1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [ X ] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTER ENDED MARCH 31, 1997 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER 0-26536 SMITH MICRO SOFTWARE, INC. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 33-0029027 (STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER) 51 COLUMBIA, SUITE 200, ALISO VIEJO, CA 92656 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE) REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (714) 362-5800 SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, $.001 PAR VALUE Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES (X) NO ( ) As of April 30, 1997, there were 14,074,698 shares of Common Stock outstanding. 2 SMITH MICRO SOFTWARE, INC. FORM 10-Q TABLE OF CONTENTS PART I. FINANCIAL INFORMATION UNAUDITED CONSOLIDATED BALANCE SHEETS AS OF MARCH 31, 1997 AND DECEMBER 31, 1996 3 UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS FOR THE THREE MONTHS ENDED MARCH 31, 1997 AND MARCH 31, 1996 4 UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE THREE MONTH PERIODS ENDED MARCH 31, 1997 AND MARCH 31, 1996 5 NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 7 MANAGEMENT'S DISCUSSION AND ANALYSIS 9 PART II OTHER INFORMATION ITEM 1. EXHIBITS AND REPORTS ON FORM 8-K 26 SIGNATURES 29 FORWARD LOOKING STATEMENTS The statements contained in this Quarterly Report on Form 10-Q (the "Form 10-Q") which are not statements of historical fact may be forward looking statements subject to a number of risks and uncertainties. The following factors, together with those additional risks discussed in this Form 10-Q (particularly in "Risk Factors" commencing on page 15), could cause actual results of the Company to materially differ from those anticipated by forward looking statements set forth in this Form 10-Q: demand for communication software; demand for modems and other electronic communication devices; national, regional and international economic conditions affecting the supply of and demand for communication software, modems or offerings by the Company; the Company's ability to compete in and sell its products through the retail channel and OEM distribution channel; the Company's ability to compete and sell its products through the corporate and government marketplaces; demand for the Company's products; the Company's ability to maintain its customer base and to expand that base; and the Company's ability to anticipate and adjust to technological shifts and changes in the electronic communication software and hardware industries. All forward looking statements contained in this Form 10-Q should be considered in light of these and any other factors which might cause the Company's future performance to materially differ from that anticipated by this Form 10-Q. 2 3 PART I - FINANCIAL INFORMATION SMITH MICRO SOFTWARE, INC. CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) MARCH 31, DECEMBER 31, 1997 1996 --------- ------------ (UNAUDITED) CURRENT ASSETS Cash & Cash Equivalents $ 12,939 $ 14,487 Accounts Receivable, net of allowances for doubtful accounts and other adjustments of $2,879 (1997) and $1,822 (1996) 5,265 6,017 Income Tax Receivable 1,252 520 Deferred Tax Asset 850 850 Inventories 568 561 Prepaids and Other Assets 598 415 -------- -------- Total Current Assets 21,472 22,850 Equipment and Improvements, net 527 548 Intangible Assets, net 656 709 -------- -------- 1,183 1,257 -------- -------- TOTAL ASSETS $ 22,655 $ 24,107 ======== ======== LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES Accounts Payable $ 1,413 $ 892 Accrued Liabilities 434 1,223 -------- -------- Total Current Liabilities 1,847 2,115 DEFERRED TAX LIABILITY 162 162 COMMITMENTS AND CONTINGENCIES STOCKHOLDERS' EQUITY Preferred stock, par value $.001 per share: authorized 5,000,000 shares; none issued and outstanding -- -- Common stock, par value $.001 per share: authorized 20,000,000 shares; issued and outstanding 14,074,700 (1997) and 14,074,000 (1996) 14 14 Additional paid-in capital 21,250 21,250 Retained Earnings (Deficit) (618) 566 -------- -------- Total Stockholder's Equity 20,646 21,830 -------- -------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 22,655 $ 24,107 ======== ======== SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 3 4 SMITH MICRO SOFTWARE, INC. UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) FOR THE THREE MONTHS ENDED MARCH 31, 1997 1996 -------- -------- Net Revenues $ 2,658 $ 7,290 Cost of Revenues 1,246 2,899 -------- -------- Gross Profit 1,412 4,391 Operating Expenses: Sales & Marketing 995 608 Research & Development 882 504 Acquired R & D Expenses 5,169 General & Administrative 1,536 804 -------- -------- Total Operating Expenses 3,413 7,085 Operating Loss (2,001) (2,694) Other Income, net 180 207 -------- -------- Loss Before Income Tax (1,821) (2,487) Income Tax Expense (Benefit) (637) 1,073 -------- -------- Net Loss $ (1,184) $ (3,560) ======== ======== Net Loss per share $ (.08) $ (.26) ======== ======== Weighted Average Shares Outstanding 14,074 13,814 SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 4 5 SMITH MICRO SOFTWARE, INC. UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) FOR THE THREE MONTHS ENDED MARCH 31, 1997 1996 ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net Loss ($1,184) ($ 3,560) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Write-off of in process research and development due to the acquisition of Performance Computing Incorporated -- 5,169 Depreciation and Amortization 132 70 Provision for doubtful accounts and other adjustments to accounts receivable 1,057 (120) Deferred income taxes Change in Operating Accounts: Accounts Receivable, net (309) (1,673) Income Tax Receivable (732) -- Interest receivable -- Inventories (7) (121) Prepaid Expenses and Other Current (183) (6) Intangibles (1) -- Accounts Payable 521 444 Accrued Liabilities (789) 376 Income Tax Payable 891 -------- -------- Net Cash Provided (Used in) Operating Activities (1,491) 1,470 CASH FLOWS FROM INVESTING ACTIVITIES: Acquisition of PCI -- (2,100) Capital Expenditures (57) (59) -------- -------- Net Cash Used in Investing Activities (57) (2,159) CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from stock offering -- -- Distributions to S Corporation stockholders -- -- Proceeds from the Exercise of Stock Options -- -- Repayment of Notes Payable to Founders -- (1,935) -------- -------- Net Cash Used in Financing Activities -- (1,935) -------- -------- NET CHANGE IN CASH & CASH EQUIVALENTS ($ 1,548) ($ 2,626) CASH & CASH EQUIVALENTS, Beginning of Period $ 14,487 $ 19,020 -------- -------- CASH & CASH EQUIVALENTS, End of Period $ 12,939 $ 16,394 ======== ======== 5 6 For The Three Months Ended March 31, 1997 1996 ---- ---- SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION Cash paid during the period for: Interest -- $ 41 Income taxes -- 180 Detail of businesses acquired in purchase transactions: Acquired in-process research and development $5,169 Fair value of assets acquired $ 796 Common Stock Issued in acquisition $2,944 Cash paid for acquisition $2,100 Liabilities assumed or created $ 921 SEE NOTES TO CONSOLIDATED FINANCIAL STATEMENTS. 6 7 SMITH MICRO SOFTWARE, INC. NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Basis of Presentation - The accompanying unaudited consolidated financial statements have been prepared by Smith Micro Software, Inc. (the "Company") pursuant to Securities and Exchange Commission regulations. On March 14, 1996, the Company acquired Performance Computing Incorporated (PCI), a video software application provider. The periods presented in the financial statements include PCI's operations from the date of acquisition. In the opinion of management, such information contains all adjustments, necessary for a fair presentation of the results of such periods. These financial statements should be read in conjunction with the audited financial statements included in the Company's report on Form 10-K for the year ended December 31, 1996. Cash Equivalents - Cash equivalents are considered to be highly liquid investments with initial maturities of 3 months or less. Accounts Receivable - The Company sells its products worldwide. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. The Company maintains reserves for potential credit losses, and those losses have been within management's expectations. Allowances for product returns and price protection are included in other adjustments to accounts receivable on the accompanying balance sheets. Inventories - Inventories consist principally of manuals and diskettes and are stated at the lower of cost (determined by the first- in, first-out method) or market. Equipment and Improvements - Equipment and Improvements are stated at cost. Depreciation is computed using the straight-line method based on the estimated useful lives of the assets, generally ranging from three to seven years. Leasehold improvements are amortized using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. Intangible Assets - Intangible assets relate primarily to goodwill, existing technology and noncompete agreements, which are amortized over periods ranging from three to five years. Revenue Recognition - The Company recognizes revenues from sales of its software as completed products are shipped and from royalties from customers who are authorized to duplicate the Company's software as the individual duplication rights are granted. The Company generally allows its retail distributors to exchange unsold products for other products and provides inventory price protection in the event of price reductions by the Company. Allowances for product returns and price protection are estimated based on previous experience and are recorded as a reduction of revenue at the time sales are recognized. The Company provides technical support and customer services to its customers. Such costs have historically been insignificant. Income Taxes - The Company accounts for income taxes under Statement of Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes. This statement requires the recognition of deferred tax assets and liabilities for the future consequences of events that have been recognized in the Company's financial statements or tax returns. 7 8 The measurement of the deferred items is based on enacted tax laws. In the event the future consequences of differences between financial reporting bases and the tax bases of the Company's assets and liabilities result in a deferred tax asset, SFAS No. 109 requires an evaluation of the probability of being able to realize the future benefits indicated by such asset. A valuation allowance related to a deferred tax asset is recorded when it is more likely than not that some portion or all of the deferred tax asset will not be realized. Software Development Costs - Development costs incurred in the research and development of new software products and enhancements to existing software products are expensed as incurred until technological feasibility has been established. The Company considers technological feasibility to be established when all planning, designing, coding and testing has been completed according to design specifications. After technological feasibility is established, any additional costs are capitalized. Through December 31, 1996, software has been substantially completed concurrently with the establishment of technological feasibility; and, accordingly, no costs have been capitalized to date. Fair Value of Financial Instruments - Pursuant to SFAS No. 107, Disclosures about Fair Value of Financial Instruments, the Company is required to estimate the fair value of all financial instruments included on its balance sheet at December 31, 1996. The Company considers the carrying value of such amounts in the financial statements to approximate their fair value due to (1) the relatively short period of time between origination of the instruments and their expected realization, (2) interest rates which approximate current market rates, or (3) the overall immateriality of the amounts. Stock-Based Compensation - The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees. Per Share Information - Net loss per share is based on the weighted average number of shares of common stock and common stock equivalents (stock options) outstanding during the period. For the three months ended March 31, 1997, and 1996, common stock equivalents were excluded from the computation as the effect was anti-dilutive. Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting years. Actual results could differ from those estimates. 2. NEW ACCOUNTING PRONOUNCEMENT In February 1997, the Financial Accounting Standards board issued Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share", which is effective for financial statements for both interim and annual periods ending after December 15, 1997. Early adoption of the statement is not permitted. The Company has determined that the adoption of this statement would not have had a material impact on the earnings per share calculation for the periods presented. 8 9 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL Smith Micro was founded in March 1982 to design and market financial software. In the mid-1980s, the Company shifted its focus to communication software for modem manufacturers. The Company shipped its first data communication software product in 1985 and, since that time, the Company's growth in revenues has been the result of the market acceptance of its data, fax and video communication software products. The Company recognizes revenues from sales of its software as completed products are shipped and from royalties from customers who are authorized to duplicate the Company's software. The Company expects that revenues from its QuickLink products will continue to account for a substantial portion of the Company's revenues. The Company believes that the video and retail based products will also represent a substantial portion of the revenue in the future. Any material reduction in demand for the Company's products would have a material adverse effect on the Company's business, results of operations and financial condition. The Company has continued to expand its business by introducing new products and its future success will depend in part on the continued introduction of new and enhanced OEM and retail products that achieve market acceptance. Revenues are net of estimated returns and other adjustments at the time the products are shipped. The Company has allowed its customers to return unused software, constituting 2.3% and 16.8% of the Company's net revenues for 1995 and 1996, respectively. The increase in returns during 1996 is primarily the result of the increased volume of business in the retail distribution channel which has experienced a higher rate of returns than the OEM channel. A small number of customers have historically accounted for a substantial portion of the Company's revenues. Sales to U.S. Robotics (including, for 1995, sales to Megahertz which U.S. Robotics acquired in February 1995), in particular, which became a customer in the fourth quarter of 1993, accounted for approximately 36%, 52%, 46% and 51% of the Company's net revenues for the years ended 1994, 1995, 1996, and the three months ended March 31, 1997, respectively. During 1994, 1995 and 1996, the Company's three largest customers, including U.S. Robotics, accounted for approximately 57%, 67% and 71%, respectively, of net revenues. For the three months ended March 31, 1997 the Company's three largest customers, including U.S. Robotics, accounted for approximately 73% of net revenues. Any reduction, delay or change in orders from such customers could have a material adverse affect on the Company's business, results of operations and financial condition. In April 1996, the Company entered into an OEM agreement having an initial one year term with U.S. Robotics Access Corp., one of several wholly-owned subsidiaries of U.S. Robotics Corporation which agreement superseded the previous agreement between the parties. The agreement renews automatically at the end of each one year term unless either party provides at least 60 days notice of its intention to terminate the agreement at the end of the then-current term. Under the terms of the agreement, the Company granted certain pricing incentives to U.S. Robotics Access Corp. in consideration for which the Company became the exclusive provider of fax, data, voice and telephony communications software for certain U.S. Robotics modems. In addition, under the terms of the agreement, U.S. Robotics Access Corp. has agreed to place Smith Micro retail products and commercials for such products on certain U.S. Robotics compact disks. Moreover, the agreement does not 9 10 require U.S. Robotics Access Corp. or any other U.S. Robotics-affiliated entity to purchase any minimum quantity of Smith Micro products and may be terminated by either party at any time for any reason upon 90 days written notice. As a result, there can be no assurance that U.S. Robotics will continue to purchase the Company's products. While the Company believes that it has been the principal supplier of OEM communication software products to U.S. Robotics (excluding Megahertz), there can be no assurance that U.S. Robotics will not seek additional sources for such products in the future. Accordingly, there can be no assurance that sales to U.S. Robotics will reach or exceed historical levels in any future period. A substantial decrease or delay in sales to U.S. Robotics would have a material adverse effect on the Company's business, results of operations and financial condition. Assuming the number of products sold to U.S. Robotics Access Corp. were to remain at 1996 levels, in light of the pricing incentives provided in the agreement, gross revenues from U.S. Robotics with respect to products covered by the agreement could be adversely affected, although the Company believes that net income attributable to such sales would not be impacted negatively. During February 1997, 3Com announced its intent to acquire U.S. Robotics. Upon completion, there can be no assurance that the acquisition will not result in a change in the resulting entity's purchasing habits, a decrease in orders, or delays in orders previously made by U.S Robotics, or the loss of that customer entirely. The Company entered into an agreement having an initial one-year term with Motorola in January 1996 to provide retail and OEM products to Motorola's PCMCIA Division and Information Systems Group. This agreement is automatically renewable for consecutive one-year terms, but either party may terminate the agreement at the end of the then-current term by providing 60 days notice to the other party. Moreover, as with the U.S. Robotics Access Corp. agreement, the Motorola agreement does not require Motorola to purchase any minimum quantity of Smith Micro products and, as a result, there can be no assurance that Motorola will order any additional products or that it will develop into a substantial customer of the Company. The OEM product ordering cycle beginning from placement of an order to shipping is very short. OEM customers generally operate under a just-in-time system and order software to be delivered as needed by their manufacturing operations. The Company's products are generally shipped as orders are received and, accordingly, the Company has historically operated with little backlog, and does not consider backlog to be a significant indication of future performance. As a result, sales in any quarter are dependent on orders booked and shipped in that quarter and are not predictable with any degree of certainty. Moreover, the Company does not generally produce software in advance of orders and therefore has not maintained a material amount of inventory. As the Company's retail sales have grown there has been an increase of inventory held by distributors and retail stores. As inventory in the retail channel builds it increases the Company's exposure to product returns. This exposure is considered when the allowance is made for product returns. Substantial returns of product from the retail channel could have a material adverse affect on the Company's business, results of operations and financial condition. On March 14, 1996, the Company acquired Performance Computing Incorporated ("PCI"). In connection with the acquisition, all the outstanding PCI shares were converted into the right to receive an aggregate of 350,000 shares of the Company's common stock, valued at $2,944,000, and $2,100,000 in cash 10 11 with an additional $800,000 payable to the seller group or at its direction contingent on the achievement of certain milestones. The $800,000 additional payment was accrued as part of the purchase price; all of the milestones have subsequently been met and the entire amount was paid subsequent to year-end. The Company also incurred direct costs of approximately $111,000 related to the acquisition. The Company obtained an independent valuation of the net assets acquired in the purchase transaction which resulted in the allocation of the purchase price to $996,000 of identified assets, $321,000 of liabilities and $5,169,000 of in-process research and development. As the technological feasibility of the in-process research and development had not been established and such technology had no alternative future use, the acquired in-process research and development was expensed in accordance with interpretation 4 of APB Opinion No. 16. The following discussion should be read in conjunction with, and is qualified in its entirety by, the Financial Statements and related notes thereto included elsewhere. Historical results of operations, percentage relationships and any trends that may be inferred from the discussion below are not necessarily indicative of the operating results for any future period. 11 12 RESULTS OF OPERATIONS The following table sets forth for the periods indicated, the percentages of net revenues represented by each item in the Company's statement of income. The proforma information for 1996, includes activity for Performance Computing Incorporated since March 15, 1996. Three Months Ended March 31, 1997 1996 ---- ---- Net revenues 100.0% 100.0% Cost of revenues 46.9 39.8 ----- ----- Gross profit 53.1 60.2 Operating expenses: Sales and marketing 37.4 8.3 Research and development 33.2 6.9 Acquired research and development 70.9 General and Administrative 57.8 11.0 ----- ----- Total operating expenses 128.4 97.2 Operating loss -75.3 -37.0 Other income, net 6.8 2.8 ----- ----- Loss before income tax expense -68.5 -34.1 Income tax expense 24.0 14.7 ----- ----- Net loss -44.5% -48.8% ===== ===== NET REVENUES Net revenues decreased 64%, from $7.3 million in the three months ended March 31, 1996 to $2.7 million in the three month period ended March 31, 1997. This decrease was primarily due to a broad based slowdown in the Company's OEM business as well as lower than expected increases in sell-through rates of the Company's retail products, which required increased rates for returns reserves. GROSS PROFIT Gross profit represents net revenues, less cost of revenues, which includes costs of materials, costs related to the operations of the Company's duplicating facilities, freight charges and royalties to licensers. Gross profit decreased $3.0 million from $4.4 million in the three months ended March 31, 1996, to $1.4 million in the three months ended March 31, 1997. As a percentage of net revenues, gross profits decreased 7% from 60% in the three months ended March 31, 1996, to 53% in the three months ended March 31, 1997. Margins for the Company decreased primarily due to the reduced mix of retail sales and increased rate of retail returns reserves, as well as the higher percentage of fixed overhead resulting from the lower sales volume. 12 13 SALES AND MARKETING EXPENSES Sales and marketing expenses consist primarily of personnel costs, advertising costs, sales commissions and trade show expenses. These expenses vary considerably from quarter to quarter based on the timing of trade shows and new product introductions. Sales and marketing expenses increased 64% from $608,000 in the three months ended March 31, 1996, to $995,000 in the three months ended March 31, 1997. The increase in sales and marketing expenses is primarily due to promotional campaigns in the retail channel as well as additional personnel. As a percent of net revenues, sales and marketing expenses increased to 37% from 8% of net revenues, primarily due to the decline in revenues. RESEARCH AND DEVELOPMENT EXPENSES Research and development expenses consist primarily of personnel and supply costs required to conduct the Company's software development activities. Research and development expenses rose 75% from $504,000 in the three months ended March 31, 1996, to $882,000 in the three months ended March 31, 1997. This increase is primarily due to the addition of staff as a result of the acquisition of PCI late in the first quarter of 1996. As a percent of net revenues, research and development expenses increased to 33% from 7% of net revenues, due to the additional staff mentioned above as well as the impact of reduced revenues. On March 14, 1996 the Company acquired PCI. In accordance with Interpretation 4 of APB Opinion No. 16, $5,169,000 of in-process research and development was expensed as of the date of the acquisition. GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses encompass expenses related to general operations, which are not included as costs of sales, sales and marketing or research and development. General and administrative expenses rose 91%, from $804,000 in the three months ended March 31, 1996, to $1,536,000 in the three months ended March 31, 1997. The majority of this increase is due to additional reserves for bad debt as the Company experienced slower overall payment patterns from customers. This was largely influenced by increased receivables from retail channel customers experiencing sluggish sales of videoconferencing products. The increase is also due to increased costs related to additional legal and professional fees and increased headcount in technical support. As a percent of net revenues, general and administrative expenses increased to 58% from 11% of net revenues, due to the factors mentioned above as well as the decrease in revenues. INCOME TAXES Income tax expense was $1,073,000 in the quarter ended March 31, 1996 based on pre-tax earnings of $2,682,000, prior to the one time charge for acquired research and development expenses. During the quarter ended March 31, 1997, the Company provided for a tax benefit of $637,000 based on a 35% estimated effective tax rate. 13 14 LIQUIDITY AND CAPITAL RESOURCES Since its inception, the Company has financed its operations primarily through cash generated from operations. Net cash used by operating activities was $691,000 in the three month period ended March 31, 1997 as compared to $1.5 million provided by operations in the three month period ended March 31, 1996. The primary use of cash during the three month period ended March 31, 1997 was the result of operating losses and the final PCI milestone payment. During the three month period ended March 31, 1996, the Company used $2.2 million in investing activities, primarily for the acquisition of PCI. At March 31, 1997, the Company had $13.0 million in cash and cash equivalents and $19.6 million of working capital. The Company had $5.2 million of accounts receivable, net of allowance for doubtful accounts and other adjustments. The Company has no significant capital commitments and currently anticipates that growth in capital expenditures will not vary significantly from recent periods. RISK FACTORS In addition to the other information contained in this Form 10-Q, the following risk factors should be considered in evaluating the Company and a decision to invest in the Company. This Form 10-Q contains forward looking statements which involve risks and uncertainties and the Company's actual results may materially differ from the results anticipated in those statements. Factors that might cause such a difference include, without limitation, those discussed in this section and elsewhere in this Form 10-Q. Fluctuations in Quarterly Operating Results. Certain of the Company's significant customers and other modem manufacturers have announced in recent quarters that there was an increase of inventory in the channel which may reduce their rates of growth during subsequent quarters. The rate at which this inventory is moved out of the channel could have a significant impact on the Company's operating results in future quarters. The Company's operating results have in the past fluctuated, and may in the future fluctuate, from quarter to quarter as a result of a number of factors including, but not limited to, the size and timing of orders from, and shipments to, major customers; the ability to maintain or increase gross margins; the ability of the Company's customers to obtain financing for the purchase of the Company's products; changes in pricing policies or price reductions by the Company or its competitors; variations in the Company's sales channels or the mix of product sales; the timing of new product announcements and introductions by the Company or its competitors and customers; the availability and cost of supplies; the financial stability of major customers; market acceptance of new products, applications and product enhancements; the Company's ability to develop, introduce and market new products, applications and product enhancements; the Company's ability to control costs; possible delays in the shipment of new products; the Company's success in expanding its sales and marketing programs; deferrals of customer orders in anticipation of new products, applications, product enhancements or operating systems; changes in Company strategy; personnel changes; and general economic factors. The Company's software products are generally shipped as orders are received and accordingly, the Company has historically operated with little backlog. As a result, sales in any quarter are dependent on orders booked and shipped in that quarter and are not predictable with any degree of certainty. In addition, the Company's expense levels are based, in part, on its expectations as to future revenues. If revenue 14 15 levels are below expectations, operating results are likely to be adversely affected. The Company's net income may be disproportionately affected by a reduction in revenues because of fixed costs related to generating its revenues. While the Company has not historically experienced seasonality in its sales, many of the Company's OEM customers experience seasonality in their sales, and the Company's sales may, in the future, be subject to seasonality particularly as its sales of retail products increase. Quarterly results in the future may be influenced by these or other factors and, accordingly, there may be significant variations in the Company's quarterly operating results. Further, the Company's historical operating results are not necessarily indicative of future performance for any particular period and there can be no assurance that the Company's recent revenue growth or its profitability will continue on a quarterly or annual basis. Due to all of the foregoing factors, it is possible that in some future quarter the Company's operating results may be below the expectations of public market analysts and investors. In such event, the price of the Company's Common Stock would likely be materially adversely affected. Reliance on U.S. Robotics. In 1994, 1995 and 1996, U.S. Robotics (including, with respect to 1995, Megahertz, which U.S. Robotics acquired in February 1995), represented 35.8%, 52.1%, and 46.4% respectively, of the Company's net revenues. The Company expects that U.S. Robotics, which became a customer in the fourth quarter of 1993, will continue to account for a significant portion of the Company's revenues in future periods. In April 1996, the Company entered into an OEM agreement with U.S. Robotics Access Corp., one of several wholly-owned subsidiaries of U.S. Robotics Corporation. This agreement was amended and restated in June of 1996 and runs until April 1997. This OEM agreement superseded the previous agreement between the parties. The agreement renews automatically at the end of each one year term unless either party provides at least 60 days notice of its intention to terminate the agreement at the end of the then-current term. Under the terms of the agreement, the Company granted certain pricing incentives to U.S. Robotics Access Corp. in consideration for which the Company became the exclusive provider of fax, data, voice and telephony communications software for certain U.S. Robotics modems. In addition, under the terms of the agreement, U.S. Robotics Access Corp. has agreed to place Smith Micro retail products and commercials for such products on certain U.S. Robotics compact disks. The agreement renews automatically at the end of each one year term unless either party provides at least 60 days notice of its intention to terminate the agreement at the end of the then-current term. Moreover, the agreement does not require U.S. Robotics Access Corp. or any other U.S. Robotics-affiliated entity to purchase any minimum quantity of Smith Micro products and moreover may be terminated by U.S. Robotics at any time for any reason upon 90 days written notice. As a result, there can be no assurance that U.S. Robotics will continue to purchase the Company's products. While the Company believes that it has been the principal supplier of OEM communication software products to U.S. Robotics (excluding Megahertz), there can be no assurance that U.S. Robotics will not seek additional sources for such products in the future. In addition, 3Com has announced its intention to acquire U.S. Robotics. Accordingly, there can be no assurance that sales to U.S. Robotics will reach or exceed historical levels in any future period. A substantial decrease or delay in sales to U.S. Robotics would have a material adverse effect on the Company's business, results of operations and financial condition. Assuming the number of products sold to U.S. Robotics Access Corp. were to remain at 1996 levels, in light of the pricing incentives provided in the agreement, gross revenues from U.S. Robotics with respect to products covered by the agreement could be adversely affected, although the Company believes that net income attributable to such sales would not be impacted negatively. Accordingly, there can be no assurance that sales to U.S. Robotics will reach or exceed historical levels in any future period. A substantial decrease or delay in sales 15 16 to U.S. Robotics would have a material adverse effect on the Company's business, results of operations and financial condition. Assuming the number of products sold to U.S. Robotics Access Corp. were to remain at 1996 levels, in light of the pricing incentives provided in the agreement, gross revenues from U.S. Robotics with respect to products covered by the agreement could be adversely affected. Concentration of Customer Revenues. In addition to its reliance on U.S. Robotics, the Company has in the past derived, and expects in the future to derive, a significant portion of its revenues from a relatively small number of customers. Approximately 57%, 67%, and 71% of the Company's net revenues in 1994, 1995 and 1996, respectively, were derived from sales of products to the Company's three largest customers, including U.S. Robotics. The Company expects that it will continue to be dependent upon relatively large orders from these customers and a limited number of other OEM customers for a significant portion of its revenues in future periods, although none of them is obligated to purchase any products. Accordingly, there can be no assurance that any sales to these entities, individually or as a group, will continue or, if continued, will reach or exceed historical levels in any future period. Any substantial decrease or delay in sales to one or more of these entities would have a material adverse effect on the Company's business, results of operations and financial condition. In addition, certain of the Company's OEM customers have in the past and may in the future acquire competitors or be acquired by competitors, causing further consolidation in the modem industry. Hayes Microcomputer Products ("Hayes"), one of the Company's significant OEM customers, previously acquired Practical Peripherals, another OEM customer of the Company. Hayes (including Practical Peripherals) accounted for 15.4%, 9.8% and 3.8% of the Company's net revenues for 1994, 1995 and 1996, respectively. Previous acquisitions in the modem industry have often caused the purchasing departments of the combined companies to reevaluate their purchasing decisions. Finally, during February 1997, 3Com announced its intent to acquire U.S. Robotics. There can be no assurance that such acquisitions will not result in a change in a current customer's purchasing habits, including a loss of the customer, a decrease in orders from that customer or a delay in orders previously made by the customer. Moreover, acquisitions involving existing OEM customers may cause the concentration of the Company's customer revenues to increase if the combined companies continue to purchase the Company's software products. Although the Company maintains allowances for doubtful accounts, the insolvency of one or more of the other major customers of the Company could substantially impair the Company's business, results of operations and financial condition. Product Concentration. The Company has in the past derived, and may in the future derive, a significant portion of its revenues from a relatively small number of products. In 1995 and 1996 approximately 84% and 64% respectively, of the Company's net revenues were derived from the sale of various versions of QuickLink II Fax, and 10% and 7%, respectively, of the Company's net revenues were derived from MacComCenter, which is the QuickLink II Fax equivalent for the Macintosh market. The Company expects that revenues from these products will continue to account for a substantial portion of the Company's total revenues in the foreseeable future. The decline in the percentages of QuickLink II Fax sales during 1996 was primarily due to increased retail sales. Declines in the revenues from these software products, whether as a result of competition, technological change, price pressures or other factors, would have a material adverse effect on the Company's business, results of operations and financial condition. Further, life cycles of the Company's products are difficult to estimate due in large measure to the recent emergence of the Company's market, the effect of new products, applications or product enhancements, technological changes in the communication software industry in which the 16 17 Company operates and future competition. The Company's future financial performance will depend in part on the successful development, introduction and market acceptance of new products, applications and product enhancements. There can be no assurance that the Company will continue to be successful in marketing its current products or any new products, applications or product enhancements. Technological Change. The communication software market for personal computers is characterized by rapid technological change, changing customer needs, frequent product introductions and evolving industry standards. The introduction of products incorporating new technologies and the emergence of new industry standards could render the Company's existing products obsolete and unmarketable. The Company's future success will depend upon its ability to develop and introduce new software products (including new releases, applications and enhancements) on a timely basis that keep pace with technological developments and emerging industry standards and address the increasingly sophisticated needs of its customers. There can be no assurance that the Company will be successful in developing and marketing new products that respond to technological changes or evolving industry standards, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and marketing of these new products, or that its new products will adequately meet the requirements of the marketplace and achieve market acceptance. If the Company is unable, for technological or other reasons, to develop and introduce new products in a timely manner in response to changing market conditions or customer requirements, the Company's business, results of operations and financial condition would be materially adversely affected. Microsoft is the leading developer of operating systems for personal computers. There can be no assurance that the Company will successfully develop new versions of its software products that will operate on future Microsoft operating systems, or that any such development, even if successful, will be completed concurrently with or prior to introductions by competitors of communication software products for those new operating systems. Any such failure or delay could affect the Company's competitive position or lead to product obsolescence in the future. While the Company ships software to a number of computer manufacturers, its primary OEM customers are modem manufacturers. The Company is aware that technology is being developed to enable the functions of the modem to be performed by a chip embedded into the computer. This development, if and when it comes to market, could impair the business of those of the Company's customers that rely on the existence of a separate modem component for their continued success. A downturn in the business of one or more of its principal customers could adversely affect the Company's business, results of operations and financial condition. Competitive Threat from Microsoft and Other Operating Systems. The Company faces competition from Microsoft, which dominates the personal computer software industry. Due to its market dominance and the fact that it is the publisher of the most prevalent personal computer operating platforms, DOS and Windows, Microsoft represents a significant competitive threat to all personal computer software vendors, including the Company. In addition, Windows 95 and Windows NT, the latest Microsoft operating systems, include capabilities now provided by certain of the Company's OEM and retail software products, including the Company's principal product, QuickLink II Fax. Other operating systems, such as OS/2, offer communications capabilities as well. If the communications capabilities of Windows 95, Windows NT or other operating systems are adopted by users, sales of the Company's products could decline. 17 18 Competition. The markets in which the Company operates are highly competitive and subject to rapid changes in technology. The strategic directions of major personal computer hardware manufacturers and operating system developers are also subject to changes. The Company competes with other software vendors for access to distribution channels, retail shelf space and the attention of customers. The Company also competes with other software companies in its efforts to acquire software technology developed by third parties. These factors may result in increased price competition. Additionally, there can be no assurance that competitors will not develop or acquire products that are superior to the Company's products or that achieve greater market acceptance. The Company's new retail products face significant competition. In the retail market, HotFax, the Company's principal retail product competes directly with Symantec/Delrina's WinFax Pro 7.5. Symantec/Delrina is well established in the retail distribution channel. There can be no assurance that HotFax, Audiovision, HotPage or any other of the retail product line will capture a significant share of the retail market for communication software. In addition, the Company's newly released retail video conferencing product, AudioVision, competes in a new and rapidly changing software market. Some of the current competitors in the video conferencing software market are White Pine, Connectix, and VDONet, and there can be no assurance that the Company will compete successfully with these and any future competitors in the retail video conferencing software market. In the OEM distribution channel, the Company has several strong competitors, among them Symantec/Delrina, Global Village, White Pine and VDONet. Some of the Company's competitors have a retail emphasis and offer OEM products with a reduced set of features. The opportunity for retail upgrade sales may induce these and other competitors to make OEM products available at their own cost or even at a loss. Such a pricing strategy could have an adverse affect on the Company's business, results of operations and financial condition. Symantec/Delrina currently make certain products that are complementary with products sold by each other. The combined entity may be able to enhance its competitive position by bundling certain of these products to attract customers seeking integrated, cost-effective software applications. The Company also believes that the market in which it competes has been characterized by the consolidation of established communication software suppliers and that this trend, which may lead to the creation of additional large and well-financed competitors, may continue. In addition, other competitors have entered the market. Moreover, because there are low barriers to entry into the software market, the Company believes that competition will increase in the future. To remain competitive, the Company believes that it will need to make continuing investments in research and development and sales and marketing. There can be no assurance that the Company will have sufficient resources to make such investments, or that it will be successful in its research and development or sales and marketing efforts. Symantec/Delrina and many of the Company's current and prospective competitors have significantly greater financial, marketing, service, support, technical and other resources than the Company. Moreover, these companies may introduce additional products that are competitive with those of the Company, and there can be no assurance that the Company's products would compete effectively with such products. The Company believes that its ability to compete depends on elements both within and outside its control, including the success and timing of new product development, product performance and price, distribution and customer support and introduction by the Company and its competitors of new products. There can be no assurance that the Company will be able to compete 18 19 successfully with respect to these and other factors. The Company believes that the market for its software products has been and will continue to be characterized by significant price competition. A material reduction in the price of the Company's products could negatively affect the Company's profitability. Many of the Company's existing and potential OEM customers are major manufacturers of modems and have substantial technological capabilities. These customers may currently be developing, or may in the future develop, products that compete directly with the Company's products and may, therefore, discontinue purchases of the Company's products. The Company's future performance is substantially dependent upon the extent to which existing OEM customers elect to purchase communication software from the Company rather than design and develop their own software. In light of the fact that the Company's customers are not contractually obligated to purchase any of the Company's products, there can be no assurance that the Company's existing OEM customers will continue to rely, or expand their reliance, on the Company as an external source for communication software. Dependence on New Product Offerings. The Company's future success will depend, in significant part, on its ability to successfully develop and introduce new software products and improved versions of existing software products on a timely basis and in a manner that will allow such products to achieve broad customer acceptance. There can be no assurance that new products will be introduced on a timely basis, if at all. If new products are delayed or do not achieve market acceptance, the Company's business, results of operations and financial condition will be materially adversely affected. In the past, the Company has also experienced delays in purchases of its products by customers anticipating the launch of new products by the Company. There can be no assurance that material order deferrals in anticipation of new product introductions will not occur. There can also be no assurance that the Company will be successful in developing, introducing on a timely basis and marketing such software or that any such software will be accepted in the market. Retail Product Strategy Unproven. The Company's revenues have increased during the past five years almost entirely on the strength of its OEM sales. The Company is developing retail products with expanded functionality from its OEM products and expects to introduce other products in the retail distribution channel as well. The ability to maintain distributor and retailer relationships is largely a function of volumes. If the Company does not meet certain minimum volume requirements, it will not be able to maintain its relationships. With unproven products and its distribution system at early stages, there can be no assurance that the Company's retail marketing plan will succeed. Further, while retail products provide higher unit revenues than OEM products, retail distribution entails significantly higher costs. These costs include advertising, trade shows, public relations and the expenses related to the development and maintenance of a sales force dedicated to the retail distribution effort. Accordingly, there can be no assurance that retail sales will provide the margins that the Company has been able to achieve on its OEM sales or that distributor and retailer minimum volume requirements will be met. In implementing its retail sales strategy, the Company expects to rely on distributors, retailers and value added resellers (collectively, "resellers") for the marketing and distribution of HotFax, HotFax MessageCenter, HotPage, AudioVision and its other retail products. The Company's agreements with resellers are not exclusive and in many cases may be terminated by either party without cause. Many of the Company's resellers carry product lines that are competitive with those of the Company. There can be no assurance that these resellers will give a high priority to the marketing of the 19 20 Company's products or that resellers will continue to carry the Company's products. These resellers typically are allowed to return products without charge or penalty. A component of the Company's revenue recognition policy is that the Company calculates an allowance for product returns based on its historical experience. If retail sales of the Company's products increase, the risk of product returns will increase. While the Company's revenue recognition policy contemplates this risk, it is possible that returns may occur in excess of the Company's previous experience, causing the Company to revise its estimates and increase the allowances for such returns. Excessive or unanticipated returns could materially adversely affect the Company's business, results of operations and financial condition. The Company's results of operations could also be materially adversely affected by changes in reseller inventory strategies, which could occur rapidly, and in many cases, may not be related to end user demand. There can be no assurance that the Company will be successful in recruiting resellers to represent it. Any of these anticipated changes in the Company's distribution channels could materially adversely affect the Company's business, results of operations and financial condition. Corporate and Government Product and Marketing Strategy Unproven. The Company's revenues have increased during the past five years almost entirely on the strength of its OEM sales, and more recently, retail sales. During 1997 the Company plans to add the infrastructure necessary to support a focus on the corporate and government markets. The corporate market includes vertical applications that are industry specific and require the investment of engineering resources. There can be no assurance that the additional infrastructure required in sales and marketing to the corporate and government markets, or the investment in engineering resources for applications specific to such markets, will yield significant sales growth for the Company or provide the margins the Company has achieved historically on its OEM sales. Potential for Undetected Errors. Software products as complex as those offered by the Company may contain undetected errors. The Company has in the past discovered software errors in certain of its products and has experienced delayed or lost revenues during the period required to correct these errors. There can be no assurance that, despite testing by the Company and by current and potential customers, errors will not be found in new or existing products after commencement of commercial shipments, resulting in loss of or delay in market acceptance or the recall of such products, which could have a material adverse effect upon the Company's business, results of operations and financial condition. The Company provides customer support for most of its products. The Company is preparing to launch several new products. If these products are flawed or are more difficult to use than traditional Company products, customer support costs could rise and customer satisfaction levels could fall. Pre-Load and Royalty Based Software Market. The Company primarily sells its software in a form that includes a disk and a manual. Some of its customers "pre-load" the Company's software onto a hard disk or pay a royalty based on units produced or shipped. These arrangements eliminate the need for a disk and may eliminate the need for a manual. The pre-load arrangements produce smaller unit revenues for the Company and eliminate the Company's ability to generate revenues from its production facilities. The Company believes these facilities contribute profits to the Company. Currently, the Company has the capability to produce its products in-house on 3 1/2-inch diskettes. The Company does not currently have the capability to produce CD-ROMs and the cost to develop such production capability may be prohibitive. As the size of software programs grow, CD-ROM is becoming a more prominent medium. The Company currently contracts CD-ROM production to specialized CD-Rom facilities. In the event of a shift of this kind, more of the 20 21 Company's relationships would involve product pre-loads and CD-ROM production and the Company's business, results of operations and financial condition could be adversely affected. Dependence Upon Key Personnel. The Company's future performance depends in significant part upon the continued service of William Smith and Rhonda Smith, the Company's co-founders, and other key technical and senior management personnel. The Company is dependent on its ability to identify, hire, train, retain and motivate high quality personnel, especially highly skilled engineers involved in the ongoing research and development required to develop and enhance the Company's communication software products and introduce enhanced future applications. The industry is characterized by a high level of employee mobility and aggressive recruiting of skilled personnel. There can be no assurance that the Company's current employees will continue to work for the Company. Loss of services of key employees could have a material adverse effect on the Company's business, results of operations and financial condition. In addition, the Company may need to grant additional options and provide other forms of incentive compensation to attract and retain key personnel. Acquisition of Performance Computing Incorporated. The Company acquired PCI in March 1996. The Company's future financial results will depend in part on its ability to successfully integrate PCI's business with its own, and there can be no assurance that the Company will be able to successfully coordinate its business activities with those of PCI. Furthermore, there can be no assurance that the Company will be successful in integrating PCI products with those of the Company or that the results of PCI's operations will not have an adverse effect upon the Company's operating results. The Company has sold only a limited amount of PCI products to date. PCI products compete in a new and rapidly changing market and there can be no assurance that such products will receive or gain market acceptance. Lack of market acceptance of such products, or delays in or non-completion of the development of new PCI products, could have an adverse impact on the Company's business, results of operations and financial condition. In addition, PCI products compete against those of several competitors, including White Pine, Connectix, Intel and VDONet, some of whom have greater financial and other resources than the Company, and there can be no assurance that the Company will be able to compete successfully against these and any future competitors in the video conferencing software market. Fluctuations in Gross Margins. The Company has recently experienced fluctuations in gross margins, primarily as a result of changes in the mix of retail and OEM sales. Other factors that can contribute to margin fluctuations are inventory obsolescence as a result of new retail product releases and return of retail product, price competition, expediting costs, and changes in OEM sales mix and the related variances in OEM product pricing. An erosion of the gross margins as a result of any of the aforementioned reasons or for any other reasonsnot contemplated by the Company at this time, could have a material adverse affect on the Company's operating results. Management of Growth. The Company has recently experienced a period of significantly expanding operations and headcount, which has placed, and will continue to place, a significant strain on the Company's limited personnel and other resources. One of the Company's executive officers commenced employment with the Company in March 1996. The Company's ability to manage any future increases in the scope of its operations or headcount, should they occur, will depend on significant expansion of its manufacturing, 21 22 research and development, marketing and sales, management and financial and administrative capabilities. The failure of the Company's management to effectively manage any expansion in its business could have a material adverse effect on the Company's business, results of operations and financial condition. Duplication of Software. The Company duplicates nearly all of its software at its Aliso Viejo, California facility. The Company believes that its internal duplication capability provides it with a competitive advantage since it eliminates the profit margin required by outside duplication sources and enables a high degree of scheduling control. This concentration of production does, however, expose the Company to the risk that production could be disrupted by natural disaster or other events, such as the presence of a virus in the Company's duplicators. The Company believes that it could retain outside duplication alternatives quickly, but there is no assurance that it could do so or, if such arrangements could be made, that duplication could take place in an economical or timely manner. When CD-ROMs are required, the Company uses outside third parties for CD-ROM replication. The equipment to replicate CD-ROMs is very costly making it unlikely that the Company will add this capability internally. Because the Company is dependent on CD-ROM replication facilities for both the timing and pricing of the software produced in CD-ROM format, any adverse changes in the timing of such replication could impair the Company's ability to deliver products to customers and any price increases could reduce gross margins which, in each case, could have a material adverse effect on the Company's business, results of operations and financial condition. Reliance on Third Party Suppliers; Shortage of Modem Chips. The Company relies on third party suppliers who provide the components used in its kitted products. These components include disks, CDs and printed manuals. Disk shortages have occurred in the past and there can be no assurance that shortages will not recur. If the Company cannot obtain a sufficient quantity of disks or other components, or cannot obtain disks or other components at prices at least comparable to prices paid currently, the Company's business, results of operations and financial condition could be adversely affected. Modem manufacturers purchase chips from a relatively limited number of chip manufacturers. Production problems or product quality problems experienced by a chip manufacturer could reduce modem sales or slow the growth of modem sales. Chip manufacturers have a limited capacity to produce chips. This capacity cannot be quickly expanded and the capital investment to expand capacity is high. If chip suppliers are unable to meet demand, the growth of modem sales will slow. The Company believes that chip suppliers currently lack sufficient capacity to meet the demand for certain chips used by modem manufacturers, including the Company's OEM customers. If this shortage continues, it could adversely affect sales of the Company's OEM communication software. International Sales. The Company presently operates in foreign markets and intends to expand its international presence. For the twelve months ended December 31, 1996 net revenues generated outside the U.S. grew 6.6% to $3.2 million. As a percentage of total net revenues, international sales decreased to 14.4% during 1996 from 16.6% for the twelve months ended December 31, 1995. International business is subject to risks in addition to those inherent in the Company's United States business including substantially different regulatory requirements in different jurisdictions, varying technical standards, tariffs and trade barriers, political and economic instability, reduced protection for intellectual property rights in certain countries, difficulties in staffing and maintaining foreign operations, difficulties in managing distributors, potentially adverse tax consequences, foreign currency exchange fluctuations, the burden of complying with a 22 23 wide variety of complex foreign laws and treaties and the possibility of difficulties in collecting accounts receivable. There can be no assurance that the Company will be able to continue to generate significant international sales. While the Company does not currently accept payment in foreign currencies and invoices all of its sales in U.S. dollars, there can be no assurance that the Company will be able to continue this policy if it is able to grow international sales. If the Company begins to receive payment in foreign currencies, it is likely to be subjected to the risks of foreign currency losses due to fluctuations in foreign currency exchange rates. In addition, in the event the Company is successful in doing business outside of the United States, the Company may also face economic, political and foreign currency situations that are substantially more volatile than those commonly experienced in the United States. There can be no assurance that any of these factors will not have a material adverse effect on the Company's business, results of operations and financial condition. Intellectual Property Rights. The Company's success is dependent upon its software code base, its programming methodologies and other intellectual properties. To protect its proprietary technology, the Company relies on a combination of trade secret, nondisclosure and copyright and trademark law which may afford only limited protection. The Company owns United States trademark registrations for certain of its trademarks, including QUICKLINK GOLD, but has not yet obtained registrations for all of its trademarks in the United States or other countries, such as for the mark QUICKLINK II FAX. Until recently, the Company did not require its employees to sign proprietary information and inventions agreements stipulating, among other things, software ownership rights. In addition, the Company has recently started the patent application process for a number of technologies that could provide additional protection for existing products and products under development. There can be no assurance that the steps taken by the Company will be adequate to deter misappropriation of its proprietary information, will prevent the successful assertion of an adverse claim to software utilized by the Company or that the Company will be able to detect unauthorized use and take effective steps to enforce its intellectual property rights. In selling its products, the Company relies primarily on "shrink wrap" licenses that are not signed by licensees and, therefore, may be unenforceable under the laws of certain jurisdictions. In addition, the laws of some foreign countries do not protect the Company's proprietary rights to as great an extent as do the laws of the United States. There can be no assurance that the Company's means of protecting its proprietary rights will be adequate or that the Company's competitors will not independently develop similar technology. Further, although the Company believes that its services and products do not infringe on the intellectual property rights of others, there can be no assurance that such a claim will not be asserted against the Company in the future. The failure of the Company to protect its proprietary information could have a material adverse effect on the Company's business, results of operations and financial condition. From time to time, the Company has received and may receive in the future communications from third parties asserting that the Company's trade name or that features, content, or trademarks of certain of the Company's products infringe upon intellectual property rights held by such third parties. For example, the Company has received correspondence from a third party asserting that the use by the Company of the mark QUICKLINK in the United States and Canada constitutes trademark infringement and unfair competition. The Company believes that it has meritorious defenses to the claims asserted, particularly in light of the length of time the Company has continuously used its QUICKLINK-based marks. While no litigation has been initiated by this party, the Company is attempting to resolve all such assertions. Should there be a successful 23 24 challenge to the Company's use of the QUICKLINK mark or any other mark, the Company could incur significant expenses in connection with changing the name and experience a loss of goodwill related to its QUICKLINK product line. The Company has also received correspondence from another third party asserting that the Company's videoconferencing products violate certain patents that they hold. No litigation has been initiated by this party and the Company is attempting to resolve all such assertions. As the number of trademarks, patents, copyrights and other intellectual property rights in the Company's industry increases, and as the coverage of these patents and rights and the functionality of products in the market further overlap, the Company believes that products based on its technology may increasingly become the subject of infringement claims. Such claims could materially adversely affect the Company, and may also require the Company to obtain one or more licenses from third parties. There can be no assurance that the Company would be able to obtain any such required licenses upon reasonable terms, if at all, and the failure by the Company to obtain such licenses could have a material adverse effect on its business, results of operations and financial condition. In addition, the Company licenses technology on a non-exclusive basis from several companies for inclusion in its products and anticipates that it will continue to do so in the future. The inability of the Company to continue to license these technologies or to license other necessary technologies for inclusion in its products, or substantial increases in royalty payments under these third party licenses, could have a material adverse effect on its business, results of operations and financial condition. Litigation in the software development industry has increasingly been used as a competitive tactic both by established companies seeking to protect their existing position in the market and by emerging companies attempting to gain access to the market. If the Company is forced to defend itself against a claim, whether or not meritorious, the Company could be forced to incur substantial expense and diversion of management attention, and may encounter market confusion and reluctance of customers to purchase the Company's software products. Concentration of Ownership. As of March 31, 1997, William Smith and Rhonda Smith beneficially own, as community property, approximately 69.6% of the outstanding shares of the Company. William Smith and Rhonda Smith are married to one another and, acting together, will have the ability to elect the Company's directors and determine the outcome of any corporate action requiring stockholder approval, irrespective of how other stockholders of the Company may vote. This concentration of ownership may have the effect of delaying or preventing a change in control of the Company. Potential Effect of Anti-Takeover Provisions. The Company's Certificate of Incorporation and Bylaws contain provisions that may discourage or prevent certain types of transactions involving an actual or potential change in control of the Company, including transactions in which the stockholders might otherwise receive a premium for their shares over then current market prices, and may limit the ability of the stockholders to approve transactions that they may deem to be in their best interest. In addition, the Board of Directors has the authority to fix the rights and preferences of shares of the Company's Preferred Stock and to issue such shares, which may have the effect of delaying or preventing a change in control of the Company, without action by the Company's stockholders. Certain provisions of Delaware law applicable to the Company, including Section 203 of the Delaware General Corporation Law, could also have the effect of delaying, deferring or preventing a change of control of the Company. It is possible that the provisions in the Company's Certificate of Incorporation and Bylaws, the ability 24 25 of the Board of Directors to issue the Company's Preferred Stock, and Section 203 of the Delaware General Corporation Law may have the effect of delaying, deferring or preventing a change of control of the Company without further action by the stockholders, may discourage bids for the Company's Common Stock at a premium over the market price of the Common Stock and may adversely affect the market price of the Common Stock and the voting and other rights of the holders of Common Stock. Possible Volatility of Stock Price. The trading price of the Common Stock is likely to be subject to significant fluctuations in response to variations in quarterly operating results, the gain or loss of significant orders, changes in management, announcements of technological innovations or new products by the Company, its customers or its competitors, legislative or regulatory changes, general trends in the industry and other events or factors. In addition, the stock market has experienced extreme price and volume fluctuations which have particularly affected the market price for many high technology companies similar to Smith Micro, and which have often been unrelated to the operating performance of these companies. These broad market fluctuations may adversely affect the market price of the Company's Common Stock. Further, factors such as announcements of new contracts or product offerings by the Company or its competitors and market conditions for stocks similar to that of the Company could have significant impact on the market price of the Common Stock. Shares Eligible for Future Sale. No prediction can be made as to the effect, if any, that future sales of Company Common Stock or the availability of such Common Stock for future sales will have on the market price of the Company's Common Stock. As of March 31, 1997, the Company had 14,074,698 shares of Common Stock outstanding. Of this amount, the 9,781,670 shares held by William Smith and Rhonda Smith will be available for sale in the public market (subject to the volume and other applicable restrictions of Rule 144) following the expiration in September 1997 of a two year lock-up agreement with certain representatives of the underwriters of the Company's initial public offering which consummated in September 1995. However, this lock-up agreement does not preclude William Smith and Rhonda Smith from selling shares in an underwritten offering meeting certain parameters commencing no sooner than 180 days after September 19, 1995. Sales of a substantial number of shares of Common Stock by William Smith, Rhonda Smith or any other person, either individually or when aggregated with sales by other persons, could adversely affect the market price of the Common Stock. 25 26 PART II -- OTHER INFORMATION ITEM 1. EXHIBITS AND REPORTS ON FORM 8-K Exhibit No. Title Method of Filing - ------- ----- ---------------- 3.1 Amended and Restated Certificate of Incorporated by reference to Exhibit 3.1 Incorporation of the Company to the Registrant's Registration Statement No. 33-95096 3.2 Amended and Restated Bylaws of the Incorporated by reference to Exhibit 3.2 Company to the Registrant's Registration Statement No. 33-95096 4.1 Specimen certificate representing Incorporated by reference to Exhibit 4.1 shares of Common Stock of the Company to the Registrant's Registration Statement No. 33-95096 10.1 Form of Indemnification Agreement Incorporated by reference to Exhibit 10.1 to the Registrant's Registration Statement No. 33-95096 10.2 1995 Stock Option/Stock Issuance Plan Incorporated by reference to Exhibit 10.2 to the Registrant's Registration Statement No. 33-95096 10.3 Form of Notice of Grant of Stock Option Incorporated by reference to Exhibit 10.3 under 1995 Stock Option/Stock Issuance Plan to the Registrant's Registration Statement No. 33-95096 10.4 Form of 1995 Stock Option Agreement under Incorporated by reference to Exhibit 10.4 1995 Stock Option /Stock Issuance Plan to the Registrant's Registration Statement No. 33-95096 10.5 Form of 1995 Stock Purchase Agreement Incorporated by reference to Exhibit 10.5 under 1995 Stock Issuance Plan to the Registrant's Registration Statement No. 33-95096 26 27 Exhibit No. Title Method of Filing - ------- ----- ---------------- 10.6 Distribution License Agreement dated Incorporated by reference to Exhibit 10.6 September 30, 1991, by and between the to the Registrant's Registration Statement Company and Crandell Development No. 33-95096 Corporation. 10.7 Application Program Interface Retail Incorporated by reference to Exhibit 10.7 License Agreement July 28, 1992 by and to the Registrant's Registration Statement between the Company and Rockwell No. 33-95096 International Corporation. 10.8 Application Program Interface License Incorporated by reference to Exhibit 10.8 Agreement July 28, 1992 by and between the to the Registrant's Registration Statement Company and Rockwell International No. 33-95096 Corporation. 10.9 Rockwell High Speed Interface License Incorporated by reference to Exhibit 10.9 Agreement dated June 2, 1994, by and to the Registrant's Registration Statement between the Company and Rockwell No. 33-95096 International Corporation. 10.10 Letter Agreement dated February 22, 1994, Incorporated by reference to Exhibit 10.10 by and between the Company and Rockwell to the Registrant's Registration Statement International Corporation. No. 33-95096 10.111 Letter Agreement dated April 22, 1993, by Incorporated by reference to Exhibit 10.11 and between the Company and Rockwell to the Registrant's Registration Statement International Corporation. No. 33-95096 10.12 Software Distribution Agreement dated May Incorporated by reference to Exhibit 10.12 8, 1995, by and between the Company and to the Registrant's Registration Statement International Business Machines Corporation. No. 33-95096 10.13 Office Building Lease, dated June 10, Incorporated by reference to Exhibit 10.13 1992, by and between the Company and to the Registrant's Registration Statement Developers Venture Capital Corporation. No. 33-95096 27 28 10.14 Amendment No. 1 To Office Building Lease, Incorporated by reference to Exhibit 10.14 dated July 9, 1993, by and between the to the Registrant's Registration Statement Company and Pioneer Bank. No. 33-95096 10.15 Amendment No. 2 To Office Building Lease, Incorporated by reference to Exhibit 10.15 dated August 15, 1994, by and between the to the Registrant's Registration Statement Company and T&C Development. No. 33-95096 10.16 Fourth Addendum to Office Building Lease, Incorporated by reference to Exhibit 10.16 dated April 21, 1995, by and between the to the Registrant's Registration Statement Company and T&C Development. No. 33-95096 10.17 Form of Promissory Note related to Incorporated by reference to Exhibit 10.17 S Corporation Distribution. to the Registrant's Registration Statement No. 33-95096 10.18 Smith Micro Software, Inc. Amended and Restated Incorporated by reference to Exhibit 10.21 Software Licensing and Distribution Agreement, to the Registrant's Quarterly Report on Form dated April 18, 1996 by and between the Company 10-Q for the quarter ended September 30, 1996 and U.S. Robitics Access Corp. 10.19 Office Building Lease, dated March 1, Incorporated by reference to Exhibit 10.19 1994, by and between Performance Computing to the Registrant's Annual Report on Form Incorporated and Petula Associates, 10-K for the fiscal year ended December 31, 1995 Ltd./KC Woodside. 10.20 Agreement and Plan of Merger by and Incorporated by reference to Exhibit 2 to between Smith Micro Software, Inc., the Registrant's Current Report on Form Performance Computing Incorporated and PCI 8-K filed with the Commission on March 28, Video Products, Inc. dated as of March 14, 1996 1996. 28 29 10.21 Amendment No. 1, dated as of March 10, 1997 Incorporated by reference to Exhibit 10.21 to Agreement and Plan of Merger by and to the Registrant's Annual Report on Form 10-K between Smith Micro Software, Inc., for the fiscal year ended December 31, 1996 Performance Computing Incorporated and PCI Video Products, Inc. dated as of March 14, 1996 20.1 1996 Investment Profile. Filed Herewith 21.1 Subsidiaries of Registrant. Incorporated by reference to Exhibit 21.1 to the Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1995 27.0 Financial Data Schedule. Filed Herewith (B) REPORTS ON FORM 8-K No Current reports on Form 8-K were filed during the quarter ended March 31, 1997. 29 30 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SMITH MICRO SOFTWARE, INC. May 13, 1997 By /s/ WILLIAM W. SMITH, JR. William W. Smith, Jr. Chairman, President and Chief Executive Officer (Principal Executive Officer) May 13, 1997 By /s/ ROBERT E. GRICE, JR. Robert E. Grice, Jr. Chief Financial Officer (Principal Financial Officer) 30