1 - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 ------------------------ FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED AUGUST 31, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ____________ . COMMISSION FILE NUMBER: 0-26880 ------------------------ VERITY, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 77-0182779 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.) 894 ROSS DRIVE SUNNYVALE, CALIFORNIA 94089 (408) 541-1500 (ADDRESS AND TELEPHONE NUMBER OF PRINCIPAL EXECUTIVE OFFICES) ------------------------ Indicate by check mark whether registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES [X] NO [ ] The number of shares outstanding of the Registrant's Common Stock, $0.001 par value, were 11,680,000 as of August 31, 1998. This report consists of 20 pages. The Exhibit Index to this report is located on page 19. - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- 2 VERITY, INC. FORM 10-Q TABLE OF CONTENTS PAGE ---- PART I: FINANCIAL INFORMATION Item 1. Financial Statements........................................ 1 Condensed Consolidated Balance Sheets as of May 31, 1998 and August 31, 1998........................................... 1 Condensed Consolidated Statements of Operations for the Three Months Ended August 31, 1997 and 1998............... 2 Condensed Consolidated Statements of Cash Flows for the Three Months Ended August 31, 1997 and 1998............... 3 Notes to Condensed Consolidated Financial Statements........ 4 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations................................. 6 PART II: OTHER INFORMATION Item 1. Legal Proceedings........................................... 17 Item 2. Changes in Securities....................................... 17 Item 3. Defaults upon Senior Securities............................. 17 Item 4. Submission of Matters to a Vote of Security Holders......... 17 Item 5. Other Information........................................... 17 Item 6. Exhibits and Reports on Form 8-K............................ 17 Signatures........................................................... 18 i 3 PART I: FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS VERITY, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE DATA) ASSETS MAY 31, AUGUST 31, 1998 1998 -------- ----------- (UNAUDITED) Current assets: Cash and cash equivalents................................. $ 5,505 $ 5,243 Short-term investments.................................... 12,433 18,460 Trade accounts receivable, less allowance for doubtful accounts of $706 in 1998 and $666 in 1999.............. 14,488 9,090 Prepaid and other current assets.......................... 878 993 -------- -------- Total current assets.............................. 33,304 33,786 Property and equipment, at cost, net of accumulated depreciation and amortization.......................... 7,567 6,878 Other assets.............................................. 578 502 -------- -------- Total assets...................................... $ 41,449 $ 41,166 ======== ======== LIABILITIES Current liabilities: Current portion of long-term debt and capital lease obligations............................................ $ 149 $ 41 Accounts payable.......................................... 3,749 3,520 Accrued compensation...................................... 3,861 3,072 Other accrued liabilities................................. 1,705 1,831 Deferred revenue.......................................... 7,928 6,663 -------- -------- Total current liabilities......................... 17,392 15,127 Long-term debt and capital lease obligations, net of current portion........................................ 2 2 -------- -------- Total liabilities................................. 17,394 15,129 -------- -------- STOCKHOLDERS' EQUITY Common stock, $0.001 par value: Authorized: 30,000,000 shares in 1998 and 1999; Issued and outstanding: 11,565,000 shares in 1998 and 11,680,000 shares in 1999.............................. 12 12 Additional paid-in capital.................................. 92,212 92,970 Unrealized gain on investments.............................. 7 1 Accumulated deficit......................................... (68,176) (66,946) -------- -------- Total stockholders' equity........................ 24,055 26,037 -------- -------- Total liabilities and stockholders' equity........ $ 41,449 $ 41,166 ======== ======== The accompanying notes are an integral part of these condensed consolidated financial statements. 1 4 VERITY, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) THREE MONTHS ENDED AUGUST 31, ------------------ 1997 1998 ------- ------- (UNAUDITED) Revenues: Software products......................................... $ 3,116 $ 9,889 Service and other......................................... 2,224 3,331 ------- ------- Total revenues.................................... 5,340 13,220 ------- ------- Costs of revenues: Software products......................................... 705 437 Service and other......................................... 1,685 1,082 ------- ------- Total costs of revenues........................... 2,390 1,519 ------- ------- Gross profit.............................................. 2,950 11,701 ------- ------- Operating expenses: Research and development.................................. 5,033 3,275 Marketing and sales....................................... 5,745 5,952 General and administrative................................ 2,152 1,381 ------- ------- Total operating expenses.......................... 12,930 10,608 ------- ------- Income (loss) from operations............................... (9,980) 1,093 Other income, net........................................... 264 287 ------- ------- Net income (loss) before provision for income taxes......... (9,716) 1,380 Provision for income taxes.................................. 50 150 ------- ------- Net income (loss)........................................... $(9,766) $ 1,230 ======= ======= Net income (loss) per share -- basic........................ $ (0.89) $ 0.11 ======= ======= Net income (loss) per share -- diluted...................... $ (0.89) $ 0.10 ======= ======= Number of shares used in per share calculation -- basic..... 11,033 11,627 ======= ======= Number of shares used in per share calculation -- diluted... 11,033 12,882 ======= ======= The accompanying notes are an integral part of these condensed consolidated financial statements. 2 5 VERITY, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) THREE MONTHS ENDED AUGUST 31, ------------------- 1997 1998 ------- -------- (UNAUDITED) Cash flows from operating activities: Net income (loss)......................................... $(9,766) $ 1,230 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization.......................... 1,288 874 Other.................................................. -- (25) Provision for doubtful accounts........................ (130) 363 Amortization of discount on securities................. (24) (134) Changes in operating assets and liabilities: Trade accounts receivable............................ 3,519 5,081 Prepaid and other current assets..................... 41 (171) Accounts payable..................................... (1,147) (229) Accrued compensation and other accrued liabilities... 328 (635) Deferred revenue..................................... 138 (1,198) ------- -------- Net cash provided by (used in) operating activities....................................... (5,753) 5,156 ------- -------- Cash flows from investing activities: Acquisition of property and equipment..................... (796) (184) Purchases of marketable securities........................ (3,691) (19,552) Maturity of marketable securities......................... 1,400 5,000 Proceeds from sale of marketable securities............... 9,272 8,652 Capitalization of software................................ (198) -- ------- -------- Net cash provided by (used in) investing activities....................................... 5,987 (6,084) ------- -------- Cash flows from financing activities: Borrowings under line of credit........................... 1,500 -- Payments on line of credit................................ (1,500) -- Proceeds from stockholders on notes receivable............ 1,027 -- Proceeds from the sale of common stock.................... 50 758 Principal payments on notes payable and capital lease obligations............................................ (145) (109) ------- -------- Net cash provided by financing activities......... 932 649 ------- -------- Effect of exchange rate changes on cash..................... 1 17 ------- -------- Net increase (decrease) in cash and cash equivalents...................................... 1,167 (262) Cash and cash equivalents, beginning of period.............. 2,934 5,505 ------- -------- Cash and cash equivalents, end of period.................... $ 4,101 $ 5,243 ======= ======== SUPPLEMENTAL SCHEDULE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Acquisition consideration included in accrued liabilities............................................ $ 200 The accompanying notes are an integral part of these condensed consolidated financial statements. 3 6 VERITY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (INFORMATION AS OF AUGUST 31, 1998 AND FOR THE QUARTERS ENDED AUGUST 31, 1997 AND 1998 AND THEREAFTER IS UNAUDITED) 1. INTERIM FINANCIAL DATA (UNAUDITED) The unaudited financial statements for the quarters ended August 31, 1997 and 1998 have been prepared on the same basis as the audited financial statements and, in the opinion of management, include all material adjustments, consisting of normal recurring adjustments, necessary for a fair presentation of the financial position and results of operations in accordance with generally accepted accounting principles. Although certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to the rules and regulations of the Securities and Exchange Commission, the Company believes the disclosures made are adequate to make the information presented not misleading. It is suggested that the accompanying financial statements be read in conjunction with the Company's annual financial statements on Form 10-K for the year ended May 31, 1998. The Company's balance sheet as of May 31, 1998 was derived from the Company's audited financial statements, but does not include all disclosures necessary for the presentation to be in accordance with generally accepted accounting principles. 2. COMPUTATION OF NET INCOME AND LOSS PER SHARE The Company has adopted Statement of Financial Accounting Standards No. 128 (SFAS 128), "Earnings Per Share," which requires the dual presentation of basic and diluted earnings per share. Basic earnings per share are computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share are computed using the weighted average number of common and common equivalent shares outstanding during the period. Dilutive common equivalent shares consist of stock options. For the three months ended August 31, 1997, the effects of outstanding stock options were excluded from the computation of diluted earnings per share because their effect was antidilutive. Accordingly, no adjustments were required to previously reported earnings per share amounts. 3. RECENT ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130 (SFAS 130), "Reporting Comprehensive Income." This statement establishes requirements for disclosure of comprehensive income and becomes effective for the Company for its fiscal year 1999, with reclassification of earlier financial statements for comparative purposes. Comprehensive income generally represents all changes in stockholders' equity except those resulting from investments or contributions by stockholders. SFAS 130 requires unrealized gains or losses on the Company's available-for-sale securities, which prior to adoption were reported separately in stockholders' equity, to be included in other comprehensive income. The Company has adopted SFAS 130, however, the effects of the adoption were immaterial to all periods presented. In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 (SFAS 131), "Disclosures about Segments of an Enterprise and Related Information." This statement establishes standards for disclosures about operating segments in annual financial statements and selected information in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. This statement supersedes statement of Financial Accounting Standards No. 14, "Financial Reporting for Segments of a Business Enterprise." The new standard becomes effective for the Company's fiscal year 1999, and requires that comparative information from earlier years be restated to conform to the requirements of this standard. The Company is evaluating the requirements of SFAS 131 and the effects, if any, on the Company's current reporting and disclosures. 4 7 VERITY, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) (INFORMATION AS OF AUGUST 31, 1998 AND FOR THE QUARTERS ENDED AUGUST 31, 1997 AND 1998 AND THEREAFTER IS UNAUDITED) During October 1997, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position No. 97-2 (SOP 97-2), "Software Revenue Recognition." This statement delineates the accounting for software product and maintenance revenues. It supersedes Statement of Position No. 91-1, "Software Revenue Recognition," and is effective for transactions entered into in fiscal years beginning after December 15, 1997. The Company has evaluated the requirements of SOP 97-2 and its current revenue recognition policy is in compliance with this pronouncement. 4. BANK LINE OF CREDIT In March 1998, the Company negotiated a $5,000,000 line of credit under an agreement with a bank, which expires on September 30, 1998. The line of credit is collateralized by all corporate assets, excluding leased equipment. Borrowings under the line of credit bear interest at the lender's prime rate (8.5% at August 31, 1998). The agreement requires the Company to comply with certain financial covenants and prohibits the assumption of any major debt, except for equipment leases, without the bank's approval. As of August 31, 1998, no borrowings were outstanding under the line of credit. On September 22, 1998, the Company extended the term on its bank line of credit for an additional two months until November 30, 1998. The Company plans to renegotiate the agreement upon its expiration on November 30, 1998, but there is no assurance that such financing will be available on commercially reasonable terms, or at all. 5. RESTRUCTURING CHARGES During the quarter ended November 30, 1997, the Company implemented a worldwide restructuring of its operations, which resulted in workforce reductions and business consolidations. In connection with the restructuring, the Company recorded a $3.0 million restructuring charge in the quarter ended November 30, 1997, of which approximately $1.6 million was related to severance costs associated with the reduction in the worldwide workforce, approximately $0.5 million to the termination of certain lease agreements, approximately $0.6 million to the write-off of certain assets and approximately $0.3 million to other costs associated with the restructuring. Of the total $3.0 million in restructuring charges, approximately $0.8 million is a current liability at August 31, 1998. 6. SUBSEQUENT EVENTS On September 24, 1998, the stockholders of the Company approved to amend the 1995 Stock Option Plan (the "Option Plan") of the Company to increase the number of shares of Common Stock of the Company authorized for issuance thereunder from 3,310,836 shares to 4,060,836 shares. 5 8 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW THE FOLLOWING DISCUSSION CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE DISCUSSED HEREIN. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED BELOW IN "RISK FACTORS." Verity develops, markets and supports knowledge retrieval software products for application developers, corporate Intranet users and e-commerce sites. Verity's technology enables organizations to manage text-based information residing on their networks, making corporate content reusable across Intranets, the Internet and CD-ROM. Verity's knowledge retrieval products are designed to primarily index, search, retrieve, organize and disseminate unstructured information, which typically constitutes the substantial majority of an enterprise's business information and does not reside in a traditional relational database. Verity's products also enable application developers to embed powerful search and retrieval functionality into their own commercial applications. The Company's knowledge retrieval and KeyView viewing and filtering products are used within the Company's own suite of applications and have been embedded by many leading OEMs, including Lotus, Sybase, SAP and Netscape. Verity has licensed its technology to key e-commerce vendors, including Adobe Systems, AT&T WorldNet Services, CNET, Cisco, Compaq, Dow Jones, Ernst & Young, Financial Times, NewsEDGE Corporation, Informix, NEC, SCO, Siemens Nixdorf, Tandem and Time-Warner's Pathfinder. Verity's software has been licensed to over 1,000 corporations, government agencies, software developers, online service providers and Internet publishers worldwide. For the three months ended August 31, 1998, total revenues increased 147.6% over the corresponding fiscal 1997 period, primarily as a result of a 217.4% increase in software product revenues. Total revenues for the three months ended August 31, 1998 increased 0.7% from the $13.1 million for the previous three months ended May 31, 1998. Operating expenses for the three months ended August 31, 1998 decreased primarily as a result of a 47.6% decrease in general and administrative expenses compared to the previous three months ended May 31, 1998. While it is the Company's goal to increase revenues and generate net income in future periods, no assurance can be given that the Company's revenues will increase from quarter to quarter in future periods, or that the Company will achieve or maintain positive cash flow or profitability. During the quarter ended November 30, 1997, the Company implemented a worldwide restructuring of its corporate structure, which resulted in workforce reductions and business consolidations. In connection with the restructuring, the Company recorded a $3.0 million restructuring charge in the quarter ended November 30, 1997, of which approximately $1.6 million was related to severance costs associated with the reduction in the worldwide workforce, approximately $0.5 million to the termination of certain lease agreements, approximately $0.6 million to the write-off of certain assets and approximately $0.3 million to other costs associated with the restructuring. The Company believes that hiring and retaining qualified individuals at all levels in the Company is essential to its success, and there can be no assurance that the Company will be successful in attracting and retaining the necessary personnel. The Company has experienced significant turnover, including turnover of several senior members of management. In particular, on July 31, 1997, Mr. Gary J. Sbona was appointed as the Company's President and Chief Executive Officer, and the Company entered into an agreement with Regent Pacific Management Corporation, a management firm of which Mr. Sbona is the Chief Executive Officer. Pursuant to the original agreement, Regent Pacific agreed to provide management services to the Company, at a fee of $50,000 per week, including the services of Mr. Sbona as Chief Executive Officer and President and at least three other Regent Pacific personnel as part of the Company's management team. The agreement had a one-year term and could be canceled by the Company after expiration of the initial 26-week period, with a minimum compensation to Regent Pacific of $1.3 million for that initial period. The agreement requires that the Company indemnify Regent Pacific and Mr. Sbona for certain liabilities arising out of the performance of services under the agreement. On April 13, 6 9 1998, the Company and Regent Pacific agreed to amend the agreement to provide that Mr. Sbona and at least four other Regent Pacific personnel would serve as part of the Company's management team. The amendment also served to extend the term of the agreement until August 31, 1999, and to extend the noncancelable period of the agreement until February 28, 1999. In connection with Mr. Sbona's service as President and CEO of the Company, the Compensation Committee of the Company's Board also granted to him an option to purchase 350,000 shares of the Company's common stock at an exercise price of $5.125 per share. The shares subject to such option will vest on a monthly basis during the 13-month period ending on February 28, 1999, subject to Mr. Sbona's continued employment as the Company's President and CEO; provided, however, that the option will vest entirely upon certain change of control transactions or upon a termination of Mr. Sbona without cause. The option will also remain exercisable for one year following the termination of Mr. Sbona's services. If Company management is unable to effectively manage the Company's operations, identify opportunities in a timely fashion, and evaluate and manage the Company's business and competitive position, the Company's results of operations and financial condition will be materially and adversely affected. Furthermore, there can be no assurance that the Company will successfully develop and introduce new products on a timely basis or that its new or recently introduced products will achieve market acceptance. On March 11, 1998, the Company announced that it had filed a lawsuit in the United States District Court for the District of Delaware against Lotus Development Corporation for copyright infringement, unfair competition, breach of a 1992 agreement under which Verity licensed certain software to Lotus, misappropriation of trade secrets, and unjust enrichment and conversion. On June 8, 1998, Verity, Inc. and Lotus Development Corporation announced that they have concluded a settlement agreement that makes available to Lotus a range of Verity technologies for use with Lotus products. The settlement agreement resolves issues that had arisen between the two companies. Accordingly, the Company has withdrawn its legal action against Lotus Development Corporation by virtue of a settlement agreement dated June 8, 1998. The Company's revenues are derived from license fees for its software products and fees for services complementary to its products, including software maintenance, consulting and training. Fees for services generally are charged separately from the license fees for the Company's software products. Effective for contracts entered into starting June 1, 1998, the Company recognizes revenues in accordance with the provisions of American Institute of Certified Public Accountants Statement of Position No. 97-2, "Software Revenue Recognition." Maintenance revenues from ongoing customer support and product upgrades are recognized ratably over the term of the applicable maintenance agreement, which is typically 12 months. Payments for maintenance fees generally are received in advance and are nonrefundable. Revenues for consulting and training generally are recognized when the services are performed. Statement of Position No. 97-2 supersedes Statement of Position No. 91-1, "Software Revenue Recognition," and is effective for transactions entered into in fiscal years beginning after December 15, 1997. This statement delineates the accounting for software product and maintenance revenues. The Company has evaluated the requirements of SOP 97-2 and its current revenue recognition policy is in compliance with this pronouncement. 7 10 RESULTS OF OPERATIONS The following table sets forth the percentage of revenues represented by certain items in the Company's Condensed Consolidated Statements of Operations for the periods indicated: THREE MONTHS ENDED AUGUST 31, ------------------- 1997 1998 ------- ------ Revenues: Software products....................................... 58.4% 74.8% Service and other....................................... 41.6 25.2 ------ ----- Total revenues.................................. 100.0 100.0 ------ ----- Costs of revenues: Software products....................................... 13.2 3.3 Service and other....................................... 31.6 8.2 ------ ----- Total costs of revenues......................... 44.8 11.5 ------ ----- Gross profit.............................................. 55.2 88.5 ------ ----- Operating expenses: Research and development................................ 94.2 24.8 Marketing and sales..................................... 107.6 45.0 General and administrative.............................. 40.3 10.4 ------ ----- Total operating expenses........................ 242.1 80.2 ------ ----- Income (loss) from operations............................. (186.9) 8.3 Interest and other expenses............................... 4.9 2.1 ------ ----- Income (loss) before provision for income taxes........... (182.0) 10.4 Provision for income taxes................................ 0.9 1.1 ------ ----- Net income (loss)......................................... (182.9)% 9.3% ====== ===== Revenues Total revenues increased 147.6% from $5.3 million for the three months ended August 31, 1997 to $13.2 million for the three months ended August 31, 1998. Total revenues as compared to the three-month period ended August 31, 1997 increased primarily due to increased revenues from licensing of enterprise products and topic tools products. Software product revenues increased as a percentage of total revenues from 58.4% for the three months ended August 31, 1997, to 74.8% for the comparable period in fiscal 1999. Conversely, service and other revenues decreased as a percentage of total revenues from 41.6% for the three months ended August 31, 1997 to 25.2% for the three months ended August 31, 1998. Software product revenues. Software product revenues increased 217.4% from $3.1 million for the three months ended August 31, 1997 to $9.9 million for the three months ended August 31, 1998. The increase for the three months ended August 31, 1998 in comparison to the three months ended August 31, 1997 was due principally to increased revenues from licensing of enterprise products and topic tools products. Service and other revenues. Service and other revenues increased 49.8% from $2.2 million for the three months ended August 31, 1997 to $3.3 million for the three months ended August 31, 1998. Maintenance and consulting revenues increased significantly between the comparable periods, but these increases were partially offset by reduced training revenues. Revenues derived from European operations accounted for 10.6% and 5.5%, respectively, for the three months ended August 31, 1997 and 1998. For the three months ended August 31, 1997 and 1998, export sales accounted for 21.9% and 22.4% of total revenues, respectively. The decrease in revenues from European operations as a percentage of total revenues resulted primarily from increased domestic revenues. The Company expects that revenues derived from European operations and export sales will continue to vary in future periods as a percentage of total revenues. 8 11 No single customer accounted for more than 10% of the Company's revenues for the three months ended August 31, 1997. For the three months ended August 31, 1998, revenues derived from sales to Lotus Development Corporation accounted for 16.6% of the Company's total revenues. Revenues derived from sales to the federal government and its agencies were 8.8% and 3.8% of the Company's revenues for the three months ended August 31, 1997 and 1998, respectively. The Company expects that revenues from such government sales will continue to vary in future periods as a percentage of revenues. Costs of Revenues Costs of software products. Costs of software products decreased 38.0% from $705,000 for the three months ended August 31, 1997 to $437,000 for the three months ended August 31, 1998, representing 22.6% and 4.4%, respectively, of the software product revenues. In the three months ended August 31, 1997, the Company incurred amortization expense relating to capitalized software, which represented a significant part of the software costs. The decrease in absolute dollars during the periods ended August 31, 1998, was primarily due to the elimination of the amortization expense related to the capitalized software. The decrease in costs as a percentage of software product revenues was primarily related to the increased software product revenues for the three months ended August 31, 1998. Costs of service and other. Costs of service and other revenues decreased 35.8% from $1.7 million for the three months ended August 31, 1997 to $1.1 million for the three months ended August 31, 1998, representing 75.8% and 32.5%, respectively, of service and other revenues. The decrease in absolute dollars was due principally to a decrease in consulting and technical support personnel. Operating Expenses Research and development. Research and development expenses decreased 34.9% from $5.0 million for the three months ended August 31, 1997 to $3.3 million for the three months ended August 31, 1998, representing 94.2% and 24.8%, respectively, of total revenues. The decrease in absolute dollars was primarily due to a significant decrease in research and development personnel during fiscal 1999 as a result of a discontinuation of the operations of Insite, Cognisoft and 64K in fiscal 1998. The decrease in costs as a percentage of total revenues was primarily related to the increased revenues for the three months ended August 31, 1998. Future research and development expenses may vary as a percentage of total revenues. The Company believes that research and development expenses will increase in the future primarily due to the introduction of new products to the Company's product line and other anticipated product development efforts. Future research and development expenses may vary as a percentage of total revenues. Marketing and sales. Marketing and sales expenses increased 3.6% from $5.7 million for the three months ended August 31, 1997 to $6.0 million for the three months ended August 31, 1998, representing 107.6% and 45.0%, respectively, of total revenues. The increase in absolute costs for the three months ended August 31, 1998, was primarily related to the Company's expansion of its sales organization in the United States and Europe. The decrease in costs as a percentage of total revenues was primarily related to the increased revenues for the three months ended August 31, 1998. The Company anticipates it will continue to make significant investments in marketing and sales. General and administrative. General and administrative expenses decreased 35.8% from $2.2 million in the three months ended August 31, 1997 to $1.4 million for the three months ended August 31, 1998, representing 40.3% and 10.4%, respectively, of total revenues. The decrease in absolute costs was primarily related to decreased expenses associated with management in transition and personnel. The decrease in costs as a percentage of total revenues was primarily related to the increased revenues for the three months ended August 31, 1998. Restructuring charges. During the quarter ended November 30, 1997, the Company implemented a worldwide restructuring of its corporate structure, which resulted in workforce reductions and business consolidations. In connection with the restructuring, the Company recorded a $3.0 million restructuring charge in the quarter ended November 30, 1997, of which $1.6 million was related to severance costs associated with the reduction in the worldwide workforce, $0.5 million to the termination of certain lease 9 12 agreements, $0.6 million to the write-off of certain assets and $0.3 million to other costs associated with the restructuring. Of the total $3.0 million in restructuring charges, approximately $0.8 million is a current liability at August 31, 1998. Income Taxes The Company has established a valuation allowance against its deferred tax assets due to the uncertainty surrounding the realization of such assets. Management evaluates on a quarterly basis the recoverability of the deferred tax assets and the level of the valuation allowance. At such time as it is determined that it is more likely than not that deferred tax assets are realizable, the valuation allowance will be appropriately reduced. LIQUIDITY AND CAPITAL RESOURCES Since its inception, the Company has financed its operations primarily through proceeds of approximately $23.6 million from private sales of Preferred Stock, proceeds from its initial public offering and secondary public offering of Common Stock and, to a lesser extent, bank credit lines and capital operating leases. The Company completed its initial public offering of Common Stock in October 1995 and realized net proceeds of $32.5 million. In January 1996, the Company completed its secondary public offering of Common Stock, which generated net proceeds of $16.5 million. The Company has used a portion of those proceeds to repay borrowings under its line of credit in the amount of $1.6 million. As of August 31, 1998, the Company had $23.7 million in cash and cash equivalents and available-for-sale securities. The Company's operating activities used cash of $5.8 million and provided cash of $5.2 million for the three months ended August 31, 1997 and 1998, respectively. In the three months ended August 31, 1997, the Company's net loss for the period offset cash provided by a decrease in accounts receivable and depreciation and amortization expense. For the three months ended August 31, 1998, the Company's net income, a decrease in accounts receivable, and depreciation and amortization expense provided cash associated with operating activities. The Company's investing activities provided cash of $6.0 million and used cash of $6.1 million for the three months ended August 31, 1997 and 1998, respectively. For the three months ended August 31, 1997, cash provided by investing activities consisted primarily of proceeds from the sale and maturity of marketable securities partially offset by purchases of marketable securities. For the three months ended August 31, 1998, cash used by investing activities consisted primarily of purchases of marketable securities partially offset by proceeds from the sale and maturity of marketable securities. Cash provided by financing activities was $932,000 and $649,000 for the three months ended August 31, 1997 and 1998, respectively. In the three months ended August 31, 1997, financing activities consisted primarily of proceeds from the sale of Common Stock in connection with the proceeds from stockholders on notes receivable. In the three months ended August 31, 1998, financing activities consisted primarily of proceeds from the sale of Common Stock. At August 31, 1998, the Company's principal sources of liquidity were its cash, cash equivalents, and short-term investments of $23.7 million. In March 1998, the Company obtained a $5.0 million line of credit under an agreement with a bank, which expires on September 30, 1998. The line of credit is collateralized by all corporate assets, excluding leased equipment. Borrowings under the line of credit bear interest at the lender's prime rate. The agreement requires the Company to comply with certain financial covenants and prohibits the assumption of any major debt, except for equipment leases, without the bank's approval. The agreement was extended until November 30, 1998. As of August 31, 1998, no borrowings were outstanding under the line of credit. See Note 4 of Notes to Condensed Consolidated Financial Statements. Capital expenditures, including capital leases, were approximately $796,000 and $184,000 for the three months ended August 31, 1997 and 1998, respectively. For the three months ended August 31, 1997 and 1998, these expenditures consisted principally of purchases of property and equipment, primarily for computer hardware and software. 10 13 The Company believes that its current cash and cash equivalents, its bank line of credit and its funds generated from operations, if any, will provide adequate liquidity to meet the Company's capital and operating requirements through at least fiscal 1999. Thereafter, or if the Company's spending plans change, the Company may find it necessary to seek to obtain additional sources of financing to support its capital needs, but there is no assurance that such financing will be available on commercially reasonable terms, or at all. RECENT ACCOUNTING PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 130 (SFAS 130), "Reporting Comprehensive Income." This statement establishes requirements for disclosure of comprehensive income and becomes effective for the Company for its fiscal year 1999, with reclassification of earlier financial statements for comparative purposes. Comprehensive income generally represents all changes in stockholders' equity except those resulting from investments or contributions by stockholders. SFAS 130 requires unrealized gains or losses on the Company's available-for-sale securities, which prior to adoption were reported separately in stockholders' equity, to be included in other comprehensive income. The Company has adopted SFAS 130, however, the effects of the adoption were immaterial to all periods presented. In June 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 131 (SFAS 131), "Disclosures about Segments of an Enterprise and Related Information." This statement establishes standards for disclosures about operating segments in annual financial statements and selected information in interim financial reports. It also establishes standards for related disclosures about products and services, geographic areas and major customers. This statement supersedes statement of Financial Accounting Standards No. 14, "Financial Reporting for Segments of a Business Enterprise." The new standard becomes effective for the Company's fiscal year 1999, and requires that comparative information from earlier years be restated to conform to the requirements of this standard. The Company is evaluating the requirements of SFAS 131 and the effects, if any, on the Company's current reporting and disclosures. During October 1997, the Accounting Standards Executive Committee of the American Institute of Certified Public Accountants issued Statement of Position No. 97-2 (SOP 97-2), "Software Revenue Recognition." This statement delineates the accounting for software product and maintenance revenues. It supersedes Statement of Position No. 91-1, "Software Revenue Recognition," and is effective for transactions entered into in fiscal years beginning after December 15, 1997. The Company has evaluated the requirements of SOP 97-2 and its current revenue recognition policy is in compliance with this pronouncement. YEAR 2000 COMPLIANCE Many currently installed computer systems are not capable of distinguishing 21st century dates from 20th century dates. As a result, in less than two years, computer systems or applications used by many companies in a wide variety of industries will experience operating difficulties unless the systems or applications are modified to process information related to the century change adequately. Significant uncertainty exists in the software and other industries concerning the scope and magnitude of problems associated with the century change. To the extent Year 2000 issues cause significant delay in, or cancellation of, decisions to purchase the Company's products or product support, due to the relocation of resources to address Year 2000 issues or otherwise, the Company's business, results of operations and financial condition could be materially and adversely affected. Products Based on the Company's recent assessment of Year 2000 issues, the Company has determined that the current versions of its products are "Year 2000 compliant." In spite of the fact that the Company has not been a party to any litigation or any proceedings to date involving its products or services related to Year 2000 compliance issues, there can be no assurance that the Company will not in the future be required to defend its products or services in such proceedings, or to negotiate the resolution of claims based on Year 2000 issues. The costs of defending and resolving Year 2000-related disputes, and any liability of the Company for Year 11 14 2000-related damages, including consequential damages, could have a material adverse effect on the Company's business, results of operations and financial condition. Operations The Company is reviewing its internal management information and other systems in order to identify and modify those products, services or systems that are not Year 2000 compliant. The total cost of these Year 2000 compliance activities has not been material to date. There can be no assurance that the Company will identify and remedy all significant Year 2000 problems in a timely fashion, that remedial efforts in this regard will not involve significant time and expense, or that such problems will not have a material adverse effect on the Company's business, results of operations and financial condition. The Company faces additional risk to the extent that suppliers of products, services and systems purchased by the Company and others with whom the Company transacts business are not Year 2000 compliant. In the event that any such third parties can not provide the Company with products, services or systems that are Year 2000 compliant on a timely basis, or in the event Year 2000 issues prevent such third parties from delivering products, services or systems required by the Company on a timely basis, the Company's business, results of operations and financial condition could be materially and adversely affected. RISK FACTORS The Company operates in a rapidly changing environment that involves numerous risks, a number of which are beyond the Company's control. The following discussion highlights some of those risks. A comprehensive summary of the risks can be found in the Company's Annual Report on Form 10-K for the fiscal year ended May 31, 1998 and the Company's definitive Proxy Statement on Schedule 14A as filed on August 27, 1998. History of Losses; Strategic Realignment. Since inception, the Company has incurred significant losses and substantial negative cash flow. The Company was founded in 1988, and historically derived the substantial majority of its revenues from the licensing of high-priced, custom search and retrieval applications for use almost entirely by large organizations and government agencies. During these years, the Company also generated a substantial portion of its revenues by providing the consulting services required to support these products. In early fiscal 1994, the Company shifted its strategy to focus increasingly on more versatile, lower-priced software applications, which require less specialized consulting. To achieve revenue growth, the Company must, among other things, increase market acceptance of the Company's technology, achieve significantly increased sales levels, respond effectively to competitive developments, continue to attract, retain and motivate qualified persons, and continue to upgrade its technologies and commercialize products and services incorporating such technologies. There can be no assurance that the Company's strategy will be successful or that the Company will experience increased revenues or become profitable or cash flow positive at any time in the future. Management in Transition; Employee Turnover. The Company is experiencing a period of transition and new product introductions that have placed, and will continue to place, a significant strain on its resources, including personnel. During the past few years, management and other personnel have focused on modifying and enhancing the Company's core technology to support a broader set of search and retrieval solutions for use on desktop and enterprise-wide systems, and over online services, the Internet and on CD-ROM. In order for the Company's strategy to succeed, the Company must, among other things, leverage its core technology to develop new product offerings by the Company and by its original equipment manufacturer ("OEM") customers that address the needs of these new markets. Many of the Company's products are still being developed or have only recently been introduced, and there is no assurance that such products will be successfully completed on a timely basis, will achieve market acceptance or will generate significant revenues. Projects relating to these efforts, including Verity's suite of products, continued enhancement of the functionality of the Company's search engine and related products, and technical integration of the Company's products with the products of the Company's strategic partners, when added to the day-to-day activities of the Company, will continue to strain the Company's resources and personnel. 12 15 In connection with its strategy, the Company has also replaced the majority of its work force and substantially reorganized all of the departments within the Company. Continuity of personnel can be an important factor in the successful completion of the Company's development projects, and ongoing turnover in the Company's research and development personnel could materially and adversely impact the Company's development and marketing efforts. The Company believes that hiring and retaining qualified individuals at all levels in the Company is essential to its success, and there can be no assurance that the Company will be successful in attracting and retaining the necessary personnel. As noted above, the Company has experienced significant turnover, including turnover of several senior members of management. In particular, on July 31, 1997, Mr. Gary J. Sbona was appointed as the Company's President and Chief Executive Officer, and the Company entered into an agreement with Regent Pacific Management Corporation, a management firm of which Mr. Sbona is the Chief Executive Officer. Pursuant to the original agreement, Regent Pacific agreed to provide management services to the Company, including the services of Mr. Sbona as Chief Executive Officer and President and at least three other Regent Pacific personnel as part of the Company management team. The agreement had a one-year term and could be canceled by the Company after expiration of the initial 26-week period, with a minimum compensation to Regent Pacific of $1.3 million for that initial period. On April 13, 1998, the Company and Regent Pacific agreed to amend the agreement to provide that Mr. Sbona and at least four other Regent Pacific personnel would serve as part of the Company's management team. The amendment also served to extend the term of the agreement until August 31, 1999, and to extend the noncancelable period of the agreement until February 28, 1999. In connection with Mr. Sbona's service as President and CEO of the Company, the Compensation Committee of the Company's Board also granted to him an option to purchase 350,000 shares of the Company's common stock at an exercise price of $5.125 per share. The shares subject to such option will vest on a monthly basis during the 13-month period ending on February 28, 1999, subject to Mr. Sbona's continued employment as the Company's President and CEO; provided, however, that the option will vest entirely upon certain change of control transactions or upon a termination of Mr. Sbona without cause. The option will also remain exercisable for one year following the termination of Mr. Sbona's services. If Company management is unable to effectively manage the Company's operations, identify opportunities in a timely fashion, and evaluate and manage the Company's business and competitive position, results of operations and financial condition will be materially and adversely affected. Fluctuations in Operating Results. The Company's quarterly operating results have varied and are expected to vary significantly in the future. These fluctuations may be caused by many factors, including, among others, the size and timing of individual orders; customer order deferrals in anticipation of new products; changes in the budgets or purchasing patterns of government agencies; timing of introduction or enhancement of products by the Company or its competitors; market acceptance of new products; technological changes in search and retrieval, database, networking, or communications technology; competitive pricing pressures; changes in the Company's operating expenses; personnel changes; foreign currency exchange rates; mix of products sold; quality control of products sold; and general economic conditions. A significant portion of the Company's revenues in recent quarters have been derived from relatively large sales to a limited number of customers, and the Company currently anticipates that future quarters will continue to reflect this trend. Sales cycles for these customers can be up to six months or longer. In addition, like many software companies, the Company has generally recognized a substantial portion of its revenues in the last month of each quarter, with these revenues concentrated in the last weeks of the quarter. Accordingly, the cancellation or deferral of even a small number of purchases of the Company's products could have a material adverse effect on the Company's business, results of operations and financial condition in any particular quarter. To the extent that significant sales occur earlier than expected, operating results for subsequent quarters may fail to keep pace or even decline. Product revenues are also difficult to forecast because the market for search and retrieval software is uncertain and evolving. Because the Company generally ships software products within a short period after receipt of an order, the Company typically does not have a material backlog of unfilled orders, and revenues in any quarter are substantially dependent on orders booked in that quarter. In addition, a portion of the Company's revenues is derived from royalties based upon sales by third-party vendors of products incorporating the Company's technology. These revenues may be subject to extreme fluctuation and are difficult for the 13 16 Company to predict. The Company's expense levels are based, in part, on its expectations as to future revenues and to a large extent are fixed. Therefore, the Company may be unable to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Any significant shortfall of demand in relation to the Company's expectations or any material delay of customer orders would have an almost immediate adverse affect on the Company's operating results and on the Company's ability to achieve profitability. As a result of the foregoing and other factors, the Company believes that period-to-period comparisons of its results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. Fluctuations in operating results have in the past, and may in the future, also result in volatility in the price of the shares of the Company's Common Stock. Litigation. On March 11, 1998, the Company announced that it had filed a lawsuit in the United States District Court for the District of Delaware against Lotus Development Corporation for copyright infringement, unfair competition, breach of a 1992 agreement under which Verity licensed certain software to Lotus, misappropriation of trade secrets and unjust enrichment and conversion. On June 8, 1998, Verity, Inc. and Lotus Development Corporation announced that they have concluded a settlement agreement that makes available to Lotus a range of Verity technologies for use with Lotus products. The settlement agreement resolves issues that had arisen between the two companies. Accordingly, the Company has withdrawn its legal action against Lotus Development Corporation by virtue of a settlement agreement dated June 8, 1998. Developing Market; Unproven Acceptance of the Company's Products. The Company's development efforts are focused on expanding Verity's suite of products, designing enhancements to the Company's core technology, and addressing additional technical challenges inherent in developing new applications for enterprise, e-commerce, OEM and sophisticated CD-ROM publishing markets. The Company plans to undertake development of further enhancements of the search performance, scalability, functionality and deployability of its products. There is no assurance that such products will be developed and released on a timely basis, or that such products will achieve market acceptance. As is typical in the case of a new and evolving industry, demand and market acceptance for recently introduced products and services are subject to a high level of uncertainty. The software industry addressing the information management requirements of networked systems, CD-ROM, online services and the Internet is young and has few proven products. Moreover, critical issues concerning the commercial use of online services and the Internet (including security, reliability, cost, ease of use and access, and quality of service) remain unresolved and may impact the growth of the Internet and online markets, together with the software standards and electronic media employed in such markets. The Company's future operating results will depend in substantial part upon its ability to increase the installed base of its intelligent search and filtering technology and to begin to generate significant product revenues from its CD Publisher, Information Server, Agent Server, KeyView products and other products addressing the information retrieval and viewing requirements of individuals and corporations from data sources within an enterprise and on CD-ROM, online services and the Internet. The Company's future operating results will also depend upon its ability to successfully market its technology to online and Internet publishers who use such technology to index their published information in the format used by Verity. To the extent that such publishers do not adopt the Company's technology for indexing their published information, users will be unable to search such information using the Company's search and retrieval products, which in turn will limit the demand for the Company's products. Because the market for certain of the Company's products and services is new and evolving, it is difficult to assess or predict with any assurance the growth rate, if any, and size of this market. There can be no assurance that the market for the Company's products and services will develop, or that the Company's products or services will achieve market acceptance. If the market fails to develop, develops more slowly than expected or becomes saturated with competitors, or if the Company's products do not achieve significant market acceptance, the Company's business, operating results and financial condition will be materially and adversely affected. 14 17 A significant element of the Company's strategy is to embed Verity's technology in products offered by the Company's OEM customers. Many of the markets for such products are also new and evolving and, therefore, subject to the same risks faced by the Company in the markets for its own products. In addition, consolidation in the industries served by the Company could, and acquisition or development by any of the Company's significant customers of technology competitive with the Company's would, materially and adversely affect the Company's business and prospects. Dependence on International Operations. Revenues derived from European operations accounted for 10.6% and 5.5%, respectively, for the three months ended August 31, 1997 and 1998. For the three months ended August 31, 1997 and 1998, export sales accounted for 21.9% and 22.4% of total revenues, respectively. The decrease in revenues from European operations as a percentage of total revenues resulted primarily from the increased domestic revenues. The Company expects that revenues derived from European operations and export sales will continue to account for a significant percentage of the Company's revenues for the foreseeable future; however, these revenues may fluctuate significantly as a percentage of revenues from period to period. Certain of these revenues have been derived from sales to foreign government agencies, which may be subject to risks similar to those described below. There are a number of risks inherent in the Company's international business activities, including unexpected changes in regulatory requirements, tariffs and other trade barriers, costs and risks of localizing products for foreign countries, longer accounts receivable payment cycles, potentially adverse tax consequences, limits on repatriation of earnings and the burdens of complying with a wide variety of foreign laws. Additionally, the Company does not engage in hedging activities to protect against the risk of currency fluctuations. Fluctuations in currency exchange rates could cause sales denominated in U.S. dollars to become relatively more expensive to customers in a particular country, leading to a reduction in sales or profitability in that country. Also, such fluctuations could cause sales denominated in foreign currencies to affect a reduction in the current U.S. dollar revenues derived from sales in a particular country. Furthermore, future international activity may result in increased foreign currency denominated sales and, in such event, gains and losses on the conversion to U.S. dollars of accounts receivable and accounts payable arising from international operations may contribute significantly to fluctuations in the Company's results of operations. The financial stability of foreign markets could also affect the Company's international sales. In addition, revenues of the Company earned in various countries where the Company does business may be subject to taxation by more than one jurisdiction, thereby adversely affecting the Company's earnings. There can be no assurance that such factors will not have an adverse effect on the revenues from the Company's future international sales and, consequently, the Company's results of operations. Dependence on United States Government and the Risk of Contract Termination. Agencies of the United States government have accounted for a significant portion of the Company's revenues. Specifically, these agencies accounted for approximately 8.8% and 3.8% of revenues for the three months ended August 31, 1997 and 1998, respectively. Sales to government agencies fluctuated as a percentage of revenues during these periods, and may decline in the future. In recent years, budgets of many government agencies have been reduced, causing certain customers and potential customers of the Company's products to re-evaluate their needs. Such budget reductions are expected to continue over at least the next several years. Future reductions in United States spending on information technologies could have a material adverse effect on the Company's operating results. Almost all of the Company's government contracts contain termination clauses, which permit contract termination upon the Company's default or for convenience of the other contracting party. There can be no assurance such cancellations will not occur in the future, and any such termination could adversely affect the Company's operating results. Technological Change; Market Acceptance of Evolving Standards. Historically, the Company has derived substantially all of its revenues from the license of custom search and retrieval applications and consulting and other services related to such applications. Recently, the Company has refined and enhanced its core technology to add functionality and facilitate incorporation of the Company's technology in a variety of applications addressing the desktop, CD-ROM, enterprise, online and Internet markets. Nevertheless, the 15 18 Company expects that for the foreseeable future it will continue to derive the largest portion of its revenues from licensing its technology for enterprise applications. The computer software industry is subject to rapid technological change, changing customer requirements, frequent new product introductions and evolving industry standards that may render existing products and services obsolete. As a result, the Company's position in its existing markets or other markets that it may enter could be eroded rapidly by product advancements by competitors. The life cycles of the Company's products are difficult to estimate. The Company's future success will depend, in part, upon its ability to enhance existing products and to develop new products on a timely basis. In addition, its products must keep pace with technological developments, conform to evolving industry standards, particularly client/server and Internet communication and security protocols, as well as publishing formats such as Hypertext Markup Language ("HTML"), and address increasingly sophisticated customer needs. There can be no assurance that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of new products, or that new products and product enhancements will meet the requirements of the marketplace and achieve market acceptance. If the Company is unable to develop and introduce products in a timely manner in response to changing market conditions or customer requirements, the Company's financial condition and results of operations would be materially and adversely affected. In addition, a significant strategy of the Company is to achieve compatibility between the Company's products and the text publication formats the Company believes are or will become popular and widely adopted. The Company invests substantial resources in development efforts aimed at achieving such compatibility. Any failure by the Company to anticipate or respond adequately to technology or market developments could result in a loss of competitiveness or revenue. For instance, to date the Company has focused its efforts on integration with the Adobe PDF and Lotus Notes environments and, more recently, the Microsoft Exchange environment. Should any of these products or technologies lose or fail to achieve acceptance in the marketplace or be replaced by other products or technologies, the Company's business could be materially and adversely affected. Because one of the Company's strategies is to embed its basic search engine in key OEM application products, the Company's sales of its intelligent search and filtering products depend in part on its ability to maintain compatibility with these OEM applications. There is no assurance that the Company will be able to maintain compatibility with these vendors' products or continue to be the search technology of choice for such OEMs, and the failure to maintain compatibility with or be selected by such OEMs would materially and adversely affect the Company's sales. Further, the failure of the products of the Company's key OEM partners to achieve market acceptance could have a material adverse effect on the Company's results of operations. Software products as complex as those offered by the Company may contain errors that may be detected at any point in the products' life cycles. The Company has in the past discovered software errors in certain of its products and has experienced delays in shipment of products during the period required to correct these errors. There can be no assurance that, despite testing and quality assurance efforts by the Company and by current and potential customers, errors will not be found, resulting in loss of or delay in market acceptance and sales, diversion of development resources, injury to the Company's reputation, or increased service and warranty costs, any of which could have a material adverse effect on the Company's business, results of operations and financial condition. Although the Company generally attempts to limit by contract its exposure to incidental and consequential damages, and to cap the Company's liabilities under the contract, if a court failed to enforce the liability limiting provisions of the Company's contracts for any reason, or if liabilities arose which were not effectively limited, the Company's operating results could be materially and adversely affected. 16 19 PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On March 11, 1998, the Company announced that it had filed a lawsuit in the United States District Court for the District of Delaware against Lotus Development Corporation for copyright infringement, unfair competition, breach of a 1992 agreement under which Verity licensed certain software to Lotus, misappropriation of trade secrets, and unjust enrichment and conversion. On June 8, 1998, Verity, Inc. and Lotus Development Corporation announced that they have concluded a settlement agreement that makes available to Lotus a range of Verity technologies for use with Lotus products. The settlement agreement resolves issues that had arisen between the two companies. Accordingly, the Company has withdrawn its legal action against Lotus Development Corporation by virtue of a settlement agreement dated June 8, 1998. ITEM 2. CHANGES IN SECURITIES Not Applicable. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company's Annual Meeting of Stockholders was held on September 24, 1998. Proxies for the meeting were solicited pursuant to Regulation 14A. At the meeting, management's nominee for director and three proposals were submitted to the stockholders of the Company. Management's nominee for director was elected by the following vote: SHARES ---------------------- NOMINEE VOTING FOR WITHHELD ------- ---------- -------- Gary J. Sbona.................................. 9,456,089 107,864 Steven M. Krausz, Charles P. Waite, Jr. and Stephen A. MacDonald continued to serve as directors of the Company after the annual meeting. Mr. Krausz and Mr. Waite will continue to serve until the Annual Meeting of Stockholders to be held in 1999, and Mr. MacDonald will continue to serve until the Annual Meeting of Stockholders to be held in 2000. A second proposal to amend the 1995 Stock Option Plan (the "Option Plan") of the Company to increase the number of shares of Common Stock of the Company authorized for issuance thereunder from 3,310,836 shares to 4,060,836 shares, was submitted to a vote of the stockholders of the Company. The proposal was approved by the following vote: FOR THE PROPOSAL AGAINST THE PROPOSAL ABSTENTIONS BROKER NON-VOTES - ---------------- -------------------- ----------- ---------------- 2,431,021 1,241,356 38,058 5,853,518 A final proposal to ratify the selection of PricewaterhouseCoopers LLP as independent accountants of the Company for its fiscal year ending May 31, 1999 was also submitted to a vote of the stockholders of the Company. The proposal was approved by the following vote: FOR THE PROPOSAL AGAINST THE PROPOSAL ABSTENTIONS BROKER NON-VOTES - ---------------- -------------------- ----------- ---------------- 9,548,340 4,905 10,708 0 ITEM 5. OTHER INFORMATION Not Applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K A. Exhibits -- See Exhibit Index B. Reports on Form 8-K None. 17 20 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 thereunto duly authorized. VERITY, INC. By: /s/ JAMES E. TICEHURST ------------------------------------ James E. Ticehurst Vice President, Administration and Controller (Principal Financial Officer) Dated: October 6, 1998 18 21 EXHIBIT INDEX EXHIBIT SEQUENTIAL NUMBER DESCRIPTION OF DOCUMENT PAGE NO. - ------- ----------------------- ---------- 2.1 Form of Agreement and Plan of Merger between Verity, Inc., a California corporation, and Verity Delaware Corporation, a Delaware corporation, filed September 22, 1995.(1).......... 2.2 Agreement and Plan of Reorganization dated January 10, 1997 among Verity, Inc., Cognisoft Acquisition Corporation and Cognisoft Corporation, and certain shareholders of Cognisoft.(7)............................................... 2.3 Form of Stock Purchase Agreement dated as of May 31, 1997 among Verity, 64k and certain shareholders of 64k.(8)....... 2.4 Agreement for Purchase and Sale of Assets dated as of May 30, 1997 among FTP US, FTP Canada, Verity US and Verity Canada.(9).................................................. 3.1 Certificate of Incorporation of the Company.(1)............. 3.2 By-Laws.(1)................................................. 3.3 Certificate of Retirement of Series of Preferred Stock.(7)................................................... 3.4 Certificate of Designation, Preferences and Rights of Series A Preferred Stock.(7)....................................... 4.1 Amended and Restated Rights Agreement dated August 1, 1995, as amended.(1).............................................. 4.2 Form of Rights Agreement between Verity, Inc. and First National Bank of Boston dated September 18, 1996.(6)........ 10.1 Form of Indemnification Agreement for directors and officers.(1)................................................ 10.2 Amended and Restated 1995 Stock Option Plan and forms of agreements thereunder.(7)................................... 10.3 1995 Employee Stock Purchase Plan.(1),(4)................... 10.4 1995 Outside Directors Stock Option Plan and forms of agreement thereunder.(1),(4)................................ 10.5 Employment Agreement between Philippe F. Courtot and the Company dated July 15,1993, together with related Amended and Restated Stock Purchase Agreement dated as of June 1, 1995.(1),(4)................................................ 10.7 Series G Preferred Stock Purchase Agreement dated August 29, 1994.(2).................................................... 10.8 Series H Preferred Stock Purchase Agreement dated August 1, 1995.(2).................................................... 10.18 Lease Agreement between Ross Drive Investors and the Company dated January 22, 1996.(3).................................. 10.19 Retainer Agreement between Regent Pacific Management Corporation and Verity, Inc. dated July 13, 1997.(10)....... 10.20 Confidential Severance Option Agreement between Verity, Inc. and Richard Lo dated August 20, 1997.(10)................... 10.21 Employment Agreement between Anthony J. Bettencourt and the Company dated August 28, 1997.(11).......................... 10.22 Security and Loan Agreement between Imperial Bank and the Company dated November 30, 1997.(12)........................ 10.23 Amendment to Retainer Agreement between Regent Pacific Management Corporation and Verity, Inc. dated February 1, 1998.(13)................................................... 27.1 Financial Data Schedule..................................... 19 22 - --------------- (1) Incorporated by reference from the exhibits with corresponding numbers from the Company's Registration Statement (No. 33-96228), declared effective on October 5, 1995. (2) Incorporated by reference from the exhibits with corresponding numbers from the Company's Registration Statement (No. 33-80567), declared effective on January 17, 1996. (3) Incorporated by reference from the exhibits with corresponding numbers from the Company's Form 10-Q for the quarter ended February 29, 1996. (4) Management contract or compensatory plan covering executive officers and directors of the Company. (5) Confidential Treatment has been granted for portions of these exhibits. (6) Incorporated by reference from exhibit no. 1 from the Company's Form 8-K as filed with the Securities and Exchange Commission on October 10, 1996. (7) Incorporated by reference from the exhibits with corresponding numbers from the Company's Form 10-Q for the quarter ended August 31, 1996. (8) Relating to the 64k acquisition, incorporated by reference from Exhibit No. 2.1 to the Company's report on Form 8-K as filed with the Securities and Exchange Commission on June 13, 1997. (9) Relating to the KeyView acquisition, incorporated by reference from Exhibit No. 2.1 to the Company's report on Form 8-K as filed with the Securities and Exchange Commission on June 13, 1997. (10) Incorporated by reference from the exhibits with corresponding numbers from the Company's Form 10-K for the year ended May 31, 1997. (11) Incorporated by reference from the exhibits with corresponding numbers from the Company's Form 10-Q for the quarter ended August 31, 1997. (12) Incorporated by reference from the exhibits with corresponding numbers from the Company's Form 10-Q for the quarter ended February 28, 1998. (13) Incorporated by reference from the exhibits with corresponding numbers from the Company's Form 10-K for the year ended May 31, 1998. 20