a material adverse effect on the
Company's business, operating results and financial condition.
Over the past three years, the Company has made Year 2000 compliance a
priority in IT purchasing and installation decisions. The Company's internal
information technology group has adopted a Year 2000 compliance program to
assess and address any Year 2000 issues which remain related to the Company's IT
and non-IT systems. The program consists of the following phases: identifying
Year 2000 application issues, updating applications, identifying Year 2000
systems and operating systems issues (such phases are complete), collecting
manufacturer's compliance statements, verifying solutions to Year 2000 issues,
updating and/or patching operating systems, updating firmware and phasing out
unsupported hardware (such phases are in process and scheduled to be completed
in the first quarter of fiscal 1999). As of January 1, 1999, the Company has
spent approximately $25,000 of the currently estimated $30,000 total cost of the
program. Costs incurred and expected to be incurred consist primarily of the
cost of Company personnel involved in updating applications and operating
systems and the costs of software updates and patches (many of which are
provided free of charge from the vendors). Funds for the Year 2000 compliance
program are expected to be provided from available working capital. The Company
has utilized the Company's internal technical personnel, and intends to continue
to use such personnel, to address Year 2000 issues, rather than contract with
third-party consultants.
22
Although the Company has not completed its survey of third parties with
which it has a material relationship, the majority of the Company's customers
are sophisticated IT vendors and users who are addressing their own Year 2000
issues and the Company relies primarily on its own technical personnel and
internal IT systems, rather than third party suppliers. As the Company's Year
2000 compliance program is on schedule to be completed in the first quarter of
fiscal year 1999, the Company has not formulated a most reasonably likely worst
case scenario or formulated a contingency plan should the program fail to be
completed by such date. The Company has verified 95% of its third party supply
chain. Any third party supplier that does not respond by the end of the first
quarter of 1999 will be replaced, if necessary.
Significant uncertainty still exists as to the global implications of
the Year 2000 issue. The Company believes that the purchasing patterns of
customers and potential customers may be affected by Year 2000 issues in a
variety of ways. Many companies (including customers of the Company, and
customers or potential customers of the Company's customers) are expending
significant resources to correct or patch their current hardware and software
systems for Year 2000 compliance. Such expenditures may result in reduced funds
available for the Company's customers to pursue product development programs or
IT systems enhancements for which the Company's services would otherwise be
utilized. Any of the foregoing, including costs of defending and resolving Year
2000-related disputes, reductions in development programs or IT systems
enhancements by customers and their customers or the failure of the Company to
adequately resolve internal Year 2000 compliance issues could result in a
material adverse effect on the Company's business, operating results and
financial condition.
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" and "Additional Factors that May
Affect Future Results" in Item 1 of this Form 10-K.
23
Item 7.A. Quantitative and Qualitative Disclosures about Market Risks
The Company does not use derivative financial instruments in its
non-trading investment portfolio. The Company places its investments in
instruments that meet high credit quality standards, as specified by the
Company's investment policy.
The Company is exposed to cash flow and fair value risk from changes in
interest rates, which may affect its financial position, results of operations
and cash flows. In seeking to minimize the risks from interest rate
fluctuations, the Company manages exposures through ongoing evaluation of its
investment portfolio. The Company does not use financial instruments for trading
or other speculative purposes.
The table below provides information about the Company's non-trading investment
portfolio. For investment securities, the table presents principal cash flows
and related weighted average fixed interest rates by expected maturity dates.
Investments Weighted Fair Value
Maturing Average At
At December 31, 1998 During Interest December 31,
(in thousands, except interest rates) 1999 Rate 1998
- ----------------------------------------- -------------- -------------- ----------------
Money market funds $ 1,571 4.70% $ 1,571
Government issues 2,723 4.79% 2,710
Corporate issues 13,411 5.42% 13,234
Commercial paper 1,635 5.14% 1,621
============== ============== ================
$ 19,340 5.25% $ 19,136
============== ============== ================
24
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, 1997 and 1998...................................................... F-3
Statements of Income (Loss) for the years ended December 31, 1996, 1997 and 1998..................... F-4
Statements of Stockholders' Equity for the years ended December 31, 1996, 1997
and 1998 .............................................................................................F-5
Statements of Cash Flows for the years ended December 31, 1996, 1997 and 1998........................ 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, 1997 and 1998 and the related statements of income (loss),
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 1998. These statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of PSW Technologies, Inc. at
December 31, 1997 and 1998, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1998, in conformity
with generally accepted accounting principles.
/s/ Ernst & Young LLP
Austin, Texas
January 28, 1999
F-2
PSW Technologies, Inc.
Balance Sheets
(in thousands, except share and per share data)
December 31,
1997 1998
--------------------- -----------------------
Assets
Current assets:
Cash $ 835 $ 1,167
Short-term investments 22,470 19,136
Accounts receivable, net of allowance for doubtful
accounts of $165 and $260 in 1997 and 1998,
respectively 7,429 6,171
Unbilled revenue under customer contracts 418 1,070
Income tax receivable 46 896
Net current deferred income taxes - 334
Prepaid expenses and other current assets 437 572
--------------------- -----------------------
Total current assets 31,635 29,346
Property and equipment, net 3,551 4,005
Net deferred income taxes 234 -
----------------------- -----------------------
Total assets $ 35,420 $ 33,351
===================== =======================
Liabilities and stockholders' equity
Current liabilities:
Accounts payable and accrued expenses 2,834 1,967
Net current deferred income taxes 727 -
--------------------- -----------------------
Total current liabilities 3,561 1,967
Net deferred income taxes - 316
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, 8,960,935 and 9,293,866 shares issued and
outstanding at December 31, 1997 and 1998, respectively
90 93
Additional paid-in capital 29,484 29,995
Deferred compensation (243) (44)
Accumulated and other comprehensive income (27) (69)
Retained earnings 2,555 1,093
--------------------- -----------------------
Total stockholders' equity 31,859 31,068
--------------------- -----------------------
Total liabilities and stockholders' equity $ 35,420 $ 33,351
===================== =======================
See accompanying notes.
F-3
PSW Technologies, Inc.
Statements of Income (Loss)
(in thousands, except per share data)
Year ended December 31,
1996 1997 1998
---- ---- ----
Revenue $ 31,274 $ 44,118 $ 39,101
Operating expenses:
Technical staff 16,444 22,479 23,440
Selling and administrative staff 5,622 8,405 10,121
Other expenses 5,684 7,979 8,933
Special compensation expense 2,193 268 75
--------- --------- ----------
Total operating expenses 29,943 39,131 42,569
--------- --------- ----------
Income (loss) from operations 1,331 4,987 (3,468)
Interest income (expense), net (170) 431 946
--------- --------- ----------
Income (loss) before provision (benefit) for
income taxes 1,161 5,418 (2,522)
--------- --------- ----------
Provision (benefit) for income taxes:
Nonrecurring charge for termination
of Subchapter S election - 1,200 -
C Corporation - 1,000 (1,060)
--------- --------- ----------
Total provision (benefit) for income taxes - 2,200 (1,060)
--------- --------- ----------
Net income (loss) $ 1,161 $ 3,218 $ (1,462)
========= ========= ==========
Basic loss per share $ (0.16)
==========
Diluted loss per share $ (0.16)
==========
Unaudited pro forma information:
Historical income before provision for
income taxes $ 1,161 $ 5,418
Pro forma provision for income taxes 441 1,900
--------- ---------
Pro forma net income $ 720 $ 3,518
========== =========
Pro forma basic earnings per share $ 0.13 $ 0.48
========== =========
Pro forma diluted earnings per share $ 0.11 $ 0.41
========== =========
Shares used in basic earnings (loss)
per share calculation 5,538 7,384 9,113
========== ========= =========
Shares used in diluted earnings (loss)
per share calculation 6,689 8,517 9,113
========== ========= =========
See accompanying note.
F-4
F-12
PSW Technologies, Inc.
Statements of Stockholders' Equity
(in thousands, except shares)
Retained Other
Common Stock Additional Earnings Comprehensive Total
$.01 Par Value Paid-in Deferred (Accumulated Income Stockholders'
-------------------
Shares Amounts Capital Compensation Deficit) (Loss) Equity
--------- ---------- ------------ -------------- -------------- ------------ --------------
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
Comprehensive Income:
Net income - - - - 3,218 - 3,218
Net unrealized loss on investments - - - - - (27) (27)
Comprehensive income - - - - - - 3,191
---------- ---------- ---------- ---------- ---------- ---------- ----------
Balance at December 31, 1997 8,960,935 90 29,484 (243) 2,555 (27) 31,859
Employee stock purchase plan
issuance of stock 93,747 2 417 - - - 419
Exercise of stock options and
warrants 239,184 1 63 - - - 64
Tax benefit related to stock
option exercises - - 155 - - - 155
Forfeiture of stock options - - (124) 124 - - -
Amortization of deferred
compensation - - - 75 - - 75
Comprehensive income:
Net loss - - - - (1,462) - (1,462)
Net unrealized loss on investments - - - - - (42) (42)
----------
Comprehensive income - - - - - - (1,504)
---------- ---------- ---------- ---------- ---------- ---------- ----------
Balance at December 31, 1998 9,293,866 $ 93 $ 29,995 $ (44) $ 1,093 $ (69) $ 31,068
========== ========== ========== ========== ========== ========== ==========
See accompanying notes.
F-5
PSW Technologies, Inc.
Statements of Cash Flows
(in thousands)
1996 1997 1998
------------ ------------ ------------
Operating activities
Net income (loss) $ 1,161 $ 3,218 $ (1,462)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Amortization of deferred compensation 2,193 268 75
Depreciation and amortization 424 825 1,100
Bad debt expense 75 45 249
Changes in operating assets and liabilities:
Accounts receivable (2,344) (1,367) 1,009
Due from related party (323) (258) -
Unbilled revenue under customer contracts (144) (174) (652)
Prepaid expenses and other current assets (864) (157) (135)
Income tax receivable - (46) (695)
Due to related party 581 - -
Accounts payable and accrued expenses 1,154 299 (639)
Deferred revenue 227 (227) -
Deferred income taxes - 675 (511)
------------ ------------ ------------
Net cash provided by (used in) operating activities 2,140 3,101 (1,661)
------------ ------------ ------------
Investing activities
Purchase of short-term investments - (22,497) -
Proceeds from sale of short-term investments - - 3,292
Acquisition of property and equipment (1,247) (2,646) (1,782)
------------ ------------ ------------
Net cash provided by (used in) investing activities (1,247) (25,143) 1,510
------------ ------------ ------------
Financing activities
Proceeds from (repayments on) line of credit, net 5,125 (5,125) -
Capital distributions, net (2,870) - -
Proceeds from issuance of common stock, net of
issuance costs - 26,220 483
Dividend paid to S corporation stockholders - (1,400) -
------------ ------------ ------------
Net cash provided by financing activities 2,255 19,695 483
------------ ------------ ------------
Net increase (decrease) in cash 3,148 (2,347) 332
Cash, beginning of year 34 3,182 835
============ ============ ============
Cash, end of year $ 3,182 $ 835 $ 1,167
============ ============ ============
Supplemental disclosure of cash flow information
Interest paid $ 154 $ 137 $ 20
Income taxes paid $ - $ 1,571 $ 148
Supplemental schedule of non-cash activities
Unrealized loss on investments $ - $ 27 $ 42
Reduction of income taxes payable associated
with the exercise of stock options $ - $ 182 $ 155
See accompanying notes.
F-6
PSW Technologies, Inc.
Notes to the Financial Statements
1. Nature of Business
PSW Technologies, Inc., (the "Company"), is a software services firm that
provides high value solutions to information technology ("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. 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. 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 IT 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.
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 effected on
December 18, 1996 and the 8-for-13 reverse stock split 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.
F-7
PSW Technologies, Inc.
Notes to the Financial Statements (continued)
2. Summary of Significant Accounting Policies (continued)
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 and (ii) all commissions and bonuses.
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 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.
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 and $50,000 in 1997 and
1998, respectively. Advertising costs were not material for 1996.
F-8
2. Summary of Significant Accounting Policies (continued)
Stock Based Compensation
The Company has adopted the disclosure provisions 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.
The pro forma basic and 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 Statement of Financial
Accounting Standards No. 128, Earnings Per Share, and the Securities and
Exchange Commission Staff Accounting Bulletin 98.
Reclassifications
Certain amounts in the prior year financial statements have been restated to
conform with the current year presentation.
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).
F-9
3. Stockholders' Equity (continued)
On February 3, 1997, the Company's Board of Directors approved i.) an 8-for-13
reverse stock split, which was effected on April 2, 1997, ii.) an increase in
the Company's authorized common stock from 11,250,000 to 34,000,000 shares and
iii.) an authorization of 1,000,000 shares of preferred stock of $.01 par value.
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. These 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.
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. During 1997, the Company declared and paid a dividend of $1.4
million to the stockholders of the Company prior to the termination of the S
corporation status to pay the income taxes for the 1997 taxable earnings of the
Company allocated to them. 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.
In May 1998, the Company's Board of Directors approved an amendment to the
Company's 1996 Stock Option/Stock Issuance Plan to increase the number of shares
of Common Stock authorized to be issued by 1,000,000 shares resulting in
2,715,000 shares available for issuance under the plan.
In September 1998, the Company's Board of Directors authorized the repricing of
options to purchase 737,495 shares of Common Stock effective as of the close of
business on September 29, 1998 to the then fair market value of $1.94 per share.
Under the terms of the repricing, the repriced options shall become exercisable
in four successive equal annual installments from the September 29,1998 grant
date. The repriced options have a maximum term of ten years measured from this
date of grant. The Chief Executive Officer did not participate in the repricing.
At December 31, 1998, the Company has reserved 505,654 shares of Common Stock
for issuance in connection with warrants outstanding and 2,647,000 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):
1997 1998
-------------------- -------------------
Furniture and fixtures $ 1,192 $ 1,243
Computer equipment 3,480 3,440
Computer software 603 860
Leasehold improvements 379 460
-------------------- -------------------
5,654 6,003
Less accumulated depreciation and amortization 2,103 1,998
==================== ===================
$ 3,551 $ 4,005
==================== ===================
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 short-term investments at December 31, 1997
and 1998 are as follows (in thousands):
Amortized Unrealized Unrealized Market
December 31, 1997 Cost Gains Losses Value
--------------- ----------------- ---------------- ---------------
Money market funds $ 1,801 $ - $ - $ 1,801
Government issues 16,391 17 29 16,379
Corporate issues 4,305 20 35 4,290
=============== ================= ================ ===============
$ 22,497 $ 37 $ 64 $ 22,470
=============== ================= ================ ===============
Amortized Unrealized Unrealized Market
December 31, 1998 Cost Gains Losses Value
--------------- ----------------- ---------------- ---------------
Money market funds $ 1,571 $ - $ - $ 1,571
Government issues 2,714 - 4 2,710
Corporate issues 13,294 4 64 13,234
Commercial paper 1,626 - 5 1,621
=============== ================= ================ ===============
$ 19,205 $ 4 $ 73 $ 19,136
=============== ================= ================ ===============
Gross gains and gross losses on the sale of investments were not significant in
1997 and 1998. 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):
1997 1998
------------------ ------------------
Trade payables $ 532 $ 460
Accrued vacation 442 320
Accrued bonuses 455 141
Payroll and other taxes payable 437 124
Other accounts payable and accrued expenses 968 922
================== ==================
$ 2,834 $ 1,967
================== ==================
F-11
7. Note Payable to Bank
The Company has a revolving line of credit with a bank which was amended and
extended until May 1, 1999 and 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 Company did not draw on the line of credit
during 1998. The line of credit contained certain restrictive convenants which,
among other things, required the Company to maintain a minimum net worth and to
meet certain financial ratios. At December 31, 1998, 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%.
8. Significant Customers
One customer and two of its wholly-owned subsidiaries accounted for
approximately 52%, 39% and 35% of total revenue for the years ended December 31,
1996, 1997 and 1998, respectively. This customer accounted for approximately 18%
of accounts receivable at December 31, 1998. Another customer accounted for
approximately 14% of total revenue for the year ended December 31, 1996. No
other customer accounted for more than 10% of revenue in 1996, 1997 or 1998.
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 2,715,000 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, 1997 and 1998 amounting to approximately $1,538,000, $268,000 and $75,000,
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 - $2.65 $3.00 - $9.00 $10.25 - $15 Total
-------------------- --------------------- --------------------- ------------------------
Weighted Weighted Weighted Weighted
Number Average Number Average Number Average Number Average
of shares Exercise of shares Exercise of shares Exercise of shares Excercise
Price Price Price Price
--------- --------- --------- --------- --------- --------- --------- ------------
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
Cancelled 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
Granted during the year (a) ....... 780,745 1.96 983,082 4.77 12,800 11.15 1,776,627 3.59
Exercised during the year ......... (229,452) 0.11 (7,732) 4.98 - - (237,184) 0.27
Cancelled during the year (a) ..... (72,896) 1.50 (963,760) 6.40 (163,665) 12.31 (1,200,321) 6.90
---------- --------- --------- ---------- ---------- ---------- ---------- ----------
Balance at December 31, 1998 ...... 984,969 $ 1.63 729,347 $ 3.98 24,936 $ 11.76 1,739,252 $ 2.73
========== ========== ========== ========== ========== ========== ========== ==========
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
========== ========== ========== ========== ========== ========== ========== ==========
Exercisable at December 31, 1998 .. 203,536 $ 0.46 149,093 $ 4.55 17,994 $ 11.75 370,623 $ 2.65
========== ========== ========== ========== ========== ========== ========== ==========
Weighted average fair value of
options granted during 1998 .. $ 1.96 $ 4.77 $ 11.15 $ 3.59
========== ========== ========== ==========
Weighted average remaining
contractual life in years, at
December 31, 1998 ............ 8.84 9.09 9.03 8.95
========== ========== ========== ==========
(a) Amount includes 737,495 shares pertaining to options repriced in September 1998.
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. The Company sold 53,732 and 93,747 shares of Common
Stock to employees through the Purchase Plan in 1997 and 1998, respectively.
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 and $52,000
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 and 1998, respectively,
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 and 1998 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.
The Company contributed approximately $132,000 to the Plan in 1998. No
contributions were made to the Plan in 1996 or 1997 by the Software Division or
PSW.
F-14
9. Employee Benefit Plans (continued)
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
------------------------------------- 1997 1998
Vested at Non-vested at Option Option
Assumption Grant Date Grant Date Grants Grants
- ---------------- ---------------- ---------------- -------------- -------------
Risk-free interest rate 5.93% 6.23% 6.34% 6.00%
Dividend yield 0% 0% 0% 0%
Volatility factor of the expected
market price of the Company's
common stock 0.374 0.374 0.521 0.771
Average life 3 years 6 years 6 years 6 years
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, 1997 and 1998, pro forma net income (loss) under
SFAS 123 amounted to approximately $658,000, $2.7 million and ($4.7) million,
respectively and pro forma basic earnings (loss) per share and pro forma diluted
earnings (loss) per share under SFAS 123 amounted to approximately $.012 and
$0.09 in 1996, $0.36 and $0.32 in 1997 and ($0.52) and ($0.52) in 1998,
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,
1996 1997 1998
---- ---- ----
Services performed by related party:
Recruiting services $ 316 $ 60 $ -
Contracted technical services - 9 62
Legal and accounting 21 28 -
Allocated expenses:
Rent 448 37 -
Corporate and officers' salaries 125 - -
---------------- --------------- ---------------
Total expenses included in other expenses 910 134 62
Interest 104 - -
---------------- --------------- ---------------
Total related party expenses $ 1,014 $ 134 $ 62
================ =============== ===============
F-15
10. Related Party Transactions (continued)
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.
11. Commitments
The Company leases its office space through noncancellable operating lease
arrangements. Future minimum rental commitments (including amounts payable under
leases held by Pencom) are as follows:
Years ending December 31 (in thousands):
1999 $ 1,959
2000 1,840
2001 1,790
2002 1,824
2003 1,626
Thereafter -
================
Total $9,039
================
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 subleased these premises. However, the Company entered into an agreement
with Pencom to guarantee Pencom's sublease income. Future minimum sublease
rental income that the Company has guaranteed is as follows:
Years ending December 31 (in thousands):
1999 $ 380
2000 285
----------------
Total $ 665
================
Rent expense, including rent allocated by Pencom, for the years ended December
31, 1996, 1997 and 1998 was approximately $601,000, $1,258,000 and $1,566,000,
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 were 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.
F-16
12. Income Taxes (continued)
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 provision for income taxes for the year ended
December 31, 1996, of $441,000 is 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. The tax benefit for income taxes of $1,060,000 attributable to December
31, 1998, is computed using an effective tax rate of 42% which differs from the
federal statutory rate of 34% as a result of state taxes and tax-exempt income.
Significant components of the provision (benefit) for income taxes are as
follows:
1997 1998
-------------- -------------
Current:
Federal $ 1,526 $ (505)
State 180 (44)
-------------- -------------
Total current 1,706 (549)
Deferred:
Federal 442 (470)
State 52 (41)
-------------- -------------
Total deferred 494 (511)
============== =============
$ 2,200 $ (1,060)
============== =============
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 Historical
1996 1997 1997 1998
------------- ------------- ------------- ------------
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% 3.8% (3.4%)
Permanent differences, primarily
tax-exempt income - (3.0%) (0.7%) (4.8%)
Nonrecurring charge due to
Subchapter S termination - - 22.1% -
S Corporation income not subject to
tax - - (20.7%) -
Other - - 2.1% 0.2%
============= ============= ============= ============
Effective tax rate 38.0% 35.0% 40.6% (42.0%)
============= ============= ============= ============
F-17
12. Income Taxes (continued)
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 1998
------------ ---------------
Deferred tax assets:
Allowances and reserves $ 183 $ 122
Accrued expenses 246 278
Stock option compensation expense 575 286
------------ ---------------
Total deferred tax assets 1,004 686
Deferred tax liabilities:
Fixed assets (84) (263)
Cash to accrual adjustment (1,151) -
Prepaid expenses and other (262) (405)
------------ ---------------
Total deferred tax liabilities (1,497) (668)
------------ ===============
Net deferred tax liabilities $ (493) $ 18
============ ===============
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.
13. Special Compensation Expense
As described in Notes 9 and 10, 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 and
$75,000 was recognized for the years ended December 31, 1997 and 1998,
respectively. These transactions reduced income from operations, net income and
diluted earnings per share for the years ended December 31, 1996, 1997 and 1998
as follows (in thousands, except per share data):
1996(a) 1997(a) 1998
---------------- ---------------- -------------------
Operating income $ 2,193 $ 268 $ 75
Net income 1,360 169 43
Diluted earnings per share 0.19 0.02 0.01
(a) Net income and earnings per share amounts are presented on a pro forma
basis as if the Company had been subject to federal and state income taxes.
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 the provisions of SFAS 128 and SAB 98 resulted in an
increase to pro forma diluted earnings per share for 1996 of $.01 per
share.
Deferred compensation as of December 31, 1998 of approximately $44,000 will be
amortized over the remaining vesting periods in 1999 and 2000.
F-18
14. Earnings per Share
The following table sets forth the computation of basic and diluted earnings per
share (in thousands, except per share data):
1996(a) 1997(a) 1998
---------------- ---------------- -----------------
Numerator:
Net income (loss) $ 720 $ 3,518 $ (1,462)
================ ================ =================
Denominator:
Shares used in basic earnings (loss)
per share calculation 5,538 7,384 9,113
Effect of dilutive securities:
Employee stock options 646 627 -
Warrants 505 506 -
---------------- ---------------- -----------------
Shares used in diluted earnings (loss)
per share calculation 6,689 8,517 9,113
================ ================ =================
Basic earnings (loss) per share $ 0.13 $ 0.48 $ (0.16)
================ ================ =================
Diluted earnings (loss) per share $ 0.11 $ 0.41 $ (0.16)
================ ================ =================
(a) Net income and earnings per share amounts are presented on a pro forma
basis as if the Company had been subject to federal and state income taxes.
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 the provisions of SFAS 128 and SAB 98 resulted
in an increase to pro forma diluted earnings per share for 1996 of $.01 per
share.
Options to purchase 1.74 million shares of Common Stock at an average exercise
price of $2.73 per share were outstanding at December 31, 1998, but were not
included in the computation of diluted net loss per share as its effect would be
anti-dilutive.
F-19
15. Comprehensive Income
As of January 1, 1998, the Company adopted SFAS No. 130, Reporting Comprehensive
Income. SFAS No. 130 establishes new rules for the reporting and display of
comprehensive income and its components; however, the adoption of this Statement
had no impact on the Company's net income or stockholders' equity. SFAS No. 130
requires unrealized gains or losses on the Company's available-for-sale
securities, which prior to adoption were reported separately in shareholders'
equity, to be included in other comprehensive income. Prior year financial
statements have been reclassified to conform to the requirements of SFAS No.
130.
The components of comprehensive income for the years ended 1996, 1997 and 1998
are as follows:
1996(a) 1997(a) 1998
--------------- --------------- ---------------
Net income (loss) $ 720 $ 3,518 $ (1,462)
Unrealized gain (loss) on short-term
investments - (41) (74)
Income tax (expense) benefit related to items
of other comprehensive income - 14 32
--------------- --------------- ---------------
Comprehensive income (loss) $ 720 $ 3,491 $ (1,504)
=============== =============== ===============
(a) Net income and comprehensive income amounts are presented on a
pro forma basis as if the Company had been subject to federal and
state income taxes.
The components of accumulated other comprehensive income at December 31, 1997
and 1998 are as follows:
1997 1998
--------------- ---------------
Unrealized loss on short-term investments $ (27) $ (69)
=============== ===============
16. Litigation
The Company is involved in legal proceedings, claims and litigation arising in
the ordinary course of business. In the opinion of management, the outcome of
such current legal proceedings, claims and litigation could have a material
effect on quarterly or annual operating results or cash flows when resolved in a
future period. However, in the opinion of management, these matters will not
materially affect the Company's financial position.
F-20
17. Quarterly Information (Unaudited)
Summarized quarterly financial information for 1996, 1997 and 1998 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 (a) $ .06 $ .06 $ - $ (.02)
Shares used in diluted earnings
per share calculation (a) 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 (a) $ .09 $ .10 $ .11 $ .11
Shares used in diluted earnings
per share calculation (a) 6,740 7,290 9,973 10,063
1998
Total revenues $ 9,758 $ 9,867 $ 9,255 $ 10,221
Operating loss (564) (433) (2,415) (56)
Net income (loss) (212) (210) (1,130) 90
Diluted earnings (loss)
per share $ (0.02) $ (0.02) $ (0.12) $ 0.01
Shares used in diluted earnings
(loss) per share calculation 8,990 9,057 9,146 10,053
(a) 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 the provisions of SFAS 128 and SAB 98
resulted in an increase to pro forma diluted earnings per share for
1996 of $.01 per share.
F-21
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 1996 Stock Option/Stock Issuance Plan.
**10.17 Employee Stock Purchase Plan.
**10.18 PSW Profit Sharing Plan.
**10.19 Description of Executive Bonus Plan.
**10.20 Stock Purchase Agreement dated as of January 1, 1997 between Michael J. Maples and the Registrant.
**10.21 Stock Subscription dated October 1, 1996 between Pencom Systems Incorporated and the Registrant.
**10.22 Asset Contribution Agreement dated October 1, 1996 between Pencom Systems Incorporated and the Registrant.
**10.23 Assignment and Assumption Agreement dated October 1, 1996 between the Registrant and Pencom Systems Incorporated.
**10.24 Warrant dated October 1, 1996 issued by the Registrant to Pencom Systems Incorporated.
**10.25 Warrant dated October 1, 1996 issued by the Registrant to Stephen Markman.
**10.26 Warrant dated October 1, 1996 issued by the Registrant to Thomas Pallister.
**10.27 Warrant dated October 1, 1996 issued by the Registrant to Joy Venegas.
(1)10.28 Mountainview Lease Agreement dated May 11, 1998 between the Registrant and South Bay/Copley Joint Venture
(1)10.29 1996 Stock Option/Stock Issuance Plan Amendment
(2)10.30 Employment Agreement dated August 28, 1998 between the Registrant and Timothy D. Webb.
10.31 Employment Agreement dated January 18, 1999 between the Registrant and Pedro A. Fernandez.
10.32 Employment Agreement dated January 25, 1999 between the Registrant and John M. Velasquez.
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.
(1) Incorporated herein by reference to the exhibits to the Company's Report on Form 10-Q for the three-month period
ended June 30, 1998.
(2) Incorporated herein by reference to the exhibits to the Company's Report on Form 10-Q for the three-month period
ended September 30, 1998.
Reports on Form 8-K:
During the quarter ended December 31, 1998, 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 31, 1999 By: /s/ Timothy D. Webb____________________
Date Timothy D. Webb, President, Chief Executive Officer
and Director (Principal Executive 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 31, 1999 By: /s/ Keith D. Thatcher__________________
Date Keith D. Thatcher, Chief Financial Officer
(Principal Financial Officer)
March 31, 1999 By: /s/ Kasaundra L. Smith_________________
Date Kasaundra L. Smith, Financial Reporting Manager
(Principal Accounting Officer)
March 31, 1999 By: /s/ Wade E. Saadi______________________
Date Wade E. Saadi, Chairman of the Board of Directors
March 31, 1999 By: /s/ Edward C. Ateyeh, Jr.______________
Date Edward C. Ateyeh, Jr., Director
March 31, 1999 By: /s/ W. Frank King______________________
Date Dr. W. Frank King, Director
March 31, 1999 By: /s/ Thomas A. Herring__________________
Date Thomas A. Herring, Director
March 31, 1999 By: /s/ Kevin B. Kurtzman__________________
Date Kevin B. Kurtzman, Director
March 31, 1999 By: /s/ Michael J. Maples__________________
Date Michael J. Maples, Director
March 31, 1999 By: /s/ Jonathan D. Wallace________________
Date Jonathan D. Wallace, Esq., Director