Virage 10Q 2001 Q2 Quarterly report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-Q


[X]	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2001


[ ]	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER: 0-30903

VIRAGE, INC.
(Exact name of registrant as specified in its charter)


DELAWARE (State or other jurisdiction of incorporation or organization)		38-3171505 (I.R.S. Employer Identification No.)

177 BOVET ROAD, SUITE 520
SAN MATEO, CALIFORNIA 94402-3116
(650) 573-3210
(Address, including zip code, and telephone number, including area code,
of the registrant’s principal executive offices)

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. [X] Yes [ ] No

The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 20,384,321 as of August 1, 2001.

TABLE OF CONTENTS


PART I. FINANCIAL INFORMATION
	Item 1. Financial Statements
		CONDENSED CONSOLIDATED BALANCE SHEETS
		CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
		CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
		NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
	Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3. Quantitative and Qualitative Disclosures About Market Risk
PART II: OTHER INFORMATION
	Item 1. Legal Proceedings.
	Item 2. Changes in Securities and Use of Proceeds
	Item 3. Defaults Upon Senior Securities
	Item 4. Submission of Matters to a Vote of Security Holders
	Item 5. Other Information
	Item 6. Exhibits and Report on Form 8-K.
SIGNATURE

VIRAGE, INC.

INDEX


		PAGE

PART I: FINANCIAL INFORMATION




Item 1. Financial Statements (unaudited)




Condensed Consolidated Balance Sheets — June 30, 2001 and March 31, 2001.		3




Condensed Consolidated Statements of Operations — Three Months Ended June 30, 2001 and 2000		4




Condensed Consolidated Statements of Cash Flows — Three Months Ended June 30, 2001 and 2000.		5




Notes to Condensed Consolidated Financial Statements		6




Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations		12




Item 3. Quantitative and Qualitative Disclosures About Market Risk		28




PART II: OTHER INFORMATION




Item 1. Legal Proceedings		29




Item 2. Changes in Securities and Use of Proceeds		29




Item 3. Defaults Upon Senior Securities		29




Item 4. Submission of Matters to a Vote of Security Holders		29




Item 5. Other Information		29




Item 6. Exhibits and Reports on Form 8-K		29




Signature		30

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VIRAGE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)


				June 30,			March 31,
				2001			2001

			ASSETS




Current assets:




	Cash and cash equivalents			$	6,892		$	19,680




	Short-term investments				35,530			28,451




	Accounts receivable, net				2,490			2,331




	Prepaid expenses and other current assets				939			515

		Total current assets			45,851			50,977




Property and equipment, net					6,072			6,692




Other assets					2,528			2,537





		Total assets		$	54,451		$	60,206

		LIABILITIES AND STOCKHOLDERS’ EQUITY




Current liabilities:




	Accounts payable			$	1,014		$	1,153




	Accrued payroll and related expenses				2,439			3,279




	Accrued expenses				3,398			3,003




	Deferred revenue				3,254			2,954

		Total current liabilities			10,105			10,389




Deferred rent					167			111




Stockholders’ equity:




	Common stock				20			20




	Additional paid-in capital				121,241			120,707




	Deferred compensation				(8,697	)		(9,847	)




	Accumulated deficit				(68,385	)		(61,174	)

		Total stockholders’ equity			44,179			49,706

		Total liabilities and stockholders’ equity		$	54,451		$	60,206

See accompanying notes.

VIRAGE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)


			Three Months Ended
			June 30,

			2001			2000

Revenues:




	License revenues		$	1,882		$	1,093




	Service revenues			2,047			819




	Other revenues			61			19

		Total revenues		3,990			1,931




Cost of revenues:




	License revenues			154			148




	Service revenues(1)			2,532			1,481




	Other revenues			57			55





		Total cost of revenues		2,743			1,684

Gross profit				1,247			247




Operating expenses:




	Research and development(2)			2,473			2,033




	Sales and marketing(3)			4,439			3,983




	General and administrative(4)			1,332			1,242




	Stock-based compensation			782			836





		Total operating expenses		9,026			8,094

Loss from operations				(7,779	)		(7,847	)




Interest and other income, net				568			112





Net loss			$	(7,211	)	$	(7,735	)

Basic and diluted net loss per share			$	(0.36	)	$	(2.41	)

Shares used in computation of basic and diluted net loss per share				20,133			3,214

(1)		Excluding $74 in amortization of deferred employee stock-based compensation for the three months ended June 30, 2001 ($76 for the three months ended June 30, 2000).




(2)		Excluding $117 in amortization of deferred employee stock-based compensation for the three months ended June 30, 2001 ($138 for the three months ended June 30, 2000).




(3)		Excluding $233 in amortization of deferred employee stock-based compensation for the three months ended June 30, 2001 ($264 for the three months ended June 30, 2000).




(4)		Excluding $358 in amortization of deferred employee stock-based compensation for the three months ended June 30, 2001 ($358 for the three months ended June 30, 2000).

See accompanying notes.

VIRAGE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)


			Three Months Ended
			June 30,

			2001			2000

CASH FLOWS FROM OPERATING ACTIVITIES:




Net loss			$	(7,211	)	$	(7,735	)




Adjustments to reconcile net loss to net cash used in operating activities:




	Depreciation and amortization			705			341




	Amortization of deferred compensation related to stock options			987			1,061




	Amortization of deferred advertising costs and technology right			9			204




	Amortization of warrant fair values			219			—




	Changes in operating assets and liabilities:




		Accounts receivable		(159	)		509




		Prepaid expenses and other current assets		(424	)		(242	)




		Other assets		—			(509	)




		Accounts payable		(139	)		(286	)




		Accrued payroll and related expenses		(840	)		738




		Accrued expenses		395			51




		Deferred revenue		300			191




		Deferred rent		56			—

Net cash used in operating activities				(6,102	)		(5,677	)




CASH FLOWS FROM INVESTING ACTIVITIES:




Purchase of property and equipment				(85	)		(1,160	)




Purchase of short-term investments				(30,407	)		—




Sales and maturities of short-term investments				23,328			—

Net cash used in investing activities				(7,164	)		(1,160	)




CASH FLOWS FROM FINANCING ACTIVITIES:




Proceeds from bank line of credit				—			806




Principal payments on loans and capital leases				—			(64	)




Proceeds from exercise of stock options, net of repurchases				(11	)		—




Proceeds from employee stock purchase plan				489			—




Proceeds from exercise of warrants to purchase preferred and common stock				—			2,125

Net cash provided by financing activities				478			2,867

Net increase (decrease) in cash and cash equivalents				(12,788	)		(3,970	)




Cash and cash equivalents at beginning of period				19,680			10,107

Cash and cash equivalents at end of period			$	6,892		$	6,137

SUPPLEMENTAL DISCLOSURES OF NONCASH OPERATING, INVESTING AND FINANCING ACTIVITIES:




Deferred compensation related to stock options			$	71		$	29




Reversal of deferred compensation upon employee termination			$	234		$	232




Cash advance for common stock subscription			$	—		$	13,000

See accompanying notes.

VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2001
(unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and in accordance with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) necessary for a fair presentation of the financial statements at June 30, 2001 and for the three month periods ended June 30, 2001 and 2000 have been included.

The condensed consolidated financial statements include the accounts of Virage, Inc. (the “Company”) and its majority owned subsidiaries, Virage Europe, Ltd. and Virage GmbH. All significant intercompany balances and transactions have been eliminated in consolidation.

Results for the three months ended June 30, 2001 are not necessarily indicative of results for the entire fiscal year or future periods. These financial statements should be read in conjunction with the consolidated financial statements and the accompanying notes included in the Company’s Annual Report on Form 10-K, dated June 20, 2001 as filed with the United States Securities and Exchange Commission. The accompanying balance sheet at March 31, 2001 is derived from the Company’s audited consolidated financial statements at that date.

Revenue Recognition

The Company enters into arrangements for the sale of licenses of software products and related maintenance contracts, application services and professional services offerings; and also receives revenues under U.S. government agency research grants. Service revenues include revenues from maintenance contracts, application services, and professional services. Other revenues are primarily U.S. government agency research grants.

The Company’s revenue recognition policy is in accordance with the American Institute of Certified Public Accountants’ (“AICPA”) Statement of Position No. 97-2 (“SOP 97-2”), “Software Revenue Recognition”, as amended by Statement of Position No. 98-4, “Deferral of the Effective Date of SOP 97-2, “Software Revenue Recognition” (“SOP 98-4”), and Statement of Position No. 98-9, “Modification of SOP No. 97-2 with Respect to Certain Transactions” (“SOP 98-9”). For each arrangement, the Company determines whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all criteria are met. The Company considers all arrangements with payment terms extending beyond twelve months and other arrangements with payment terms longer than normal not to be fixed or determinable. If collectibility is not considered probable, revenue is recognized when the fee is collected. No customer has the right of return.

Arrangements consisting of license and maintenance.For those contracts that consist solely of license and maintenance, the Company recognizes license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by SOP 98-9. The Company recognizes maintenance revenues over the term of the maintenance contract as vendor specific objective evidence of fair value for maintenance exists. In accordance with paragraph ten of SOP 97-2, vendor specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration. Revenue is recognized on a per copy basis for licensed software when each copy of the license requested by the customer is delivered.

VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
June 30, 2001
(unaudited)

Revenue is recognized on licensed software on a per user or per server basis for a fixed fee when the product master is delivered to the customer. There is no right of return or price protection for sales to domestic and international distributors, system integrators, or value added resellers (collectively, “resellers”). In situations where the reseller has a purchase order from the end user that is immediately deliverable, the Company recognizes revenue on shipment to the reseller, if other criteria in SOP 97-2 are met, since the Company has no risk of concessions. The Company defers revenue on shipments to resellers if the reseller does not have a purchase order from an end user that is immediately deliverable or other criteria in SOP 97-2 are not met. The Company recognizes royalty revenues upon receipt of the quarterly reports from the vendors.

When licenses and maintenance are sold together with professional services such as consulting and implementation, license fees are recognized upon shipment, provided that (1) the criteria in the previous paragraph have been met, (2) payment of the license fee is not dependent upon the performance of the professional services, and (3) the services do not include significant alterations to the features and functionality of the software. Historically, very few license and maintenance arrangements were sold together with professional services as the Company had not formally established a professional services organization until the end of fiscal 2001.

Should professional services be essential to the functionality of the licenses in a license arrangement which contains professional services or should an arrangement not meet the criteria mentioned previously in this paragraph, both the license revenues and professional service revenues are recognized in accordance with the provisions of the AICPA’s Statement of Position No. 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts” (“SOP 81-1”). When reliable estimates are available for the costs and efforts necessary to complete the implementation services and the implementation services do not include contractual milestones or other acceptance criteria, the Company accounts for the arrangements under the percentage of completion contract method pursuant to SOP 81-1 based upon input measures such as hours or days. When such estimates are not available, the completed contract method is utilized. When an arrangement includes contractual milestones, the company recognizes revenues as such milestones are achieved.

Application services.Application services revenues consist of web design and integration fees, video processing fees and application hosting fees. Web design and integration fees are recognized ratably over the contract term, which is generally six to twelve months. The Company generates video processing fees for each hour of video that a customer deploys. Processing fees are recognized as encoding, indexing and editorial services are performed and are based upon hourly rates per hour of video content. Application hosting fees are generated based on the number of video queries processed, subject in some cases to monthly minimums and maximums. The Company recognizes revenues on transaction fees that are subject to monthly minimums based on the greater of actual transaction fees or the monthly minimum, and monthly maximums based on the lesser of actual transaction fees or the monthly maximum, since the Company has no further obligations, the payment terms are normal and each month is a separate measurement period.

Professional Services.The Company provides professional services such as consulting, implementation and training services to its customers. Revenues from such services, when not sold in conjunction with product licenses, are generally recognized as the services are performed.

Other revenues.Other revenues consist primarily of U.S. government agency research grants that are best effort arrangements. The software-development arrangements are within the scope of the Financial Accounting Standards Board’s Statement of Financial Accounting Standards No. 68, “Research and Development Arrangements.” As the financial risks associated with the software-development arrangement rests solely with the U.S. government agency, the Company is recognizing revenues as the services are performed. The cost of these services are included in cost of other revenues. The Company’s contractual obligation is to provide the required level of effort (hours), technical reports, and funds and man-hour expenditure reports.

VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
June 30, 2001
(unaudited)

Use of Estimates

The preparation of the accompanying unaudited condensed consolidated financial statements requires management to make estimates and assumptions that effect the amounts reported in these financial statements. Actual results could differ from those estimates.

Cash Equivalents and Short-Term Investments

The Company invests its excess cash in money market accounts and debt instruments and considers all highly liquid debt instruments purchased with an original maturity of three months or less to be cash equivalents. Investments with an original maturity at the time of purchase of over three months are classified as short-term investments regardless of maturity date, as all such instruments are classified as available-for-sale and can be readily liquidated to meet current operational needs. At June 30, 2001, all of the Company’s total cash equivalents and short-term investments were classified as available-for-sale and consisted of obligations issued by U.S. government agencies and multinational corporations, maturing within one year.

Comprehensive Net Loss

The Company has adopted the Financial Accounting Standards Board’s (“FASB”) Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (“FAS 130”). FAS 130 establishes standards for the reporting and display of comprehensive income (loss) and its components in a full set of general purpose financial statements. To date, unrealized gains and losses have been insignificant and the Company has had no other comprehensive income (loss), and consequently, net loss equals total comprehensive net loss.

Net Loss per Share

Basic and diluted net loss per share are computed in conformity with the FASB’s Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (“FAS 128”), for all periods presented, using the weighted average number of common shares outstanding less shares subject to repurchase.

Pro forma basic and diluted net loss per share have been computed as described above and also give effect, even if antidilutive, to common equivalent shares from preferred stock as if such conversion had occurred on April 1, 2000, or at the date of original issuance, if later.

VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
June 30, 2001
(unaudited)

The following table presents the computation of basic and diluted net loss per share and pro forma basic and diluted net loss per share (in thousands, except per share data):


	Three Months Ended
	June 30,

	2001			2000

Net loss	$	(7,211	)	$	(7,735	)

Weighted-average shares of common stock outstanding		20,343			3,704




Less weighted-average shares of common stock subject to repurchase		(210	)		(490	)





Weighted-average shares used in computation of basic and diluted net loss per share		20,133			3,214





Basic and diluted net loss per share	$	(0.36	)	$	(2.41	)





Shares used in computation of basic and diluted net loss per share		20,133			3,214




Pro forma adjustment to reflect weighted-average effect of the assumed conversion of convertible preferred stock		—			10,321





Shares used in computing pro forma basic and diluted net loss per share		20,133			13,535





Pro forma basic and diluted net loss per share	$	(0.36	)	$	(0.57	)

Impact of Recently Issued Accounting Standards

In June 2001, the FASB issued Statement of Financial Accounting Standards No. 141, “Business Combinations (“FAS 141”).” FAS 141 requires use of the purchase method for all business combinations initiated after June 30, 2001, thereby eliminating use of the pooling method. FAS 141 also provides new criteria to determine whether an acquired intangible asset should be recognized separately from goodwill. Under the new criteria, an acquired intangible asset would not be recognized separately from goodwill unless either control over the future economic benefits results from contractual or legal rights or the asset is capable of being separated or divided and sold, transferred, licensed, rented, or exchanged. The Company currently believes that FAS 141 will not have a material impact on its financial position or its results of operations or cash flows as the Company has not participated in any business combinations through June 30, 2001.

VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
June 30, 2001
(unaudited)

In June 2001, the FASB issued Statement of Financial Accounting Standards No. 142, “Goodwill and Intangible Assets (“FAS 142”).” FAS 142 states that amortization of goodwill will no longer be required. Instead, impairment to goodwill is to be tested at least annually at the reporting unit level using a two-step impairment test whereby the first step determines if goodwill is impaired and the second step measures the amount of the impairment loss. While goodwill is to be tested for impairment annually, companies may need to test for goodwill impairment on an interim basis if an event or circumstance occurs that might significantly reduce the fair value of a reporting unit below its carrying amount. Regarding amortization of intangible assets with finite lives, the FASB requires intangible assets to be amortized over their useful economic lives and reviewed for impairment under Statement 121. Intangible assets that have economic lives that are indefinite would not be subject to amortization until there is evidence that their lives no longer are indefinite, and would be tested for impairment annually using a lower of cost or fair value approach. The provisions of FAS 142 will be effective for fiscal years beginning after December 15, 2001. The Company currently believes that FAS 142 will not have a material impact on its financial position or its results of operations or cash flows as the Company has no goodwill or intangible assets subject to the requirements of FAS 142.

2. Stockholders’ Equity

In December 2000, the Company entered into a services agreement with a customer and issued an immediately exercisable, non-forfeitable warrant to purchase 200,000 shares of common stock at $5.50 per share. The warrant expires in December 2003. The value of the warrant was estimated to be $648,000 and was based upon a Black-Scholes valuation model with the following assumptions: risk free interest rate of 7.0%, no dividend yield, volatility of 90%, expected life of three years, exercise price of $5.50 and fair value of $5.38. The non-cash amortization of the warrant’s value is being recorded against service revenues as revenues from services are recognized over the one-year services agreement. During the three months ended June 30, 2001, the Company recorded $216,000 as contra-service revenues representing the pro-rata amortization of the warrant’s value for the aforementioned period.

3. Segment Reporting

The Company has two reportable segments: the sale of software and related software support services including revenues from U.S. government agencies (“software”) and the sale of its application and professional services which includes set-up fees, professional services fees, video processing fees, and application hosting fees (“application services”). The Company’s Chief Operating Decision Maker (“CODM”) is the Company’s Chief Executive Officer who evaluates performance and allocates resources based upon total revenues and gross profit (loss). Discreet financial information for each segment’s profit and loss and each segment’s total assets is not provided to the Company’s CODM, nor is it tracked by the Company.

VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
June 30, 2001
(unaudited)

Information on the Company’s reportable segments for the three months ended June 30, 2001 and 2000 are as follows (in thousands):


	Three Months Ended
	June 30,

	2001			2000

Software:




Total revenues	$	2,586		$	1,380




Total cost of revenues		358			297

Gross profit	$	2,228		$	1,083

Application and Professional Services:




Total revenues	$	1,404		$	551




Total cost of revenues		2,385			1,387

Gross loss	$	(981	)	$	(836	)

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes contained herein and the information contained in our Annual Report on Form 10-K as filed with the United States Securities and Exchange Commission on June 20, 2001. This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Exchange Act. We may identify these statements by the use of words such as “believe”, “expect”, “anticipate”, “intend”, “plan” and similar expressions. These forward-looking statements involve several risks and uncertainties. Our actual results may differ materially from those set forth in these forward-looking statements as a result of a number of factors, including those described under the caption “Risk Factors” herein and in our Annual Report on Form 10-K as filed with the United States Securities and Exchange Commission on June 20, 2001. These forward-looking statements speak only as of the date of this quarterly report, and we caution you not to rely on these statements without also considering the risks and uncertainties associated with these statements and our business as addressed elsewhere in this quarterly report and in our Annual Report on Form 10-K as filed with the United States Securities and Exchange Commission on June 20, 2001.

Overview

Virage is a leading provider of video content management and publishing solutions. Depending on their particular needs and resources, our customers may elect to license our software products or employ our application or professional services to outsource their needs. Our customers include media and entertainment companies, other corporations, government agencies and educational institutions.

Revenue Recognition

We enter into arrangements for the sale of licenses of software products and related maintenance contracts, application and professional services offerings and we also receive revenues under U.S. government agency research grants. Service revenues include revenues from maintenance contracts, application services and professional services. Other revenues are primarily U.S. government agency research grants.

Our revenue recognition policy is in accordance with the American Institute of Certified Public Accountants, or AICPA’s, Statement of Position No. 97-2, or SOP 97-2, “Software Revenue Recognition,” as amended by Statement of Position No. 98-4, “Deferral of the Effective Date of SOP 97-2, “Software Revenue Recognition,” ” or SOP 98-4, and Statement of Position No. 98-9, “Modification of SOP No. 97-2 with Respect to Certain Transactions” or SOP 98-9. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is probable. If any of these criteria are not met, revenue recognition is deferred until such time as all of the criteria are met. We consider all arrangements with payment terms extending beyond 12 months and other arrangements with payment terms longer than normal not to be fixed or determinable. If collectibility is not considered probable, revenue is recognized when the fee is collected provided all other criteria are met. No customer has the right of return.

Arrangements consisting of license and maintenance.For those contracts that consist solely of license and maintenance, we recognize license revenues based upon the residual method after all elements other than maintenance have been delivered as prescribed by SOP 98-9. We recognize maintenance revenues over the term of the maintenance contract as vendor specific objective evidence of fair value for maintenance exists. In accordance with paragraph 10 of SOP 97-2, vendor specific objective evidence of fair value of maintenance is determined by reference to the price the customer will be required to pay when it is sold separately (that is, the renewal rate). Each license agreement offers additional maintenance renewal periods at a stated price. Maintenance contracts are typically one year in duration. Revenue is recognized on a per copy basis for licensed software when each copy of the license requested by the customer is delivered. Revenue is recognized on licensed software on a per user or per server basis for a fixed fee when the product master is delivered to the customer. There is no right of return or price protection for sales to domestic and international distributors, system integrators, or value added resellers. In situations where the distributor, integrator or reseller has a purchase order from the end user that is immediately deliverable, we recognize revenue on shipment to the distributor, integrator or reseller, if other criteria in SOP 97-2 are met, since we have no risk of concessions. We defer revenues on shipments to distributors, integrators or

resellers if the party does not have a purchase order from an end user that is immediately deliverable or other criteria in SOP 97-2 are not met. We recognize royalty revenues upon receipt of the quarterly reports from the vendors.

When licenses and maintenance are sold together with professional services such as consulting and implementation, license fees are recognized upon shipment, provided that (1) the criteria in the previous paragraph have been met, (2) the Company believes that the services are not essential to the other elements of the arrangement and the Company has sufficient experience in providing the services, (3) the services do not involve a significant degree of risk or unique acceptance, (4) payment of the license fee is not dependent upon the performance of the services, (5) the services are available from other vendors, and (6) the services do not include significant alterations to the features and functionality of the software. In such an arrangement, the Company uses vendor specific objective evidence of fair value for the services and the maintenance to account for the arrangement using the residual method, regardless of any separate prices stated within the contract for each element. Vendor-specific objective evidence of fair value of services within a multiple element arrangement is based upon hourly or daily rates—the same rates used when the Company enters into stand-alone service contracts based upon time and materials.

Should professional services be essential to the functionality of the licenses in a license arrangement which contains professional services or should an arrangement not meet the criteria mentioned previously in the above paragraph, both the license revenues and professional service revenues are recognized in accordance with the provisions of the AICPA’s SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts” (“SOP 81-1”). When reliable estimates are available for the costs and efforts necessary to complete the implementation services and the implementation services do not include contractual milestones or other acceptance criteria, the Company accounts for the arrangements under the percentage of completion contract method pursuant to SOP 81-1 based upon input measures such as hours or days. When such estimates are not available, the completed contract method is utilized. When an arrangement includes contract milestones, the Company recognizes revenues as such milestones are achieved.

Application services.Our application services revenues consist of web design and integration fees, video processing fees and application hosting fees. Web design and integration fees are recognized ratably over the contract term, which is generally six to twelve months. We generate video processing fees for each hour of video that a customer deploys. Processing fees are recognized as encoding, indexing and editorial services are performed and are based upon hourly rates per hour of video content. We generate application hosting fees based on the number of video queries processed, subject in some cases to monthly minimums and maximums. We recognize revenues on transaction fees that are subject to monthly minimums based on the greater of actual transaction fees or the monthly minimum, and monthly maximums based on the lesser of actual transaction fees or the monthly maximum, since we have no further obligations, the payment terms are normal and each month is a separate measurement period.

Other revenues.Other revenues consist primarily of U.S. government agency research grants that are best effort arrangements. The software-development arrangements are within the scope of the FASB’s Statement of Financial Accounting Standards No. 68, “Research and Development Arrangements”. As the financial risks associated with the software-development arrangement rests solely with the U.S. government agency, we are recognizing revenues as the services are performed. The cost of these services are included in cost of other revenues. Our contractual obligation is to provide the required level of effort (hours), technical reports, and funds and man-hour expenditure reports.

Cost of license revenues consist primarily of royalty fees for third-party software products integrated into our products. Our cost of service revenues includes personnel expenses, related overhead, communication expenses and capital depreciation costs for maintenance and support activities and application and professional services. Our cost of other revenues includes engineering personnel expenses and related overhead for custom engineering and government projects.

We incurred a net loss of $7,211,000 during the three months ended June 30, 2001. As of June 30, 2001, we had an accumulated deficit of $68,385,000. We expect to continue to incur operating losses for the foreseeable future. In view of the rapidly changing nature of our market and our limited operating history, we believe that period-to-period comparisons of our revenues and other operating results are not necessarily meaningful and should not be relied upon as indications of future performance. Our historic revenue growth rates are not necessarily sustainable or indicative of our future growth.

Results of Operations

The following table sets forth consolidated financial data for the periods indicated, expressed as a percentage of total revenues.


			Three Months Ended
			June 30,

			2001			2000

Revenues:




	License revenues			47	%		57	%




	Service revenues			51			42




	Other revenues			2			1

		Total revenues		100			100

Cost of revenues:




	License revenues			4			8




	Service revenues			63			76




	Other revenues			2			3

		Total cost of revenues		69			87

Gross profit				31			13




Operating expenses:




	Research and development			62			105




	Sales and marketing			111			206




	General and administrative			33			64




	Stock-based compensation			20			44

		Total operating expenses		226			419

Loss from operations				(195	)		(406	)




Interest and other income, net				14			5

Net loss				(181	)%		(401	)%

Total Revenues.Total revenues increased 107% to $3,990,000 for the three months ended June 30, 2001 from $1,931,000 for the three months ended June 30, 2000. This increase was due to increases in license, service and other revenues. International revenues increased to $1,164,000, or 29% of total revenues, for the three months ended June 30, 2001 from $393,000, or 20% of total revenues, for the three months ended June 30, 2000. Sales to two customers (one of which is a reseller of our products) each accounted for 16% of total revenues for the three months ended June 30, 2001 (no customer constituted more than 10% of total revenues for the three months ended June 30, 2000).

License revenues increased to $1,882,000 for the three months ended June 30, 2001 from $1,093,000 for the three months ended June 30, 2000, an increase of $789,000. The increase was primarily due to the introduction of new product lines and the expansion of our domestic and international sales and marketing operations.

Service revenues increased to $2,047,000 for the three months ended June 30, 2001 from $819,000 for the three months ended June 30, 2000, an increase of $1,228,000. Approximately 30% of this growth was due to an increase in revenues from customers purchasing maintenance contracts, while the remainder was due to the revenue growth of our services offerings.

Other revenues increased to $61,000 for the three months ended June 30, 2001 from $19,000 for the three months ended June 30, 2000, an increase of $42,000. This increase was attributable to the level of engineering services performed pursuant to federal government research contracts.

Total Cost of Revenues.Total cost of revenues increased to $2,743,000, or 69% of total revenues, for the three months ended June 30, 2001 from $1,684,000, or 87% of total revenues, for the three months ended June 30, 2000. This increase in total cost of revenues in absolute dollars was due to an increase in the cost of service revenues, particularly the cost of our application services in order to support the growth of our application services revenues.

Cost of license revenues increased to $154,000, or 8% of license revenues, for the three months ended June 30, 2001 from $148,000, or 14% of license revenues, for the three months ended June 30, 2000. This increase was due to an increase in revenues from our products that are subject to unit-based, rather than fixed, license royalty obligations during the three months ended June 30, 2001.

Cost of service revenues increased to $2,532,000, or 124% of service revenues for the three months ended June 30, 2001 from $1,481,000, or 181% of service revenues, for the three months ended June 30, 2000. The majority of this increase in absolute dollars was due to expenditures for the expansion of our application services. We expect the cost of service revenues to increase substantially, and margins on our service revenues could remain negative for the foreseeable future as we expand our application services and worldwide support capabilities.

Cost of other revenues increased in absolute dollars to $57,000, or 93% of other revenues, for the three months ended June 30, 2001 from $55,000, or 289% of other revenues, for the three months ended June 30, 2000. This increase in absolute dollars was due to slightly higher costs associated with engineering services performed for a government agency.

Research and Development Expenses.Research and development expenses consist primarily of personnel and related costs for our development efforts. Research and development expenses increased in absolute dollars to $2,473,000, or 62% of total revenues, for the three months ended June 30, 2001 from $2,033,000, or 105% of total revenues, for the three months ended June 30, 2000. The increase in absolute dollars was due to an increase in our research and development staff. We expect research and development expenses to increase for the foreseeable future as we believe that significant product development expenditures are essential for us to maintain and enhance our market position. To date, we have not capitalized any software development costs as they have been insignificant.

Sales and Marketing Expenses.Sales and marketing expenses consist of personnel and related costs for our direct sales force, pre-sales support and marketing staff, and marketing programs including trade shows and advertising. Sales and marketing expenses increased in absolute dollars to $4,439,000, or 111% of total revenues, for the three months ended June 30, 2001 from $3,983,000, or 206% of total revenues, for the three months ended June 30, 2000. This increase in absolute dollars was due to growth in our sales and marketing personnel and increased expenses incurred in connection with trade shows and additional marketing programs. We expect sales and marketing expenses to increase for the foreseeable future as we hire additional sales and marketing personnel, increase spending on advertising and marketing programs, and expand our operations in North America and internationally.

General and Administrative Expenses.General and administrative expenses consist primarily of personnel and related costs for general corporate functions, including finance, accounting, legal, human resources, facilities and costs of our external audit firm and our outside legal counsel. General and administrative expenses increased in absolute dollars to $1,332,000, or 33% of total revenues, for the three months ended June 30, 2001 from $1,242,000, or 64% of total revenues, for the three months ended June 30, 2000. This increase in absolute dollars was due to an increase in headcount and increased external legal and audit costs. We expect general and administrative expenses to increase for the foreseeable future as we incur additional professional services costs, such as legal and audit costs, to support our growth as a public company.

Stock-Based Compensation Expense.Stock based compensation expense represents the amortization of deferred compensation (calculated as the difference between the exercise price of stock options granted to our employees and the then deemed fair value of our common stock) for stock options granted to our employees. We recognized stock-based compensation expense of $782,000 and $836,000 for the three months ended June 30, 2001 and 2000, respectively.

Interest and Other Income, Net.Interest and other income, net, includes interest income from cash, cash equivalents and short-term investments, offset by interest on capital leases and bank debt. Interest and other income, net, increased to $568,000 for the three months ended June 30, 2001 from $112,000 for the three months ended June 30, 2000, an increase of $456,000. The increase was due to interest income from increased cash balances.

Provision for Income Taxes.We have not recorded a provision for federal and state or foreign income taxes for the three months ended June 30, 2001 or 2000 because we have experienced net losses since inception, which have resulted in deferred tax assets. We have recorded a valuation allowance for the entire deferred tax asset as a result of uncertainties regarding the realization of the asset balance through future taxable profits.

Liquidity and Capital Resources

As of June 30, 2001, we had cash, cash equivalents and short-term investments of $42,422,000, a decrease of $5,709,000 from March 31, 2001 and our working capital, defined as current assets less current liabilities, was $35,746,000, a decrease of $4,842,000 in working capital from March 31, 2001. The decrease in our working capital is primarily attributable to cash used in operating activities.

Our operating activities resulted in net cash outflows of $6,102,000 and $5,677,000 for the three months ended June 30, 2001 and 2000, respectively. The cash used in these periods was primarily attributable to net losses of $7,211,000 and $7,735,000 in the three months ended June 30, 2001 and 2000, respectively.

Investing activities resulted in net cash outflows of $7,164,000 and $1,160,000 for the three months ended June 30, 2001 and 2000, respectively. These outflows were primarily for the purchase of short-term investments during the three months ended June 30, 2001 and for the purchases of computer hardware and software and furniture and fixtures for the three months ended June 30, 2000. We expect that we will continue to use cash resources for capital expenditure purposes for the foreseeable future as we increase our headcount and expand our operations.

Financing activities provided net cash inflows of $478,000 and $2,867,000 during the three months ended June 30, 2001 and 2000, respectively. These inflows were primarily from the proceeds from our employee stock purchase plan during the three months ended June 30, 2001 and from warrant exercises to purchase our preferred and common stock and a draw on our senior line of credit facility for the three months ended June 30, 2000.

We anticipate that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, we may need to raise additional funds in future periods through public or private financings, or other sources, to fund our operations and potential acquisitions, if any, until we achieve profitability, if ever. We may not be able to obtain adequate or favorable financing when necessary to fund our business. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, the percentage of ownership of our stockholders would be reduced. Furthermore, these equity securities might have rights, preferences or privileges senior to our common stock.

Risk Factors

The occurrence of any of the following risks could materially and adversely affect our business, financial condition and operating results. In this case, the trading price of our common stock could decline and you might lose all or part of your investment.

Risks Related to Our Business

Our revenue, cost of sales, and expense forecasts were only recently introduced to the public and there are a number of risks that make it difficult for us to foresee or accurately evaluate factors that may impact such forecasts.

We have limited visibility into future demand, and our limited operating history makes it difficult for us to foresee or accurately evaluate factors that may impact such future demand. Visibility over potential sales is typically limited to the current quarter. In order to provide a revenue forecast for the current quarter, we must make assumptions about conversion of these potential sales into current quarter revenues. Such assumptions may be materially incorrect due to competition for the customer order including pricing pressures, sales execution issues, customer selection criteria or length of the customer selection cycle, the failure of sales contracts to meet our revenue recognition criteria, our inability to hire and retain qualified personnel, our inability to develop new markets in Europe or Asia, and other factors that may be beyond our control. In addition, we are reliant on third party resellers for a significant portion of our license revenues, and we have limited visibility into the status of orders from such third parties.

For quarters beyond the current quarter, we have very limited visibility into potential sales opportunities, and thus we have a lower confidence level in any revenue forecast or forward-looking guidance. In developing a revenue forecast for such quarters, we assess any customer indications about future demand, general industry trends, marketing lead development activities, productivity goals for the sales force and expected growth in sales personnel, and any demand for products that we may have.

Our cost of sales and expense forecasts are based upon our budgets and spending forecasts for each area of the Company. Circumstances we may not foresee could increase cost and expense levels beyond the levels forecasted. Such circumstances may include competitive threats in our markets which we may need to address with additional sales and marketing expenses, legal claims, employee turnover, additional royalty expenses should we lose a source of current technology, losses of key management personnel, unknown defects in our products, and other factors we cannot foresee.

Because we have only recently introduced our video software products, application services and professional services we face a number of risks which may seriously harm our business.

We incorporated in April 1994 and to date we have generated only limited revenues. We introduced our first video software products in December 1997, our application services in May 1999 and our professional services in March 2001. Because we have a limited operating history with our video software products, application services and professional services and because our revenue sources may continue to shift as our business develops, you must consider the risks and difficulties that we may encounter when making your investment decision. These risks include our ability to:

	•		expand our customer base;

	•		increase penetration into key customer accounts;

	•		maintain our pricing structure;

	•		develop new products and services; and

	•		adapt our products and services to meet changes in the Internet video infrastructure marketplace.

If we do not successfully address these risks, our business will be seriously harmed.

Our business model is unproven and may fail, which may decrease significantly the market price of our common stock.

We do not know whether our business model and strategy will be successful. Our business model is based on the premise that content providers will use our licensed products and application services to catalog, manage, and distribute their video content over the Internet and intranets. Our potential customers may elect to rely on their internal resources or on lower priced products and services that do not offer the full range of functionality offered by our products and services. If the assumptions underlying our business model are not valid or if we are unable to implement our business plan, our business will suffer.

We have not been profitable and if we do not achieve profitability, our business may fail.

We have experienced operating losses in each quarterly and annual period since we were formed and we expect to incur significant losses in the future. As of June 30, 2001, we had an accumulated deficit of $68,385,000. We expect to continue to incur increasing research and development, sales and marketing and general and administrative expenses. Accordingly, our failure to increase our revenues significantly or improve our gross margins will harm our business. In addition, our cash, cash equivalent and short-term investment resources (collectively, “cash resources”) totaled $42,422,000 as of June 30, 2001 and we used $6,102,000 in our operating activities during the three months ended June 30, 2001. We anticipate that our operating activities will use additional cash resources for at least the next 12 months. This may leave us with a deteriorated cash position in comparison to our cash position as of June 30, 2001 and this may affect our ability to transact future strategic operating and investing activities in a timely manner, which may harm our business and cause our stock price to fall. Even if we should achieve profitability, we may not be able to sustain or increase profitability on a quarterly or annual basis in the future. If our revenues grow more slowly than we anticipate, if our gross margins do not improve, or if our operating expenses exceed our expectations, our operating results will suffer and our stock price may fall.

Our quarterly operating results are volatile and difficult to predict. If we fail to meet the expectations of public market analysts or investors, the market price of our common stock may decrease significantly.

Our quarterly operating results have varied significantly in the past and are likely to vary significantly in the future. We believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as indicators of future performance. If securities analysts follow our stock, our operating results will likely fall below their expectations in some future quarter or quarters. Our failure to meet these expectations would likely cause the market price of our common stock to decline.

Our quarterly revenues depend on a number of factors, many of which are beyond our control and which makes it difficult for us to predict our revenues going forward. We plan to increase our operating expenses and if our revenues and gross margins do not increase, our business could be seriously harmed. We plan to increase our operating expenses to expand our sales and marketing operations, fund greater levels of research and development, expand our application and professional services and develop our internal organization. Many of these expenditures are planned or committed in advance in anticipation of future revenues, and if our revenues in a particular quarter are lower than we anticipate, we may be unable to reduce spending in that quarter. As a result, any shortfall in revenues or a failure to improve gross margins would likely hurt our quarterly operating results.

Our revenues may be harmed if general economic conditions continue to worsen.

Our revenues are dependent on the health of the economy and the growth of our customers and potential future customers. If the economy remains stagnant, our customers may continue to delay or reduce their spending on our software and service solutions. When economic conditions weaken, sales cycles for sales of software products and related services tend to lengthen and companies’ information technology budgets tend to be reduced. If that continues to happen, our revenues could suffer and our stock price may decline. Further, if the economic conditions in the United States worsen or if a wider or global economic slowdown occurs, we may experience a material adverse impact on our business, operating results, and financial condition.

Our service revenues have a substantially lower margin than our license revenues, and an increase in service revenues relative to license revenues could harm our gross margins.

Our service revenues, which includes fees for our application services as well as professional services such as consulting, implementation, maintenance and training, were 51% of our total revenues for the three months ended June 30, 2001 and 42% of our total revenues for the three months ended June 30, 2000. Our service revenues have substantially lower gross margins than our license revenues. Our cost of service revenues for the three months ended June 30, 2001 and 2000 were 124% and 181%, respectively, of our service revenues. An increase in the percentage of total revenues represented by service revenues could adversely affect our overall gross margins.

Service revenues as a percentage of total revenues and cost of service revenues as a percentage of total revenues have varied significantly from quarter to quarter due to our relatively early stage of development. Historically, the relative amount of service revenues as compared to license revenues has varied based on customer demand for our application services revenues. However, we anticipate an increase in the percentage of license customers requesting professional services as a result of our introduction of professional services in the fourth quarter of fiscal 2001, which will also impact the relative amount of service revenues as compared to license revenues. We expect that the amount and profitability of our professional services will depend in large part on:

	•		the software solution which has been licensed;

	•		the complexity of the customers’ information technology environments;

	•		the resources directed by customers to their implementation projects;

	•		the size and complexity of customer implementations; and

	•		the extent to which outside consulting organizations provide services directly to customers.

If our internal professional services organization does not provide implementation services effectively and according to schedule, our revenues and profitability would be harmed.

Customers that license our products may require consulting, implementation, maintenance and training services and obtain them from our internal professional services, customer support and training organizations. When we provide these services, we may be required to recognize revenue from the licensing of our software products as the implementation services are performed. If our internal professional services organization does not effectively implement and support our products or if we are unable to expand our internal professional services organization as needed to meet our customers’ needs, our ability to sell software, and accordingly our revenues, will be harmed.

The failure of any significant future contracts to meet our policies for recognizing revenue may prevent us from achieving our revenue objectives for a quarter or a fiscal year, which would hurt our operating results.

Our sales contracts are typically based upon standard agreements that meet our revenue recognition policies. However, our future sales may include site licenses, consulting services or other transactions with customers who may negotiate special terms and conditions that are not part of our standard sales contracts. If these special terms and conditions cause sales under these contracts to not qualify under our revenue recognition policies, we would defer revenues to future periods, which may hurt our reported operating results and cause our stock price to fall.

The length of our sales and deployment cycle is uncertain, which may cause our revenues and operating results to vary significantly from quarter to quarter.

During our sales cycle, we spend considerable time and expense providing information to prospective customers about the use and benefits of our products and services without generating corresponding revenues. Our expense levels are relatively fixed in the short term and based in part on our expectations of future revenues. Therefore, any delay in our sales cycle could cause significant variations in our operating results, particularly because a relatively small number of customer orders represent a large portion of our revenues.

Some of our largest sources of revenues are government entities and large corporations that often require long testing and approval processes before making a decision to license our products. In general, the process of entering into a licensing arrangement with a potential customer may involve lengthy negotiations. As a result, our sales cycle has been and may continue to be unpredictable. In the past, our sales cycle has ranged from one to 12 months. Our sales cycle is also subject to delays as a result of customer-specific factors over which we have little or no control, including budgetary constraints and internal approval procedures. In addition, because our technology must often be integrated with the products and services of other vendors, there may be a significant delay between the use of our software and services in a pilot system and our customers’ volume deployment of our products and services.

If our customers fail to generate traffic on the video-related sections of their Internet sites, our recurring revenues may decrease, which may adversely affect our business and financial results.

Our ability to achieve recurring revenues from our application services is largely dependent upon the success of our customers in generating traffic on the video-related sections of their Internet sites. Generally, we generate recurring revenue from our application services whenever our customers add more hours of video to an existing project. If our customers do not attract and maintain traffic on video-related sections of their sites, video queries may decrease and customers may decide not to add more hours of video to existing projects. This result would cause revenues from our application services to decrease, which will prevent us from growing our business.

If we fail to increase the size of our customer base or increase our revenues with our existing customers, our business will suffer.

Increasing the size of our customer base and increasing the revenues we generate from our customer base are critical to the success of our business. To expand our customer base and the revenues we generate from our customers, we must:

	•		generate additional revenues from different organizations within our customers;

	•		conduct effective marketing and sales programs to acquire new customers; and

	•		establish and maintain distribution relationships with value added resellers and system integrators.

Our failure to achieve one or more of these objectives will hurt our business.

The prices we charge for our products and services may decrease, which would reduce our revenues and harm our business.

The prices we charge for our products and services may decrease as a result of competitive pricing pressures, promotional programs and customers who negotiate price reductions. For example, some of our competitors have provided their services without charge in order to gain market share or new customers and key accounts. The prices at which we sell and license our products and services to our customers depend on many factors, including:

	•		purchase volumes;

	•		competitive pricing;

	•		the specific requirements of the order;

	•		the duration of the licensing arrangement; and

	•		the level of sales and service support.

If we are unable to sell our products or services at acceptable prices relative to our costs, or if we fail to develop and introduce on a timely basis new products and services from which we can derive additional revenues, our financial results will suffer.

We rely on, and expect to continue to rely on, a limited number of customers for a significant portion of our revenues and if any of these customers stops licensing our software or purchasing our services, our operating results will suffer.

Historically, a limited number of customers has accounted for a significant portion of our revenues. For example, our two largest customers accounted for 32% of our total revenues for the three months ended June 30, 2001. One of these large customers has an application services contract that expires within our current fiscal year ending March 31, 2002 with no obligation to renew. If we were to lose one of our large customers, our operating results could be significantly harmed.

We anticipate that our operating results in any given period will continue to depend to a significant extent upon revenues from a small number of customers. We cannot be certain that we will retain our current customers or that we will be able to recruit additional or replacement customers. If we were to lose one or more customers, our operating results could be significantly harmed.

Any failure of our network could lead to significant disruptions in our application services business that could damage our reputation, reduce our revenues or otherwise harm our business.

Our application services business is dependent upon providing our customers with fast, efficient and reliable services. To meet our customers’ requirements, we must protect our network against damage from, among other things:

	•		human error;

	•		physical or electronic security breaches;

	•		computer viruses;

	•		fire, earthquake, flood and other natural disasters;

	•		power loss;

	•		telecommunications failure; and

	•		sabotage and vandalism.

Our failure to protect our network against damage from any of these events will hurt our business.

We depend on outside third parties to maintain our communications hardware and perform most of our computer hardware operations and if these third parties’ hardware and operations fail, our reputation and business will suffer.

We have communications hardware and computer hardware operations located at Exodus Communications’ facility in Santa Clara, California, at AboveNet Communications’ facility in New York City, and at Phoenix Communications in New Jersey. We do not have complete backup systems for these operations. A problem with, or failure of, our communications hardware or operations could result in interruptions or increases in response times on the Internet sites of our customers. Furthermore, if these third party partners fail to adequately maintain or operate our communications hardware or do not perform our computer hardware operations adequately, our services to our customers may not be available. We have experienced system failures in the past. Other outages or system failures may occur. Any disruptions could damage our reputation, reduce our revenues or otherwise harm our business. Our insurance policies may not adequately compensate us for any losses that may occur due to any failures or interruptions in our systems.

Power outages in California could adversely affect us.

We have significant operations in the state of California and are dependent on a continuous power supply. California’s energy crisis could substantially disrupt our operations and increase our expenses. California has recently implemented, and may in the future continue to implement, rolling blackouts throughout the state. Although state lawmakers are working to minimize the impact, if blackouts interrupt our power supply, we may be temporarily unable to continue operations at our California facilities. Any such interruption in our ability to continue operation at our facilities could delay the development of our products and services and disrupt communications with our customers or other third parties on which we rely, such as web hosting service providers. Future interruptions could damage our reputation and could result in lost revenue, either of which could substantially harm our business and results of operations. Furthermore, shortages in wholesale electricity supplies have caused power prices to increase. If energy prices continue to increase, our operating expenses will likely increase which could have a negative effect on our operating results, which in turn may cause our stock price to fall.

If we are unable to perform or scale our capacity sufficiently as demand for our services increases, we may lose customers which would be detrimental to our business.

We cannot be certain that if we increase our customers we will be able to correspondingly increase our personnel and to perform our application services at satisfactory levels. Certain customer contracts contain cash penalty provisions in the event that we do not perform our application services at satisfactory levels and such penalty provisions will reduce our revenues and harm our business. In addition, our application services may need to accommodate an increasing volume of traffic. If we are not able to expand our internal operations to accommodate such an increase in traffic, our customers’ Internet sites may in the future experience slower response times or outages. If we cannot adequately handle a significant increase in customers or customers’ traffic, we may lose customers or fail to gain new ones, which may reduce our revenues and harm our business.

If we do not successfully develop new products and services to respond to rapid market changes due to changing technology and evolving industry standards, our business will be harmed.

The market for our products and services is characterized by rapidly changing technology, evolving industry standards, frequent new product and service introductions and changes in customer demands. The recent growth of video on the Internet and intense competition in our industry exacerbate these market characteristics. Our future success will depend to a substantial degree on our ability to offer products and services that incorporate leading technology, and respond to technological advances and emerging industry standards and practices on a timely and cost-effective basis. To succeed, we must anticipate and adapt to customer requirements in an effective and timely manner, and offer products and services that meet customer demands. If we fail to do so, our products and services will not achieve widespread market acceptance, and we may not generate significant revenues to offset our development costs, which will hurt our business.

The development of new or enhanced products and services is a complex and uncertain process that requires the accurate anticipation of technological and market trends. We may experience design, manufacturing, marketing and other technological difficulties that could delay our ability to respond to technological changes, evolving industry standards, competitive developments or customer requirements. You should additionally be aware that:

	•		our technology or systems may become obsolete upon the introduction of alternative technologies, such as products that better manage and search video content;

	•		we could incur substantial costs if we need to modify our products and services to respond to these alternative technologies;

	•		we may not have sufficient resources to develop or acquire new technologies or to introduce new products or services capable of competing with future technologies; and

	•		when introducing new or enhanced products or services, we may be unable to manage effectively the transition from older products and services and ensure that we can deliver products and services to meet anticipated customer demand.

We depend on technology licensed to us by third parties, and the loss of or our inability to maintain these licenses could result in increased costs or delay sales of our products.

We license technology from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. We anticipate that we will continue to license technology from third parties in the future. This software may not continue to be available on commercially reasonable terms, if at all. Although we do not believe that we are substantially dependent on any licensed technology, some of the software we license from third parties could be difficult for us to replace. The loss of any of these technology licenses could result in delays in the licensing of our products until equivalent technology, if available, is developed or identified, licensed and integrated. The use of additional third-party software would require us to negotiate license agreements with other parties, which could result in higher royalty payments and a loss of product differentiation. In addition, the effective implementation of our products depends upon the successful operation of third-party licensed products in conjunction with our products, and therefore any undetected errors in these licensed products could prevent the implementation or impair the functionality of our products, delay new product introductions and/or damage our reputation.

If we are unable to retain our key personnel, our business may be harmed.

Our future success depends to a significant extent on the continued services of our senior management and other key personnel, and particularly Paul Lego, our Chief Executive Officer. The loss of either this individual or other key employees would likely have an adverse effect on our business. We do not have employment agreements with most of our senior management team. If one or more of our senior management team were to resign, the loss could result in loss of sales, delays in new product development and diversion of management resources.

Our common stock price has declined in value below the exercise price of many employee stock options and, as a result, we may experience difficulties retaining employees.

Our common stock price has recently declined in value below the exercise price of many stock options granted to employees pursuant to our stock option plans. Thus, the intended benefit of the stock option, the creation of performance and retention incentives, may not be realized. As a result, we may lose employees whom we would prefer to retain which would harm our business. We may be required to create additional performance and retention incentives in order to retain these employees including the granting of additional stock options to these employees at current prices or issuing incentive cash bonuses. Such incentives may either dilute our existing stockholder base or result in unforeseen operating expenses, which may cause our stock price to fall.

Because competition for qualified personnel is intense, we may not be able to recruit or retain personnel, which could impact the development and acceptance of our products and services.

We expect that we will need to hire additional personnel in all functional areas in the foreseeable future. Competition for personnel throughout our industry is intense. We may be unable to attract or assimilate other highly qualified employees in the future. We have in the past experienced, and we expect to continue to experience, difficulty in hiring highly skilled employees with appropriate qualifications. In addition, new hires frequently require extensive training before they achieve desired levels of productivity. Some members of our existing management team have been employed at Virage for less than one year. We may fail to attract and retain qualified personnel, which could have a negative impact on our business.

Failure to properly manage our potential growth would be detrimental to our business.

Any growth in our operations will place a significant strain on our resources. As part of this growth, we will have to implement new operational and financial systems, procedures and controls to expand, train and manage our employee base and to maintain close coordination among our technical, accounting, finance, marketing, sales and editorial staffs. We will also need to continue to attract, retain and integrate personnel in all aspects of our operations. To the extent we acquire other businesses, we will also need to integrate and assimilate new operations, technologies and personnel. Failure to manage our growth effectively could hurt our business.

We have leases for our facilities that expire on various dates through 2006 that we may not be able to fully utilize and this may cause us to incur large, one-time charges for excess capacity.

Our principal administrative, research and development, sales, services and marketing activities are conducted on two leased properties in San Mateo, California: the first property consists of 21,000 square feet and expires in May 2002 and the second property consists of 48,000 square feet and expires in September 2006. In addition, we lease a property in New York City for services and sales under a lease that expires in March 2005, a property near Boston, Massachusetts where we perform research and development under a lease that expires in June 2003 and a property near London, England where we perform sales, services, marketing and administrative activities and that expires in February 2002.

During the three months ended June 30, 2001, we were able to sublease our excess capacity at our facilities and received rental payments from these tenants. These sublease agreements will expire during our current fiscal year ended March 31, 2002, and we may not be successful in renewing our arrangements with our current sublease tenants or finding new sublease tenants. If this should occur, we would be required to record a one-time charge at the end of the sublease agreement for a portion of the rental payments that we owe to our landlord relating to any excess capacity that exists at our facilities. Such a charge will harm our operating results and may cause our stock price to fall.

If demand for our application services decreases, we may not be able to fully utilize our capacity and this may cause us to incur large, one-time charges for excess capacity.

Our application services use significant capital equipment resources that have been purchased to support our current customer requirements. Our application services are new and unproven and revenues and related expenses are difficult to forecast. Customers typically engage in contracts for our application services for a period of six to twelve months and while some customers renew their contracts, none have any obligation to do so. For example, a customer that accounted for 16% of our revenues for the three months ended June 30, 2001 has a contract that expires within our current fiscal year ending March 31, 2002 with no obligation to renew. If we were to lose this customer or other customers for our application services, we may have excess capacity and be required to record a one-time charge for excess capital equipment.

Defects in our software products could diminish demand for our products, which may cause our stock price to fall.

Our software products are complex and may contain errors that may be detected at any point in the life of the product. We cannot assure you that, despite testing by us and our current and potential customers, errors will not be found in new products or releases after shipment, resulting in loss of revenues, delay in market acceptance and sales, diversion of development resources, injury to our reputation or increased service and warranty costs. If any of these were to occur, our business would be adversely affected and our stock price could fall.

Because our products are generally used in systems with other vendors’ products, they must integrate successfully with these existing systems. System errors, whether caused by our products or those of another vendor, could adversely affect the market acceptance of our products, and any necessary revisions could cause us to incur significant expenses.

We could be subject to liability claims and negative publicity if our customers’ systems, information or video content is damaged through the use of our products or our application services.

If our customers’ systems, information or video content is damaged by software errors, product design defects or use of our application services, our business may be harmed. In addition, these errors or defects may cause severe customer service and public relations problems. Errors, bugs, viruses or misimplementation of our products or services may cause liability claims and negative publicity ultimately resulting in the loss of market acceptance of our products and services. Our agreements with customers that attempt to limit our exposure to liability claims may not be enforceable in jurisdictions where we operate.

Others may bring infringement claims against us which could be time consuming and expensive for us to defend.

Other companies, including our competitors, may obtain patents or other proprietary rights that would prevent, limit or interfere with our ability to conduct our business. These companies could assert, and it may be found, that our technologies infringe their proprietary rights. We could incur substantial costs to defend any litigation, and intellectual property litigation could force us to do one or more of the following:

	•		cease using key aspects of our technology that incorporate the challenged intellectual property;

	•		obtain a license from the holder of the infringed intellectual property right; and

	•		redesign some or all of our products.

From time to time, we have received notices claiming that our technology infringes patents held by third parties. In the event any such a claim is successful and we are unable to license the infringed technology on commercially reasonable terms, our business and operating results would be significantly harmed.

If the protection of our intellectual property is inadequate, our competitors may gain access to our technology, and we may lose customers.

We depend on our ability to develop and maintain the proprietary aspects of our technology. We seek to protect our software, documentation and other written materials under trade secret and copyright laws, which afford only limited protection. Our proprietary rights may not prove viable or of value in the future since the validity, enforceability and type of protection of proprietary rights in Internet related industries are uncertain and still evolving.

Unauthorized parties may attempt to copy aspects of our products or to obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult, and while we are unable to determine the extent to which piracy of our software or code exists, software piracy can be expected to be a persistent problem. We license our proprietary rights to third parties, and these licensees may not abide by our compliance and quality control guidelines or they may take actions that would materially adversely affect us. In addition, the laws of some foreign countries do not protect our proprietary rights to as great an extent as do the laws of the United States, and effective patent, copyright, trademark and trade secret protection may not be available in these foreign jurisdictions. To date, we have not sought patent protection of our proprietary rights in any foreign jurisdiction. Our efforts to protect our intellectual property rights through patent, copyright, trademark and trade secret laws may not be effective to prevent misappropriation of our technology, or may not prevent the development and design by others of products or technologies similar to or competitive with those developed by us. Our failure or inability to protect our proprietary rights could harm our business.

As we expand our operations internationally, we will face significant risks in doing business in foreign countries.

As we expand our operations internationally, we will be subject to a number of risks associated with international business activities, including:

	•		costs of customizing our products and services for foreign countries, including localization, translation and conversion to international and other foreign technology standards;

	•		compliance with multiple, conflicting and changing governmental laws and regulations, including changes in regulatory requirements that may limit our ability to sell our products and services in particular countries;

	•		import and export restrictions, tariffs and greater difficulty in collecting accounts receivable; and

	•		foreign currency-related risks if a significant portion of our revenues become denominated in foreign currencies.

Failure to increase our brand awareness among content owners could limit our ability to compete effectively.

We believe that establishing and maintaining a strong brand name is important to the success of our business. Competitive pressures may require us to increase our expenses to promote our brand name, and the benefits associated with brand creation may not outweigh the risks and costs associated with brand name establishment. Our failure to develop a strong brand name or the incurrence of excessive costs associated with establishing our brand name, may harm our business.

We may need to make acquisitions or form strategic alliances or partnerships in order to remain competitive in our market, and potential future acquisitions, strategic alliances or partnerships could be difficult to integrate, disrupt our business and dilute stockholder value.

We may acquire or form strategic alliances or partnerships with other businesses in the future in order to remain competitive or to acquire new technologies. As a result of these acquisitions, strategic alliances or partnerships, we may need to integrate products, technologies, widely dispersed operations and distinct corporate cultures. The products, services or technologies of the acquired companies may need to be altered or redesigned in order to be made compatible with our software products and services, or the software architecture of our customers. These integration efforts may not succeed or may distract our management from operating our existing business. Our failure to successfully manage future acquisitions, strategic alliances or partnerships could seriously harm our operating results. In addition, our stockholders would be diluted if we finance the acquisitions, strategic alliances or partnerships by incurring convertible debt or issuing equity securities.

We have adopted certain anti-takeover measures that may make it more difficult for a third party to acquire us.

Our board of directors has the authority to issue up to 2,000,000 shares of preferred stock and to determine the price, rights, preferences and privileges 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 shares of preferred stock, while potentially providing desirable flexibility in connection with possible acquisitions and for other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. We have no present intention to issue shares of preferred stock. Further, on November 8, 2000, our board of directors adopted a preferred stock purchase rights plan intended to guard against certain takeover tactics. The adoption of this plan was not in response to any proposal to acquire us, and the board is not aware of any such effort. The existence of this plan could also have the effect of making it more difficult for a third party to acquire a majority of our outstanding voting stock. In addition, certain provisions of our certificate of incorporation may have the effect of delaying or preventing a change of control, which could adversely affect the market price of our common stock.

Risks Relating to the Internet Video Infrastructure Marketplace

Competition among Internet video infrastructure companies is intense. If we are unable to compete successfully, our business will fail.

Competition among Internet video infrastructure companies seeking to attract new customers is intense and we expect this intensity of competition to increase in the future. Our competitors vary in size and in the scope and breadth of the products and services they offer and may have significantly greater financial, technical and marketing resources. Our direct competition in the marketplace comes primarily from Convera Corporation. We may also compete indirectly with system integrators to the extent they may embed or integrate competing technologies into their product offerings, and in the future we may compete with video service providers and searchable video portals. In addition, we may compete with our current and potential customers who may contemplate developing software or performing application services internally. Increased competition could result in price reductions, reduced margins or loss of market share, any of which will cause our business to suffer.

If broadband technology is not adopted or deployed as quickly as we expect, demand for our products and services may not grow as quickly as anticipated.

Broadband technology such as digital subscriber lines, commonly referred to as DSL, and cable modems, which allows video content to be transmitted over the Internet more quickly than current technologies, has only recently been developed and is just beginning to be deployed. The growth of our business depends in part on the broad market acceptance of broadband technology. If the market does not adopt broadband technology, or adopts it more slowly than we anticipate, demand for our products and services may not grow as quickly as we anticipate, which will harm our business.

We depend on the efforts of third parties to develop and provide the technology for broadband transmission. Even if broadband access becomes widely available, heavy use of the Internet may negatively impact the quality of media delivered through broadband connections. If these third parties experience delays or difficulties establishing the technology to support widespread broadband transmission, or if heavy usage limits the broadband experience, the market may not accept our products and services.

Because the anticipated growth of our business depends in part on broadband transmission infrastructure, we are subject to a number of risks, including:

	•		changes in content delivery methods and protocols;

	•		the need for continued development by our customers of compelling content that takes advantage of broadband access and helps drive market acceptance of our products and services;

	•		the emergence of new competitors, including traditional broadcast and cable television companies, which have significant control over access to content, substantial resources and established relationships with media providers;

	•		the development of relationships by our competitors with companies that have significant access to or control over the broadband transmission technology or content; and

	•		the need to establish new relationships with non-PC based providers of broadband access, such as providers of television set-top boxes and cable television.

Government regulation of the Internet could limit our growth.

We are not currently subject to direct regulation by any government agency, other than laws and regulations generally applicable to businesses, although certain U.S. export controls and import controls of other countries may apply to our products. While there are currently few laws or regulations that specifically regulate communications or commerce on the Internet, due to the increasing popularity and use of the Internet, it is possible that a number of laws and regulations may be adopted in the U.S. and abroad in the near future with particular applicability to the Internet. It is possible that governments will enact legislation that may be applicable to us in areas such as content, network security, access charges and retransmission activities. Moreover, the applicability to the Internet of existing laws governing issues such as property ownership, content, taxation, defamation and personal privacy is uncertain. The adoption of new laws or the adaptation of existing laws to the Internet may decrease the growth in the use of the Internet, which could in turn decrease the demand for our services, increase the cost of doing business or otherwise hurt our business.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our market risk disclosures as set forth in our Annual Report on Form 10-K as filed with the United States Securities and Exchange Commission on June 20, 2001 have not changed significantly.

PART II: OTHER INFORMATION

Item 1. Legal Proceedings.

From time to time, we may become involved in litigation claims arising from our ordinary course of business. We believe that there are no claims or actions pending or threatened against us, the ultimate disposition of which would have a material adverse effect on us.

Item 2. Changes in Securities and Use of Proceeds

	(d)		Use of Proceeds.

			On July 5, 2000, we completed a firm commitment underwritten initial public offering of 3,500,000 shares of our common stock, at a price of $11.00 per share. Concurrently with our initial public offering, we also sold 1,696,391 shares of common stock in a private placement at a price of $11.00 per share. On July 17, 2000, our underwriters exercised their over-allotment option for 525,000 shares of our common stock at a price of $11.00 per share. The shares of the common stock sold in the offering and exercised via our underwriters’ over-allotment option were registered under the Securities Act of 1933, as amended, on a Registration Statement on Form S-1 (File No. 333-96315). The Securities and Exchange Commission declared the Registration Statement effective on June 28, 2000. The public offering was underwritten by a syndicate of underwriters led by Credit Suisse First Boston, FleetBoston Robertson Stephens Inc. and Wit SoundView Corporation, as their representatives.

			The initial public offering and private placement resulted in net proceeds of $57,476,000, after deducting $3,099,000 in underwriting discounts and commissions and $1,800,000 in costs and expenses related to the offering. None of the costs and expenses related to the offering or the private placement were paid directly or indirectly to any director, officer, general partner of Virage or their associates, persons owning 10 percent or more of any class of equity securities of Virage or an affiliate of Virage. Proceeds from the offering and private placement have been used for general corporate purposes, including working capital and capital expenditures. The remaining net proceeds have been invested in cash, cash equivalents and short-term investments. The use of the proceeds from the offering and private placement does not represent a material change in the use of proceeds described in our prospectus.

Item 3. Defaults Upon Senior Securities

None.

Item 4. Submission of Matters to a Vote of Security Holders

None.

Item 5. Other Information

None.

Item 6. Exhibits and Report on Form 8-K.

(b)

Reports on Form 8-K

None.

SIGNATURE

Pursuant to the requirements 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.


	VIRAGE, INC.

Date: August 6, 2001	By:	/s/ Alfred J. Castino

		Alfred J. Castino Vice President, Finance and Chief Financial Officer (Duly Authorized Officer and Principal Financial Officer)

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Virage Inactive 10-Q2001 Q2 Quarterly report

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