SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ______________________ FORM 8-K/A CURRENT REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES AND EXCHANGE ACT OF 1934 April 2, 2002 Date of Report (Date of earliest event reported) ______________________ FILENET CORPORATION (Exact name of registrant as specified in its charter) Delaware 000-15997 95-3757924 (State or other Jurisdiction (Commission File Number) (IRS Employer of Incorporation) Identification Number) 3565 Harbor Boulevard 92626 Costa Mesa, California (Zip Code) (Address of principal executive offices) (714) 327-3400 (Registrant's telephone number, including area code) N/A (Former Name or Former Address, if Changed Since Last Report)Amendment No. 1 On April 12, 2002, FileNET Corporation ("FileNET" or the "Company") filed a Form 8-K to report its acquisition of certain assets and liabilities of eGrail Inc. ("eGrail"). Pursuant to Item 7 of Form 8-K, FileNET indicated that it would file certain financial information no later than the date required by Item 7 of Form 8-K. This Amendment No. 1 to Form 8-K is filed to provide the required financial information as set forth in items 7(a) and 7(b) below and Exhibit 99.2. Item 2. Acquisition or Disposition of Assets. On April 2, 2002, FileNET acquired certain assets and assumed certain liabilities of eGrail, a privately-owned Web content management company. The purchase price for the transaction was $9,000,000 in cash plus the assumption of certain liabilities. The acquisition was made pursuant to an Asset Purchase Agreement entered into between 3565 Acquisition Corporation, a wholly-owned subsidiary of FileNET, and eGrail on April 2, 2002 (the "Asset Purchase Agreement"). The purchase price was determined by an arm's-length negotiation between FileNET and eGrail, and was funded with cash on hand of FileNET. The acquired assets were used by eGrail in its Web content management business, and they will be used by FileNET to compliment its product offerings in its Enterprise Content Management business. Alliant Partners acted as financial advisors to eGrail in this transaction and was paid approximately $500,000. John Savage, a member of FileNET's Board of Directors and audit committee is Managing Partner of Alliant Partners and accordingly, abstained from voting on this transaction. For a more complete description of the terms of the acquisition, please refer to the Asset Purchase Agreement, which is an Exhibit to our Form 10-Q filed May 13, 2002, with the Securities and Exchange Commission. Item 7. Financial Statements and Exhibits. (a) Financial statements of business acquired. The following financial statements of eGrail are attached hereto as Exhibit 99.2 and incorporated herein by this reference: Audited balance sheet of eGrail as of December 31, 2001 and audited statement of operations, stockholder's equity and cash flows for the year ended December 31, 2001. (b) Pro forma financial information. The following unaudited pro forma condensed financial information is included herein: Unaudited pro forma condensed combined balance sheet as of December 31, 2001, and unaudited pro forma condensed combined statement of operations for the year ended December 31, 2001. (c) Exhibits 23.1 Consent of Independent Auditors 99.2 Financial Statements of Business acquired Item 7. (b) Pro Forma Financial Information. The accompanying unaudited pro forma condensed combined financial statements give effect to the acquisition completed on April 2, 2002 by FileNET of eGrail. The unaudited pro forma condensed combined financial information does not reflect any cost savings or other synergies that might result from the transaction. They are presented for illustrative purposes only and are not necessarily indicative of the combined financial position or results of operations for future periods or the financial position or results of operations that actually would have been realized had the Company and eGrail been a combined company during the specified periods. The accompanying unaudited pro forma condensed combined statement of operations (the "Pro Forma Statement of Operations") for the year ended December 31, 2001 gives effect to the acquisition by FileNET of eGrail using the purchase method as if it occurred on January 1, 2001. The Pro Forma Statement of Operations is based on the respective historical financial statements of FileNET and eGrail for the year ended December 31, 2001. The unaudited pro forma condensed combined balance sheet as of December 31, 2001 (the "Pro Forma Balance Sheet") gives effect to the acquisition as if it took place on December 31, 2001. The Pro Forma Statement of Operations and Pro Forma Balance Sheet and accompanying notes (the "Pro Forma Financial Information") should be read in conjunction with, and are qualified by reference to, the historical financial statements of the Company, included in its Form 10-K filed with the Securities and Exchange Commission on March 28, 2002 and the historical consolidated financial statements and related notes of eGrail, included elsewhere in this Form 8-K/A. In accordance with Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations," the acquisition has been accounted for under the purchase method of accounting. The estimates of fair value of the assets acquired and liabilities assumed are based on a preliminary independent appraisal report and our estimates. The following table summarizes the components of the purchase price (in thousands): Cash $ 9,000 Transaction costs 351 Total purchase price 9,351 Fair value of net tangible assets at 4/02/02 $ 581 Assumed liabilities (739) Developed technology 387 Patents 24 In-process research and development 1,300 Goodwill 7,798 Net assets acquired $ 9,351 In-process research and development consists of new product projects that were under development at the date of the acquisition and were expected to eventually lead to new products but had not yet established feasibility and for which no future alternative use was identified. The assigned value of $1.3 million for the in-process technology was expensed immediately upon the closing date of the acquisition. The valuation of the in-process research and development projects was based upon the discounted expected future net cash flows of the products over their expected life. The assigned value of $387,000 for acquired developed technology was based upon the multi-period excess earnings method under the income approach. Acquired intangibles will be amortized on a straight-line basis over two years. Goodwill, the excess of purchase price over net assets acquired, will be subject to an annual impairment test and effective January 1, 2002 will not be amortized, in accordance with SFAS No. 142, "Goodwill and Other Intangible Assets". UNAUDITED PRO FORMA CONDENSED COMBINED BALANCE SHEET December 31, 2001 (In thousands) Historical FileNET eGrail Adjustments Combined ASSETS Current assets: Cash and cash equivalents $ 107,502 $ 853 $ (9,853) a), b) $ 98,502 Short-term investments 64,660 64,660 Accounts receivable, net 36,909 399 (298) b) 37,010 Inventories, net 2,993 b) 2,993 Prepaid expenses and other assets 9,521 474 (347) b) 9,648 Deferred income taxes 2,779 2,779 Total current assets 224,364 1,726 (10,498) 215,592 Restricted cash 77 77 Property, net 44,206 357 (82) b) 44,481 Goodwill and other intangibles 10,135 29 7,794 a) 17,958 Developed technology 387 a) 387 Deferred income taxes 21,445 21,445 Other assets 1,489 1,489 Total assets $ 301,639 $ 2,189 $ (2,399) $ 301,429 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $8,282 277 97 b) 8,656 Accrued compensation and benefits 17,804 389 (115) b) 18,078 Customer deposits and advances 4,848 4,848 Unearned revenue 30,996 814 (788) a), b) 31,022 Accrued interest-convertible debt 276 (276) b) Convertible debt 6,131 (6,131) b) Income taxes payable 3,999 3,999 Other accrued liabilities 13,685 277 135 b), c) 14,097 Total current liabilities 79,614 8,164 (7,078) 80,700 Other liabilities and unearned maintenance revenue 6,200 4 6,204 Series A convertible redeemable preferred stock 5,100 (5,100) d) Stockholders' equity: Common stock 199,526 996 (996) d) 199,526 Retained earnings (deficit) 44,906 (12,075) 10,775 d), h) 43,606 Accumulated other comprehensive operations (14,040) (14,040) 230,392 (11,079) 4,679 229,092 Treasury stock, at cost; 1,098,000 shares (14,567) (14,567) Net stockholders' equity 215,825 (11,079) 4,679 214,525 Total $ 301,639 $ 2,189 $ (2,399) $ 301,429 Note: See notes to unaudited pro forma condensed combined financial statements UNAUDITED PRO FORMA CONDENSED COMBINED STATEMENT OF OPERATIONS (In thousands, except per share data) Year Ended December 31, 2001 Historical Pro Forma FileNET eGrail Adjustments Combined Revenue: Software $ 118,972 $ 1,719 $ 120,691 Service 199,722 3,721 203,443 Hardware 13,840 13,840 Total revenue 332,534 5,440 337,974 Costs and expenses: Cost of software revenue 7,481 2 7,483 Cost of service revenue 100,447 3,045 103,492 Cost of hardware revenue 10,021 10,021 Total cost of revenue 117,949 3,047 120,996 Gross profit 214,585 2,393 216,978 Operating expenses: Research and development 68,838 2,395 71,233 Selling, general and administrative 169,505 7,514 177,019 Amortization of purchased intangibles 194 e) 194 Total operating expenses 238,343 9,909 194 248,446 Operating loss (23,758) (7,516) (194) (31,468) Other income (expense), net 2,503 (827) (382) f) 1,294 Loss before income taxes (21,255) (8,343) (576) (30,174) Benefit for income taxes (4,633) (127) g) (4,760) Net loss $ (16,622) $ (8,343) $ (449) $ (25,414) Loss per share: Basic $ (0.47) $ (0.72) Diluted $ (0.47) $ (0.72) Weighted average shares outstanding: Basic 35,117 35,117 Diluted 35,117 35,117 Note: See notes to unaudited pro forma condensed combined financial statements NOTES TO UNAUDITED PRO FORMA CONDENSED COMBINED FINANCIAL INFORMATION The following adjustments have been reflected in the unaudited pro forma condensed combined financial statements: a) To record cash paid of $9.0 million, and the allocation of the purchase price applicable to purchase accounting entries, including goodwill of $7.3 million, developed technology of $0.4 million and in-process research and development of $1.3 million (see "h" below). b) To eliminate assets not acquired and liabilities not assumed as part of the Agreement as follows: Assets Cash and cash equivalents $ 853 Accounts receivable 298 Prepaid expenses and other assets 347 Property, net 82 Other intangibles 5 Liabilities Accounts payable (97) Accrued compensation and benefits 115 Unearned revenue 322 Other accrued liabilities 216 Convertible debt 6,131 Accrued interest-convertible debt 276 Convertible redeemable preferred stock 5,100 Equity Common stock 996 Retained deficit $ (12,075) c) To accrue estimated transaction costs of $351,000. d) To eliminate eGrail stockholders' equity accounts of $996,000 for common stock, $12.1 million for retained deficit and $5.1 million for convertible redeemable preferred stock. e) To reflect the amortization of developed technology valued at $387,000 over two years on a straight-line basis. For the year ended December 31, 2001 amortization expense is $194,000. In accordance with SFAS 142, goodwill is not amortized. f) To reflect the decrease in interest income for the year ended December 31, 2001 of $382,000 due to the use of cash in the acquisition. Interest income was calculated based on FileNET's historical interest rates earned on investments during this twelve-month period. g) To adjust the income tax provision to reflect the estimated income tax benefit from amortization expense and the reduction of interest income using a 22% effective tax rate for the year ended December 31, 2001. This rate represents FileNET's historical effective tax rate for the period. h) To record write off of in-process research and development of $1.3 million as a reduction to retained earnings. The Pro Forma Condensed Combimed Statement of Operations does not include the in-process research and development write-off as it is considered a non-recurring charge directly attributable to the transaction. SIGNATURES 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 hereunto duly authorized. FILENET CORPORATION Date: June 11, 2002 By: /s/ Sam M. Auriemma Name: Sam M. Auriemma Title: Senior Vice President, Finance, and Chief Financial Officer Item 7. (c) Exhibits EXHIBIT INDEX Exhibits: Description of Document 23.1 Consent of Independent Auditors 99.2 Financial Statements of Business acquired Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statement Nos. 33-90454, 33-96076, 33-80899, 333-02194, 333-09075, 333-34031, 333-66997, 333-89983, 333-43254, 333-59274, and 333-71598 of FileNET Corporation on Form S-8 of our report dated May 31, 2002 on the financial statements of eGrail, Inc. as of and for the year ended December 31, 2001, appearing in this Current Report on Form 8-K/A of FileNET Corporation. /s/ DELOITTE and TOUCHE LLP Costa Mesa, California June 10, 2002 Exhibit 99.2 eGrail, Inc. Financial Statements as of and for the Year Ended December 31, 2001, and Independent Auditors' Report eGrail, Inc. TABLE OF CONTENTS Page INDEPENDENT AUDITORS' REPORT 1 FINANCIAL STATEMENTS FOR THE YEAR ENDED DECEMBER 31, 2001: Balance Sheet 2 Statement of Operations 3 Statement of Changes in Capital Deficiency 4 Statement of Cash Flows 5 Notes to Financial Statements 6-15 INDEPENDENT AUDITORS' REPORT To the Board of Directors of eGrail, Inc.: We have audited the accompanying balance sheet of eGrail, Inc. (the "Company"), as of December 31, 2001, and the related statements of operations, changes in capital deficiency, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of eGrail, Inc., at December 31, 2001, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America. The accompanying financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has experienced recurring net operating losses, net cash outflows from operations, and has negative working capital. The Company's ability to continue operating is dependent on its ability to secure additional financing in the near term. These conditions raise substantial doubt about the Company's ability to continue as a going concern. Management's plans regarding these matters are also described in Note 1. The financial statements do not include any adjustments that might result from the outcome of this uncertainty. /s/ DELOITTE and TOUCHE LLP May 31, 2002 Costa Mesa, California eGrail, Inc. BALANCE SHEET AS OF DECEMBER 31, 2001 (In Thousands, Except Share and Per Share Data) ASSETS CURRENT ASSETS: Cash and cash equivalents $ 853 Accounts receivable 399 Deferred Interest - net 243 Deferred financing costs 38 Prepaid expenses and other current assets 193 Total current assets $ 1,726 RESTRICTED CASH 77 PROPERTY AND EQUIPMENT - Net 357 INTANGIBLE ASSETS - Net 29 TOTAL $ 2,189 LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $277 Accrued compensation and benefits 389 Accrued liabilities 140 Deferred revenues 814 Accrued interest 276 Convertible debt 6,131 Short-term capital lease obligations 137 Total current liabilities 8,164 LONG-TERM CAPITAL LEASE OBLIGATIONS 4 SERIES A CONVERTIBLE REDEEMABLE PREFERRED STOCK $0.01 par value; 10,000,000 shares authorized; 2,115,714 shares issued and outstanding (liquidation preference $5,714) 5,100 COMMITMENTS AND CONTINGENCIES (Notes 5 and 10) CAPITAL DEFICIENCY Common stock, $.01 par value; 30,000,000 shares authorized; 15,980,000 shares issued and outstanding 160 Additional paid in capital 836 Accumulated deficit (12,075) Net capital deficiency (11,079) TOTAL $ 2,189 See accompanying notes to the financial statements. -2- eGrail, Inc. STATEMENT OF OPERATIONS FOR THE YEAR ENDED DECEMBER 31, 2001 (In Thousands) REVENUE: Software licenses $ 1,719 Services 3,231 Maintenance 490 Total revenue 5,440 COST OF REVENUE Cost of software revenue 2 Cost of service revenue 3,045 Total cost of revenue 3,047 GROSS PROFIT 2,393 OPERATING EXPENSES: Sales and Marketing 5,124 Product Development 2,395 General and administrative 2,390 Total Expenses 9,909 OPERATING LOSS (7,516) INTEREST INCOME 27 INTEREST EXPENSE (854) NET LOSS $ (8,343) See accompanying notes to the financial statements -3- eGrail, Inc. STATEMENT OF CHANGES IN CAPITAL DEFICIENCY FOR THE YEAR ENDED DECEMBER 31, 2001 (In Thousands, Except Share Data) Additional Common Stock Paid in Accumulated Shares Amount Capital Deficit Net BALANCES AT JANUARY 1, 2000 9,180,000 $ 92 $ - $ (3,732) $ (3,640) Issuance of warrants to purchase common stock - - 122 - 122 Beneficial conversion feature of convertible - - 714 - 714 debt Exercise of common stock warrant 6,800,000 68 - - 68 Net loss - - - (8,343) (8,343) BALANCES AT DECEMBER 31, 2001 15,980,000 160 $ 836 $ (12,075) $ (11,079) See accompanying notes to the financial statements -4- eGrail, Inc. STATEMENT OF CASH FLOWS FOR THE YEAR ENDED DECEMBER 31, 2001 (In Thousands) CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $ (8,343) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization 288 Issuance of warrants to executive search firm 36 Amortization of deferred financing costs 83 Amortization of beneficial conversion feature of convertible debt 471 Loss on disposal of fixed assets 13 Changes in assets and liabilities: Accounts receivable 509 Prepaid expenses and other current assets 1,085 Accounts payable and accrued liabilities (737) Accrued compensation and benefits 252 Accrued liabilities 1 Deferred revenue (447) Accrued interest 276 Net cash used in operating activities (6,513) CASH FLOWS FROM INVESTING ACTIVITIES Purchases of property and equipment (142) Proceeds from sales of fixed assets 2 Purchases of intangible assets (2) Net cash used in investing activities (142) CASH FLOWS FROM FINANCING ACTIVITIES Payments for debt issuance costs (54) Proceeds from issuance of convertible debt 6,150 Proceeds from issuance of preferred stock 1,030 Proceeds from issuance of common stock 68 Principal payments on capital lease obligations (204) Net cash provided by financing activities 6,990 NET INCREASE IN CASH AND CASH EQUIVALENTS 335 CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 518 CASH AND CASH EQUIVALENTS AT END OF YEAR $ 853 SUPPLEMENTAL CASH FLOW INFORMATION: Interest paid $ 26 Non-cash disclosures: Beneficial conversion feature of convertible debt $ 714 Fair value of issuance of warrants for the purchase of common stock $ 122 See accompanying notes to the financial statements. -5- eGrail, Inc. NOTES TO FINANCIAL STATEMENTS YEAR ENDED DECEMBER 31, 2001 1. ORGANIZATION AND NATURE OF OPERATIONS eGrail, Inc. (eGrail or the Company) develops next-generation web content management solutions that are engineered to address complex multilanguage, multichannel, multiuser requirements of global enterprise-class customers. eGrail's object-based platform brings flexibility to companies seeking to maintain sites in multiple languages and deliver content in multiple formats while eGrail's open architecture interface supports a variety of major platforms. The Company was founded in May 1997 under the name GUI Works, L.L.C. (a Maryland limited liability corporation). In December 1999, GUI Works, Inc., was incorporated in the State of Delaware and merged with GUI Works, L.L.C. under the name of GUI Works, Inc., the surviving company. In February 2000, GUI Works, Inc., changed its name to eGrail, Inc. In October 2000, the Company incorporated a wholly owned subsidiary in the United Kingdom named eGrail Europe Limited. eGrail Europe Limited was a subsidiary sales and service office focused on serving the European market. In July 2001, this subsidiary was closed. The accompanying financial statements include the results of operations of the subsidiary through the date of its disposal. From the Company's inception through June 2000, the Company's operations generated sufficient cash flows to fund the Company's cash needs. In June 2000, the Company received a commitment for a private equity placement of $5.1 million, of which approximately $4.07 million had been received at December 21, 2000, and $1.03 million was received in January, 2001. In conjunction with the private equity placement received in June, the Company launched aggressive growth plans requiring funding beyond that being generated from operations. These growth plans included the development and launch of additional software products, sales personnel, marketing and infrastructure, etc. In April 2001, the Company's Board of Directors approved a three-for-one stock split. The accompanying financial statements have been adjusted to reflect such stock-split for all periods presented. Consistent with its business plan, the Company remains in a growth phase and is generating net operating losses. The Company has experienced recurring net operating losses, net cash outflows from operations, and has negative working capital. Management is actively seeking financing from existing and new investors to meet its operating needs and anticipates securing funding during fiscal 2002. This uncertainty raises substantial doubt about the Company's ability to continue as a going concern. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should the Company be unable to continue as a going concern. 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation - The accompanying financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America. Financial Instruments - The carrying values of the Company's cash and cash equivalents, accounts receivable, investments, accounts payable, and accrued expenses approximate their fair values. -6- Cash and Cash Equivalents - The Company considers all highly liquid investments with an original maturity of three months or less to be cash equivalents. Cash equivalents consist primarily of funds deposited in money market accounts. Deferred Interest - Deferred interest represents the unamortized balance of the beneficial conversion feature of the convertible debt (Note 6). The cost is amortized to interest expense over the life of the loan using the effective interest method. The cost basis of the deferred interest at December 31, 2001 was approximately $714,000 and the related accumulated amortization was approximately $471,000. Deferred Financing Costs - Deferred financing costs represent the unamortized transaction costs and value of stock warrants issued in connection with the Company's convertible debt (Note 6). At December 31, 2001, the cost basis of the transaction costs and warrants was approximately $54,000 and $86,000, respectively. The Company amortizes deferred financing costs to interest expense over the life of the convertible debt using the effective interest method. Accumulated amortization at December 31, 2001 was approximately $83,000. Restricted Cash - The Company holds certain certificates of deposit that have been pledged as collateral to secure letters of credit issued on the Company's behalf. These investments are carried at their approximate fair values. Property and Equipment - Property and equipment are recorded at cost and depreciated using the straight-line method over the estimated useful life of the asset, ranging from one to seven years. The Company has entered into certain leases that are classified as capital leases. The present value of the future lease payments, which approximates the fair value of the asset under lease, is recorded as equipment and depreciated over its estimated useful life or the lease term, whichever is shorter. As required by Statement of Position ("SOP") 98-1, Accounting for Costs of Computer Software Developed or Obtained for Internal Use, eGrail capitalized certain costs related to computer software developed or obtained for internal use. Capitalized computer software costs are depreciated using the straight-line method over the shorter of the estimated life of the software or two years. Normal repairs and maintenance are charged to expense when incurred. Intangible Assets - Intangible assets primarily consist of costs incurred to establish patents on the Company's software products. Patents are being amortized using the straight-line method over a period of five years. As of December 31, 2001, accumulated amortization was approximately $17,000. The Company periodically evaluates whether changes have occurred that would require revision of the remaining estimated useful life, and based on its most recent assessment, no impairment exists as of December 31, 2001. Long-Lived Assets - The Company evaluates its long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of any asset to future net undiscounted cash flows expected to be generated by the asset. If such assets are considered to be impaired, the impairment to be recognized is measured by the future discounted cash flows compared to the carrying amount of the asset. Based on managements' most recent analysis, assets are not impaired at December 31, 2001. Income Taxes - The Company provides for income taxes in accordance with the liability method. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates and laws expected to be in effect when the differences are -7- anticipated to reverse. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The Company has provided a full valuation allowance against its net deferred tax asset as of December 31, 2001. Revenue Recognition - Revenue is recognized when persuasive evidence of an agreement exists, the product or service has been delivered, the fee is fixed or determinable, and collection of the fee is probable. The Company's revenue recognition policies are in compliance with American Institute of Certified Public Accountants Statements of Position 97-2, Software Revenue Recognition (SOP 97-2); SOP 98-4, Deferral of the Effective Date of a Provision of SOP No. 97-2(SOP 98-4); and SOP 98-9, Modification of SOP No. 97-2 with Respect to Certain Transactions (SOP 98-9). The Company had not established vendor-specific objective evidence (VSOE) of fair value for its software licenses, maintenance services or professional services as of December 31, 2000. For those agreements that include more than one element, for which there is no VSOE, the Company recognizes revenue ratably over the term of the agreement, which is generally 12 months. During the year ended December 31, 2001, the Company established VSOE for some maintenance services through the existence of stated renewal rates in the contracts. For those agreements that include more than one element for which VSOE exists for all undelivered elements, the Company generally recognizes revenue using the residual method as specified in SOP 98-9. For the year ended December 31, 2000, certain of the Company's software license agreements included a significant discount on future upgrades of the software then under license. The term of these agreements was generally one year. The Company had not completed the upgrades as of December 31, 2000, nor had the Company established VSOE of fair value for the upgrades. In accordance with SOP 97-2, the Company deferred all revenues associated with the software license agreements that contained discounts on future upgrades. For those agreements where the Company provides significant customization of its software, the Company recognizes revenues in accordance with contract accounting principles, generally on a percentage-of-completion basis. The Company measures percentage completion based on labor-hours incurred in relation to total estimated labor-hours associated with a given project. The Company recognizes these revenues as service revenues. The Company provides professional services through separate professional service agreements on a time-and-materials basis. Revenues are recognized as the services are performed. The Company records these amounts as service revenues. The Company provides maintenance and support services on an annual fee basis paid annually at the inception of the maintenance and support contract and on renewal dates. Since these fees are related to services provided during the term of the agreement, revenue is recognized ratably over the term of the contract. Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. Comprehensive Income - No difference exists between the Company's net loss and comprehensive income. Computer Software Development Costs - All costs in the software development process that are classified as research and development are expensed as incurred until technological feasibility has been established. Once technological feasibility has been established, such costs are capitalized -8- until the software has completed testing and is generally available for sale. To the extent the Company retains the rights to software development funded by third parties, such costs are capitalized in accordance with the Company's normal accounting policies. The period between achievement of technological feasibility until the general availability of such software to customers has been short and software development costs qualifying for capitalization have been insignificant. Accordingly, no amounts were capitalized for the year ended December 31, 2001. Stock - Based Compensation - The Company accounts for its stock-based compensation in accordance with Accounting Principles Board ("APB") No. 25, Accounting for Stock Issued to Employees. The Company's stock options are generally issued with the strike price greater than or equal to the fair market value of the underlying common stock on the date of grant. As a result, the Company has not recognized compensation expense associated with its stock option plan. The Company provides disclosures in its financial statements as required by Statement of Financial Accounting Standards ("SFAS") No. 123, Accounting for Stock-Based Compensation. SFAS No. 123 requires the Company to disclose the pro forma effects on its results of operations as if the Company had followed the fair value methodology of accounting for stock options. Significant Customers - During 2001, a single customer accounted for approximately 72% of total billings and approximately 61% of the Company's recognized revenue. Concentration of Credit Risk - Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash and cash equivalents and accounts receivable. The Company deposits its cash with high credit quality financial institutions, which at times, may be in excess of the Federal Deposit Insurance Corporation ("FDIC") insurance limits. With respect to accounts receivable, the Company performs ongoing credit evaluations of its customers, generally does not require collateral, and maintains an allowance for doubtful accounts based on historical bad debt experience and management's expectations. 3. LETTERS OF CREDIT During 2000, eGrail obtained letters of credit totaling approximately $73,000 to facilitate leases of equipment. Interest accrues on draws against the balance at London InterBank Offered Rate ("LIBOR") plus 2.0%. The letters of credit do not have any financial covenants. The letters of credit are collateralized by the Company's investments in certain certificates of deposit. There were no draws against the letters of credit during the year ended December 31, 2001. -9- 4. PROPERTY AND EQUIPMENT Property and equipment consist of the following at December 31, 2001 (in thousands): Computer equipment $ 642 Office equipment 23 Furniture and fixtures 60 Leasehold improvements 14 Total property and equipment 739 Less accumulated depreciation and amortization (382) Property and equipment, net $ 357 Property and equipment includes computer equipment under capital leases totaling approximately $367,000 at December 31, 2001. Approximately $197,000 related to this equipment under capital lease is included in accumulated depreciation and amortization above. Depreciation and amortization expense related to property and equipment, including assets under capital lease, for the year ended December 31, 2001, totaled approximately $279,000. 5. COMMITMENTS The Company has entered into two operating lease agreements for office space expiring through September 30, 2005. The leases contain clauses for payment of real estate taxes, insurance, and operating costs. In April 2001, the Company terminated one of these operating leases and subsequently made a lease termination payment of $193,750 in full settlement of all obligations under the lease . The Company has entered into a three-year operating phone lease that expires in 2003. Expenses related to operating leases were $458,700 (includes the above-referenced lease termination payment) for the year ended December 31, 2001. Future minimum lease payments, by year and in the aggregate, under these noncancelable operating leases at December 31 are as follows (in thousands): 2002 $ 195 2003 149 2004 120 2005 61 $ 525 The Company is the lessee of computer equipment under capital leases expiring at various times beginning in March 2002 through March 2003. The assets and liabilities under capital leases are recorded at the lower of the present value of the future minimum lease payments or the fair value of the asset. The assets are depreciated over their estimated productive lives of two years. Depreciation of assets under capital leases is included in depreciation expense for 2001. -10- Minimum future lease payments under capital leases as of December 31, 2001 are as follows (in thousands): Future Payments on Capital Leases 2002 $ 144 2003 5 Total minimum lease payments 149 Less: Amount representing interest (8) Present value of net minimum lease payments $ 141 6. CONVERTIBLE DEBT During March 2001 to July 2001, the Company issued $3.09 million of Secured Convertible Promissory Notes (the Notes). The Notes were amended in August 2001 to increase the total amount of funds available under the Notes from $3.09 million to $7.94 million. The Notes are secured by substantially all of the Company's assets. The notes bear a 10% interest rate per annum compounded quarterly, payable on the maturity date of February 28, 2002, or on the date the entire outstanding principal is paid in full (Note 12). As of December 31, 2001, the Company had borrowed $6.2 million under the Notes. The total balance outstanding as of December 31, 2001 is $6.4 million, which includes approximately $276,000 of accrued, unpaid interest. At the holders' option, the notes and all accrued interest are convertible at any time on or before the maturity date into an equivalent amount of any class of the Company's equity at 90% of the issuance price. Total fair value of the 10% beneficial conversion feature was determined to be $714,000, based on the fair market value of the Company's common stock on the date of each note issuance. The estimated fair value of this beneficial conversion feature is recorded as Deferred Interest and is expensed over the remaining term of the Notes. For the twelve months ended December 31, 2001, $470,616 of the total deferred interest expense was recognized as interest expense. As consideration for the increase in the amount available under the Notes, the Company issued warrants for approximately 7 million shares of common stock to the holders of the secured convertible debt. Such warrants, with a life of ten years, allow the holders to purchase common stock at any time from the Company for the exercise price of $0.01 per share. The estimated fair value of these warrants upon issuance was approximately $86,000 and was determined using the Black-Scholes option-pricing model using the following assumptions: Risk-free interest rate 5.09% Term of Warrant 10 years Expected stock volatility 123% The estimate fair value of the warrants has been recorded as a Deferred Financing Cost and is amortized ratably over the term of the Notes. For the year ended December 31, 2001, $48,057 was included in interest expense as amortization of this deferred loan cost. -11- 7. INCOME TAXES At December 31, 2001, the Company had a net operating loss carryforward (NOL) of approximately $9.8 million that expires in the year 2021. The realization of the benefit of the NOL is dependent on sufficient taxable income in future fiscal years. Lack of future earnings, changes in the ownership of the Company, or the application of the alternative minimum tax rules could adversely affect the Company's ability to utilize the NOL. The Company's net deferred tax assets at December 31, 2001 were as follows (in thousands): Gross deferred tax assets: Net operating loss carryforward $ 3,780 Other 497 Total gross deferred tax assets 4,277 Deferred tax liabilities (52) 4,225 Less: Valuation allowance (4,225) Net deferred tax assets $ - At December 31, 2001, the Company's net deferred tax asset is fully offset by a valuation allowance. The Company will continue to assess the valuation allowance and, to the extent it is determined that such allowance is no longer required, the tax benefit of the remaining deferred tax assets will be recognized. The net increase in the valuation allowance for the year ended December 31, 2001 was approximately $2.8 million. 8. CAPITAL DEFICIENCY Common Stock - In October 2001, the Company issued 6,800,000 shares of common stock from the exercise of warrants to purchase common stock (Note 6). Net proceeds from these issuance amounted to $68,000. The Company used the proceeds for general operating purposes. The shares of common stock reserved for the exercise of issued and unissued common stock options are 3,239,238. Stock Purchase Warrants - In connection with retaining the Company's Chief Executive Officer, the Company granted a warrant to an executive search firm to purchase 115,077 shares of the Company's common stock for $0.81 for a period of seven years. As the warrant was granted to a third party recruiting firm, the Company recorded expense equal to the estimated fair value of the warrants totaling approximately $36,000. Stock Incentive Plan - During the year ended December 31, 2000, the Company's Board of Directors approved the Company's 2000 Stock Incentive Plan (the Plan). The Plan provides for the granting of stock options, stock appreciation rights, restricted stock, performance awards, and other stock-based awards. During the year ended December 31, 2001, the Company's Board of Directors granted 1,055,930 stock options, net of cancellations through December 31, 2001, to certain officers and employees at an exercise price at or above 100% of fair market value of the shares underlying the options on the date of grant. Accordingly, no compensation expense was recorded for these options. These options expire ten years from the date of vesting. The stock options granted vest over a period of three years. -12- The Company has adopted the disclosure provisions of SFAS No. 123. Had compensation expense for the Company's stock option plan been determined based upon fair value at the grant date for awards under the Plan consistent with the underlying methodology prescribed under SFAS No. 123, the Company's net loss for the year ended December 31, 2001, would have been greater by approximately $413,000. The fair value of the options granted during the year ended December 31, 2001 is estimated at a weighted average per option of $0.28, on the date of the grant, using the Black Scholes option-pricing model with the following assumptions: a dividend yield of 0%, a weighted average risk-free interest rate of 6.14%, expected volatility of 118%, and an expected life of 3.5 years from date of grant. A summary of the stock option activity is as follows: Weighted-Average Shares Exercise Price Outstanding at January 1, 2001 1,199,904 $ 0.48 Granted 2,647,334 0.79 Canceled (1,591,404) 0.57 Outstanding at December 31, 2001 2,255,834 $ 0.78 Exercisable at December 31, 2001 483,133 $ 0.76 The following tables summarize information about stock options and warrants outstanding and exercisable at December 31, 2001: Stock Options Outstanding Warrants Outstanding Range of Weighted-Average Weighted-Average Exercise Number of Remaining Contractual Number of Remaining Contractual Prices Shares Life (in years) Shares Life (in years) $ 0.01 - - 204,000 9.8 $ 0.17 54,000 8.3 - - $ 0.50 16,500 8.5 - - $ 0.67 127,500 8.8 - - $ 0.81 2,057,834 9.4 115,077 6.2 2,255,834 9.3 319,077 5.9 -13- Stock Options Exercisable Warrants Exercisable Range of Weighted-Average Weighted-Average Exercise Number of Remaining Contractual Number of Remaining Contractual Prices Shares Life (in years) Shares Life (in years) $ 0.01 - - 204,000 9.8 $ 0.17 27,000 8.3 - - $ 0.50 6,875 8.5 - - $ 0.67 35,000 8.7 - - $ 0.81 414,258 9.3 115,077 6.2 483,133 9.2 319,077 5.9 9. PREFERRED STOCK During the year ended December 31, 2000, the Company issued 1.69 million shares of its Series A 8% Convertible Redeemable Preferred Stock for approximately $4.07 million. In January 2001, as part of the same private equity placement, the Company issued 423,142 additional shares of its Series A preferred stock for approximately $1.03 million (collectively, the Preferred Shares). The Preferred Shares have an annual dividend rate of 8% payable only when declared by the Company's Board of Directors out of legally available funds, upon liquidation of the Company (other than a sale of the company), at the option of the holder upon the consummation of a sale of the Company, or at the option of the holder upon the consummation of a sale or exclusive license of all, or a material portion, of the Company's intellectual property. Dividends are cumulative from the date of issuance. Cumulative unpaid dividends as of December 31, 2001, were approximately $614,000. The Preferred Shares are redeemable, in whole or in part, by the holder any time after the third anniversary from the date of issuance or in the event the Company does not comply with the provision of the preferred stock agreement. The Preferred Shares are to be redeemed by the Company at the greater of the liquidation value or the fair market value on the date of redemption. The liquidation value is equal to the original issuance price for each share, as adjusted for stock splits, dividends, combinations or other recapitalizations with respect to such share, plus all accrued and unpaid dividends. The Preferred Shares are convertible, in whole or in part, at the option of the holder into common shares of stock at a three for one ratio, subject to adjustment in certain circumstances. Holders of the Preferred Shares rank senior to the common shareholders and have the same voting rights as common shareholders. 10. CONTINGENCIES The Company is a party in various legal proceedings and potential claims arising in the ordinary course of business. Management does not believe that the resolution of these matters will have a material adverse effect on the Company's financial position or results of operations. -14- MicroStrategy vs. eGrail et al., Virginia: Circuit Court of Fairfax County, Case No. 195282. In this lawsuit, MicroStrategy alleges, among other things, that Joseph Payne, the Company's President and CEO, had breached his MicroStrategy Agreement dated on or about April 22, 1999, which agreement purportedly imposes certain restrictive covenants on Mr. Payne. The lawsuit also alleges, among other things, tortuous interference with contract by the Company. MicroStrategy is seeking relief and damages of $11.5 million. On April 2, 2002, MicroStrategy entered a voluntary nonsuit in the case pursuant to which the case was dismissed. On April 4, 2002, Microstrategy re-filed its case in MicroStrategy Incorporated v. eGrail, Inc., et al., Virginia: Circuit Court of Fairfax County, Case No. 177631. MicroStrategy is asserting the same claims that were voluntarily dismissed in the prior suit, and in the second case, MicroStrategy added as defendant one of eGrail's preferred stock investors and a principal of the preferred stock investor. The new case seeks injunctive relief and $18 million in damages. Management believes these claims to be without merit and intends to vigorously defend this case. The Company is unable, however, to predict the outcome of this case, or reasonably estimate a range of possible loss given the current status of the litigation. 11. RELATED PARTY TRANSACTIONS The Company paid $37,500 for management services to a related - party, Mercator Management LLC, the general partner of Mercator Broadband Partners, LP. Mercator Broadband Partners, LP is the majority owner of eGrail's Preferred Shares (Note 9). 12. SUBSEQUENT EVENTS During February 2002, the maturity date of the convertible debt note (Note 6) was extended to May 28, 2002. As consideration for the extension, the Company issued additional warrants for approximately one million shares of preferred stock to the holders of the secured convertible debt. Such warrants, with a life of ten years, allow the holders to purchase preferred stock at any time from the Company for the exercise price of $0.01 per share. On April 2, 2002, the Company sold certain assets of eGrail for $9 million plus the assumption of approximately $600,000 of eGrail's net liabilities over book asset value. * * * * * * -15-
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Filed: 11 Jun 02, 12:00am