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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001
/ / 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 0-24752
WAVE SYSTEMS CORP.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 13-3477246
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
480 PLEASANT STREET
LEE, MASSACHUSETTS 01238
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
413-243-1600
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
CLASS A COMMON STOCK, $.01 PAR VALUE
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. YES |X| NO [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
The aggregate market value of the shares of Common Stock of the
registrant held by non-affiliates as of March 18, 2002 was $103,218,887. (For
purposes of this calculation, the market value of a share of Class B Common
Stock was assumed to be the same as a share of Class A Common Stock, into
which it is convertible.)
As of March 18, 2002 there were 50,061,506 shares of the registrant's
Class A Common Stock and 327,083 shares of the registrant's Class B Common Stock
outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement for the Annual Stockholders'
Meeting to be held on or about June 24, 2002 are incorporated by reference into
Part III. The Exhibit index is located on page 23.
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EXCEPT FOR HISTORICAL INFORMATION CONTAINED HEREIN, THIS FORM 10-K CONTAINS
FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE U.S. SECURITIES LITIGATION
REFORM ACT OF 1995. THESE STATEMENTS INVOLVE KNOWN AND UNKNOWN RISKS AND
UNCERTAINTIES THAT MAY CAUSE THE COMPANY'S ACTUAL RESULTS OR OUTCOMES TO BE
MATERIALLY DIFFERENT FROM THOSE ANTICIPATED AND DISCUSSED HEREIN. FURTHER, THE
COMPANY OPERATES IN AN INDUSTRY SECTOR WHERE SECURITIES VALUES MAY BE VOLATILE
AND MAY BE INFLUENCED BY REGULATORY AND OTHER FACTORS BEYOND THE COMPANY'S
CONTROL. IMPORTANT FACTORS THAT THE COMPANY BELIEVES MIGHT CAUSE SUCH
DIFFERENCES ARE DISCUSSED IN THE CAUTIONARY STATEMENTS ACCOMPANYING THE
FORWARD-LOOKING STATEMENTS AND IN THE RISK FACTORS DETAILED IN THE COMPANY'S
OTHER FILINGS WITH THE COMMISSION DURING THE PAST 12 MONTHS. IN ASSESSING
FORWARD-LOOKING STATEMENTS CONTAINED HEREIN, READERS ARE URGED TO READ CAREFULLY
ALL RISK FACTORS AND CAUTIONARY STATEMENTS CONTAINED IN THIS FORM 10-K AND IN
THOSE OTHER FILINGS WITH THE COMMISSION.
TABLE OF CONTENTS
PART I............................................................................................................1
Item 1. Business........................................................................................1
Item 2. Properties......................................................................................8
Item 3. Legal Proceedings...............................................................................8
Item 4. Submission of Matters to a Vote of Security Holders.............................................8
PART II...........................................................................................................9
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters...........................9
Item 6. Selected Financial Data........................................................................10
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations..........................................................................11
Item 7A. Quantitative and Qualitative Disclosure about Market Risk......................................20
Item 8. Financial Statements and Supplementary Data....................................................20
Item 9. Changes in and Disagreements with Accountant on Accounting and
Financial Disclosure...........................................................................20
PART III.........................................................................................................20
Item 10. Directors and Executive Officers of the Registrant.............................................20
Item 11. Executive Compensation.........................................................................20
Item 12. Security Ownership of Certain Beneficial Owners and Management.................................21
Item 13. Certain Relationships and Related Transactions.................................................21
PART IV..........................................................................................................22
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K...............................22
EXHIBIT 23.1
CONSENT OF INDEPENDENT AUDITORS...........................................................................F-44
PART I
ITEM 1. BUSINESS
Wave Systems Corp. ("Wave" or "we") develops, produces and markets
hardware and software based digital security products for the Internet and
e-commerce. Wave's technology involves the use of encryption, which is the
process of making data indecipherable. At the heart of Wave's technology is the
EMBASSY (EMBedded Application Security SYstem) Trust System (the "ETS"). The ETS
is a combination of client hardware and software and a back-office
infrastructure that manages its security functions. The client hardware consists
of the EMBASSY 2100 security chip (the "EMBASSY chip"). EMBASSY chips may be
embedded in such user devices as computer keyboards, smart card readers, PC
motherboards, PC and/or cable modems, personal digital assistants, cable set-top
boxes and potentially a wide variety of other user devices. The EMBASSY chip is
used to securely store the user's personal information such as usernames,
passwords, personal identification numbers, credit card information and personal
information such as social security number, name and address. In addition, the
EMBASSY system stores encrypted applets that can be called upon to perform a
variety of secure functions such as strong authentication, e-commerce and
digital rights management, electronic payments, metering of digital content and
other functions.
The ETS has been designed to combine the security strength of
hardware, with the flexibility of software, providing a distributed, open and
fully programmable platform. Wave believes the flexibility of the ETS positions
it to exploit future opportunities as privacy and security requirements evolve
and change. This flexibility allows EMBASSY to fulfill developing security
requirements, while addressing a broad range of advanced applications such as
content protection, user managed privacy, strong authentication of user
identities, and distributed e-commerce. While single function security solutions
are available, the architecture achieved by EMBASSY provides the capability for
multiple entities, such as service providers, content owners and individuals to
share a single device while trusting that their individual interests have been
strongly protected from both local and network sources of attack.
WAVE COMMERCE SYSTEM
The Wave Commerce System (the "Commerce System") comprises two
main functions: authentication and commerce. Each of these functions provides
multiple services enabled by the ETS. The authentication services component
positively identifies the person wishing to access protected content. It
accomplishes this through a protected applet in conjunction with the EMBASSY
device. The goal of the Commerce System is to provide digital commerce,
completely secure from unauthorized access. Web site owners would use
authentication services to replace less secure username/password pairs with
strong authentication. Content providers use commerce services to distribute
digital content. The Commerce System allows flexible purchase models for the
sale of digital content including rental, rent-to-own and event-based
charges. This means that content, goods and services can be consumed with
more efficient and flexible pricing, broader distribution opportunities and
greater protection against unauthorized usage, with better privacy protection
of the consumer's sensitive information.
The Commerce System utilizes the Wavenet back-office ("Wavenet").
Wavenet is a network of servers that supply full e-commerce functions, customer
relationship management tools, security capabilities and digital rights
management. Wavenet is transparent to the consumer. All of the account specific
commerce functionality occurs at the EMBASSY Client PC. Wavenet provides the
back-office capabilities that support the following capabilities: content
protection, content use metering, micro-transactions, Internet based
communities, Internet based strong authentication and e-commerce (multiple
language and currency capabilities, sales and value added tax capabilities,
transaction clearing services, royalty payment system and business logic and
royalty rule definition).
DIGITAL SIGNATURE AND ELECTRONIC DOCUMENT MANAGEMENT
On October 4, 2001 Wave acquired digital signature technology,
SmartSignature and SmartSAFE from SignOnLine, Inc. ("SignOnLine"), a
California-based company. SmartSignature is a digital signature application that
allows for the interaction of users ("Signers") and financial service providers,
such as banks,
brokerage houses, lessors and mortgage companies ("Providers"), whereby the
Signer can digitally sign a document that will then be considered a legally
binding signature. SmartSAFE is a web-based document management application,
with an upload process initiated by the Signer. Once uploaded, the documents are
validated and archived. A Provider may then log into the SmartSAFE to review and
manage documents that have been signed. When a document is requested for
viewing, the SmartSAFE creates a certified copy including pertinent signature
information. SmartSAFE also supports archival and management of unsigned
documents in virtually any format.
DATA BROADCAST
WaveXpress, Inc. ("WaveXpress"), a joint venture between Wave and
Sarnoff Corporation ("Sarnoff") which is 82% owned by Wave (assuming all of
Wave's and Sarnoff's convertible securities are converted), has developed
products designed to offer cable television multiple service operators ("MSOs")
a complete solution for implementing a new high speed delivery offering called
IP (Internet Protocol) Multicast that allows the consumer to experience and
manage rich digital content on their PC. These products are being actively
marketed to MSOs. Wave believes that benefits of these products to MSOs
include: new incremental revenue streams from dormant, underutilized and
off-peak bandwidth, service bundling opportunities, flexible content and pricing
offerings, strength of the ETS security products and an advanced consumer
experience.
Wave was incorporated in Delaware under the name Indata Corp. on
August 12, 1988. We changed our name to Cryptologics International, Inc. on
December 4, 1989. We changed our name again to Wave Systems Corp. on January 22,
1993. Our principal executive offices are located at 480 Pleasant Street, Lee,
Massachusetts 01238 and our telephone number is (413) 243-1600.
Wave is a development stage company and has realized minimal
operating revenues since our inception. Substantially all of Wave's revenues in
each of the three years ended December 31, 2001 have been related to the ETS.
For the years ended December 31, 2001, 2000, and 1999 Wave incurred losses to
common shareholders of $48,701,057, $47,656,000, and $28,066,000, respectively.
At December 31, 2001 we had an accumulated deficit of approximately
$189,624,000. There can be no assurance that we will ever be successful in
achieving commercial acceptance of the Wave System.
MARKETS AND BUSINESS STRATEGY
Wave is seeking to become a leader in digital security and
e-commerce technology. Our objective is to make our EMBASSY Trust System the
preferred infrastructure for security in the digital economy. Key components in
achieving this goal include:
CAPITALIZING ON SECURITY INDUSTRY TRENDS
Wave believes that a key differentiator of the ETS is that it is
open and programmable and combines the strong security of hardware with the
flexibility of software. Wave believes that ultimately, a truly secure system
must include hardware protection. Additionally, Wave foresees that single
purpose hardware solutions will not be effective as the hardware will have to
support multiple applications to be an effective solution. Therefore, in a
business environment of evolving encryption algorithms, multiple digital rights
management solutions, multiple platforms needing to be supported (PC, PDA,
Mobile, set-top box); Wave's open and programmable, hardware based solution will
have significant advantages over software only, or single purpose hardware
device solutions.
CAPITALIZING ON E-COMMERCE INDUSTRY TRENDS
Wave has designed the ETS with features and functionality that it
believes uniquely positions its platform to capitalize on e-commerce issues and
trends. Wave sees these issues and trends as follows:
o Rampant piracy of digital goods including music, video,
software, and the need for digital goods providers to securely
distribute their content and prevent theft
o Mass media broadcast networks merging with the internet
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o Rapid development of new business and distribution models
o Lack of adequate security for e-commerce and vulnerability to
attacks
o Major privacy concerns o Convergence of consumer electronics and
PC's
o Legal status of digital identities and digital signatures
o Increased focus on security and privacy by government entities
Wave will continue to pursue strategic relationships with hardware
manufacturers, systems integrators and companies involved in the development of
commerce in electronic content and services to achieve broad market acceptance
of its products as a distributed security platform for commerce performed in
user devices.
PURSUE STRATEGIC MARKETING AND DISTRIBUTION ALLIANCES
We intend to continue to enter into strategic alliances with key
partners that could distribute our products in enterprise, government and
consumer markets. Over the past several months, we have formed alliances with
such industry leaders as Samsung Electro-Mechanics Co., Ltd, Maximus, Thomcast,
Inc. and SSP Solutions, Inc. ("SSP"). In addition, we are pursuing strategic
relationships with PC OEM's, Internet Service Providers and major systems
integrators.
ENHANCING OUR CURRENT PRODUCT OFFERINGS
We intend to continue to develop and extend our product offerings
to include features and functionality that will satisfy the changing needs in
the computer security arena and the computing and e-commerce industries in
general. Planned development efforts include a significantly enhanced version of
our SmartSignature and SmartSAFE products. We intend to also build upon and
enhance our Trusted PC concept, to continue development efforts towards
standards-based security platforms (such as the European Transactional IC Card
Reader standard, FINREAD) and to also pursue efforts to port the ETS to
different computing platforms, as needed.
MARKETING, SALES AND CUSTOMERS
Wave's business model targets revenues from various sources
including: licensing of our technology including EMBASSY and its supporting
software infrastructure; fees from entities who use EMBASSY to secure their
applets on PCs; and usage and transaction-based fees from content management,
e-commerce and other services enabled by EMBASSY. In addition, we derive revenue
from outright sales of hardware and development contracts.
Wave has identified four key markets where we believe the EMBASSY
Trust System provides unique benefits:
o Banking and Finance - in addition to our European initiatives to
be a leader in delivering FINREAD-standard devices, we are
aggressively cultivating interest and support from U.S.
financial institutions.
o Broadband Media - through our WaveXpress joint venture, we are
developing a broadband architecture for persistent protection of
content to the hard disk at home.
o PCs - Wave-sponsored market research strongly confirms the
existence of substantial consumer demand for PC trust and
security and a willingness to pay for such features. We are
aggressively targeting a PC manufacturer deployment opportunity.
o Government and Enterprise - the market for electronic security
systems in governmental units and large business enterprises is
growing and Wave believes this market represents a key
opportunity.
Directly and through our partners, Wave is aggressively targeting opportunities
in these markets as we believe the ETS provides an unequaled range of security
and trust capabilities.
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Our sales force will focus on business development opportunities
in these key markets and others. Within these key markets we will focus on
closing business with large systems integrators, financial institutions, Cable
MSOs, personal computer manufacturers, and government and enterprise customers.
BACKLOG
Wave's backlog consists of hardware sales and development contract
revenue expected to be recognized in 2002. Wave's backlog as of December 31,
2001 totaled $243,000. Backlog can fluctuate greatly based upon, among other
matters, the timing and receipt of orders. Therefore, backlog may not represent
a fair indication of future business trends.
COMPETITION
We operate in a highly competitive and fragmented environment that
is characterized by rapidly evolving technology. Many of our competitors and
potential competitors in these markets have substantially greater financial,
technical and marketing resources than Wave does. Also, many current and
potential competitors have greater name recognition and more extensive customer
bases that could be leveraged, thereby they can gain market share or product
acceptance to our detriment. In addition, the rate of market acceptance of
content protection solutions has remained slow. Wave Systems has developed
and/or acquired products and services in the following four primary areas:
o EMBASSY Trust System Platform
o Wave Commerce System
o Data Broadcasting
o Digital Signature Electronic Document Management Applications
These are developing markets, which have not yet established clearly defined
industry standards. Wave views these markets as having any number of competitors
and potential competitors from small emerging enterprises developing niche
technologies and products, to large well established computer and electronic
manufacturers, software companies and systems integrators.
The competitive factors defining these markets include product
performance, compatibility, standards compliance, quality and reliability,
ease of use, client services and support, distribution and price. Wave
believes its products meet the requirements to be successful viable products
in these markets. Wave's features that should allow its products to compete
favorably include product differentiation of a combined software/hardware
solution, system integrity, secure communication, fault tolerance, data
privacy, and independent customer operation. In addition, Wave may have the
opportunity to be "first to market" with its data broadcasting and digital
signature products.
One of the market challenges facing Wave is to the establishment
of a new market category for multifunction security devices that includes a more
complex business model for adoption. While Wave has developed a very complex
cryptographic system that required significant skills and resources, it is also
possible for other competitors to develop similar offerings to compete with the
ETS, or new technologies may emerge that could replace existing technology that
our products rely on, thereby making our products non-competitive or obsolete.
We can offer no assurances that Wave's products will become industry standards
or become widely accepted by the marketplace.
INTERNATIONAL MARKET
Most of our products and many components of the ETS are controlled
under various United States export control laws and regulations and may require
export licenses for certain exports of the products and components outside of
the United States and Canada. We have received full export license from the U.S.
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Department of Commerce for the sale and export of our single-key Data Encryption
Standard ("DES") products. We have also received an export license for our
triple-key DES chips under the provisions of License Exceptions KMI or ECN,
granted by the Bureau of Export Administration of the U.S. Department of
Commerce ("BXA"). The remainder of our products and components of the ETS are
generally exportable to any end-user in any country throughout the world with
the exception of Cuba, Iran, Iraq, Libya, North Korea, Sudan and Syria.
We can provide no assurance that we will have patent protection or
that we will not infringe patents of other parties in foreign jurisdictions.
Because electronic monitoring and the transmission of audited usage and
financial information on end users or payment instructions may be subject to
varying statutory or regulatory controls in foreign jurisdictions, the use of
all portions of the ETS may not be permitted in any particular foreign
jurisdiction.
PROPRIETARY RIGHTS AND LICENSES AND INTELLECTUAL PROPERTY
Our success depends, in part, on our ability to enjoy or obtain
protection for our products and technologies under United States and foreign
patent laws, copyright laws and other intellectual property laws, to preserve
our trade secrets and to operate without infringing the proprietary rights of
third parties. Any issued patent owned or licensed by us may not, however,
afford adequate protection to us and may be challenged, invalidated, infringed
upon or circumvented. Furthermore, you should understand that our activities may
infringe upon patents owned by others.
In addition, we may be required to obtain licenses to patents or
other proprietary rights of other parties. Licenses required under any such
patents or proprietary rights may not be made available on terms acceptable to
us, if at all. If we are required to and do not obtain such licenses, we would
be prevented from or encounter delays in the development and marketing of our
products and technologies while we attempt to design around such patents or
other rights. Such attempts may not be successful. Failure to obtain such
licenses or to design around such patents or other rights would have a material
adverse effect on us.
We hold non-exclusive patent rights relating to the metered use of
encrypted data in local memory under a limited license from Titan Corporation to
a patent jointly held by Titan and a third party (the "Licensed Patent"). This
license agreement restricts us from metering information produced and used
solely by a government entity or producing products that meter this information.
In addition, this license agreement is subject to the rights of the joint owners
of this patent, who have the right to exploit, or to license this patent to
third parties in a manner that may be competitive with us. The joint owners of
this patent may compete with us or license this patent to a competitor of ours,
or our business may exceed the scope of this license agreement. Pursuant to this
license agreement, we are obligated to pay certain royalties to Titan. Pursuant
to this license agreement, we have granted to Titan the exclusive right to use
our patents for products distributed to government entities. On February 28,
1997 Wave and Titan executed an addendum to this license agreement whereby we
received a sole license to this patent to develop and distribute products to the
in-home consumer microcomputer market segment. Under this addendum to this
license agreement, Titan waived any and all defaults by us under this license
agreement occurring prior to February 28, 1997.
We are aware of four United States patents (the "Third Party
Patents") each having some claims that are similar to some of the claims in the
Licensed Patent. Based upon information currently known to us, some of the
claims of both the Licensed Patent and the Third Party Patents cover certain
material aspects of our technology. Therefore, the commercialization of our
technology would be subject to the rights of the holder of the Third Party
Patents unless we are able to invalidate such claims or license such technology.
Also, the holder of the Third Party Patents or a licensee of the Third Party
Patents could seek to invalidate such claims of the Licensed Patent and
therefore be able to commercialize a technology similar to our technology. In
either case, in order to invalidate the other party's patent rights, the party
claiming invalidity might need to prove that it invented the claimed subject
matter prior to the other party. We cannot provide any assurance that we would
be successful in invalidating such claims of the Third Party Patents or that the
holder of the Third Party Patents or a licensee of the Third Party Patents would
not be successful in invalidating the claims of the Licensed Patent.
Furthermore, we cannot provide any assurance that the Third Party Patents could
be proven to be invalid on any other basis. Any proceeding involving the
validity of the Licensed Patent and the Third Party Patents would be protracted
and costly. In any suit contesting the validity of a patent, the
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patent being contested would be entitled to a presumption of validity and the
contesting party would be required to demonstrate invalidity of such patent by
clear and convincing evidence.
If the Third Party Patents are not invalid insofar as their claims
relate to our technology, then we would require a license from the holder of the
Third Party Patents to commercialize our technology and make, use, or sell
products or practice methods, or license others to sell products or use methods,
utilizing this technology in the United States. Due to the uncertainty as to
whether the Third Party Patents could be proved to be invalid, we engaged in
negotiations with the holder of the Third Party Patents to obtain a license
under the Third Party Patents. As a result of these negotiations, Wave has
entered into a license of limited rights to use the Third Party Patents in
connection with certain uses. Wave did not obtain, however, a general license to
use such patents in connection with activities not connected with the licensor.
Wave has been issued ten (10) United States patents relating to
encryption and to our proprietary EMBASSY and Wave Commerce technology. We also
have six patents pending before the United States Patent Office. In addition, we
have filed foreign patent applications for seven patents. Our patents are
material to protecting some of our technology.
Some of our patent rights derive from a license from Wave's
Chairman, Mr. Peter J. Sprague, of his rights in these patents, and several
agreements with former officers regarding their rights in these patents. The
license agreement with Mr. Sprague requires us to make royalty payments to him
and Dr. John R. Michener, a former officer, in a total amount equal to two
percent of gross revenues less certain adjustments. This royalty payment is
apportioned 75 percent to Mr. Sprague and 25 percent to Dr. Michener. The
payment of royalties is secured by a security interest in and to our patents. We
believe that these agreements as a whole provide us with exclusive rights under
our patents. There can be no assurance that we will enjoy exclusive rights
to these patents under such agreements.
We rely on trade secrets and proprietary know-how, which we
protect, in part, by confidentiality agreements with our employees and contract
partners. However, we caution you that our confidentiality agreements may be
breached and we may not have adequate remedies if such a breach occurs.
Furthermore, we can provide no assurance that our trade secrets will not
otherwise become known or be independently discovered by competitors.
We also rely on copyright law to prevent the unauthorized
duplication of our software and hardware products. We have and will continue to
protect our software and our copyright interest therein through agreements with
our consultants. We can provide no assurance that copyright laws will adequately
protect our technology.
We have registered trademark and service mark registrations with
the United States Patent and Trademark Office for the marks WaveMeter and
WaveNet, EMBASSY, Great Stuff Network, Second Shift (the Wave juggler logo),
WaveCommerce, Wave Interactive Network, WaveDirect, WINPublish,
WINPurchase,CablePC, iShopHere and Face/Eye logo (iShopHere.com face logo). We
have submitted trademark registrations for, EMBASSY System, Netpass, CharityWave
and Trust @ the Edge, Signon-line, Inc., Smartsignature, Smartsafe and others.
Wave intends to apply for additional name and logo marks in the United States
and foreign jurisdictions as appropriate. No assurance can be given that federal
registration of any of these trademarks in the United States will be granted. We
have abandoned our prior applications for DataWave, InfoWave, and WaveTrac.
RESEARCH AND DEVELOPMENT
Wave's products incorporate semiconductor, encryption/decryption,
software transaction processing and other technologies in which we have made a
substantial investment in research and development. We will likely be required
to continue to make substantial investments in the design of the ETS, the
Commerce System our SmartSignature and SmartSafe products, and IP Multicasting
products. For the years ended December 31, 2001, 2000, and 1999 we expended
approximately $17.7 million, $20.9 million, and $10.7 million, respectively, on
research and development activities (such amounts include the value of stock
issued). In addition to our ongoing research and development activities, in July
1997 we licensed
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technology and in-process research and development from Aladdin Knowledge
Systems ("Aladdin") for cash and warrants valued at $3.9 million. This
technology is an integral part of the Commerce System. The success of the Wave
System depends to a large extent on our ability to adapt the Wave System for use
with various methods for the distribution of electronic content, the ability of
Wave's technology to interface with various platform environments, and the
ability of Wave's products to work in many application environments.
Incorporation of Aladdin's Hasp technology furthered these efforts and
illustrates the adaptive capabilities of Wave's products. A significant portion
of our future research and development expenditures will be used to adapt the
Wave System accordingly.
We will also continue to expend a significant amount of resources
on the development of new iterations of the ETS and the Commerce System. By
providing various means of linking the ETS to the customer's computer or
network, we will be more likely to achieve broad acceptance of our technology.
We are currently researching other form factors for the EMBASSY chip to target
other market needs.
We are now focusing increased resources on developing our
operational infrastructure. We are placing greater emphasis on developing
internal production and fulfillment systems and marketing infrastructure to
distribute Wave's products. We will also increase the resources available to the
Commerce System to adapt to changing market requirements. We plan to continue to
expand the Commerce System to handle more end users, to implement more
sophisticated pricing methodologies and to add greater financial system
flexibility.
RECENT DEVELOPMENTS
On February 2, 2001, Wave entered into a stock purchase agreement
(the "Agreement") with BIZ Interactive Zone, Inc. ("BIZ"), a privately held
company, under which it acquired 3,600,000 shares of the Series B Preferred
Stock of BIZ in exchange for 2,000,000 shares of Wave's Class A Common Stock, at
a price of $7.16 per share, for an aggregate purchase price of $14,312,800.
Wave's investment in BIZ represented approximately 17.8% of the outstanding
capital stock of BIZ. Accordingly, Wave accounted for this investment using the
Cost Method of accounting, as the investment represents less than a 20%
ownership interest in BIZ and because Wave does not have significant influence
over BIZ. On August 24, 2001 Litronic, Inc. ("Litronic"), a provider of
authentication and encryption security technology, completed a merger with BIZ
to form SSP. SSP trades on the NASDAQ National Stock Market as SSPX. As a result
of the merger, Wave now holds 3,083,083 shares (14.95%) of the common stock of
SSP. (See also Item 7A. Quantitative and Qualitative Disclosure about Market
Risk).
In June of 2001, Wave and SCM Microsystems, Inc. formed a
strategic relationship to produce EMBASSY smart card readers designed to address
European Level 5 standards for secure pin entry and secure display. Level 5
specifications guarantee a level of online security that is among the highest in
the world, enabling secure electronic transaction protocols and other forms of
secure financial services transactions. The new EMBASSY readers will have the
ability to support a continually high level of flexibility and security by
working in conjunction with Wave's back office infrastructure for secure
distribution of applets to the devices that can provide various security
functions.
In August of 2001, Wave and Maximus signed a strategic
agreement to identify and close joint business opportunities through
co-marketing their products and services to government agencies nationwide.
Maximus, a leading provider of program management, information technology and
consulting services to government agencies, will offer the ETS as part of their
total security solutions portfolio. Wave will co-market Maximus development
services for creating EMBASSY applications.
In October of 2001, Wave acquired digital signature and electronic
document management technology from SignOnLine, Inc. Wave acquired two products,
SmartSignature and SmartSAFE, which combine powerful e-signature capability with
secure storage functions thus meeting both the signing and authoritative record
requirements of the e-Sign legislation. The technology ensures the integrity of
a legally-binding digital contract by a process of ensuring a signer's identity
through strong authentication methods. Wave is marketing these products to
financial institutions as a means for them to enable their customers to sign
documents electronically, thus eliminating the need to move paper documents back
and forth between the
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institution and the consumer. The financial institution will then have the
ability to store legally executed documents electronically, as opposed to
keeping paper copies of these documents.
In November of 2001, Wave and Samsung Electro-Mechanics Co., Ltd
began working together to manufacturer and market secure keyboards containing a
built in smart card reader built around Wave's EMBASSY chip. Wave believes this
is a key step to bring its secure smart card reader technology to market by
integrating a secure EMBASSY-based smart card reader directly into the PC
keyboard, with no other attachments needed.
EMPLOYEES
As of December 31, 2001, we employed 180 full-time employees, 86
of whom were involved in sales, marketing and administration and 94 of whom were
involved in research and development (including 34 employed by WaveXpress, 14 of
whom were in sales, marketing and administration and 20 of whom were involved in
research and development.) As of December 31, 2001 we retained the services of 7
full-time consultants, 1 of whom was retained by WaveXpress. We believe our
employee relations are satisfactory.
ITEM 2. PROPERTIES
Summarized below is a listing of properties leased by Wave. Our
principal research and development activities are conducted at the Princeton and
Cupertino facilities.
UTILITY/COMMON
FACILITY SQ. FT. MONTHLY BASE RENT COSTS LEASE EXPIRES
Lee, MA 16,548 $ 12,258 - 0 - Aug. 2004
New York, NY 4,500 14,250 - 0 - May 2002
Nashville, TN 5,757 3,409 526 Sept. 2002
Princeton, NJ 21,673 43,346 2,312 Dec. 2002
Cupertino, CA 12,329 42,712 2,609 Oct. 2002
New York, NY 12,282 42,987 9,371 Apr. 2010
Orvault, France 1,000 2,674 400 Sept. 2010
ITEM 3. LEGAL PROCEEDINGS
As of December 31, 2001 Wave was not involved in any material
litigation, nor, to management's knowledge is any material litigation threatened
against them or their properties other than routine litigation arising in the
ordinary course of business.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
-8-
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Class A Common Stock trades on the Nasdaq National Market
under the symbol "WAVX". The following table sets forth, for the periods
indicated, the high and low closing sales prices per share for the Class A
Common Stock. There is no established trading market for our Class B Common
Stock.
HIGH LOW
Year Ended December 31, 2001
First Quarter $9.34 $3.47
Second Quarter 5.37 3.26
Third Quarter 4.19 1.69
Fourth Quarter 3.48 1.52
Year Ended December 31, 2000
First Quarter $47.94 $11.50
Second Quarter 32.44 13.00
Third Quarter 24.06 15.06
Fourth Quarter 16.00 4.50
As of March 18, 2002, there were approximately 33,000 holders of
our Class A Common Stock. As of such date, there were 30 holders of our Class B
Common Stock.
On March 18, 2002, the last sale price reported on the Nasdaq
National Market for the Class A Common Stock was $2.10.
We have never declared nor paid any cash dividends on our capital
stock. We currently anticipate that we will retain all future earnings, if any,
to fund the development and growth of our business and do not anticipate paying
any cash dividends on our capital stock in the foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
On February 2, 2001, Wave issued 2,000,000 shares of its Class A Common
Stock, at a price of $7.16 per share, for an aggregate purchase price of
$14,312,800 to acquire 3,600,000 shares of the Series B Preferred Stock of
BIZ, then a privately held company. Wave's investment in BIZ represented
approximately 17.8% of the outstanding capital stock of BIZ. Accordingly, the
investment had been accounted for under the cost method of accounting,
because the investment is less than 20% of the outstanding capital stock of
BIZ and because Wave could not exercise significant influence over BIZ. On
August 24, 2001, Litronic and BIZ completed a merger of the two companies and
renamed the newly formed company SSP Solutions, Inc. ("SSP"). As a result of
the merger, Wave now holds 3,083,083 shares (14.95%) of the common stock of
SSP. Wave has accounted for this investment as non-current marketable equity
securities available for sale based upon our intent to hold these securities
as a long-term investment. As of December 31, 2001, this investment was
valued at $11,160,758 based on that day's closing price of SSP Common Stock
on the NASDAQ national exchange of $3.62 per share.
-9-
ITEM 6. SELECTED FINANCIAL DATA
STATEMENT OF OPERATIONS DATA
YEAR-ENDED DECEMBER 31,
2001 2000 1999 1998 1997
------------ ------------ ------------ ------------ ------------
Revenues, Net ............................ $ 692,125 $ 332,522 $ 187,515 $ 47,681 $ 23,659
Cost of Sales ......................... 369,959 58,864 93,170 37,488 12,947
------------ ------------ ------------ ------------ ------------
Gross Margin .......................... 322,166 273,658 94,345 10,193 10,712
------------ ------------ ------------ ------------ ------------
Operating expenses:
Selling, general and
administrative ..................... 24,184,317 26,553,634 16,749,276 11,945,273 9,557,198
Research and development .............. 17,691,051 20,866,055 10,697,971 6,247,105 4,715,334
Acquisition Costs ..................... -- -- 1,494,000 -- --
Amortization of Goodwill .............. 1,720,632 573,544 -- -- --
Write-off of
Goodwill ........................... 2,284,570 -- -- -- 769,886
Write-off Impaired Assets ............. 1,761,917 -- -- -- --
Aladdin Technology License
Expense ............................ -- -- -- -- 3,889,000
In- Process Research &
Development ...................... -- 2,176,000 -- -- --
------------ ------------ ------------ ------------ ------------
47,642,487 50,169,233 28,941,247 18,192,378 18,931,418
------------ ------------ ------------ ------------ ------------
Other income (expense):
ITG Technology License Fee ............ -- -- 1,250,000 2,750,000 1,000,000
License ITG Warrant Cost .............. -- -- -- (1,100,000) --
Loss on Other than Temporary
Decline in Equity Securities ....... (1,736,682) -- -- -- --
Equity in net losses of Global
Wave ............................... (2,332,159) (3,406,491) -- -- --
Net interest and other income
(expense) ............................. 2,688,105 5,646,173 (455,670) (53,842) (91,929)
============ ============ ============ ============ ============
Net loss ................................. (48,701,057) (47,655,893) (28,052,572) (16,586,027) (18,012,635)
Accrued dividends on preferred
stock ................................. -- -- 13,239 108,863 809,982
Assured incremental yield ................ -- -- -- 750,000 1,673,000
------------ ------------ ------------ ------------ ------------
Net loss to common stockholders........... $(48,701,057) $(47,655,893) $(28,065,811) $(17,444,890) $(20,495,617)
Weighted average number of common
shares outstanding during the
period ................................ 49,949,875 46,149,587 38,365,573 31,580,665 23,224,569
Loss per common share-basic and
diluted ............................... $ (0.97) $ (1.03) $ (.73) $ (.55) $ (.88)
============ ============ ============ ============ ============
Cash dividends declared per common
share ................................. -0- -0- -0- -0- -0-
See Notes to Financial Statements
-10-
BALANCE SHEET DATA
AS OF DECEMBER 31
-----------------------------------------------------------------------------------
2001 2000 1999 1998 1997
----------- ----------- ----------- ----------- ----------
Working capital (deficiency) ........... $36,963,617 $76,099,347 $ 4,870,443 $ (770,959) $ 4,772,873
Total assets ............................ 60,234,302 98,084,06 16,531,883 6,023,991 7,965,827
Long-term liabilities ................... -- -- -- -- 522,124
Total Liabilities ....................... 6,428,896 7,870,009 6,823,643 5,289,634 2,342,526
Redeemable preferred stock .............. -- -- -- 493,201 471,601
----------- ----------- ----------- ----------- ----------
Total stockholders' equity ............. $53,805,406 $90,214,452 $ 9,708,240 $ 241,156 $ 5,151,700
=========== =========== =========== =========== ==========
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Wave Systems Corp. develops, produces and markets hardware and
software based digital security products for the Internet and e-commerce. The
Company is also engaged in various research, development and marketing efforts
to commercialize the Wave Commerce System to provide more efficient and flexible
pricing (e.g., pay per use or rent-to-own) and greater security on the usage of
the electronic content. The Company also develops data broadcasting and products
that perform digital signature and electronic document management functions.
Since our inception in February of 1988, we have devoted substantially all of
our efforts and resources to research, feasibility studies, design, development,
and market testing of our products and technology. As our research and
development activities matured, we have been able to devote increased resources
to the creation of content distribution services, market development and the
application of the our technology to end-user products and services. From
inception through December 31, 2001, we have realized only minimal operating
revenues, and do not anticipate significant revenues in the near future. There
are numerous risks that could adversely affect our efforts to achieve
profitability.
In June 2000, Wave increased its ownership percentage of Global
Wave Limited ("Global Wave"), from 25% to 40% through its wholly owned
holding company Earthquest Limited ("Earthquest"). On October 10, 2000, Wave
and Earthquest entered into an agreement with Global Wave and its Joint
Venture partner Redwave, Plc. ("Redwave"), formerly Internet Technology
Group, plc. ("ITG"), to subscribe for additional shares to maintain a 40%
ownership interest in the venture. As consideration for the additional
shares, Wave committed to invest approximately $5.7 million in cash and
development services. Wave accounts for its investment in Globalwave using
the equity method of accounting, and accordingly recognizes its share (40%)
of Globalwave's results of operations in the accompanying consolidated
statement of operations.
On July 27, 1999, Wave completed the acquisition of N*ABLE
Technologies, Inc., ("N*ABLE") a security solutions company that produces
hardware-based security solutions for the protection of sensitive user data
within network client systems, including a hardware-based security co-processor
that manages the secure transfer of payment or sensitive personal information to
and from desktop computers. Wave paid the shareholders of N*ABLE total
consideration of 2,280,821 shares of our Class A Common Stock (subject to
certain post closing adjustments). The closing price per share as of the closing
date was $10.38. Founded in 1996, N*ABLE was located in Danvers, Massachusetts,
with offices in Cupertino, California and Bouguenais, France. The transaction
was accounted for under the pooling-of-interests method of accounting and the
financial data in the Selected Financial Data table above and in the discussion
below has been restated for all periods assuming the acquisition occurred on the
first day of the first period presented.
-11-
In April 1999, WaveXpress, a joint venture between Wave and
Sarnoff Corporation was established. For technology licensed to WaveXpress,
Sarnoff and affiliates received a 40% equity stake in WaveXpress. Wave and
its affiliates who purchased, for a nominal amount, founders stock in April
1999 owned the remaining 60% of the outstanding capital stock. The affiliates
of Wave include Peter Sprague and Steven Sprague, the Chairman and Chief
Executive Officer of Wave, respectively, certain members of the Board of
Directors of Wave and certain employees of Wave. This affiliate group owned,
in the aggregate, 7% of the outstanding capital stock of WaveXpress. As of
December 31, 2001. the equity interests of Wave, Sarnoff and the Company's
affiliates referred to above, assuming all of Wave's and Sarnoff's
convertible securities are converted and warrants are exercised, would be
approximately 82%, 15%, and 3%, respectively. Wave is also funding WaveXpress
through a series of convertible notes and expects to continue to provide
funding until an external round of funding can be attained. These notes can
be converted into equity by Wave. Through December 31, 2001, Wave has loaned
approximately $25.9 million in funds under these notes, of which $9.5 million
had been converted to WaveXpress Common Stock as of December 31, 2001.
The financial statements of WaveXpress have been consolidated with
those of Wave for the years ended December 31, 2001, 2000 and 1999. As the joint
venture minority partners, Sarnoff Corporation and the Wave affiliates, have not
contributed any cash and are not required to fund the operations of the joint
venture, Wave has not recorded a minority interest in WaveXpress in the
consolidated financial statements and therefore, has reflected 100% of
WaveXpress' operating results in these consolidated financial statements.
The following discussion related to the consolidated financial
statements of Wave should be read in conjunction with the financial statements
appearing in Item 8.
-12-
CRITICAL ACCOUNTING POLICIES
The following accounting policies are deemed critical to the
understanding of the consolidated financial statements included under Item 8 -
Financial Statements and Supplementary Data.
Method of Accounting for Joint Ventures - Wave accounts for its investments in
joint ventures using the equity method of accounting when its ownership interest
in the joint venture is less than fifty percent and it is determined that Wave
has the ability to exercise significant influence over the joint venture's
operating and financial policies. The financial statements of joint ventures in
which Wave owns greater than a fifty percent interest are consolidated with
Wave's financial statements pursuant to APB Opinion No. 18.
Marketable Securities - debt securities and publicly traded equity
securities are classified as available for sale and are recorded at market using
the specific identification method. Unrealized gains and losses are reflected in
other comprehensive income. Unrealized losses that are determined to be other
than temporary are recognized as charges against earnings. Factors considered
when determining if an other than temporary declines has occurred include:
whether a decline in market value is related to specific concerns of the issuer
of the securities as opposed to general market conditions, the length of time of
the decline in market price, the financial condition and near-term prospects of
the issuer and other factors that may indicate that the value of the securities
will not recover. All other investments, excluding joint venture arrangements,
are recorded at cost.
Inventories - Inventories, which are stated at the lower of cost
or net realizable value, consist of inventory held for resale to customers. Cost
is determined on the first-in, first-out basis and includes freight and other
incidental costs incurred. Wave provides inventory allowances based on excess
and obsolete inventories.
Goodwill and Purchased Intangible Assets - Goodwill and purchased
intangible assets are carried at cost less accumulated amortization.
Amortization is computed using the straight-line method over the expected useful
life of the asset (currently 2 to 3 years). In accordance with the Financial
Accounting Standards Board's ("FASB") Statement of Financial Accounting Standard
No. 121 ("SFAS 121"), Wave assesses the recoverability of goodwill and purchased
intangible assets by determining whether the amortization of the goodwill
balance over its remaining life can be recovered through undiscounted future
operating cash flows of the related acquired operation. The amount of goodwill
impairment, if any, is measured based on projected discounted future operating
cash flows using a discount rate reflecting Wave's average cost of funds. The
assessment of the recoverability of goodwill is impacted if estimated future
operating cash flows are less than the net carrying value of the asset.
Research and Development and Software Development Costs - Research
and development costs are expensed as incurred. Software development costs are
accounted for pursuant to Statement of Financial Accounting Standards No. 86
"Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise
Marketed" which requires software development costs to be capitalized when a
product's technological feasibility has been established. In accordance with
SFAS 121, Wave assesses the recoverability of capitalized costs of software
development costs by determining whether the amortization of the balance over
their remaining life can be recovered through undiscounted future operating cash
flows of the related acquired operation. The amount of capitalized software
development costs impairment, if any, is measured based on projected discounted
future operating cash flows using a discount rate reflecting Wave's average cost
of funds. The assessment of the recoverability of capitalized software
development costs is impacted if estimated future operating cash flows are less
than the net carrying value of the asset.
Impairment of Long-Lived Assets and Long-Lived Assets to Be
Disposed Of - Wave reviews its long-lived assets and certain identifiable
intangibles for impairment whenever events or changes in circumstances indicate
that the carrying amount of an asset may not be recoverable. Recoverability of
assets to be held and used is measured by a comparison of the carrying amount of
an asset to future net cash flows expected to be generated by the asset. If such
assets are considered to be impaired, the impairment to be recognized is
measured by the amount by which the carrying amount of the assets exceed the
fair value of the assets. Assets to be disposed of are reported at the lower of
the carrying amount or fair value less costs to sell.
-13-
Revenue Recognition - Wave generally recognizes product revenue
when delivery has occurred, the price is fixed and determinable, and collection
is probable. Wave recognizes revenue on fixed-price long-term service contracts
using the percentage-of-completion method. Cash payments received in advance of
product or service contract revenue are recorded as deferred revenue.
-14-
COMPARISON OF THE YEARS ENDED DECEMBER 31, 2001 AND 2000
RESULTS OF OPERATIONS
For the twelve months ended December 31, 2001 and December 31,
2000, revenues were $692,125 and $332,522 respectively. Revenue growth can be
primarily attributed to a significant increase in hardware sales and contract
revenues. The contract revenue is derived primarily from a development contract
with SSP, a shareholder of Wave. Wave also owns 14.95% of SSP. Revenue on the
contract is being recognized on a percentage of completion basis, and is subject
to cash received and milestones accomplished. Cost of sales for the twelve
months ended December 31, 2001, was $369,166 compared with $58,864 for the same
period in 2000. Cost of sales in 2001 is not comparable to costs of sales for
2000, as the sales mix differed substantially in 2001 versus 2000. Sales in the
year-ended 2001 from contracts and hardware produced margins of 45% versus sales
for the year ended 2000 which consisted largely of license revenues, producing a
much higher overall profit margin of 82%.
Research and development expenses for the twelve months ended
December 31, 2001 were $17,691,051, as compared to $20,866,055 for the
comparable period of 2000. This 15% decrease in research and development
expenses was primarily attributable to a decrease in consultant costs associated
with a lessened design and development effort with respect to our proprietary
integrated circuit technology and software. Significant development initiatives
undertaken during the year ended December 31, 2000 included major enhancements
to Wavenet, the development of EMBASSY II, the development of the EMBASSY applet
developers kit, the creation of the "Trust Assurance Network" and the
development of core EMBASSY applets. Many of these projects were substantially
completed near the end of the 1st quarter of 2001. Accordingly, as the
development of these projects were substantially complete, Wave reduced its
consultant work force early in 2001 resulting in significantly less research and
development costs incurred during the year. WaveXpress' research and development
expenses were $3,916,845 for the year ended December 31, 2001 versus $5,188,098
for the year ended December 31, 2000. The amounts set forth above include the
WaveXpress amounts referred to here in. Also, the reasons for the reduction in
expenditures set forth above pertain to both Wave as a whole and WaveXpress.
Selling, general and administrative expenses for the twelve months
ended December 31, 2001 were $24,184,317 as compared to $26,553,634 for the
comparable period of 2000. The 9% decrease in selling, general and
administrative expenses was attributable to several factors. A number of
consultant positions were eliminated during 2001 and were either not replaced or
were converted to in-house employees, reducing the overall cost per headcount.
Consultants that supported products and/or lines of business that Wave
de-emphasized, including MyPublish, Wave Direct and IshopHere.com were
eliminated. Wave also realized significant savings in trade show costs,
advertising and marketing. These savings were achieved by attending fewer trade
shows and by bringing the corporate marketing function in-house and using fewer
outside marketing consultants. Additionally, during 2001 Wave undertook an
aggressive cost cutting program that resulted in significant reductions in
travel and office supplies expenses. Finally, substantial savings were achieved
by eliminating recruiting expenses as Wave stabilized its work force late in the
year-ended 2000 and into 2001. WaveXpress incurred selling, general and
administrative expenses of $4,800,927 in 2001, compared to $4,992,285 for 2000,
for a decrease of 4%. The reasons set forth above encompass WaveXpress as well
as Wave as a whole.
Goodwill amortization associated with the acquisition of
iShopHere.com, for the year ended December 31, 2001 was $1,720,632 versus
$573,544 in the year ended December 31, 2000. This is the result of a full
year's amortization having been taken for the year-ended December 31, 2001,
while only four months' expense was taken in the year ended December 31,
2000, as the acquisition took place on August 31, 2000.
In the first quarter of 2001, Wave took a charge of $1,562,500 to
write off a technology license that it had purchased in connection with the
development of the WaveXpress data broadcast system. Additionally in the fourth
quarter of 2001, Wave wrote off $199,417 for hardware; also part of the
WaveXpress terrestrial data casting system. These write-offs totaling $1,761,917
were the result of modifications to WaveXpress' business model; consequently,
the value of these assets became impaired because they were no longer needed in
the business and had no alternative uses.
-15-
As a result of the decline in current business conditions, and
Wave's realignment of resources to focus on what it considers high-growth
markets and core opportunities, Wave recorded in the fourth quarter of 2001, a
charge of $2,284,570 related to the impairment of goodwill and purchased
intangible assets associated with the Indigo asset purchase. This amount is
equal to the carrying amount of the assets prior to the impairment charge.
Accordingly, the carrying amount of the goodwill and purchased intangible assets
as of December 31, 2001 is $0.
Wave recorded a provision for inventory obsolescence totaling
$933,304 in 2001. This charge related to chips based on legacy technology
that wave is no longer actively marketing, and therefore became impaired.
The in-process research and development ("IPRD") expense incurred
in the year-ended December 31, 2000 was related to the acquisition of Indigo
Networks LLC ("Indigo") and its e-commerce shopping network, iShopHere.com. The
portion of the purchase price allocated to in-process research and development
for this acquisition was approximately 29% of the total purchase price of
$7,445,000. The IPRD was valued using an income approach. The cash flows were
discounted to present value at an appropriate rate. The discount rate was
determined by an analysis of the risks associated with each of the identified
intangible assets. The resulting net cash flows to which the discount rate of
27% was applied were based on management's estimates of revenues, operating
expenses and income taxes from such acquired in-process technology.
OTHER INCOME AND EXPENSES
Interest income for the year ended December 31, 2001 was
$2,688,105 versus $5,103,716 for the year ended December 31, 2000, for a
decrease of 47%. This decrease resulted from a decrease in interest bearing
assets during 2001 and lower rates earned on those interest bearing assets.
Equity in losses of Global Wave were $2,332,159 and $3,406,491 for the year
ended December 31, 2001 and 2000, respectively. The decrease resulted from a
reduction in Global Wave's net loss, and Wave's portion being limited to Wave's
investment in Global Wave of $5.7 million, which was reached in the fourth
quarter of 2001.
As of December 31, 2001 the Company took a charge for an "other
than temporary decline" in the value of its investment in SSP of $1,736,682.
This charge was taken because a decline in SSP's share price had occurred due to
concerns about SSP's financial condition and near-term prospects. As a result of
this charge the cost basis of the investment as of December 31, 2001 has been
adjusted to $12,576,118.
The Gain on Sale of marketable equity securities in the year ended
December 31, 2000 resulted from the acquisition of ITG. Wave recognized the gain
as the amount of cash received in the transaction over the book basis of the
1,000,000 shares.
COMPARISON OF THE YEARS ENDED DECEMBER 31, 2000 AND 1999
For the twelve months ended December 31, 2000 and December 31,
1999, revenues were $332,522 and $187,515 respectively. Revenue growth can be
attributed to increased software and technology licensing agreements in 2000 as
opposed to hardware security co-processor and associated software products from
which most of the 1999 revenues were derived. The cost of sales for the twelve
months ended December 31, 2000, was $58,864 compared with $93,170 for the same
period in 1999. This was the result of higher margins on sales associated with
licensing arrangements versus sales of hardware products.
Research and development expenses for the twelve months ended
December 31, 2000 were $20,866,055, as compared to $10,697,971 for the
comparable period of 1999. This 95% increase in research and development
expenses was primarily attributable to an increase in headcount and consultant
costs associated with the design and development of our proprietary integrated
circuit technology and software. Significant development initiatives undertaken
during the year ended December 31, 2000 included major enhancements to Wavenet,
the development of EMBASSY II, the development of the EMBASSY applet developers
kit, the creation of the "Trust Assurance Network" and the development of core
EMBASSY applets. In addition, WaveXpress experienced significant expenditures in
developing its data broadcast system. WaveXpress' research and development
expenses were $5,188,098 for the year ended December 31, 2000 versus $769,733 in
for the year ended December 31, 1999, since its operations only began in October
of 1999.
-16-
Selling, general and administrative expenses for the twelve months
ended December 31, 2000 were $26,553,634 as compared to $16,749,276 for the
comparable period of 1999. The 58.5% increase in selling, general and
administrative expenses was primarily attributable to an increase in personnel,
consultants and professional fees, trade shows, equipment and other related
costs associated with the development and marketing of new applications and
pursuing new markets for our technology. In addition, WaveXpress was in
operation for the entire year ended December 31, 2000, as its operations began
in October of 1999. WaveXpress incurred selling, general and administrative
expenses of $4,992,285 in 2000, compared to $1,084,415 for 1999.
In addition to the increases in research and development and
selling, general and administrative expenses referred to above, Wave recognized
an in-process R&D expense of $2,176,000 and goodwill amortization of $573,544 in
the year ended December 31, 2000 associated with the acquisition of
iShopHere.com. These expenses were not incurred for the year-ended December 31,
1999. Acquisition costs associated with pooling-of-interest acquisitions were $0
for the year-ended December 31, 2000, versus $1,494,000 for the year-ended
December 31, 1999. For the reasons described above, total operating expenses for
the year-ended December 31, 2000 were $50,169,234 compared with $28,941,247 for
the year-ended December 31, 1999.
Net interest and other income/(expense) for the twelve months
ended December 31, 2000 was $5,646,173 as compared to ($455,669) for the
comparable period of 1999. This change resulted from increased interest income
of $4,486,410, primarily attributable to an increase in interest-bearing assets.
This was a direct result of the private placement of Class A Common Stock for an
aggregate purchase price of $122,427,000; a gain of approximately $542,000 on
the sale of marketable equity securities; and the elimination of $833,000 of
interest expense resulting from the pay-off of all outstanding debt. In
addition, Wave incurred other charges of $240,000 in 1999. No such charges were
incurred in 2000.
Equity in the net losses of Global Wave, an unconsolidated
subsidiary accounted for under the equity method, was $3,406,491 for the
year-ended December 31, 2000. No losses associated with this subsidiary were
recognized in 1999 or any prior years, as Wave had not funded nor had it
committed to provide any funding prior to 2000.
Wave did not realize any license fee income for the year ended
December 31, 2000 versus the $1,250,000 that was recognized for the year ended
December 31, 1999. The license fee for 1999 was the final portion of a $5
million fee paid by ITG to Wave as part of a joint venture agreement under which
ITG received the right to market the Wave technology in European and Middle
Eastern markets. Additional development work had been committed to support
increased distribution efforts in 2001 at a cost of approximately $1.6 million.
For the year ended December 31, 2000, WaveXpress incurred a net
loss of approximately $11.2 million versus approximately $1.9 million for the
year ended December 31, 1999. WaveXpress has not realized any revenues since
inception. The expense components that make up their net losses for the
years-ended December 31 2000 and 1999 are described above.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT
During the year ended December 31, 2000, Wave recorded IPRD
charges of $2,176,000 related to the acquisition of Indigo and its e-commerce
shopping network, iShopHere.com. The portion of the purchase price allocated to
in-process research and development for this acquisition was approximately 29%
of the total purchase price of $7,445,000. Wave's management was primarily
responsible for estimating the fair value of purchased in-process research and
development. At the acquisition date, Indigo was in the process of developing
technology which would add functionality and features, and developing a new
platform for its product. The IPRD had not yet reached technological
feasibility, had no alternative uses, and may not have achieved commercial
viability. At the acquisition date, management estimated that completion of the
IPRD would be accomplished in November 2000. The initial development effort had
commenced in January, 2000. At the valuation date, the new technology had not
reached a completed prototype stage, although some beta testing on portions of
the technology had begun. At the valuation date, the IPRD was approximately 75%
complete, based on costs incurred on the IPRD through the acquisition date
versus the total costs estimated to complete the project. The IPRD was
substantially completed within the time originally estimated. The IPRD project
was valued using an income approach. This approach took into consideration
earnings remaining after deducting from cash flows related to the in-process
technology, the market rates of return on contributory
-17-
assets, including assembled workforce, merchant agreements working capital and
fixed assets. The cash flows were then discounted to present value at an
appropriate rate. The discount rate was determined by an analysis of the risks
associated with each of the identified intangible assets. The resulting net cash
flows to which the discount rate of 27% was applied were based on management's
estimates of revenues, operating expenses and income taxes from such acquired
in-process technology.
LIQUIDITY AND CAPITAL RESOURCES
We have experienced net losses and negative cash flow from
operations since our inception, and, as of December 31, 2001, had a deficit
accumulated during the development stage of $189,624,124, and stockholders'
equity of $53,805,406. We have financed our operations principally through the
issuance of Class A and B Common Stock and various series of preferred stock,
for total proceeds since inception of approximately $204,775,000.
At December 31, 2001, we had $40,437,119 in unrestricted cash and
cash equivalents. At December 31, 2000, we had $80,703,890 in cash and cash
equivalents. We held marketable equity securities with a value of $11,171,124
($11,160,758 of which is classified as non-current) as of December 31, 2001
versus $1,923,305 in marketable securities at December 31, 2000. The decrease in
cash and cash equivalents resulted from $38,214,486 used in operating activities
and $1,507,598 used to purchase property and equipment, including the purchase
of software and intangible assets. In addition, $544,687 was used in financing
activities which consisted of loans to officers of $1,299,640, offset by
proceeds from the issuance of Common Stock - primarily from exercises of
employee stock options and warrants totaling $754,953. Loans to officers
totaling $963,320 came due in February and March of 2002, and were extended for
an additional one year.
Wave's commitment to invest approximately an additional $1.6
million in Global Wave was satisfied in the first quarter of 2002. This
amount is included in Accrued Expenses as of December 31, 2001. In addition,
as of December 31, 2001, Wave was committed to provide $850,000 in loans to
Specialty Broadcast Networks, Inc. ("SBN"), under an Unsecured Convertible
Term Note Agreement (the "SBN Note") that Wave entered into with SBN on
August 3, 2001. Wave owns 50% of SBN's outstanding common stock. and had
provided approximately $150,000 under the SBN Note as of December 31, 2001.
Wave's commitment to make further loans under this note expired in February
2002. Wave has no plans to renew its commitment to providing any additional
loans to SBN. Wave accounts for its investment in SBN using the equity method
of accounting. SBN's operations are not material to Wave's financial position
and results of operations. Wave's significant fixed commitments with respect
to leases and inventory purchases are as follows:
2002 2003 2004 2005 2006 Thereafter Total
------------- ------------ ----------- ------------ ------------ -------------- -------------
Leases $1,826,621 $761,281 $641,758 $621,623 $646,187 $2,208,267 $6,705,737
Inventory Purchases 983,723 - - - - - 983,723
------------- ------------ ----------- ------------ ------------ -------------- -------------
Total Committments $2,810,334 $761,281 $641,758 $621,623 $646,187 $2,208,267 $7,689,460
</Table>
WaveXpress has been funded entirely by Wave through a series of
convertible promissory notes (the "Notes"). Through December 31, 2001 Wave has
provided approximately $25.9 million in funds under the Notes, including accrued
interest of $2.3 million. Wave expects to continue funding WaveXpress through
the Notes and similar notes for the foreseeable future. Presently, Wave has
committed to funding WaveXpress up to an additional $1.6 million under the
Notes.
As of December 31, 2001, we had available net operating loss
carryforwards for Federal income tax purposes of approximately $145 million.
Because of the "change in ownership" provisions of the Tax Reform Act of 1986,
our net operating loss carryforwards may be subject to an annual limitation on
the utilization of these carryforwards against taxable income in future periods
if a cumulative change in ownership of more than 50 percent of Wave occurs
within any three-year period. We have made no determination concerning whether
there has been such a cumulative change in ownership. However, we believe that
it is likely that such a change in ownership occurred prior to or following the
completion of our initial public offering in September 1994.
-18-
At December 31, 2001, we had working capital of $36,963,617. Wave
expects to continue to incur substantial additional expenses resulting in
significant losses for the foreseeable future. However, considering our current
cash balance and Wave's projected operating cash requirements, we anticipate
that our existing capital resources will be adequate to satisfy our cash flow
requirements through the first quarter of 2003.
However, as Wave has not yet attained commercial acceptance of
its products and has not generated any significant operating revenue,
considerable uncertainty currently exists with respect to the adequacy of
current funds to support our activities beyond the first quarter of 2003.
This uncertainty will continue until a positive cash flow from operations is
achieved. Additionally, Wave is uncertain as to the availability of financing
from other sources to fund any cash deficiencies.
In order to reduce this uncertainty, Wave continues to evaluate
additional financing options and may therefore elect to raise capital, from
time to time, through equity or debt financings in order to capitalize on
business opportunities and market conditions and to insure the continued
development of Wave's technology, products and services. There can be no
assurance that Wave can raise additional financing in the future.
RECENT ACCOUNTING PRONOUNCEMENTS
On July 20, 2001, FASB issued Statements No. 141, Business
Combinations ("SFAS 141") and No. 142 Goodwill and Other Intangible Assets
("SFAS 142"). SFAS 141 requires all business combinations initiated after June
30, 2001 to be accounted for using the purchase method. Poolings initiated prior
to June 30, 2001 are grandfathered. SFAS 142 replaces the requirement to
amortize intangible assets with indefinite lives and goodwill with a requirement
for an impairment test. SFAS 142 also requires an evaluation of intangible
assets and their useful lives and a transitional impairment test for goodwill
and certain intangible assets. After the transition, the impairment tests must
be performed annually. A company must adopt SFAS 142 at the beginning of the
fiscal year. Thus, as a calendar year-end company, Wave must adopt SFAS. 142 no
later than January 1, 2002. Wave is currently examining the impact of this
pronouncement on its results of operations and financial position, but currently
believes the impact will not be material.
FASB recently issued SFAS 143, Accounting for Asset Retirement
Obligations ("SFAS 143") which addresses financial accounting and reporting for
obligations associated with the retirement of tangible long-lived assets and the
associated asset retirement costs. SFAS 143 requires an enterprise to record the
fair value of an asset retirement obligation as a liability in the period in
which it incurs a legal obligation associated with the retirement of a tangible
long-lived asset. SFAS 143 also requires the enterprise to record the contra to
the initial obligation as an increase to the carrying amount of the related
long-lived asset and to depreciate that cost over the remaining useful life of
the asset. The liability is changed at the end of each period to reflect the
passage of time and changes in the estimated future cash flows underlying the
initial fair value measurement. SFAS 143 is effective for fiscal years beginning
after June 15, 2002. Wave is currently examining the impact of this
pronouncement on the results of its operations and financial position, but
currently believes the impact will not be material.
On October 3, 2001, FASB issued SFAS 144, Accounting for the
Impairment or Disposal of Long-Lived Assets ("SFAS 144"), which addresses
financial accounting and reporting for the impairment or disposal of long-lived
assets and supersedes SFAS 121. SFAS 144, retains many of the fundamental
provisions of SFAS 121. SFAS 144 also supersedes the accounting and reporting
provisions of Accounting Principle Board Opinion 30, Reporting the Results of
Operations--Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions ("ABP
30"), for the disposal of a segment of a business. However, it retains the
requirement in APB 30 to report separately discontinued operations and extends
that reporting to a component of an entity that either has been disposed of (by
sale, abandonment, or in a distribution to owners) or is classified as held for
sale. SFAS 144 is effective for fiscal years beginning after December 15, 2001
and interim periods within those fiscal years. Wave is currently examining the
impact of this pronouncement on its results of operations and financial
position, but currently believes the impact will not be material.
-19-
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Wave's investment portfolio consists of minority equity
investments in publicly traded companies. Most predominantly, we hold a 14.95%
interest in SSP. (See Recent Sales of Unregistered Securities under Item 5).
These securities are generally classified as available for sale and,
consequently, are recorded on the balance sheet at fair value with unrealized
gains and losses reported as a separate component of accumulated other
comprehensive income (loss), net of tax. These investments are inherently risky
because the market for the technologies or products they have under development
are typically in the early stages and may never materialize. In addition, the
values of these investments are subject to significant market price volatility.
For example, as a result of market price volatility, we experienced a $3.3
million decrease in net unrealized gains during the year ended December 31,
2001. In addition, we recorded a charge against earnings associated with a loss
in value on our investment in SSP of $1.7 million that was considered to be
"other than temporary". These equity securities are held for purposes other than
trading. The following table presents the hypothetical change in fair values of
Wave's investments in marketable equity securities of publicly traded entities
using the high and low closing prices of the securities from January 1, 2001
through March 22, 2002:
Fair Value at the lowest Fair Value at the highest
closing price January 1, Fair Value as of closing price January 1,
2001 through March 22, 2002 December 31, 2001 2001 through March 22, 2002
----------------------------- ------------------------ ----------------------------
Corporate Equities $ 7,712,027 $ 11,171,124 $ 23,351,456
The exposure to market risk associated with interest
rate-sensitive instruments is not material. Wave's cash and cash equivalents
consist primarily of money market funds that meet high credit quality standards
and the amount of credit exposure to any one issue is limited.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements, the notes thereto, and the
independent auditors' report thereon are presented beginning at page F-1 of this
Form 10-K and are hereby incorporated by reference into this Item 8. The
quarterly financial information required by this Item 8 is included in the Notes
to Consolidated Financial Statements.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANT ON ACCOUNTING AND FINANCIAL
DISCLOSURE
Not Applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The response to this item is incorporated by reference from the
discussion responsive thereto under the captions "Management" and "Section 16(a)
Beneficial Ownership Reporting Compliance" in Wave's Proxy Statement for the
2002 Annual Meeting of Stockholders.
ITEM 11. EXECUTIVE COMPENSATION
The response to this item is incorporated by reference from the
discussion responsive thereto under the caption "Executive Compensation" in
Wave's Proxy Statement for the 2002 Annual Meeting of Stockholders.
-20-
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The response to this item is incorporated by reference from the
discussion responsive thereto under the caption "Security Ownership of Certain
Beneficial Owners and Management" in Wave's Proxy Statement for the 2002 Annual
Meeting of Stockholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The response to this item is incorporated by reference from the
discussion responsive thereto under the captions "Certain Relationships and
Related Transactions" in Wave's Proxy Statement for the 2002 Annual Meeting of
Stockholders.
-21-
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) (1) Financial Statements:
PAGE(S)
Index to Consolidated Financial Statements F-1
Independent Auditors' Report F-2
Consolidated Balance Sheets as of December 31, 2001 and 2000 F-3
Consolidated Statements of Operations for each of the years
ended December 31, 2001, 2000 and 1999 and
for the period from February 12, 1988 (inception)
through December 31, 2001 F-4
Consolidated Statements of Stockholders' Equity
(Deficiency) and Other Comprehensive Income (Loss)
for each of the years ended December 31, 2001, 2000
and 1999 and for the period from February 12, 1988
(inception) through December 31, 2001 F-5
Consolidated Statements of Cash Flows for each of the
years ended December 31, 2001, 2000 and 1999 and for
the period from February 12, 1988 (inception) through
December 31, 2001 F-10
Notes to Consolidated Financial Statements F-12
(a) (2) Financial Statement Schedules:
All schedules have been omitted since they are either not required or
not applicable.
(a) (3) Exhibits:
EXHIBIT NO. DESCRIPTION OF EXHIBIT
--------------------- ------------------------------------------------------------------------------------
3.1* -- Restated Certificate of Incorporation of Wave (incorporated by
reference to Exhibit 3.1 of Wave's Registration Statement on
Form S-1, File No. 33-75286)
3.2* -- Bylaws of Wave (incorporated by reference to Exhibit 3.2 of
Wave's Registration Statement on Form S-1, File No. 33-75286)
4.1* -- Form of Stock Certificate of Class A Common Stock (incorporated by reference
to Exhibit 4.1 of Wave's Registration Statement on Form S-1, File
No. 33-75286)
4.2* -- Form of Representative's Warrant Agreement, including the form of
Representative's Warrant (incorporated by reference to Exhibit 4.2 of
Wave's Registration Statement on Form S-1, File No. 33-75286).
4.3* -- Certificate of Designation of Series B Preferred Stock of Wave as filed with
the Delaware Secretary of State on May 24, 1996 (incorporated by reference to
Exhibit 3.1 of Wave's Current Report on Form 8-K filed on May 30,
1996, File No. 0-24752)
4.4* -- Certificate of Designation of Series C Convertible Preferred Stock of as
filed with the Delaware Secretary of State on December 27, 1996 (incorporated
by reference to Exhibit 3.1 of Wave's Current Report on Form 8-K
filed on January 8, 1997, File No. 0-24752)
4.5* -- Certificate of Designation of Series D Convertible Preferred Stock of as
filed with the Delaware Secretary of State on December 27, 1996 (incorporated
by reference to Exhibit 3.1 of Wave's Current Report on Form 8-K
filed on June 3, 1997, File No. 0-24752)
-22-
4.6* -- Certificate of Designation of Series F Convertible Preferred Stock of Wave
as filed with the Delaware Secretary of State on October 9, 1997
(incorporated by reference to Exhibit 3.1 of Wave's Current Report
on Form 8-K filed on October 15, 1997, File No. 0-24752)
4.7* -- Certificate of Designation of Series G Convertible Preferred Stock of Wave
as filed with the Delaware Secretary of State on March 5,--1998 (incorporated
by reference to Exhibit 3.1 of Wave's Current Report on Form 8-K
filed on March 19, 1998, File No. 0-24752)
+10.1* -- Joint Technology Development Agreement, dated as of May 1, 1992, between The
Titan Corporation and Cryptologics International, Inc. (incorporated by
reference to Exhibit 10.2 of Wave's Registration Statement on Form
S-1, File No. 33-75286)
+10.2* -- License and Cross-License Agreement, dated as of May 1, 1992, between The
Titan Corporation and Cryptologics International, Inc. (incorporated by
reference to Exhibit 10.3 of Wave's Registration Statement on
Form S-1, File No. 33-75286)
10.3* -- Amendment to License and Cross-License Agreement, dated as of August 27,
1993, between The Titan Corporation and Wave (incorporated by reference to
Exhibit 10.4 of Wave's Registration Statement on Form S-1, File No.
33-75286)
10.4* -- Amended and Restated License Agreement, dated February 14, 1994, by and among
Wave , Peter J. Sprague and John R. Michener (incorporated by reference to
Exhibit 10.5 of Wave's Registration Statement on Form S-1, File No.
33-75286)
+10.5* -- Wave Systems Corp. 1994 Stock Option Plan (incorporated by reference to
Exhibit 10.6 of Wave's Registration Statement on Form S-1, File No.
33-75286)
+10.6* -- Wave Systems Corp. Non-Employee Directors Stock Option Plan (incorporated by
reference to Exhibit 10.7 of Wave's Registration Statement on Form
S-1, File No. 33-75286)
+10.7 -- Wave Systems Corp. 1996 Performance Stock Option Plan
10.8* -- Addendum to License and Cross-License Agreement, dated February 28, 1997,
between The Titan Corporation and Wave (incorporated by
reference to Exhibit 10.10 of Wave's Current Report on Form 10-K
filed on March 24, 1997, file No. 0-24752).
+10.9* -- Employment Contract, dated June 8, 1998, between Gerard T. Feeney and Wave
(incorporated by reference to Exhibit 10.18 of Wave's Current Report
on Form 10-K filed on April 1, 1999, file No. 0-24752).
+10.10* -- Employment Contract, dated November 10, 1998, between Steven Sprague and Wave
(incorporated by reference to Exhibit 10.19 of Wave's Current Report on
Form 10-K filed on April 1, 1999, file No. 0-24752).
-23-
EXHIBIT NO. DESCRIPTION OF EXHIBIT
- --------------------------- ------------------------------------------------------------------------------------
10.11* -- Asset Purchase Agreement dated August 13, 2000, by and among Wave
and Indigo Networks, LLC (incorporated by reference to Exhibit 99.1 of
Wave's current report on Form 8-K, filed on September 15, 2000
(File #0-24752).
10.12 -- Agreement to subscribe for 40,000 shares of Global Wave, dated
October 10, 2000, by and among Wave, Redwave, Global Wave, and
Earthquest, Ltd. (a United Kingdom Company and wholly-owned subsidiary of
Wave).
10.13 -- Form of Stock Purchase Agreement, dated February 2, 2002 by and between Wave
and BIZ.
10.14 -- Consulting Services Agreement dated September 14, 2001, by and between Wave
and Archon Technologies, Inc.
10.15 -- Form of Asset Purchase Agreement dated October 4, 2001, by and between Wave
and SignOnLine.
10.16 -- First Amendment to Asset Purchase Agreement dated October 4, 2001, by and
between Wave and SignOnLine.
21.1 -- Subsidiaries of Registrant.
23.1 -- Consent of Independent Auditors - KPMG LLP
99.1 -- Demand Note, dated March 26, 2001 between Gerard T. Feeney and Wave
99.2 -- Demand Note, dated February 27, 2001 between Peter J. Sprague and Wave
99.3 -- Demand Note, dated July 25, 2001 between Peter J. Sprague and Wave
99.4 -- Demand Note, dated September 5, 2001 between Peter J. Sprague and Wave
99.5 -- Co-marketing agreement dated May 14, 2001, by and between Wave and Maximus
* Incorporated herein by reference
+ Confidential treatment has been granted as to portions of this exhibit.
+ Management contract or compensatory plan.
(b) Reports on Form 8-K
There have been no reports on Form 8-K filed during the quarter-ended
December 31, 2001.
-24-
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the
Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized.
Dated: March 27, 2002
WAVE SYSTEMS CORP.
By: /s/ PETER J. SPRAGUE
Name: Peter J. Sprague
Title: Chairman
Pursuant to the requirements of the Securities Exchange Act of
1934, this report has been signed by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
/S/ PETER J. SPRAGUE
- --------------------------------
Peter J. Sprague Chairman March 27, 2002
/S/ STEVEN SPRAGUE
Steven Sprague President, Chief Executive Officer and March 27, 2002
Director
/S/ JOHN E. BAGALAY, JR.
- --------------------------------
John E. Bagalay, Jr. Director March 27, 2002
/S/ GEORGE GILDER
George Gilder Director March 27, 2002
/S/ JOHN E. MCCONNAUGHY, JR.
John E. McConnaughy, Jr. Director March 27, 2002
/S/ NOLAN BUSHNELL
Nolan Bushnell Director March 27, 2002
/S/ GERARD T. FEENEY
- --------------------------------
Gerard T. Feeney Senior Vice President, Finance March 27, 2002
and Administration, Chief Financial
Officer and Secretary (Principal
Financial Officer and Duly Authorized
Officer of the Registrant
-25-
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
PAGE(S)
Independent Auditors' Report F-2
Consolidated Balance Sheets as of December 31, 2001 and 2000 F-3
Consolidated Statements of Operations for each of the years
ended December 31, 2001, 2000 and 1999 and for the period
from February 12, 1988 (inception) through December 31, 2000 F-4
Consolidated Statements of Stockholders' Equity (Deficiency)
and Other Comprehensive Income (Loss) for each of the
years ended December 31, 2001, 2000 and 1999 and for
the period from February 12, 1988 (inception) through
December 31, 2001 F-5
Consolidated Statements of Cash Flows for each of the years ended
December 31, 2001, 2000 and 1999 and for the period from
February 12, 1988 (inception) through December 31, 2001 F-10
Notes to Consolidated Financial Statements F-12
F-1
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
Wave Systems Corp.:
We have audited the consolidated financial statements of Wave Systems Corp. and
subsidiaries (a development stage corporation) as listed in the accompanying
index. These consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Wave Systems Corp.
and subsidiaries as of December 31, 2001 and 2000, and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 2001 and for the period from February 12, 1988 (date of
inception) to December 31, 2001 in conformity with accounting principles
generally accepted in the United States of America.
KPMG LLP
Boston, Massachusetts
March 7, 2002
F-2
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Balance Sheets
December 31, 2001 and 2000
ASSETS
2001 2000
------------------- -------------------
Current assets:
Cash and cash equivalents $ 40,437,119 $ 80,703,890
Cash Collected on Behalf of Charities 358,531 --
Marketable securities 10,366 1,923,305
Notes Receivable from Officers 1,380,050 --
Inventories 581,912 625,148
Prepaid expenses and other receivables 624,535 717,013
------------- -------------
Total current assets 43,392,513 83,969,356
Marketable Equity Securities 11,160,758 --
Investment in Global Wave
-- 735,509
Property and equipment, net 4,291,228 5,201,869
Intangible assets, net
-- 2,895,000
Goodwill and acquisition intangibles, net of accumulated amortization
-- 4,005,202
Other assets 1,389,803 1,277,525
------------- -------------
Total Assets
60,234,302 98,084,461
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities:
Accounts payable and accrued expenses 5,807,878 7,870,009
Due to Charities 423,053 --
Deferred Revenue 197,965 --
------------- -------------
Total current liabilities 6,428,896 7,870,009
Stockholders' Equity:
Common Stock, $.01 par value. Authorized 75,000,000 shares as Class A;
49,996,506 shares issued and outstanding in 2001 and 47,051,197 in 2000 499,965 470,512
Common Stock, $.01 par value. Authorized 13,000,000 shares as Class B;
357,083 shares issued and outstanding in 2001 and 779,211 in 2000 3,571 7,792
Capital in excess of par value 244,330,985 228,735,910
Deficit accumulated during the development stage (189,624,123) (140,923,066)
Other Comprehensive Income - unrealized gain (loss) on marketable securities (1,404,992) 1,923,304
------------- -------------
Total stockholders' equity 53,805,406 90,214,452
------------- -------------
Total Liabilities and Stockholders' Equity $ 60,234,302 $ 98,084,461
============= =============
See accompanying notes to consolidated financial statements.
F-3
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Statements of Operations
Years ended December 31, 2001, 2000, 1999, and
period from February 12, 1988 (date of inception)
through December 31, 2001
<Table>
<Caption>
PERIOD FROM
FEBRUARY 12,
1988 (DATE OF
INCEPTION)
THROUGH DECEMBER 31,
Net Revenues: 2001 2000 1999 2001
------------ ------------ ------------- -------------------
Product $ 192,506 $ 4,400 $ 67,234 $ 364,140
Services
430,724 -- -- 430,724
Licensing and Other 68,895 328,122 20,281 491,858
------------ ------------ ------------- -------------
Total Net Revenues 692,125 332,522 187,515 1,286,722
------------ ------------ ------------- -------------
Cost of sales:
Product 135,134 3,520 77,632 216,286
Services 227,124 -- -- 227,124
Licensing and Other 7,701 55,344 15,538 130,780
------------ ------------ ------------- -------------
Total Cost of Sales 369,959 58,864 93,170 574,190
------------ ------------ ------------- -------------
Gross margin 322,166 273,658 94,345 712,532
Operating expenses:
Selling, general and administrative 24,184,317 26,553,634 16,749,276 108,471,913
Research and development 17,691,051 20,866,055 10,697,971 71,952,976
Amortization of Goodwill 1,720,632 573,544 -- 2,294,176
Write-off of Intangibles and otherd
Impaired Assets 1,761,917 -- -- 1,761,917
Write-off of Goodwill 2,284,570 -- -- 3,054,456
In Process research and development
expense -- 2,176,000 -- 2,176,000
Acquisition Costs -- -- 1,494,000 1,494,000
Aladdin license expense -- -- -- 3,889,000
------------ ------------ ------------- -------------
47,642,487 50,169,233 28,941,247 195,094,438
Other income (expense):
Interest income 2,688,105 5,103,716 617,306 9,713,399
Interest expense -- -- (832,976) (1,695,461)
Equity in net losses of Global Wave (2,332,159) (3,406,491) -- (5,738,650)
Loss on Other than Temporary Decline in
Marketable Equity Securites (1,736,682) -- -- (1,736,682)
Gain on Sale of Marketable Securities -- 542,457 -- 542,457
License fee -- -- 1,250,000 5,000,000
License warrant cost -- -- -- (1,100,000)
Other (expense) -- -- (240,000) (227,280)
------------ ------------ ------------- -------------
(1,380,736) 2,239,682 794,330 4,757,783
------------ ------------ ------------- -------------
Net loss (48,701,057) (47,655,893) (28,052,572) (189,624,123)
Accrued dividends on preferred Stock -- -- 13,239 4,350,597
------------ ------------ ------------- -------------
Net loss to common stockholders $(48,701,057) $(47,655,893) $ (28,065,811) $(193,974,720)
------------ ------------ ------------- -------------
Loss per common share - basic and diluted $ (0.97) $ (1.03) $ (0.73) $ (10.43)
------------ ------------ ------------- -------------
Weighted average number of common
shares outstanding during the period 49,949,875 46,149,587 38,365,573 18,601,112
------------ ------------ ------------- -------------
See accompanying notes to consolidated financial statements.
F-4
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income (Loss)
<Table>
<Caption>
DEFICIT
ACCUMULATED
CLASS A CLASS B CAPITAL DURING THE
COMMON STOCK COMMON STOCK IN EXCESS OF DEVELOPMENT
SHARES AMOUNT SHARES AMOUNT PAR VALUE STAGE
------ ------ ------ ------ --------- -----
Shares issued to founders at $.003 per share -- $ -- 4,680,000 $46,800 $ (31,200) $ --
Shares issued at $1.25 per share, net of expenses of
$36,574 from September through November 1988 -- -- 300,000 3,000 335,426 --
Net loss for period ended December 31, 1988 -- -- -- -- -- (326,832)
-------- ---- --------- ------- ----------- -----------
Balance at December 31, 1988 -- -- 4,980,000 49,800 304,226 (326,832)
Shares issued at $1.25 per share, net of expenses of
$68,750, from January through December 1989 -- -- 270,000 2,700 266,050 --
Shares issued at $1.25 per share in July 1989 as
compensation for services rendered -- -- 1,920 19 2,381 --
Shares issued by principal stockholders at $1.25
per share in December 1989 as compensation
for services rendered -- -- -- -- 374,000 --
Net loss for year ended December 31, 1989 -- -- -- -- -- (982,186)
-------- ---- --------- ------- ----------- -----------
Balance at December 31, 1989 -- -- 5,251,920 52,519 946,657 (1,309,018)
Shares issued by principal stockholder at $1.25
per share in March 1990 as compensation for
services rendered -- -- -- -- 56,250 --
Shares issued by principal stockholder at $.50 per
share in March 1990 as compensation for
services rendered -- -- -- -- 60,000 --
Shares issued at $1.67 per share in May 1990 as
compensation for services rendered -- -- 6,000 60 9,940 --
Shares issued at $1.67 per share, net of expenses of
$5,000 in March, April, November and December 1990 -- -- 390,000 3,900 641,100 --
Net loss for year ended December 31, 1990 -- -- -- -- -- (1,178,129)
-------- ---- --------- ------- ----------- -----------
Balance at December 31, 1990 -- -- 5,647,920 56,479 1,713,947 (2,487,147)
Shares issued at $1.67 per share from March
through November 1991 -- -- 315,000 3,150 521,850 --
Shares issued at $1.67 per share in November
1991 as compensation for services rendered -- -- 19,800 198 32,802 --
Net loss for year ended December 31, 1991 -- -- -- -- -- (1,009,368)
-------- ---- --------- ------- ----------- -----------
Balance at December 31, 1991 (carried forward) -- -- 5,982,720 59,827 2,268,599 (3,496,515)
======== ==== ========= ======= =========== ===========
NOTE
RECEIVABLE
DEFERRED FROM
COMPENSATION STOCKHOLDER TOTAL
------------ ----------- --------
Shares issued to founders at $.003 per share $-- $-- $ 15,600
Shares issued at $1.25 per share, net of expenses of
$36,574 from September through November 1988 -- -- 338,426
Net loss for period ended December 31, 1988 -- -- (326,832)
--- --- -----------
Balance at December 31, 1988 -- -- 27,194
Shares issued at $1.25 per share, net of expenses of
$68,750, from January through December 1989 -- -- 268,750
Shares issued at $1.25 per share in July 1989 as
compensation for services rendered -- -- 2,400
Shares issued by principal stockholders at $1.25
per share in December 1989 as compensation
for services rendered -- -- 374,000
Net loss for year ended December 31, 1989 -- -- (982,186)
--- --- -----------
Balance at December 31, 1989 -- -- (309,842)
Shares issued by principal stockholder at $1.25
per share in March 1990 as compensation for
services rendered -- -- 56,250
Shares issued by principal stockholder at $.50 per
share in March 1990 as compensation for
services rendered -- -- 60,000
Shares issued at $1.67 per share in May 1990 as
compensation for services rendered -- -- 10,000
Shares issued at $1.67 per share, net of expenses of
$5,000 in March, April, November and December 1990 -- -- 645,000
Net loss for year ended December 31, 1990 -- -- (1,178,129)
--- --- -----------
Balance at December 31, 1990 -- -- (716,721)
Shares issued at $1.67 per share from March
through November 1991 -- -- 525,000
Shares issued at $1.67 per share in November
1991 as compensation for services rendered -- -- 33,000
Net loss for year ended December 31, 1991 -- -- (1,009,368)
--- --- -----------
Balance at December 31, 1991 (carried forward) -- -- (1,168,089)
=== === ===========
See accompanying notes to consolidated financial statements.
F-5
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income (Loss)- (Continued)
<Table>
<Caption>
CLASS A CLASS B CAPITAL
COMMON STOCK COMMON STOCK IN EXCESS OF
SHARES AMOUNT SHARES AMOUNT PAR VALUE
------ ------ ------ ------ ------------
Balance at December 31, 1991 (brought forward) -- -- 5,982,720 59,827 2,268,599
Shares issued at $1.67 per share
from January through October 1992 -- -- 708,000 7,080 1,172,920
Shares issued at $1.67 per share in
May 1992 in connection with License and
Cross-License Agreement -- -- 674,976 6,750 1,118,210
Shares issued at $1.67 per share in May 1992
as compensation for services rendered -- -- 18,000 180 29,820
Shares issued at $2.50 per share in May and
November 1992 as compensation for services
rendered -- -- 771,000 7,710 1,919,790
Shares issued at $2.50 per share, net of
expenses of $7,500, in November and
December 1992 -- -- 323,001 3,230 796,773
Shares issued by principal stockholder in
December 1992 at $2.50 per share as
compensation for services rendered -- -- -- -- --
Shares canceled in October and December 1992 -- -- (75,000) (750) 750
Issuance of stock options at $.003 exercise price
per share in June 1992 -- -- -- -- 798,400
Amortization of deferred compensation -- -- -- -- --
Accrued dividends on preferred stock -- -- -- -- --
Note receivable and accrued interest from
stockholder -- -- -- -- --
Net loss for the year ended December 31, 1992 -- -- -- -- --
--- --- ----------- -------- -----------
Balance at December 31, 1992 -- -- 8,402,697 84,027 8,173,879
Shares issued at $1.67 per share in February 1993 -- -- 30,000 300 49,800
Shares issued at $3.50 per share, net of
expenses of $82,427, from April through
December 1993 -- -- 550,359 5,504 1,838,294
Shares issued at $3.50 per share from May
to December 1993 as compensation for services
rendered, for the acquisition of property and
equipment and as additional interest on borrowings -- -- 73,319 733 255,884
Issuance of warrants to purchase Class B Common Stock
from September to December 1993 in conjunction with
the issuance of convertible debt -- -- -- -- --
Amortization of deferred compensation -- -- -- -- --
Accrued dividends on preferred stock -- -- -- -- --
Note receivable and accrued interest
from stockholder -- -- -- -- --
Net loss for year ended December 31, 1993 -- -- -- -- --
--- --- ----------- -------- -----------
Balance at December 31, 1993 -- -- 9,056,375 90,564 10,352,283
=== === =========== ======== ===========
<Caption>
DEFICIT
ACCUMULATED NOTE
DURING THE RECEIVABLE
DEVELOPMENT DEFERRED FROM
STAGE COMPENSATION STOCKHOLDER TOTAL
------------ ------------ ----------- -----
Balance at December 31, 1991 (brought forward) (3,496,515) -- -- (1,168,089)
Shares issued at $1.67 per share
from January through October 1992 -- -- -- 1,180,000
Shares issued at $1.67 per share in
May 1992 in connection with License and
Cross-License Agreement -- -- -- 1,124,960
Shares issued at $1.67 per share in May 1992
as compensation for services rendered -- -- -- 30,000
Shares issued at $2.50 per share in May and
November 1992 as compensation for services
rendered -- -- -- 1,927,500
Shares issued at $2.50 per share, net of
expenses of $7,500, in November and
December 1992 -- -- -- 800,003
Shares issued by principal stockholder in
December 1992 at $2.50 per share as
compensation for services rendered 75,000 -- -- --
5,000
Shares canceled in October and December 1992 -- -- -- --
Issuance of stock options at $.003 exercise price
per share in June 1992 -- (398,660) -- 399,740
Amortization of deferred compensation -- -- 155,455 --
55,455
Accrued dividends on preferred stock (6,383) -- -- --
6,383)
Note receivable and accrued interest from
stockholder -- -- (152,974) (152,974)
Net loss for the year ended December 31, 1992 (4,182,638) -- -- (4,182,638)
----------- ----------- ----------- -----------
Balance at December 31, 1992 (7,679,153) (243,205) (152,974) 182,574
Shares issued at $1.67 per share in February 1993 -- -- -- 50,100
Shares issued at $3.50 per share, net of
expenses of $82,427, from April through
December 1993 -- -- -- 1,843,798
Shares issued at $3.50 per share from May
to December 1993 as compensation for services
rendered, for the acquisition of property and
equipment and as additional interest on borrowings -- -- -- 256,617
Issuance of warrants to purchase Class B Common Stock
from September to December 1993 in conjunction with
the issuance of convertible debt 72,893 -- -- --
2,893
Amortization of deferred compensation -- -- 243,205 --
43,205
Accrued dividends on preferred stock (38,467) -- -- --
38,467)
Note receivable and accrued interest
from stockholder -- -- (39,783) (39,783)
Net loss for year ended December 31, 1993 (3,959,334) -- -- (3,959,334)
----------- ----------- ----------- -----------
Balance at December 31, 1993 (11,638,487) -- (192,757) (1,388,397)
=========== =========== =========== ===========
</Table>
See accompanying notes to consolidated financial statements.
F-6
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income (Loss)- (Continued)
<Table>
<Caption>
CLASS A CLASS B
COMMON STOCK COMMON STOCK
SHARES AMOUNT SHARES AMOUNT
------ ------ ------ ------
Balance at December 31, 1993 -- -- 9,056,375 90,564
Shares issued at $3.50 per share in January and
February 1994 -- -- 95,715 957
Shares issued at $3.50 per share in February 1994
as additional interest on borrowings -- -- 5,700 57
Issuance of warrants to purchase Class B Common
Stock in January and February 1994 in
conjunction with the issuance of convertible debt -- -- -- --
Accrued dividends on preferred stock -- -- -- --
Accrual of interest on note receivable from stockholder -- -- -- --
Sale of warrants to underwriter in September 1994 -- -- -- --
Conversion of notes payable -- -- 599,507 5,995
Shares issued at $5.00 per share in initial
public offering in September 1994, net of
expenses of $2,929,8353,728,200 37,282 -- -- 15,673,883
Net loss for year ended December 31, 1994 -- -- -- --
----------- ----------- ----------- -----------
Balance at December 31, 1994 3,728,200 37,282 9,757,297 97,573
Shares issued at prices ranging from $1.00
per share to $3.13 per share as compensation
for services rendered 31,559 315 -- --
Exercise of options to purchase Class B Common
Stock -- -- 681,700 6,817
Accrued dividends on preferred stock -- -- -- --
Accrual of interest on note receivable from stockholder -- -- -- --
Exchange of Class B Common Stock for
Class A Common Stock 2,855,859 28,559 (2,855,859) (28,559)
Net loss for the year ended December 31, 1995 -- -- -- --
----------- ----------- ----------- -----------
Balance at December 31, 1995 6,615,618 66,156 7,583,138 75,831
Exercise of options to purchase
Class A Common Stock 214,091 2,141 -- --
Shares issued at prices ranging from
$2.06 per share to $3.44 per share as
compensation for services rendered 42,077 421 -- --
Issuance of unregistered Class B Common Stock
to acquire Wave Interactive Network valued
at approximately $.98 per share -- -- 375,000 3,750
Issuance of warrants to purchase unregistered
shares of Class A Common Stock in conjunction
with the issuance of convertible debt and
preferred stock -- -- -- --
Conversion of Class B Preferred Stock 2,960,303 29,603 -- --
Accrual of interest on note receivable -- -- -- --
Accrued dividends on preferred stock -- -- -- --
Exchange of Class B Common Stock for
Class A Common Stock 1,749,997 17,500 (1,749,997) (17,500)
N*ABLE APIC in connection with the issuance of
Class A Common Stock due to merger 873,317 8,733 -- --
Net loss for the year ended December 31, 1996 -- -- -- --
----------- ----------- ----------- -----------
Balance at December 31, 1996 12,455,403 124,554 6,208,141 62,081
=========== =========== =========== ===========
<Caption>
DEFICIT
ACCUMULATED NOTE
CAPITAL DURING THE RECEIVABLE
IN EXCESS OF DEVELOPMENT DEFERRED FROM
PAR VALUE STAGE COMPENSATION STOCKHOLDER TOTAL
---------- ----------- ------------ ----------- -----
Balance at December 31, 1993 10,352,283 (11,638,487) -- (192,757) (1,388,397)
Shares issued at $3.50 per share in January and
February 1994 334,046 -- -- -- 335,003
Shares issued at $3.50 per share in February 1994
as additional interest on borrowings 19,893 -- -- -- 19,950
Issuance of warrants to purchase Class B Common
Stock in January and February 1994 in
conjunction with the issuance of convertible debt 115,234 -- -- -- 115,234
Accrued dividends on preferred stock (39,484) -- -- -- (39,484)
Accrual of interest on note receivable from stockholder -- -- -- (17,315) (17,315)
Sale of warrants to underwriter in September 1994 4 -- -- -- 4
Conversion of notes payable 2,079,131 -- -- -- 2,085,126
Shares issued at $5.00 per share in initial
public offering in September 1994, net of
expenses of $2,929,8353,728,200 -- -- -- -- 15,711,165
Net loss for year ended December 31, 1994 -- (4,271,501) -- -- (4,271,501)
----------- ----------- --- ----------- -----------
Balance at December 31, 1994 28,534,990 (15,909,988) -- (210,072) 12,549,785
Shares issued at prices ranging from $1.00
per share to $3.13 per share as compensation
for services rendered 57,184 -- -- -- 57,499
Exercise of options to purchase Class B Common
Stock 429,413 -- -- -- 436,230
Accrued dividends on preferred stock (40,600) -- -- -- (40,600)
Accrual of interest on note receivable from stockholder -- -- -- (17,318) (17,318)
Exchange of Class B Common Stock for
Class A Common Stock -- -- -- -- --
Net loss for the year ended December 31, 1995 -- (6,832,866) -- -- (6,832,866)
----------- ----------- --- ----------- -----------
Balance at December 31, 1995 28,980,987 (22,742,854) -- (227,390) 6,152,730
Exercise of options to purchase
Class A Common Stock 420,366 -- -- -- 422,507
Shares issued at prices ranging from
$2.06 per share to $3.44 per share as
compensation for services rendered 123,029 -- -- -- 123,450
Issuance of unregistered Class B Common Stock
to acquire Wave Interactive Network valued
at approximately $.98 per share 364,688 -- -- -- 368,438
Issuance of warrants to purchase unregistered
shares of Class A Common Stock in conjunction
with the issuance of convertible debt and
preferred stock 283,455 -- -- -- 283,455
Conversion of Class B Preferred Stock 3,078,921 -- -- -- 3,108,524
Accrual of interest on note receivable -- -- -- (17,315) (17,315)
Accrued dividends on preferred stock (199,014) -- -- -- (199,014)
Exchange of Class B Common Stock for
Class A Common Stock -- -- -- -- --
N*ABLE APIC in connection with the issuance of
Class A Common Stock due to merger 1,296,241 -- -- -- 1,304,974
Net loss for the year ended December 31, 1996 -- (10,126,546) -- -- (10,126,546)
----------- ----------- --- ----------- -----------
Balance at December 31, 1996 34,348,673 (32,869,400) -- (244,705) 1,421,203
=========== =========== === =========== ===========
</Table>
See accompanying notes to consolidated financial statements.
F-7
<Page>
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income (Loss)- (Continued)
<Table>
<Caption>
CLASS A CLASS B
COMMON STOCK COMMON STOCK
SHARES AMOUNT SHARES AMOUNT
------ ------ ------ ------
Balance at December 31, 1996 12,455,403 124,554 6,208,141 62,081
---------- ------------ --------- ------------
Exercise of options to purchase
Class A and B Common Stock 70,326 703 10,330 104
Shares issued at prices ranging
from $1.00 per share to $3.00
per share as compensation for
services rendered 126,885 1,269 -- --
Conversion of preferred stock into
Common Stock 7,998,860 79,989 -- --
Issuance of Class A Common Stock
and warrants to purchase Class A
Common Stock to Aladdin 500,000 5,000 -- --
Issuance of Class A Common Stock and
warrants to purchase Class A Common Stock 799,964 8,000 -- --
Reduction in note receivable -- -- -- --
Accrual of interest on note receivable -- -- -- --
Issuance of warrants to purchase
Class A Common Stock in conjunction with the
issuance of preferred stock -- -- -- --
Accrued dividend on preferred stock including
accretion of assured incremental yield -- -- -- --
Assured incremental yield on issuance of Series F
convertible preferred stock and debt -- -- -- --
N*ABLE APIC in connection with the issuance of
Class A Common Stock due to merger 1,404,723 14,047 -- --
Net loss -- -- -- --
Exchange of Class B Common Stock for
Class A Common Stock 1,796,518 17,965 (1,796,518) (17,965)
---------- ------------ --------- ------------
Balance at December 31, 1997 25,152,679 $ 251,527 4,421,953 $ 44,220
Exercise of options to purchase Class A
Common Stock 77,558 775 -- --
Options issued to employees below fair
market-value -- -- -- --
Exercise of warrants to purchase
Class A Common Stock1,652,770 16,528 -- -- 3,945,740
Warrants to purchase Class A Common Stock
to be issued as part of technology
licensing agreement and issued to
consultants for services -- -- -- --
Shares issued at prices ranging
from $1.00 per share to $5.00 per share
as compensation for services rendered 121,400 1,214 -- --
Reduction in note receivable -- -- -- --
Issuance of Series G Convertible Preferred stock
and Common Stock warrants, net of issuance
costs of $222,500 -- -- -- --
Assured incremental yield on issuance of Series G
convertible preferred stock and debt -- -- -- --
Accrual of interest on note receivable -- -- -- --
Accrued dividend on preferred stock including
accretion of assured incremental yield -- -- -- --
Conversion of Series G Preferred Stock 2,394,494 23,945 -- --
N*ABLE's APIC in connection with the
issuance of Class A Common Stock due to
the merger 2,781 28 -- --
Net loss -- -- -- --
Adjustment for net loss of N*ABLE for the
1st six months ended June 30,of 1998 -- -- -- --
Exchange of Class B Common Stock for
Class A Common Stock 1,281,288 12,813 (1,281,288) (12,813)
---------- ------------ --------- ------------
Balance at December 31, 1998 30,682,970 $ 306,830 3,140,665 $ 31,407
---------- ------------ --------- ------------
<Caption>
DEFICIT
ACCUMULATED SERIES G NOTE
CAPITAL DURING THE CONVERTIBLE RECEIVABLE
IN EXCESS OF DEVELOPMENT PREFERRED FROM
PAR VALUE STAGE STOCK STOCKHOLDER TOTAL
------------ ----------- ------------ ----------- -----
Balance at December 31, 1996 34,348,673 (32,869,400) -- (244,705) 1,421,203
------------ ------------ ------------ ------------ ------------
Exercise of options to purchase
Class A and B Common Stock 139,081 -- -- -- 139,888
Shares issued at prices ranging
from $1.00 per share to $3.00
per share as compensation for
services rendered 304,227 -- -- -- 305,496
Conversion of preferred stock into
Common Stock 6,703,028 -- -- -- 6,783,017
Issuance of Class A Common Stock
and warrants to purchase Class A
Common Stock to Aladdin 3,834,000 -- -- -- 3,839,000
Issuance of Class A Common Stock and
warrants to purchase Class A Common Stock 792,000 -- -- -- 800,000
Reduction in note receivable -- -- -- 50,000 50,000
Accrual of interest on note receivable -- -- -- (17,319) (17,319)
Issuance of warrants to purchase
Class A Common Stock in conjunction with the
issuance of preferred stock 386,462 -- -- -- 386,462
Accrued dividend on preferred stock including
accretion of assured incremental yield (1,372,984) -- -- -- (1,372,984)
Assured incremental yield on issuance of Series F
convertible preferred stock and debt 682,000 -- -- -- 682,000
N*ABLE APIC in connection with the issuance of
Class A Common Stock due to merger 10,133,497 -- -- -- 10,147,544
Net loss -- (18,012,635) -- -- (18,012,635)
Exchange of Class B stock for Class A stock -- -- -- -- --
------------ ------------ ------------ ------------ ------------
Balance at December 31, 1997 $ 55,949,984 $(50,882,035) $ -- $ (212,024) $ 5,151,672
Exercise of options to purchase Class A
Common Stock 151,180 -- -- -- 151,955
Options issued to employees below fair
market-value 234,723 -- -- -- 234,723
Exercise of warrants to purchase
Class A Common Stock1,652,770 -- -- -- 3,962,268
Warrants to purchase Class A Common Stock
to be issued as part of technology
licensing agreement and issued to
consultants for services 1,546,824 -- -- -- 1,546,824
Shares issued at prices ranging
from $1.00 per share to $5.00 per share
as compensation for services rendered 647,274 -- -- -- 648,488
Reduction in note receivable -- -- -- 75,000 75,000
Issuance of Series G Convertible Preferred stock
and Common Stock warrants, net of issuance
costs of $222,500 218,250 -- 1,809,250 -- 2,027,500
Assured incremental yield on issuance of Series G
convertible preferred stock and debt 750,000 -- -- -- 750,000
Accrual of interest on note receivable -- -- -- (12,318) (12,318)
Accrued dividend on preferred stock including
accretion of assured incremental yield (858,863) -- 837,263 -- (21,600)
Conversion of Series G Preferred Stock 2,274,756 -- (2,298,701) -- --
N*ABLE's APIC in connection with the
issuance of Class A Common Stock due to
the merger 59,182 -- -- -- 59,210
Net loss -- (16,586,027) -- -- (16,586,027)
Adjustment for net loss of N*ABLE for the
1st six months ended June 30,of 1998 -- 2,253,461 -- -- 2,253,461
Exchange of Class B Common Stock for
Class A Common Stock -- -- -- -- --
------------ ------------ ------------ ------------ ------------
Balance at December 31, 1998 $ 64,919,050 $(65,214,601) $ 347,812 $ (149,342) $ 241,156
============ ============ ============ ============ ============
</Table>
See accompanying notes to consolidated financial statements.
F-8
<Page>
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Statements of Stockholders' Equity (Deficiency)
And Comprehensive Income (Loss) - (Continued)
<Table>
<Caption>
CLASS A CLASS B CAPITAL
COMMON STOCK COMMON STOCK IN EXCESS OF
SHARES AMOUNT SHARES AMOUNT PAR VALUE
------ ------ ------ ------ -----------
Balance at December 31, 1998 30,682,970 $ 306,830 3,140,665 $ 31,407 $ 64,919,050
Net loss -- -- -- -- --
Unrealized gain on Marketable Securities -- -- -- -- --
Comprehensive loss -- -- -- -- --
Exercise of options to purchase
Class A Common Stock 964,000 9,640 -- -- 1,622,431
Warrants exercised to purchase
Class A Common Stock 3,370,238 33,702 -- -- 6,708,057
Shares Issued at $11.00 per share,
net of issuance costs 2,090,405 20,904 -- -- 21,481,665
Conversion of Bridge to Loan to purchase
Class A Common Stock 787,349 7,874 -- -- 2,567,380
Warrants to Purchase Class A Common Stock
For services rendered -- -- -- -- --
Shares issued as compensation for
services rendered 83,461 834 -- -- 1,149,486
Accrual of interest on note receivable -- -- -- -- --
Conversion of Series G Preferred Stock 377,102 3,771 -- -- 344,041
Accrued dividend on preferred stock -- -- -- -- (13,239)
Exchange of Class B Common Stock for
Class A Common Stock 1,090,158 10,902 (1,090,158) (10,902) --
Balance at December 31, 1999 39,445,683 $ 394,457 2,050,507 $ 20,505 $ 99,854,111
Net loss -- -- -- -- --
Unrealized gain (loss) on
marketable securities -- -- -- -- --
Comprehensive loss -- -- -- -- --
Shares issued at $34.00 per share,
net of issuance costs 3,600,800 36,008 -- -- 114,941,407
Shares issued in exchange for
substantially all of the assets
of Indigo Networks, LLC at $19.30
per share 374,889 3,749 -- -- 7,231,609
Shares issued as compensation for
services at $13.75 per share 7,879 79 -- -- 108,254
Exercise of warrants to purchase
Class A Common Stock 319,692 3,197 -- -- 1,331,048
Exercise of Options to purchase
Class A Common Stock 2,030,958 20,309 -- -- 4,950,872
Compensation on Employee Options issued -- -- -- -- 318,609
Exchange of Class B Common Stock for
Class A Common Stock 1,271,296 12,713 (1,271,296) (12,713) --
Repayment of note receivable
from stockholder -- -- -- -- --
Balance at December 31, 2000 47,051,197 $ 470,512 779,211 $ 7,792 $ 228,735,910
Net loss -- -- -- -- --
Investment Loss on Marketable Securities -- -- -- -- --
Comprehensive loss -- -- -- -- --
Shares issued in exchange for
3,600,000 shares of BIZ
Interactive Zone, Inc. at $7.16 per share 2,000,000 20,000 -- -- 14,292,800
Exercise of Options 523,181 5,232 -- -- 749,721
Compensation on Employee Options Issued -- -- -- -- 552,554
Exchange of Class B Common Stock for
Class A Common Stock 422,128 4,221 (422,128) (4,221) --
---------- ------------- -------- ------------- -------------
Balance at December 31, 2001 49,996,506 $ 499,965 357,083 $ 3,571 $ 244,330,985
========== ============= ======== ============= =============
<Caption>
DEFICIT
ACCUMULATED SERIES G ACCUMULATED NOTE
DURING THE CONVERTIBLE OTHER RECEIVABLE
DEVELOPMENT PREFERRED COMPREHENSIVE FROM
STAGE STOCK INCOME STOCKHOLDER TOTAL
------------- ------------ ------------- ----------- -----
Balance at December 31, 1998 $ (65,214,601) $ 347,812 -- $ (149,342) $ 241,156
Net loss (28,052,572) -- -- -- (28,052,572)
Unrealized gain on Marketable Securities -- -- 2,860,500 -- 2,860,500
Comprehensive loss -- -- -- -- (25,192,072)
Exercise of options to purchase
Class A Common Stock -- -- -- -- 1,632,071
Warrants exercised to purchase
Class A Common Stock -- -- -- -- 6,741,759
Shares Issued at $11.00 per share,
net of issuance costs -- -- -- -- 21,502,569
Conversion of Bridge to Loan to purchase
Class A Common Stock -- -- -- -- 2,575,254
Warrants to Purchase Class A Common Stock
For services rendered -- -- -- -- 1,075,240
Shares issued as compensation for
services rendered -- -- -- -- 1,150,320
Accrual of interest on note receivable -- -- -- (4,818) (4,818)
Conversion of Series G Preferred Stock -- (347,812) -- -- --
Accrued dividend on preferred stock -- -- -- (13,239)
Exchange of Class B Common stock for
Class A Common stock -- -- -- -- --
Balance at December 31, 1999 $ (93,267,173) $ 0 $ 2,860,500 $ (154,160) $ 9,708,240
Net loss (47,655,893) -- -- -- (47,655,893)
Unrealized gain (loss) on
marketable securities -- -- (937,196) -- (937,196)
Comprehensive loss -- -- -- -- (48,593,089)
Shares issued at $34.00 per share,
net of issuance costs -- -- -- -- 114,977,415
Shares issued in exchange for
substantially all of the assets
of Indigo Networks, LLC at $19.30
per share -- -- -- -- 7,235,358
Shares issued as compensation for
services at $13.75 per share -- -- -- -- 108,333
Exercise of warrants to purchase
Class A Common Stock -- -- -- -- 1,334,245
Exercise of Options to purchase
Class A Common Stock -- -- -- -- 4,971,181
Compensation on Employee Options issued -- -- -- -- 318,609
Exchange of Class B Common Stock for
Class A Common Stock -- -- -- -- --
Repayment of note receivable
from stockholder -- -- -- 154,160 154,160
Balance at December 31, 2000 $(140,923,066 $ 0 $ 1,923,304 $ 0 $ 90,214,452
Net loss (48,701,057) -- -- -- (48,701,057)
Investment Loss on Marketable Securities -- -- (3,328,296) -- (3,328,296)
Comprehensive loss -- -- -- -- (52,029,353)
Shares issued in exchange for
3,600,000 shares of BIZ
Interactive Zone, Inc. at $7.16 per share -- -- -- -- 14,312,800
Exercise of Options -- -- -- -- 754,953
Compensation on Employee Options Issued -- -- -- -- 552,554
Exchange of Class B Common Stock for
Class A Common Stock -- -- -- -- --
------------- ------------- ------------- ------------- -------------
Balance at December 31, 2001 $(189,624,123) $ 0 $ (1,404,992) $ 0 $ 53,805,406
============= ============= ============= ============= =============
</Table>
See accompanying notes to consolidated financial statements.
F-9
F-10
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Statements of Cash Flows
Years ended December 31, 2001, 2000, 1999,
and the Period From February 12, 1988 (Date of
Inception) through December 31, 2001
<Table>
<Caption>
Period from
February 12, 1988
(date of inception)
through
December 31,
2001 2000 1999 2001
---------------- ---------------- ---------------- -----------------
Cash flows from operating activities:
Net loss $ (48,701,057) $ (47,655,893) $ (28,052,572) $(189,624,123)
Adjustments to reconcile net loss to net cash
used in operating activities:
Write-off of goodwill
2,284,570 -- -- 3,054,456
Goodwill Amortization
1,720,632 573,544 -- 2,294,176
Depreciation and amortization
2,531,324 2,593,594 767,993 7,631,424
Reserve for note from ,672,934
affiliate -- -- -- 1
Non-cash expenses:
Accretion of assured incremental yield on convertible debt -- -- -- 119,000
Common stock issued in connection with License Agreement -- -- -- 1,124,960
Realized gain on marketable securities -- (542,457) -- (542,457)
Net losses realized on Global Wave investment 2,332,159 3,406,491 -- 5,738,650
Common stock issued for services rendered
and additional interest on borrowings -- 108,333 150,320 3,600,199
Warrants issued as compensation for services -- -- 1,075,240 2,751,595
Issuance of warrants to
Aladdin -- -- -- 2,939,000
Accrued interest on note
payable -- -- 15,388 121,219
In Process research and development -- 2,176,000 -- 2,176,000
Write-off of Impaired Assets 1,761,917 -- -- 1,761,917
Loss on Other than Temporary Decline in Marketable Equity
Securities
1,736,682 -- -- 1,736,682
Preferred stock issued for services rendered -- -- -- 265,600
Compensation associated with issuance of Stock Options
552,554 318,609 -- 1,505,626
Amortization of deferred compensation -- -- -- 398,660
Amortization of discount on notes payable -- -- -- 166,253
Common stock issued by principal stockholder for services -- -- -- 565,250
Changes in assets and liabilities:
Increase (decrease) in deferred revenue 197,965 -- (1,250,000) 197,965
Increase in accrued interest on note receivable (80,410) 105,985 (4,818) (80,411)
(Increase) in inventories 43,236 (193,462) (431,686) (581,912)
(Increase) decrease in prepaid expenses and other receivables 92,478 (194,834) (424,358) (594,214)
(Increase) decrease in other assets (112,278) (870,604) (243,833) (1,404,718)
Increase (decrease) in accounts payable and accrued expenses (2,638,780) 26,365 3,345,840 4,448,742
Increase in amounts due to charities 423,053 -- -- 423,053
Increase in cash restricted on behalf of Charities (358,531) -- -- (358,531)
----------- ----------- ----------- ------------
Net cash used in operating activities (38,214,486) (40,148,329) (25,052,486) (148,493,006)
</Table>
(Continued)
F-11
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Consolidated Statements of Cash Flows (Continued)
Years ended December 31, 2001, 2000, 1999
and the Period From February 12, 1988 (Date of
Inception) through December 31, 2001
<Table>
<Caption>
Period from
February 12, 1988
(date of inception)
through
December 31,
2001 2000 1999 2001
-------------- ---------------- ---------------- ------------------
Cash flows from investing activities:
Acquisition of property and equipment (1,507,598) (3,829,300) (2,106,639) (10,294,754)
Investment in Global Wave joint venture -- (4,142,000) -- (4,142,000)
Purchase of intangible assets -- (750,000) (1,750,000) (2,500,000)
Short-term loans to affiliate -- -- -- (1,672,934)
Organizational costs -- -- -- (14,966)
Proceeds from sale of marketable securities -- 2,162,457 -- 2,162,457
Exercise of warrant to acquire marketable
securities-available for sale
-- -- (1,620,000) (1,620,000)
------------- ------------- ------------- -------------
Net cash used in investing activities (1,507,598) (6,558,843) (5,476,639) (18,082,197)
Cash flows from financing activities:
Net proceeds from issuance of common stock 754,953 121,072,842 30,874,435 192,492,121
Net proceeds from issuance of preferred stock and warrants -- -- -- 12,283,027
Payment on (issuance of ) note receivable from stockholder (1,299,640) 48,175 -- (1,299,640)
Proceeds from notes payable and warrants to Stockholders -- -- 2,000,000 4,083,972
Repayments of notes payable to stockholders -- -- -- (1,069,972)
Proceeds from notes payable and warrants -- -- -- 1,284,254
Repayments of note payable -- -- -- (255,000)
Redemption of Preferred Stock -- -- (506,440) (506,440)
------------- ------------- ------------- -------------
Net cash provided by (used in) financing activities (544,687) 121,121,017 32,367,995 207,012,322
Net increase (decrease) in cash and cash equivalents (40,266,771) 74,413,845 1,838,870 40,437,119
Cash and cash equivalents at beginning of period 80,703,890 6,290,045 4,451,175 --
------------- ------------- ------------- -------------
Cash and cash equivalents at end of period $ 40,437,119 $ 80,703,890 $ 6,290,045 $ 40,437,119
============= ============= ============= =============
</Table>
SUPPLEMENTAL INFORMATION ABOUT NONCASH INVESTING AND FINANCING ACTIVITIES:
For the year ended December 31, 2001, additional common stock was issued to
acquire 3,600,000 shares of BIZ for $14,312,800. See Note 12.
For the year ended December 31, 2000, additional common stock was issued to
acquire substantially all of the assets of Indigo for $7,445,358, including
acquisition costs of $210,000. See Note 3.
See accompanying notes to consolidated financial statements.
F-12
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)
Notes to Consolidated Financial Statements
December 31, 2001, 2000, 1999 and the Period
From February 12, 1988 (Date of
Inception) Through December 31, 2001
(1) BUSINESS OF THE COMPANY
Wave Systems Corp. (the "Company" or "Wave") develops, produces and
markets hardware and software based digital security products for the
Internet and e-commerce. The Company is also engaged in various research,
development and marketing efforts to commercialize the Wave Commerce
System to provide more efficient and flexible pricing (e.g., pay per use
or rent-to-own) and greater security on the usage of the electronic
content. The Company also develops data broadcasting and products that
perform digital signature and electronic document management functions.
Wave is in the development stage and, accordingly, the accompanying
consolidated financial statements are presented in a format prescribed
for a development stage enterprise.
The Company has incurred significant losses in current and prior periods.
Management intends to continue to devote resources toward the research,
development and marketing of its products in order to generate future
revenues from licensing and product sales as well as develop the business
of WaveXpress. On March 8, 2000 the Company completed an offering of
common stock for net proceeds of approximately $114.9 million. Management
anticipates that the proceeds of this offering will be sufficient to fund
operations into 2003. However, while management believes that it can
successfully develop and market its products and obtain additional
financing to fund its operations, there can be no assurance that it will
be able to do so.
(2) SIGNIFICANT ACCOUNTING POLICIES
(A) BASIS OF CONSOLIDATION
The consolidated financial statements include the financial statements of
Wave, Wave Systems Holdings, Inc., a wholly owned subsidiary and
WaveXpress, Inc. a majority-owned joint venture. All significant
intercompany accounts and transactions have been eliminated in
consolidation.
(B) USE OF ESTIMATES
The preparation of financial statements and related disclosures in
conformity with accounting principles generally accepted in the United
States requires management to make estimates and assumptions that affect
amounts reported in the Consolidated Financial Statements and
accompanying notes. Estimates are used for, but not limited to,
depreciation and amortization, charges for other than temporary declines
in value of marketable equity securities and other special charges,
inventory allowances and contingencies. Actual results could differ from
those estimates.
(C) METHOD OF ACCOUNTING FOR JOINT VENTURES
The Company accounts for its investments in joint ventures using the
equity method of accounting when its ownership interest in the joint
venture is less than fifty percent and it is determined that the Company
has the ability to exercise significant influence over the joint
venture's operating and financial policies. The financial statements of
joint ventures in which the Company owns greater than a fifty percent
interest are consolidated with the Company's financial statements
pursuant to APB Opinion No. 16. (see note 13)
(D) CASH AND CASH EQUIVALENTS
The Company considers all highly liquid instruments with an original or
remaining maturity of three months or less to be cash equivalents.
Substantially all cash and cash equivalents are custodial with two major
financial institutions.
(Continued)
<Page>
F-13
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(E) MARKETABLE SECURITIES
Debt securities and publicly traded equity securities are classified as
available for sale and are recorded at market using the specific
identification method. Unrealized gains and losses are reflected in other
comprehensive income. Unrealized losses that are determined to be other
than temporary, are recognized as charges against earnings. All other
investments, excluding joint venture arrangements, are recorded at cost.
(F) INVENTORIES
Inventories, which are stated at the lower of cost or net realizable
value, consist of inventory held for resale to customers. Cost is
determined on the first-in, first-out basis and includes freight and
other incidental costs incurred. The Company provides inventory
allowances based on excess and obsolete inventories
(G) PROPERTY AND EQUIPMENT
Property and equipment, including purchased computer software, are stated
at cost less accumulated depreciation. Depreciation and amortization are
computed using the straight-line method over the estimated useful lives
of the assets which range from between three to five years. Amortization
of leasehold improvements is computed using the remaining lease terms.
(H) GOODWILL AND PURCHASED INTANGIBLE ASSETS
Goodwill and purchased intangible assets are carried at cost less
accumulated amortization. Amortization is computed using the
straight-line method over the expected useful life of the asset
(currently 2 to 3 years). In accordance with the Financial Accounting
Standards Board ("FASB") Statement of Financial Accounting Standards No.
121 ACCOUNTING FOR LONG-LIVED ASSETS ("SFAS No. 121"), the Company
assesses the recoverability of goodwill and purchased intangible assets
by determining whether the amortization of the goodwill balance over its
remaining life can be recovered through undiscounted future operating
cash flows of the related acquired operation. The amount of goodwill
impairment, if any, is measured based on projected discounted future
operating cash flows using a discount rate reflecting the Company's
average cost of funds. The assessment of the recoverability of goodwill
is impacted if estimated future operating cash flows are less than the
net carrying value of the asset.
(I) INCOME TAXES
The Company accounts for income taxes under the asset and liability
method. As such, deferred tax assets and liabilities are recognized for
the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities
and their respective tax bases and operating loss and tax credit
carryforwards. Deferred tax assets and liabilities are measured using
enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in
tax rates is recognized in income in the period that includes the
enactment date.
(J) STOCK OPTION PLAN
The Company accounts for its stock option plans in accordance with the
provisions of Accounting Principles Board ("APB") Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations. As
such, compensation expense is recorded on the date of grant only if the
current market price of the underlying stock exceeds the exercise price.
The Company adopted the disclosure provisions of Statement of Financial
Accounting Standards ("SFAS") No. 123, Accounting for Stock Based
Compensation and accordingly, provides pro forma net income and pro forma
earnings per share footnote disclosures for employee stock options as if
the fair value-based method defined in SFAS No. 123 had been applied.
(Continued)
<Page>
F-14
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(K) RESEARCH AND DEVELOPMENT AND SOFTWARE DEVELOPMENT COSTS
Research and development costs are expensed as incurred. Software
development costs are accounted for pursuant to Statement of Financial
Accounting Standards No. 86 "Accounting for the Costs of Computer
Software to be Sold, Leased, or Otherwise Marketed" which requires
software development costs to be capitalized when a product's
technological feasibility has been established, and once the product has
achieved marketability.
(L) LOSS PER SHARE
Basic net loss per common share has been calculated based upon the
weighted average number of shares of common stock outstanding during the
period. Diluted net loss per share is also computed using the weighted
average number of common shares and excludes dilutive potential common
shares outstanding, as their effect is anti-dilutive. Dilutive potential
common shares consist primarily of employee stock options. Diluted net
loss per share is equal to basic net loss per share and is therefore not
presented separately in the financial statements.
(M) IMPAIRMENT OF LONG-LIVED ASSETS AND LONG-LIVED ASSETS TO BE DISPOSED OF
The Company reviews its long-lived assets and certain identifiable
intangibles for impairment whenever events or changes in circumstances
indicate that the carrying amount of an asset may not be recoverable.
Recoverability of assets to be held and used is measured by a comparison
of the carrying amount of an asset to future net cash flows expected to
be generated by the asset. If such assets are considered to be impaired,
the impairment to be recognized is measured by the amount by which the
carrying amount of the assets exceed the fair value of the assets. Assets
to be disposed of are reported at the lower of the carrying amount or
fair value less costs to sell.
(N) REVENUE RECOGNITION
The Company generally recognizes product revenue when delivery has
occurred, the price is fixed and determinable, and collection is
probable. The Company recognizes revenue on fixed-price long-term
development contracts using the percentage-of-completion method. Cash
payments received in advance of product or service contract revenue are
recorded as deferred revenue. For the year-ended December 31, 2001 the
Company recognized development contract revenue totaling approximately
$358,000 associated with a contract with SSP. Wave owns approximately
14.95% of SSP
(Continued)
<Page>
F-15
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(O) RECENT ACCOUNTING PRONOUNCEMENTS
On July 20, 2001, FASB issued Statements No. 141, Business Combinations
("SFAS 141") and No. 142 Goodwill and Other Intangible Assets ("SFAS
142"). SFAS 141 requires all business combinations initiated after June
30, 2001 to be accounted for using the purchase method. Poolings
initiated prior to June 30, 2001 are grandfathered. SFAS 142 replaces the
requirement to amortize intangible assets with indefinite lives and
goodwill with a requirement for an impairment test. SFAS 142 also
requires an evaluation of intangible assets and their useful lives and a
transitional impairment test for goodwill and certain intangible assets.
After transition, the impairment tests must be performed annually. A
company must adopt SFAS 142 at the beginning of the fiscal year. Thus, as
a calendar year-end company, Wave must adopt SFAS. 142 no later than
January 1, 2002. Wave is currently examining the impact of this
pronouncement on its results of operations and financial position, but
currently believes the impact will not be material.
FASB recently issued SFAS 143, Accounting for Asset Retirement
Obligations ("SFAS 143") which addresses financial accounting and
reporting for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. SFAS 143
requires an enterprise to record the fair value of an asset retirement
obligation as a liability in the period in which it incurs a legal
obligation associated with the retirement of a tangible long-lived asset.
SFAS 143 also requires the enterprise to record the contra to the initial
obligation as an increase to the carrying amount of the related
long-lived asset and to depreciate that cost over the remaining useful
life of the asset. The liability is changed at the end of each period to
reflect the passage of time and changes in the estimated future cash
flows underlying the initial fair value measurement. SFAS 143 is
effective for fiscal years beginning after June 15, 2002. Wave is
currently examining the impact of this pronouncement on the results of
its operations and financial position, but currently believes the impact
will not be material.
On October 3, 2001, FASB issued SFAS 144, Accounting for the Impairment
or Disposal of Long-Lived Assets ("SFAS 144"), which addresses financial
accounting and reporting for the impairment or disposal of long-lived
assets and supersedes FASB Statement No.121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of ("SFAS 121"). SFAS 144, retains many of the fundamental provisions of
SFAS 121. SFAS 144 also supersedes the accounting and reporting
provisions of Accounting Principle Board Opinion 30, Reporting the
Results of Operations--Reporting the Effects of Disposal of a Segment of
a Business, and Extraordinary, Unusual and Infrequently Occurring Events
and Transactions ("ABP 30"), for the disposal of a segment of a business.
However, it retains the requirement in APB 30 to report separately
discontinued operations and extends that reporting to a component of an
entity that either has been disposed of (by sale, abandonment, or in a
distribution to owners) or is classified as held for sale. SFAS 144 is
effective for fiscal years beginning after December 15, 2001 and interim
periods within those fiscal years. Wave is currently examining the impact
of this pronouncement on its results of operations and financial
position, but currently believes the impact will not be material.
(P) RECLASSIFICATIONS
Certain reclassifications have been made to prior year balances in order
to conform to the current year presentation.
(Continued)
<Page>
F-16
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(3) BUSINESS COMBINATIONS
(A) POOLING OF INTERESTS
On July 27, 1999, the Company acquired N*ABLE. The transaction was
accounted for as a pooling of interests and the historical financial
information for all periods presented prior to the date of acquisition
were restated. The Company exchanged 2,280,821 shares of its Class A
Common Stock for all the outstanding shares of N*ABLE for a fair value of
approximately $23.7 million.
(B) PURCHASE ACQUISITION
On August 31, 2000, the Company purchased substantially all of the assets
of Indigo and its e-commerce shopping network, iShopHere.com. The
aggregate purchase price totaled $7,445,000, which consisted of 374,889
shares of Class A Common Stock priced at $19.30 per share, for a total
value of $7,235,000 plus transaction costs of $210,000. The purchase
price was based on the average closing price of the Company's Class A
Common Stock for the ten trading days immediately preceding the date of
the purchase, in accordance with the purchase agreement. The following is
a summary of the allocation of the purchase price:
<Table>
Fair market value of tangible assets $ 690,000
In-Process R&D 2,176,000
Goodwill and purchased intangible assets 4,579,000
----------
Total consideration $7,445,000
</Table>
The amount allocated to in-process research and development totaling
$2,176,000 was determined using established valuation techniques and was
expensed upon acquisition as technological and/or commercial feasibility
had not been established. The amount allocated to goodwill and purchased
intangible assets amounted to $4,578,746 and is being amortized on a
straight-line basis over periods not exceeding three years. The following
table sets forth the goodwill and purchased intangible asset values as of
December 31,
<Table>
<Caption>
2001 2000
----------- -----------
Developed Technology $ 779,000 $ 779,000
Assembled Workforce 310,000 310,000
Contracts 77,300 77,300
Goodwill and purchased intangible assets 3,412,446 3,412,446
----------- -----------
Total Goodwill and purchased intangible assets $ 4,578,746 $ 4,578,746
Accumulated Amortization (2,294,176) (573,544)
----------- -----------
Net Book Value before impairment charge 2,284,570 4,005,202
Impairment Charge (2,284,570) --
----------- -----------
Net Book Value $ -0- $ 4,005,202
</Table>
Amortization expense associated with goodwill and purchased intangibles
was $1,720,632, $573,544 and $0 for the years ended December 31, 2001,
2000 and 1999, respectively.
The consolidated financial statements include the operating results of
iShopHere.com from the date of acquisition, which consisted of a net loss
of approximately $1,561,000 in 2001 and $846,000 in 2000. The selected
unaudited pro forma condensed consolidated financial information
presented below has been derived from the audited and unaudited
historical financial statements of Wave and Indigo, and reflects
management's estimate of pro forma adjustments. This pro forma
presentation does not purport to represent what our results of operations
would actually have been if such transactions and events had in fact
occurred on those dates or to project our results of operations for any
future period. The unaudited pro forma consolidated statements of
operations give effect to the acquisition of Indigo as if it had occurred
on
(Continued)
<Page>
F-17
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
January 1, 1999. (Pro-forma information for 2001 is not presented as
there are no pro-forma adjustments applicable to 2001.)
<Table>
<Caption>
DOLLARS IN THOUSANDS EXCEPT PER SHARE DATA 2000 1999
---- ----
Net revenues $ 372 $ 220
Net loss (50,363) (34,860)
Net loss per share $ (1.08) $ (0.90)
</Table>
Due to the decline in current business conditions, the Company has realigned
resources to focus on what it considers high-growth markets and core
opportunities. As a result, the Company recorded a charge of $2,284,570 related
to the impairment of goodwill and purchased intangible assets associated with
the Indigo asset purchase in 2001. This amount is equal to the carrying amount
of the assets prior to the impairment charge.
(Continued)
<Page>
F-18
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(4) RELATED PARTY TRANSACTIONS
(A) NOTES RECEIVABLE FROM OFFICERS
On March 26, 2001 Wave made a personal loan to Mr. Gerard T. Feeney,
Senior Vice President, Chief Financial Officer and Secretary of Wave as
evidenced by a demand note for $250,000, which sum is due and payable to
Wave on March 26, 2002 and bears interest at a rate per annum equal to 1%
over the prime interest rate.
During 2001, Wave has made personal loans to Mr. Peter J. Sprague,
Chairman of Wave as evidenced by demand notes totaling approximately
$1,050,000. These notes carry a term of one year and bear interest at a
rate per annum equal to 1% over the prime rate of interest.
Loans to officers totaling $963,320 came due in February and March of
2002, and were extended for an additional one year.
Accrued interest on these notes totaled $80,000 as of December 31, 2001.
(B) PAYMENTS TO RELATED PARTY
In 1997, the Company paid $182,209 to Enterprise Engineering Associates
("EEA"), during which time Mr. Michael Sprague was an employee of EEA. On
August 1, 1997, Michael Sprague became an employee of Wave, at an annual
salary of $110,000. On November 1, 1999 he became an employee of
WaveXpress at an annual salary of $120,000. Michael Sprague is the son of
the Chairman and former Chief Executive Officer of the Company
In 1998, the Company paid $25,000 to Studio 2, during which time Mr.
Kevin Sprague was an employee of Studio 2. Kevin Sprague is the son of
the Chairman and former CEO of the Company.
(C) ACQUISITION AND DISPOSITIONS
In November 1995, the Company entered into a transaction with certain
individuals whereby shares in its newly-formed subsidiary, Wave
Interactive Network, Inc. ("WIN"), were transferred in exchange for a
demand note. The amount of the demand note was based on the level of
funding provided to WIN by the Company during 1995. The demand note from
WIN accrued interest at a rate of Prime plus 1% and, subject to certain
limitations associated with WIN's ability to raise additional capital,
was convertible into an undiluted 20% of the common shares of WIN at the
option of Wave. The Company retained a 1% ownership in WIN and
transferred the remaining ownership to certain individuals, including
former employees. Approximately 65% of the ownership was transferred to
Steven Sprague, President and CEO of WIN, and three other children of Mr.
Peter J. Sprague, Chairman and former CEO of Wave. The note was fully
reserved as its collectibility was dependent upon WIN's ability to raise
additional capital. In addition, the Company entered into a separate
commercial agreement that, among other things, granted certain
distribution rights to WIN in exchange for royalties and other
consideration.
During 1996, the Company continued to finance the operations of WIN
through additional demand notes with terms similar to the original demand
note. The additional notes amounting to $1,004,000 were also fully
reserved. On December 30, 1996, effective as of October 18, 1996, the
Company entered into a merger agreement with WIN whereby the Company
exchanged, for all of the outstanding WIN common stock that it did not
own, 375,000 shares of Class B Common Stock. These Class B shares are
restricted securities within the meaning of Rule 144 of the Securities
Act of 1933, as amended (the "Act"). Additionally, based on the
attainment of a specified milestone, the shareholders of WIN were
entitled to receive an additional 325,000 shares of the Company's Class B
Common Stock. During 1999, the time to
(Continued)
<Page>
F-19
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
attain the milestone had expired as did the entitlement to additional
shares and no additional shares were issued. The Company also issued a
10% convertible note and a warrant to refinance a convertible note
obligation of WIN amounting to approximately $456,000, which included
accrued interest to October 18, 1996, and an outstanding warrant.
Included in the results of operations are WIN's operations from October
18, 1996. The acquisition was accounted for by the purchase method.
The purchase price of $952,438 was determined based on the estimated fair
value of the consideration given to the WIN shareholders and noteholders
and was allocated to goodwill as WIN had no net tangible assets.
Subsequently, in 1997, the Company determined it was uncertain whether
the current and expected future results of operations of WIN would be
adequate to support the goodwill capitalization, and wrote-off the
goodwill as impaired.
(D) SARNOFF CORPORATION ("SARNOFF")
For the years-ended December 31, 2001, 2000 and 1999, the Company
incurred expenses for consulting and travel, payable to Sarnoff of
approximately $57,000, $924,000 and $701,000, respectively. Sarnoff is
the Company's joint venture partner in WaveXpress and owns approximately
13% of WaveXpress, on a fully diluted basis. Payments made to Sarnoff for
the years-ended December 31, 2001, 2000 and 1999 were $396,000, $986,000
and $356,000, respectively. As of December 31, 2001 and 2000, the Company
had accounts payable to Sarnoff of $6,000 and $325,000, respectively
(5) PROPERTY AND EQUIPMENT
Property and equipment as of December 31 consisted of the following:
<Table>
<Caption>
2001 2000
---- ----
Equipment $ 5,797,900 $ 5,253,854
Furniture, fixtures and improvements 1,914,405 1,919,219
Computer software 3,192,288 2,237,225
----------- -----------
10,904,593 9,410,298
Less: Accumulated depreciation 6,613,365 4,208,429
----------- -----------
Total $ 4,291,228 $ 5,201,869
=========== ===========
</Table>
Computer software includes $610,413 capitalized pursuant to SFAS 86. The
status of the project to which these costs relate is presently in
process, therefore no amortization has been taken on these capitalized
costs. It is expected that these costs will be amortized over a
three-year life, once the product is ready to bring to market.
Depreciation expense on property and equipment amounted to approximately
$2,219,000, $1,969,000, $768,000 and $6,694,000 for the years ended
December 31, 2001, 1999, 1998 and for the period from inception through
December 31, 2001, respectively.
(Continued)
<Page>
F-20
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(6) ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses as of December 31 consisted of the
following:
<Table>
<Caption>
2001 2000
---- ----
Accrual of costs related to the ITG agreement $ 188,986 $ 490,000
Accounts payable 1,631,430 4,403,424
Accrued consulting and professional fees 405,346 553,428
Accrued payroll and related costs 1,281,012 1,480,346
Accrued Rent 87,836 144,054
Annual Report and Shareholders Meeting 141,299 133,155
Accrual of committed investment in Global Wave 1,407,664 --
Accrued loss contingency 200,000 --
Franchise Tax Payable -- 225,000
Other accrued liabilities 464,305 440,602
---------- ----------
Total $5,807,878 $7,870,009
</Table>
(7) CAPITAL STOCK
(A) REDEEMABLE PREFERRED STOCK
The Company has authorized 2,000,000 shares of preferred stock having a
par value of $.01 per share. On October 19, 1992, the Board of Directors
designated and issued 360 shares of this preferred stock of the Company
as "Series A Cumulative Redeemable Preferred Stock" ("Series A Preferred
Stock").
The Series A Preferred Stock was issued in settlement of compensation
owed to a former officer of the Company for services provided to the
Company. The holder of the Series A Preferred Stock was entitled to
receive a dividend at the rate of $60 per share per annum, when and as
declared by the Board of Directors of the Company. Dividends were
cumulative from the date of original issue, and payable upon redemption.
On August 11, 1999, the Company redeemed these shares for a total payment
of $506,440, including accrued and unpaid dividends.
In May of 1996, the Company raised $3,214,026, net of issuance costs of
$285,974, through the placement of 350 shares of Series B Preferred Stock
("Series B Preferred Stock") pursuant to Regulation S of the Securities
Act of 1933 ("the Act"). The Series B Preferred Stock had a stated value
of $10,000 per share, accrued dividends for liquidation and conversion
purposes at 6% per annum and ranked senior to the Company's Common Sock
and Series C Convertible Preferred Stock ("Series C Preferred Stock") and
junior to the Series A Preferred Stock. Series B Preferred Stock was
convertible by the holder, in increments, into the Company's Class A
Common Stock. The Series B Preferred Stock was convertible at the lesser
of 110% of the average closing bid price for the five days immediately
preceding the issue date or 85% of the average closing bid price for the
five days immediately preceding the conversion date.
During 1996, 330 shares of the Company's Series B Preferred Stock were
converted into 2,960,303 shares of the Company's Class A Common Stock and
the remaining 20 shares of Series B Preferred Stock were converted in
1997 into 117,240 shares of the Company's Class A Common Stock.
In December of 1996, the Company raised $2,634,037 net of issuance costs
of $365,963 ($101,964 of which related to the value ascribed to warrants
issued) through the placement of 150,000 shares of Series C Preferred
Stock pursuant to Regulation D of the Act. The Series C Preferred Stock
had a stated value of $20 per share, which accrued dividends payable
quarterly in cash at 6% per annum.
(Continued)
<Page>
F-21
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
The Series C Preferred Stock ranked senior to the Company's Common Stock
and junior to the Series A and B Preferred Stock. Series C Preferred
Stock was convertible by the holder, in increments, into the Company's
Class A Common Stock based on the market price of the Company's Class A
Common Stock at the time of conversion. The Series C Preferred Stock was
convertible at the lesser of $2.31 per share or 80%, as adjusted, of the
average of the fair value of the Class A Common Stock for the five days
prior to the conversion date. During 1997 all of the Series C Preferred
Stock was converted into 2,850,439 shares of the Company's Class A Common
Stock.
In May of 1997 the Company raised approximately $1,316,000, net of
issuance costs of $272,000 ($162,000 of which related to the value
ascribed to warrants issued), through the placement of 80,000 shares of
newly created Series D Convertible Preferred Stock. The Series D
Preferred Stock had a stated value of $20 per share, which accrued
dividends payable quarterly in cash at 6%.
The Series D Convertible Preferred Stock was convertible into the Class A
Common Stock of the Company at an effective conversion price of the lower
of (i) $1.35, or (ii) 80% of the average closing bid price on the NASDAQ
National Market System of the Company's Class A Common Stock for the five
(5) trading days immediately preceding the date of conversion. During
1997 all of the Series D Convertible Preferred Stock was converted into
2,070,095 shares of the Company's Class A Common Stock.
(B) CONVERTIBLE PREFERRED STOCK
In October 1997 the Company raised approximately $1,850,000, net of
issuance costs of $397,000 ($224,000 of which related to the value
ascribed to warrants issued), through the private placement of 112,500
shares of newly created Series F Convertible Preferred Stock. The Series
F Convertible Preferred Stock had a stated value of $20 per share, which
accrued dividends payable quarterly in cash at 6%. The Series F
Convertible Preferred Stock was convertible into the Class A Common Stock
at an effective conversion price of the lower of (a) $1.05 and (b) 80% of
the average of the five (5) lowest trading prices of Class A Common
Stock. During 1997 all of the Series F Convertible Preferred Stock was
converted into 2,961,086 shares of the Company's Class A Common Stock.
During March of 1998, the Company issued 150,000 shares of newly created
Series G Convertible Preferred Stock for an aggregate purchase price of
$3,000,000. The Series G Convertible Preferred Stock was senior to the
Company's classes of Common Stock, and was junior to the Company' Series
A Preferred Stock in liquidation rights. The Series G Convertible
Preferred Stock accrued dividends at the rate of 6% per annum. The Series
G Convertible Preferred Stock was convertible into the Company's
unregistered Class A Common Stock at the lower of $1.12 or 80% of the
average of the five lowest closing bids for the 25 calendar days prior to
conversion. In addition, the Company issued warrants to the purchaser and
placement agent for 225,000 shares of the Company's Class A Common Stock
at an exercise price of $1.38. The Series G Convertible Preferred Stock
was converted into 2,394,494 and 377,102 shares of the Company's Class A
Common Stock during 1998 and 1999, respectively.
(Continued)
<Page>
F-22
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(C) COMMON STOCK
In December 1989, March through October 1990, and November 1991,
substantially all stockholders as of December 29, 1989 were offered the
right to acquire a number of shares equivalent to their pre-offering
holdings at a price of $.003 per share. Substantially all stockholders
that received the offer accepted this offer. This was accounted for
essentially as a stock split effected in the form of a rights offering,
and all shares issued in conjunction with this offering were reflected in
the accompanying consolidated financial statements retroactively.
Two principal stockholders did not acquire the full amount of shares to
which they were entitled. Most of the additional proportionate shares
that these stockholders would have been credited with were offered
instead to certain officers, employees and stockholders for $.003 per
share. To the extent that these rights were offered to the individuals in
compensation for services rendered to the Company, compensation expense
equal to the difference between the estimated fair value as of the date
of issuance and the purchase price of the stock was recorded. The
estimated fair value of the Common Stock was determined based on sales to
third parties near the date of issuance. Compensation expense associated
with the issuance of these shares of $430,250 is included in the
accompanying consolidated statement of operations for the period from
inception to December 31, 2000.
In May and November, 1992, the Company issued 770,000 shares of Class B
restricted Common Stock to certain employees, officers and stockholders
of the Company for a purchase price of $.003 per share, payable in the
form of services to the Company. As these shares were issued for services
rendered, compensation expense of $1,927,500 was recorded representing
the estimated fair value of $2.50 per share at the date of issuance, the
price at which Common Stock was sold to third parties near the time of
issuance.
In February 1995, the Company agreed to grant 36,000 shares of Class A
Common Stock, 12,000 of which were issued in 1995 with the remainder
issued in 1996, to two consultants and six non-employee directors as
compensation for services rendered. Expenses of $112,500 were recorded in
1995 representing the stock's fair value of $3.13 per share at the time
of the agreement to grant.
In July 1995, the Company issued 19,559 shares to two vendors in payment
for services rendered. Costs of $20,000 were recorded representing the
stock's fair value of approximately $1.00 per share at the time the
services were rendered.
In July and August 1996, the Company issued 15,000 and 3,077 shares of
Class A Common Stock to two consultants as compensation for services
rendered. Expenses of $40,938 have been recorded representing the stock's
fair value of $2.06 and $3.44 per share, respectively, at their dates of
issuance.
During 1997 the Company issued 126,885 shares of the Company's Class A
Common Stock to vendors or for the settlement of liabilities. Expenses of
$305,496 have been recorded representing the stocks' fair value at the
date of issuance.
During 1997 the Company sold approximately 800,000 shares of the
Company's Class A Common Stock and warrants to purchase 160,000 shares of
the Company's Class A Common Stock, exercisable at an exercise price of
$1.00, for an aggregate purchase price of $800,000. The warrants were
exercised or expired during 1999.
During 1997 the Company issued 500,000 shares of the Company's Class A
Common Stock in connection with a license agreement with Aladdin
Knowledge Systems, Ltd. for its proprietary persistent encryption
technology. The shares were issued at their fair value on the date of
issuance.
On March 23, 1999, the Company sold 2,090,954 shares of its Class A
Common Stock at a price of $11.00 per share, for an aggregate purchase
price of $23,000,494. These shares were sold to a group of accredited
investors pursuant to Regulation D promulgated under the securities act
of 1933, as amended. Pacific
(Continued)
<Page>
F-23
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
Growth Equities, Inc. acted as sole placement agent for the private
placement, receiving a commission of 6% or approximately $1.2 million for
their services.
On March 7, 2000 the Company sold 3,600,800 shares of its Class A Common
Stock at a price of $34.00 per share, for an aggregate purchase price of
$122,427,200. The shares were sold to a group of accredited investors
pursuant to regulation D promulgated under the securities act of 1933, as
amended. Pacific Growth Equities, Inc. acted as sole placement agent for
the private placement, receiving a commission of 6% or approximately $7.3
million for their services.
(D) RECAPITALIZATION
In January 1994, the Board of Directors authorized the Company to amend
and restate the Company's Certificate of Incorporation to reflect the
authorization of 25,000,000 shares of a newly created Class A Common
Stock, which stock has voting rights of one vote per share, and the
reclassification of the then current outstanding shares of Common Stock
into Class B Common Stock. In June 1994, the Board of Directors
authorized that the Class B Common stock will have one vote per share,
except that Class B Common Stock will have five votes per share in cases
where one or more directors are nominated for election by persons other
than the Company's Board of Directors and where there is a vote on any
merger, consolidation or other similar transaction, which is not
recommended by the Company's Board of Directors. In addition, the Class B
Common Stock will have five votes per share on all matters submitted to a
vote of the stockholders in the event that any person or group of persons
acquires beneficial ownership of 20% or more of the outstanding voting
securities of the Company. The Class B Common Stock is convertible into
shares of Class A Common Stock at any time. The classes of Common Stock
are alike in all other respects.
(8) OPTIONS AND WARRANTS
1991 PLAN
In September 1991, the Board of Directors authorized the establishment of
a stock option plan (the "1991 Plan"). The total number of shares of
Class B Common Stock subject to the Plan was 2,700,000. Options terminate
upon the earlier of the date of the expiration of the option or upon
termination of the employment relationship between the Company or a
subsidiary and the optionee for any reason other than death, disability
or retirement.
Under the 1991 plan, employees are entitled to exercise their options on
dates determined by the Compensation Committee of the Board of Directors.
Vesting provisions for options granted generally range from immediate
vesting to pro rata vesting over a three-year period. Options granted
under the 1991 Plan may, at the discretion of the Compensation Committee,
include the right to acquire a reload option. A reload option provides
for the automatic grant of a new option at the then-current market price
in exchange for each previously owned share tendered by an employee in a
Stock-for-Stock exercise.
Subsequent to January 1994 no further options, other than reload options,
may be granted under the 1991 Plan. All options outstanding under the
1991 Plan continue in full force and effect subject to their original
terms. As of December 31, 2001, there remained 235,032 options
outstanding under the 1991 plan at exercise prices ranging from between
$1.67 and $3.50 per share.
1994 PLANS
In January 1994, the Board of Directors authorized the establishment of
the 1994 Employee Stock Option Plan (the "1994 Plan"). The initial number
of shares of Class A Common Stock subject to the 1994 Plan was 1,000,000.
The terms of the 1994 Plan are similar to those of the 1991 Plan. Options
are granted with exercise prices that approximate fair market value at
the date of grant. In May 1996, July 1997, November 1998 and June 2000
the Company's shareholders approved amendments to the Company's 1994 Plan
to increase the number of shares of Class A Common Stock reserved for
issuance there under by 1,000,000, 1,000,000, 5,000,000 and 5,000,000,
respectively. Therefore, the total number of shares of Class A
(Continued)
<Page>
F-24
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
Common Stock reserved for issuance under the 1994 Plan is 13,000,000
shares. As of December 31, 2001, there were approximately 1,898,000
shares available for grant under the 1994 Plan.
In January 1994, the Board of Directors authorized the establishment of
the Non-Employee Directors Stock Option Plan (the "Directors' Plan"). The
total number of shares of Class A Common Stock subject to the Directors'
Plan was initially 200,000. Pursuant to the Directors' Plan, each
director who was not an employee of the Company received an initial grant
of options to purchase 12,000 shares of Class A Common Stock at an
exercise price of $3.50 per share.
Any person subsequently elected as a director who was not an employee of
the Company received an initial grant of options to purchase 12,000
shares of Class A Common Stock on the day he or she was elected a
director. In addition, on the day immediately following each of the dates
on which an incumbent director was reelected, he or she received an
additional grant of options to purchase 2,000 shares of Class A Common
Stock.
The Stockholders of the Company have since, authorized certain changes to
the Directors' Plan. In February 1995, the annual option grant for
directors was increased from a total of 2,000 shares of Class A Common
Stock to 10,000 shares of Class A Common Stock. In July 1995, the Board
authorized an increase to the total number of shares subject to the
Directors' Plan from 200,000 shares to 500,000 shares. In November 1998,
the stockholders of the Company authorized an increase to the total
number of shares subject to the Directors' Plan from 500,000 shares to
1,000,000 shares. The stockholders also amended the Directors' Plan to
provide that options issued to non-employee directors under such plan
vest on the day following the grant. (Initial option grants under the
Directors' Plan vested one-third upon grant, and one-third on each of the
first and second anniversaries. Annual option grants vested 25% after
each three-month period following grant.)
Options under the Directors' Plan are exercisable for a period of ten
years from the date of grant. Options may not be exercised after the
option holder ceases to be a director of the Company, except that in the
event of death or disability of the option holder, the option may be
exercised for a period of one year after the date of death or disability,
and, in the event of retirement of the option holder, the option may be
exercised for a period of three months after the date of retirement. As
of December 31, 2001, there were approximately 445,000 shares available
for grant under the Director's Plan.
In September 1996, the Board of Directors authorized the establishment of
the 1996 Performance Stock Option Plan ( the "1996 Plan"). The initial
number of shares of Class A Common Stock subject to the 1996 Plan was
800,000. The terms of the 1996 Plan are similar to those of the 1994 and
1991 Plans. Options are granted with exercise prices that approximate
fair market value at the date of grant. As of December 31, 2001, there
were approximately 125,000 shares available for grant under the 1996
Plan.
The per share weighted-average fair value of stock options granted during
2001, 2000 and 1999 was $2.89, $12.18 and $8.28 on the dates of grant
using the Black Scholes option-pricing model with the following
weighted-average assumptions:
<Table>
<Caption>
2001 2000 1999
---- ---- ----
Expected Life (Years) 5 5 10
Interest Rate 4.0% 6.0% 6.0%
Volatility 119% 123% 113%
Dividend Yield 0% 0% 0%
</Table>
(Continued)
<Page>
F-25
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
The Company applies APB Opinion No. 25 in accounting for its Plans.
Compensation expense has been recognized in the financial statements for
Stock options granted to employees at exercise prices below the market
value of $552,554 in 2001, $318,609 in 2000 and $0 in 1999. Deferred
compensation for stock options granted to employees at exercise prices
below market value was approximately $1,000,000 as of December 31, 2001;
and is being recognized over a period of three years.
Had the Company determined compensation cost based on the fair value at
the grant dates for its stock options under SFAS No. 123, the Company's
net loss would have been increased to the pro forma amounts indicated
below:
<Table>
<Caption>
2001 2000 1999
---- ---- ----
Net loss - as reported $(48,701,057) $(47,655,893) $(28,052,572)
Net loss - pro forma (69,720,636) (64,029,399) (39,811,659)
Net loss to Common stockholders - as reported (48,701,057) (47,655,893) (28,065,811)
Net loss to Common shareholders - pro forma (69,720,636) (64,029,399) (39,824,898)
Loss per Common share - as reported (0.97) (1.03) (0.73)
Loss per Common share - pro forma $ (1.40) $ (1.39) $ (1.04)
</Table>
SUMMARY OF OPTION ACTIVITY
A summary of option activity through December 31, 2001 follows:
<Table>
<Caption>
CLASS A AND B SHARES WEIGHTED AVERAGE
SUBJECT TO OPTION EXERCISE PRICE
----------------- --------------
Balance at January 1, 1991 - $ -
Options granted 30,000 1.67
-----------
Balance at December 31, 1991 30,000 1.67
Options granted 816,750 1.18
-------
Balance at December 31, 1992 846,750 1.20
Options granted 949,186 3.10
----------
Balance at December 31, 1993 1,795,936 2.20
Options granted 310,200 3.05
Options canceled (108,500) 3.38
----------
Balance at December 31, 1994 1,997,636 2.27
Options granted 777,850 2.22
Options canceled (349,205) 2.11
Options exercised (681,700) .64
----------
Balance at December 31, 1995 1,744,581 2.92
Options granted 1,342,075 2.65
Options canceled (503,879) 3.20
Options exercised (214,091) 1.97
----------
Balance at December 31, 1996 2,368,686 2.79
</Table>
(Continued)
<Page>
F-26
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
<Table>
<Caption>
CLASS A AND B SHARES WEIGHTED AVERAGE
SUBJECT TO OPTION EXERCISE PRICE
----------------- --------------
Balance at December 31, 1996 2,368,686 2.79
Options granted 707,914 1.02
Options canceled (676,741) 1.57
Options exercised (70,326) 1.90
-----------
Balance at December 31, 1997 2,329,533 2.38
Options granted 5,756,893 2.47
Options canceled (707,384) 2.48
Options exercised ( 78,653) 1.94
-------------
Balance at December 31, 1998 7,300,389 2.40
Options granted 1,925,447 10.15
Options canceled (450,378) 3.51
Options exercised ( 964,000) 1.69
------------
Balance at December 31, 1999 7,811,458 4.33
Options granted 3,444,037 13.58
Options canceled (905,145) 12.33
Options exercised (2,030,958) 2.51
--------------
Balance at December 31, 2000 8,319,392 7.90
Options Granted 2,934,272 3.46
Options Canceled (1,128,327) 8.16
Options Exercised (473,511) 1.42
------------- -----
Balance at December 31, 2001 9,651,826 $6.85
</Table>
At December 31, 2001, there were approximately 4,810,121options
exercisable at prices ranging from $.49 to $37.50.
(Continued)
<Page>
F-27
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
The following table summarizes information about stock options
outstanding at December 31, 2001:
<Table>
<Caption>
WEIGHTED
WEIGHTED AVERAGE
AVERAGE REMAINING
RANGE OF NUMBER NUMBER EXERCISE CONTRACTUAL
EXERCISE PRICES OUTSTANDING EXERCISABLE PRICE LIFE
--------------- ----------- ----------- ----- ----
$.49 - 0.74 4,585 4,585 $ .49 5.5 years
0.75 - 1.12 277,264 277,264 1.10 6.1 years
1.13 - 1.69 1,255,996 730,493 1.33 6.9 years
1.70 - 2.55 377,590 60,991 1.80 9.3 years
2.56 - 3.84 1,922,863 1,833,863 3.64 6.5 years
3.85 - 5.78 2,212,337 475,603 4.09 8.5 years
5.79 - 8.68 555,031 138,106 6.66 6.8 years
8.69 - 13.04 1,301,549 530,276 11.80 7.6 years
13.05 - 19.58 1,471,881 668,027 15.16 7.0 years
19.59 - 29.38 222,730 74,245 19.69 8.0 years
29.39 - 37.50 50,000 16,668 33.75 8.2 years
</Table>
1999 WAVEXPRESS STOCK INCENTIVE PLAN
In April 2000, the board of directors of WaveXpress authorized the
establishment of a stock option plan (the "1999 Plan"). The total number
of shares of WaveXpress' Class A Common Stock subject to the Plan is
2,500,000. Options terminate upon the earlier of the date of expiration
of the option or upon termination of the employment relationship between
WaveXpress and the optionee for any reason other than death, disability
or retirement.
Employees are entitled to exercise their options on dates determined by
WaveXpress' Compensation Committee of the Board of Directors. Vesting
provisions for options granted generally range from immediate vesting to
pro rata vesting over a three-year period.
(Continued)
<Page>
F-28
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
Stock option activity during 2001 and 2000 is as follows:
<Table>
<Caption>
2001 2000
-------------------------------------- --------------------------------------
Number of Weighted-Average Number of Weighted-Average
Shares Exercise Price Shares Exercise Price
---------------- ------------------ ---------------- -----------------
Balance at beginning of year 634,964 $ 1.23 - $ -
Granted 75,840 1.20 690,520 1.23
Exercised (27,777) 1.20 - -
Canceled (334,052) 1.20 (55,556) 1.20
---------------- ----------------
Balance at end of year 1,029,975 1.22 634,964 1.23
================ ================
Exercisable at end of year 176,682 1.30 97,089 1.23
================ ================
Additional shares available
for grant at end of year 1,442,248 1,865,036
================ ================
</Table>
The per share weighted-average fair value of stock options granted during
2001 and 2000 was $0.89 and $0.99, respectively, on the date of grant
using a Black-Scholes option-pricing model with the following
weighted-average assumptions:
<Table>
<Caption>
2001 2000
---- ----
Expected dividend yield 0% 0%
Risk-free interest rate 4% 6%
Expected Volatility 127% 149%
Expected life 3 years 3 years
</Table>
No options were outstanding at December 31, 1999.
The following table summarizes information about WaveXpress' fixed stock
options outstanding at December 31, 2001:
<Table>
<Caption>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
---------------------------------------------------------- --------------------------------
WEIGHTED
AVERAGE
REMAINING WEIGHTED
EXERCISE NUMBER CONTRACTUAL LIFE WEIGHTED AVERAGE NUMBER AVERAGE
PRICE OUTSTANDING (IN YEARS) EXERCISE PRICE OUTSTANDING EXERCISE PRICE
----- ----------- ---------- -------------- ----------- --------------
$1.20 1,021,778 9.1 $1.20 168,485 $1.20
$3.00 - 4.50 8,197 6.9 $3.37 8,197 $3.37
--------------- ---------------
$1.20 - 4.50 1,029,975 9.1 $1.22 176,682 $1.30
=============== ===============
</Table>
(Continued)
<Page>
F-29
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
WARRANTS
In 1993 and 1994, the Company issued warrants to acquire a total of
151,600 shares of Class B Common Stock at $3.50 per share in conjunction
with sales of Class B Common Stock to individuals and institutions. All
warrants were exercisable for a period of five years from the date of
issuance and were subsequently canceled or exercised in 1998 and 1999.
In 1993 and 1994, the Company issued warrants to acquire a total of
376,253 shares of Class B Common Stock at $3.50 per share in conjunction
with the issuance of its 10% Convertible Notes which have since been
repaid and in 1994, the Company issued warrants to acquire a total of
46,799 shares of Class B Common Stock at $6.00 per share in conjunction
with the issuance of its 15% Notes, also which have since been repaid.
All warrants were exercisable for a period of five years from their dates
of issuance. These warrants were exercised or canceled in 1998 and 1999.
Under the terms of the Company's initial public offering, the underwriter
acquired warrants to purchase 360,000 Class A Common Stock at a price of
$6.50 per share for nominal consideration. These warrants were
exercisable for four years commencing in September 1995. These warrants
were exercised during 1999.
As a result of the successful placement of 350 shares of Series B
Preferred Stock, a consultant from Digital Media Group, Inc. was issued
warrants by the Company to purchase 15,000 Class A Common shares at a
price of $3.09 per share. These warrants are exercisable for ten years
commencing in March 1996, and are still outstanding.
Due to the successful placement of 150,000 shares of the Company's Series
C Convertible Stock, Wharton Capital Partners Ltd. and The Shemano Group,
Inc., two financial consulting firms, were issued warrants by the Company
to purchase 37,500 Class A Common Stock each at a price of $2.54 per
share. These warrants were exercised in 1999.
In connection with the acquisition of WIN, the Company issued a warrant
that allowed the holder the ability to purchase unregistered shares of
the Company's Class A Common Stock at a price of $1.25 per share at the
earlier of the conversion of a note or April 18, 1998 for a period of
five years. The number of shares able to be purchased under this warrant
is based on a formula of $170,000 divided by 80% of the fair market value
of the Class A Common Stock at the time of conversion. This warrant was
subsequently extended one year by issuing 100,000 additional warrants to
be exercised at prices ranging from $1.49 to $3.43. These warrants were
exercised during July 1999.
As a result of the successful placement of 80,000 shares of the Company's
Series D Preferred Stock, JNC Opportunity Fund, the acquirer of the
placement, received 80,000 warrants to purchase the Company's
unregistered Class A Common Stock, and financial consultants, primarily
Wharton Capital Partners, received a total of 40,000 warrants. The
warrants were exercised in 1999 at an exercise price of $1.62.
As a result of the successful placement of 112,500 shares of the
Company's Series F Preferred Stock, Combination Inc., the acquirer of the
placement, received 112,500 warrants to purchase the Company's
unregistered Class A Common Stock, and Wharton Capital Partners received
56,250 warrants. The warrants had an exercise price of $1.26, and expire
on October 9, 2002. The warrants were exercised in 1998.
In connection with the private placement of approximately 800,000 shares
of the Company's Class A Common Stock, the Company issued 160,000
warrants to purchase shares of the Company's unregistered Class A Common
Stock at an exercise price of $1.00. The warrants were exercised or
expired during 1999.
In connection with a technology license agreement with Aladdin, the
Company issued two warrants on July 18, 1997 to purchase the Company's
Class A Common Stock. The first warrant was exercisable in 100,000 share
lots, and provided the holder with the right to acquire 1,216,136 shares
of the Company's unregistered
(Continued)
<Page>
F-30
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
Class A Common Stock at an exercise price of $1.70 per share. The first
warrant had a life of two years. The second warrant provided the holder
with the right to acquire 7% of the Company's Class A Common Stock on a
fully diluted basis for the average closing price for the 15 trading days
prior to exercise and had a three year life. During June of 1998, Aladdin
exercised a portion of the second warrant to purchase 1,000,000 shares of
Common Stock. On March 31, 1999 Aladdin exercised their entire first
warrant for 1,216,136 Class A Common Stock. Associated with the second
warrant, Aladdin had the right to acquire shares approximating 3.45% of
the Company's Class A Common Stock. The remaining shares under the second
warrant were not exercised, and expired July 17, 2000.
In connection with a $2,000,000 convertible promissory note, warrants to
acquire 275,000 shares of Class A Common Stock were issued. The Company
incurred a non-cash charge to interest expense for approximately
$666,000. These warrants were subsequently exercised in January 2000.
In connection with a software development agreement that the Company
entered into with Archon Technologies, Inc. ("Archon"), the Company
issued to Archon a warrant to purchase 50,000 shares of Wave Class A
Common Stock at $3.48 per share. The warrant is exercisable November 9,
2002, and expires on November 9, 2007.
In 2001, 50,320 warrants were exercised at $1.83 per share. In 2000,
44,692 warrants were exercised at prices ranging from between $1.10 and
$5.50 per share.
(Continued)
<Page>
F-31
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
A summary of warrants outstanding at December 31, 2001, follows:
<Table>
<Caption>
RANGE OF WEIGHTED AVERAGE
CLASS A AND B SHARES EXERCISE REMAINING
SUBJECT TO WARRANTS PRICES CONTRACTUAL LIFE
------------------- ------ ----------------
85,000 $3.09 - $14.73 5 years
</Table>
At December 31, 2001, warrants to acquire approximately 35,000 shares of
Class A and Class B Common Stock were exercisable.
(9) LICENSING AGREEMENTS
(A) LICENSED PATENTS
In February 1994, the Company entered into an Amended and Restated
License Agreement (the "Agreement") with Mr. Peter J. Sprague, the
Chairman and former Chief Executive Officer of the Company, and Mr. John
Michener, then a shareholder and officer of the Company, whereby the
Company was granted an exclusive license to make, have made, use, lease,
sell or otherwise perform services covered by certain licensed patents
(the "Licensed Patents") which are a fundamental part of the Company's
product. The Agreement amends and restates certain license agreements
entered into by the Company prior to February 1994.
The Agreement provides for royalty payments to be made to the licensors
in the aggregate amount of two percent of the total gross revenues
derived by the Company and any sublicensee of the Company from the
exploitation of the Licensed Patents, less any amounts paid, if any, to
(i) information and database providers for information distributed to or
through the Company or its sublicensees, and to (ii) the Company's
sublicensees for manufacturing the product or performing the services
covered by the Licensed Patents. Royalty payments are payable quarterly
and are to be apportioned 75% to Mr. Sprague and 25% to Mr. Michener.
Payment of royalties is secured by a security interest in and to the
Licensed Patents. Mr. Sprague assigned all of his right, title, and
interest in the Licensed Patents to the Company.
The Company believes that the agreements as a whole provide it with
exclusive rights under the Wave Patents. There can be no assurance that
the Company will enjoy exclusive rights to the Licensed patents under
these agreements. No payments have been made to date.
(Continued)
<Page>
F-32
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(B) ALADDIN LICENSE AGREEMENT
During the third quarter of 1997 the Company entered into a license
agreement with Aladdin, an Israeli company, for technology and in-process
research and development related to Aladdin's proprietary persistent
encryption system. Under the terms of the Aladdin license agreement, the
Company is prohibited from using any other encryption technology for the
first five years. This technology will be incorporated into the Wave
System to facilitate pay-per-view content distribution.
The Company acquired the license for this technology in exchange for
$950,000 plus two warrants to purchase the Company's Class A Common Stock
valued at approximately $2.9 million (see note 8). The cost of this
license was expensed as research and development costs. Aladdin also is
provided a royalty payment of 5% to 9% of the Company's net content
revenues.
In connection with this agreement, Aladdin acquired an equity position in
the Company by purchasing 500,000 shares of the Company's Class A Common
Stock for $900,000, which approximated the fair market value of the
shares on the date of purchase (see note 7).
(10) LICENSE AND CROSS-LICENSE AGREEMENTS
On May 1, 1992, the Company entered into a Joint Technology Development
Agreement and License and Cross-License Agreement ("License and
Cross-License Agreement") with The Titan Corporation ("Titan") whereby
Titan granted to the Company license rights to the use of certain patents
which are co-owned or licensed by Titan. The Company granted to Titan the
exclusive right to make for, sell in, and lease in a "Retained Market,"
as defined in the agreement, the subject matter described in any Company
patent. The Retained Market is defined generally as the market for
"Government Information," as defined in the agreement, used solely by a
government entity, and the market for products used to access such
information. The Company issued to Titan 674,976 shares of Class B Common
Stock in return for the license to Titan's patents. These shares were
valued at $1.67 per share (total $1,124,960), the estimated fair value of
the shares at the time of issuance (based on the price at which shares
were sold to third parties near the time of issuance), and were included
in research and development expense in the accompanying consolidated
statement of operations for the period from February 12, 1988 through
December 31, 2001.
The License and Cross-License Agreement provides for royalties to be paid
by the Company to Titan based upon the Company's "Net Revenues," as
defined in the agreement. Net Revenues are defined generally as gross
product revenues less amounts paid to information providers and data base
providers for information provided to the Company for use in its products
and services. Royalties are payable on a quarterly basis.
The License and Cross-License Agreement also provides for royalties to be
paid to the Company by Titan based upon Titan's "Allocable Net Revenues,"
as defined in the agreement. Allocable Net Revenues are generally defined
as that portion that a Company patent or information adds to Titan's
gross amounts invoiced to purchasers for all products or information
services making use of a Company patent or know-how and information.
Royalties are payable on a quarterly basis.
The License and Cross-License Agreement specifies certain events of
termination, some of which have already occurred but which have been
waived or extended by Titan.
A director of the Company, who resigned from the Board at the end of
1997, is also the President, Chief Executive Officer, and a director of
Titan. Pursuant to the terms of a related stockholders agreement, Titan
has the right to designate a member of the Company's Board of Directors
for as long as Titan continues to own at least 50% of the shares
originally issued to Titan. As of December 31, 2001, no royalties have
been earned by Titan. On February 28, 1997, the Company and Titan
executed an addendum to the License Agreement whereby the Company
received a sole license to Titan's patent to develop and distribute
products to the in-home consumer microcomputers market segment. Under
this addendum, Titan waived all defaults previously incurred by Wave as
well as extended the license agreement to expire at the time the patents
expire.
(Continued)
<Page>
F-33
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(11) REVENUE SHARING AGREEMENTS WITH PARTNERS
The Company has, and intends to continue to, enter into revenue sharing
arrangements with information providers, software developers, and
hardware and systems manufacturers. Such revenue sharing arrangements are
expected to be negotiated between each of the partners and the Company.
It is anticipated that revenue sharing arrangements will vary according
to the market in which the Wave system is adopted and from which revenues
are derived. Generally, a significant portion of the revenue collected by
the Company will be paid directly to the information provider or software
developer. Once these payments are made, the remainder of revenues will
be shared between the Company and other partners. There can be no
assurance that the Company will be successful in entering into definitive
agreements with these parties, or that the terms of such agreements will
be favorable to the Company.
(12) INVESTMENTS
The following table summarizes the Company's investments in securities as
of December 31,:
<Table>
<Caption>
2001 2000
------------- ---------------- ------------- ---------- ---------------- ------------
ADJUSTED GROSS ADJUSTED GROSS
COST UNREALIZED FAIR COST UNREALIZED FAIR
BASIS GAINS/(LOSSES) VALUE BASIS GAINS/(LOSSES) VALUE
------------- ---------------- ------------- ---------- ---------------- ------------
Common stock of
public companies $12,576,118 $ (1,404,992) $11,171,126 $0 $1,923,304 $1,923,304
</Table>
The investments referred to above include 3,083,083 shares of SSP which
were acquired as the result of the Company's issuance of 2,000,000 shares
of its Class A Common Stock at a price of $7.16 per share, for an
aggregate purchase price of $14,312,800 in exchange for 3,600,000 shares
of the Series B Preferred Stock of BIZ, then a privately held company. On
August 24, 2001 Litronic Inc. ("Litronic") and BIZ completed a merger to
form SSP. The 3,083,083 SSP shares now owned by the Company represent
14.95% of the outstanding common stock of SSP. The Company has accounted
for this investment as non-current marketable equity securities available
for sale based on its intent to hold these securities as a long- term
investment. As of December 31, 2001, the investment was valued at
$11,160,758 based on that day's closing price of SSP on the NASDAQ
national exchange of $3.62 per share. As of December 31, 2001 the Company
took a charge for an "other than temporary decline" in the value of its
investment in SSP of $1,736,682. This charge was taken because a
decline in SSP's share price had occurred due to concerns about SSP's
financial condition and near term prospects. As a result of this charge
the cost basis of the investment as of December 31, 2001 has been
adjusted to $12,576,118.
In addition, the Company holds 107,975 common shares of XO Communications
Corporation ("XO"). As of December 31, 2001 the stock had a market value
of $10,366 based on that day's closing price of $0.096 per share.
(13) JOINT VENTURES
(A) GLOBAL WAVE, LTD
In July of 1997, the Company entered into a joint venture with ITG, a
United Kingdom Internet service provider. The joint venture was initially
owned 25% by the Company and 75% by ITG. The Company contributed its
technical expertise and ITG contributed initial working capital and the
commitment to fund all future working capital requirements of the joint
venture. The objective of the joint venture company, Global Wave is to
promote and commercialize Wave's technology in certain European and
Middle Eastern markets. Pursuant to the joint venture agreement, the
Company received a license fee of $5 million in exchange for the joint
venture's right to market Wave's technology in European and Middle
Eastern markets. The license fee was paid by ITG as part of its
commitment to fund the joint venture. During the third quarter of 1997,
the Company received $1.0 million from the joint venture representing
partial payment of the license fee, with the remaining payments to be
made upon the Company's attaining certain
(Continued)
<Page>
F-34
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
milestones related to the number of Wave Meters distributed. The amount
received was recorded as deferred license fee income in the third quarter
of 1997 as it was uncertain whether the Company had met the contractual
requirements required in order to have earned the first payment. During
the fourth quarter of 1997, the Company met these requirements and began
recognizing the license fee ratably over the contractual period, and
recorded the $1 million as a license fee income. Also the Company accrued
$490,000 in the fourth quarter of 1997 for expenses related to the
Company's obligation to assist the joint venture in setting up the Wave
system in the designated markets. In January 1998, the joint venture
agreement was modified to extend the milestone dates and provide for the
payment of an additional $750,000 of the $5 million license fee to the
Company. The payment of $750,000 was received in January 1998. The
Company also received the final payment of $3.25 million in June 1998.
This payment and the $750,000 received in January 1998 totaled $4 million
received in 1998. As part of the Agreement, after the final license fee
was paid, the companies issued a warrant to each other to purchase
approximately one million shares of each other's Common Stock. The
exercise price of the Wave warrants was $1.75 per share. The exercise
price of the ITG warrant was approximately .995 British pound per share.
On June 5, 1998, the final milestone for the last payment on the license
fee was attained and the Company became obligated to issue its warrant to
ITG pending approval by the shareholders of ITG for it to issue its
reciprocal warrant. On this date the net fair market value of the
exchange of warrants represented a net cost to the Company of
approximately $1.1 million. The Company recorded this cost as ITG net
warrant cost in the Consolidated Statement of Operations.
On November 5, 1999, the Company exercised its warrant for 1,000,000
shares in ITG at a total cost of $1,620,000. Also during 1999, ITG
exercised its 1,000,000 warrants in the Company yielding total proceeds
of $1,750,000.
In February, 2000, ITG was acquired by Concentric Network Corporation. As
a result of this transaction, the Company received $2,162,457 in cash and
83,910 shares of Concentric Common Stock. Subsequently, Concentric was
acquired by XO, whereby Wave's 83,910 shares in Concentric were converted
into 107,975 shares of XO. (See Note 12 - Investments). In addition,
certain assets of ITG, namely the 1,000,000 shares of Wave Common Stock
and ITG's interest in Global Wave, were distributed to Redwave, Plc.
("Redwave")
In June, 2000, Wave increased its ownership percentage of Global Wave
from 25% to 40%. As part of the new joint venture agreement, Wave's
partner in the venture, Redwave, agreed to contribute $7.5 million and
500,000 shares of Wave Common Stock held by Redwave, in exchange for
600,000 shares of Global Wave class A Common Stock. Wave received 400,000
shares of Global Wave class B Common Stock in exchange for a technology
license granted by Wave to Global Wave. Prior to September 30, 2000, no
value had been assigned to these shares, as Wave had not provided any
funding to Global Wave.
On October 10, 2000, Wave entered into an agreement with Global Wave and
Redwave to subscribe for additional Class B shares of Global Wave. Under
the terms of the agreement, Wave subscribed for 40,000 additional "B"
shares of Global Wave at (pound)100 per share (approximately $142.80),
the consideration for which consisted of (pound)1.5 million
(approximately $2.14 million) in development costs incurred by Wave on
behalf of Global Wave, (pound)1.4 million in cash ($2.0 million), and
(pound)1.1 million (approximately $1.6 million) in cash and/or future
development services, for total consideration of (pound)4.0 million
(approximately $5.7 million). In addition, Redwave has agreed to
subscribe for an additional 60,000 Global Wave "A" shares, the
consideration for which will consist of the conversion of debt and cash
totaling (pound)6.0 million ((pound)5,966,615 in debt and (pound)33,385
in cash; approximately $8.6 million). The resulting ownership interest in
the venture will remain 60% for Redwave and 40% for Wave.
Also, in October, 2000, Wave and Redwave formed a joint venture holding
company, Wave European Technologies plc, ("WET") for their European
interests, including their respective 40% and 60% stakes in Global Wave.
Subsequent to the formation of WET, WET's name changed to Global Wave
Group, Plc., ("Global Wave Group")
(Continued)
<Page>
F-35
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
As of December 31, 2001, Wave has contributed approximately $4.1 million
of its committed investment in the form of development costs incurred and
cash. Pursuant to the equity method of accounting, and because Wave has
committed to provide funding to the venture, the Company has recognized
its equity share (40%) of Global Wave's net losses since inception in its
results for the year-ended December 31, 2001. Wave has recorded its
equity in the Global Wave's net losses of $2.3 million and $3.4 million
for the years-ended December 31, 2001 and 2000, respectively. Because
Wave had previously not provided any funding, and had not committed to
provide any funding to Global Wave, none of it's equity in the prior
period losses were recognized by Wave in its prior year financial
statements.
In February, 2002, the Company paid approximately $1.6 million
representing its final funding commitment to Global Wave.
(B) WAVEXPRESS
In April 1999, the Company joined with Sarnoff Corporation to form a new
joint venture, WaveXpress. WaveXpress develops secure data broadcast
architecture, infrastructure and content services. This technology and
these services will allow content providers to send digital content to
properly equipped PC's by utilizing unused bandwidth in the Digital
Television (DTV) Spectrum or broadcast over cable television lines.
Consumers will be able to purchase this content directly through a secure
network connection, thus enabling a significant new revenue stream for
broadcasters or cable television operators. On October 15, 1999, Wave and
Sarnoff signed the Joint Venture Agreement that formally established
WaveXpress. Under this agreement, Sarnoff and its affiliates received a
40% equity stake in WaveXpress. Wave received a 53% equity interest; and
its affiliates, who purchased founders stock in April 1999 for a nominal
amount, owned the remaining 7% of the outstanding capital stock. The
affiliates of Wave include Peter and Steven Sprague, the Chairman and
Chief Executive Officer of Wave, respectively, certain members of the
Board of Directors of Wave and certain Wave employees.
Wave has funded WaveXpress through a series of convertible notes, some
with attached warrants. The notes bear interest at rates of 2% to 3%
above the prime rate of Chase Manhattan Bank. Generally, the notes are
convertible into shares of Common Stock of WaveXpress at varying prices
per share. In addition, some of the notes carry attached warrants that
allow the company to purchase additional shares of WaveXpress, generally
at the conversion price of the notes. The equity interests of Wave,
Sarnoff and the Company's affiliates referred to above, assuming all of
Wave's and Sarnoff's convertible securities are converted and warrants
are exercised, would be approximately 82%, 15%, and 3%, respectively.
Through December 31, 2001, Wave had provided approximately $25.9 million
in funds, including approximately $2.3 million in accrued interest.
During 2001, some of the notes, totaling $9.5 million matured and were
converted into 1,826,570 shares of WaveXpress common stock. These amounts
are eliminated in consolidation.
Neither Sarnoff nor any of the other minority shareholders have provided
or are obligated to provide funding to WaveXpress. Accordingly, the
financial statements of WaveXpress have been included in the consolidated
financial statements of the Company as of December 31, 2001 and for the
period then ended. In addition, the Company has not recorded a minority
interest in WaveXpress in the consolidated financial statements and
therefore has reflected 100% of WaveXpress' balance sheet and operating
results in its consolidated financial statements. WaveXpress has incurred
net losses of $10.2, $11.2 million and $1.9 for the years ended December
31, 2001, 2000 and 1999, respectively.
(Continued)
<Page>
F-36
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(14) COMMITMENTS AND CONTINGENCIES
LITIGATION
During 2001 a demand for arbitration was filed against the Company by a
former supplier. The arbitration arises out of a claim that the Company
breached a contract with the supplier to purchase computer components to
be incorporated into an internet security device produced by the Company.
The demand alleges damages in the amount of approximately $1.2 million.
It is too early in the matter to assess whether the loss, if any
resulting from the demand will have a material impact on the Company's
financial position, results of operations, or cash flows in future years.
Management intends to vigorously contest the arbitration.
LEASES
Summarized below is a listing of properties leased by Wave Systems Corp.
pursuant to non-cancelable operating leases. Our principal research and
development activities are conducted at the Princeton and Cupertino
facilities.
<Table>
<Caption>
ANNUAL LEASE
LOCATION LEASE COST EXPIRATION DATE
-------- ---------- ---------------
Lee, MA $ 147,095 Aug. 2004
New York, NY 171,000 May 2002
Princeton, NJ 547,893 Dec. 2002
Cupertino, CA 543,846 Oct. 2002
Nashville, TN 47,233 Sep. 2003
Orvault, France 32,087 Sep. 2010
New York, NY (1) 628,290 Apr. 2010
----------
Total $2,117,444
==========
</Table>
(1) WAVEXPRESS FACILITY
(Continued)
<Page>
F-37
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
Future minimum lease payments under noncancelable operating leases
(with initial or remaining lease terms in excess of one year) as of
December 31, 2001 are as follows:
<Table>
2002 $ 1,826,621
2003 761,281
2004 641,758
2005 621,623
2006 646,187
Thereafter 2,208,266
-----------
Total minimum lease payments $ 6,705,737
===========
</Table>
Rent expense for the years ended December 31, 2001, 2000, 1999 and for
the period from inception through December 31, 2001 amounted to
approximately $2,101,000, $1,960,000, $957,000 and $7,180,000,
respectively.
There were no capital lease obligations as of December 31, 2001.
PURCHASE COMMITMENTS
The Company has outstanding purchase commitments totaling approximately
$984,000 for inventory.
(15) INCOME TAXES
The Company has net operating loss carryforwards for tax return purposes
of approximately $145 million, which expire beginning in 2003 through
2021.
Pursuant to the Internal Revenue Code, Section 382 of 1986, annual
utilization of the Company's net operating loss carryforwards may be
limited if a cumulative change in ownership of more than 50% occurs
within a three year period. The Company has not determined whether there
has been such a cumulative change in ownership or the impact on the
utilization of the loss carryforwards if such change has occurred.
The tax effects of temporary differences that give rise to the deferred
tax asset at December 31, 2001 and 2000 are as follows:
<Table>
<Caption>
2001 2000
---- ----
Deferred tax assets:
Net operating loss carryforwards $ 61,604,000 $ 42,263,000
Accrued expenses 831,000 324,000
Intangibles 4,609,000 1,595,000
Reserves 549,000 142,000
Depreciation 786,000 246,000
Other 42,000 --
------------ ------------
Total gross deferred tax assets 68,421,000 44,570,000
Less valuation allowance (68,421,000) (44,570,000)
Net deferred tax asset $ -- $ --
============ ============
</Table>
The valuation allowance increased by approximately $23.9 million and
$11.6 million, during the years ended December 31, 2001 and 2000,
respectively.
Management has concluded that it is more likely than not that the Company
will not have sufficient taxable income of an appropriate character
within the carryback and carryforward period permitted by current law to
allow for the utilization of certain of the deductible amounts generating
the deferred tax assets and, therefore, a valuation allowance of
$68,421,000 and $44,570,000 has been established to reduce the deferred
tax assets at December 31, 2001 and 2000 respectively.
(Continued)
<Page>
F-38
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(16) DEFINED CONTRIBUTION PLAN
The Company adopted the Wave Systems Corp. 401(k) Savings and
Investment Plan, a defined contribution plan, to which substantially
all employees can contribute, on January 1, 1995. Employees of the
Company become eligible immediately on employment. The Company has the
option to make discretionary matching contributions; no contributions
were made in 2001, 2000 or 1999.
(17) DISCLOSURES ABOUT THE FAIR VALUE OF FINANCIAL INSTRUMENTS
CASH AND CASH EQUIVALENTS, MARKETABLE SECURITIES, PREPAID EXPENSES AND
OTHER RECEIVABLE, ACCOUNTS PAYABLE AND ACCRUED EXPENSES, AND NOTE PAYABLE
The carrying amounts of these instruments, other than marketable
securities and the note payable, approximate fair value because of their
short maturities. Marketable securities are valued based on the value of
the securities as traded on the Nasdaq Stock Exchange.
Fair value estimates are made at a specific point in time, based on
relevant market information and information about the financial
instrument. These estimates are subjective in nature and involve
uncertainties and matters of significant judgment and therefore cannot be
determined with precision. Changes in assumptions could significantly
affect the estimates.
(Continued)
<Page>
F-39
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(18) SEGMENT REPORTING
Effective December 31, 2000, the Company adopted SFAS No. 131
"Disclosures about Segments of an Enterprise and Related Information."
SFAS 131 supercedes previously issued segment reporting disclosure rules
and requires reporting of segment information that is consistent with the
way in which management operates the Company. Prior to December 31, 2000,
SFAS 131 was not applicable because the Company only operated as one
segment.
The Company's products include the Wave EMBASSY(R) Trusted Client
Platform and Services and WaveXpress Data Broadcasting Products and
Services. These products and services constitute the Company's reportable
segments. Net Losses for reportable segments exclude interest income,
interest expense, equity in losses of equity method investees and
realized gains on marketable securities. These items are not reported by
segment since they are excluded from the measurement of segment
performance reviewed by the Company's management.
The following sets forth reportable segment data:
<Table>
<Caption>
FOR THE YEARS ENDED DECEMBER 31,
2001 2000 1999
---- ---- ----
Operating Revenues:
EMBASSY(R)Trusted Client Platform and Services $ 672,325 $ 332,522 $ 187,515
WaveXpress Data Broadcasting 19,800 -- --
------------ ------------ ------------
Total Operating Revenues 692,125 332,522 187,515
(Net Loss):
EMBASSY(R)Trusted Client Platform and Services (1) (37,068,320) (39,712,441) (25,983,028)
WaveXpress Data Broadcasting (10,252,001) (10,183,134) (1,853,873)
------------ ------------ ------------
Total Segments Net Loss (47,320,321) (49,895,575) (27,836,901)
------------ ------------ ------------
Interest Income 2,688,105 5,103,716 617,306
Interest Expense -- -- (832,976)
Equity in net losses of equity method investees
(2,332,159) (3,406,491) --
Loss for Other than Temporary Decline in Marketable
Equity Securities (1,736,682) -- --
Gain on sale of marketable securities -- 542,457 --
------------ ------------ ------------
Net Loss $(48,701,057) $(47,655,893) $(28,052,571)
============ ============ ============
Depreciation and Amortization Expense:
EMBASSY(R)Trusted Client Platform and Services (2) 3,281,547 2,228,078 758,223
WaveXpress Data Broadcasting 970,408 939,060 9,771
------------ ------------ ------------
Total Depreciation Expense $ 4,251,955 $ 3,167,138 $ 767,994
============ ============ ============
Capital Expenditures:
EMBASSY(R)Trusted Client Platform and Services 1,307,271 1,323,485 1,989,381
WaveXpress Data Broadcasting 200,327 4,275,815 1,867,258
------------ ------------ ------------
Total Capital Expenditures $ 1,507,598 $ 5,599,300 $ 3,856,639
============ ============ ============
Assets:
EMBASSY(R)Trusted Client Platform and Services 58,562,392 92,164,096 14,640,852
WaveXpress Data Broadcasting 1,671,910 5,920,365 1,891,031
------------ ------------ ------------
Total Assets $ 60,234,302 $ 98,084,461 $ 16,531,883
============ ============ ============
</Table>
(1) Includes $0, $2,176,000 and $0 in-process research and development for
the years-ended December 31, 2001, 2000 and 1999 respectively (See Note
12).
(2) Includes $1,720,632 $573,544 and $0 in goodwill amortization for the
year-ended December 31, 2001, 2000 and 1999 respectively (See note 12)
(Continued)
<Page>
F-40
WAVE SYSTEMS CORP. AND SUBSIDIARIES
(a development stage corporation)--(Continued)
Notes to Consolidated Financial Statements
(19) SELECTED QUARTERLY FINANCIAL DATA
<Table>
<Caption>
FOR QUARTERS-ENDED
DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31,
2001 2001 2001 2001
------------ ------------- -------- ---------
Revenues $ 202,221 $ 224,768 $ 191,698 $ 73,438
Gross Profit 50,351 140,854 60,104 70,857
Loss from Operations (9,922,017) (11,227,427) (11,722,600) (14,448,277)
Net loss (11,743,942) (11,200,084) (11,890,884) (13,866,147)
Net loss per Common Share $ (0.23) $ (0.22) $ (0.24) $ (0.28)
</Table>
<Table>
<Caption>
FOR QUARTERS-ENDED
DECEMBER 31, SEPTEMBER 30, JUNE 30, MARCH 31,
2000 2000 2000 2000
------------ ------------- -------- ---------
Revenues $ 173,380 $ 81,793 $ 54,748 $ 22,601
Gross Profit 169,832 76,680 18,556 8,590
Loss from Operations (14,361,984) (15,472,450) (10,486,614) (9,574,527)
Net loss (14,024,071) (16,182,893) (8,821,224) (8,627,705)
Net loss per Common Share $ (0.29) $ (0.34) $ (0.19) $ (0.20)
</Table>