As filed with the Securities and Exchange Commission on September 28, 2000
Registration Number 333-
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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
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CONVERGENT NETWORKS, INC.
(Exact name of registrant as specified in its charter)
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Delaware 3576 04-3420240
(State or other jurisdiction of (Primary Standard Industrial (I.R.S. Employer
incorporation or organization) Classification Code Number) Identification Number)
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900 Chelmsford Street
Lowell, Massachusetts 01851
(978) 323-3300
(Address, including ZIP code, and telephone number, including area code, of
Registrant's Principal Executive Offices)
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John C. Thibault
President and Chief Executive Officer
900 Chelmsford Street
Lowell, Massachusetts 01851
(978) 323-3300
(Name, Address, including ZIP code, and telephone number, including area code,
of Agent for Service)
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Copies to:
John A. Burgess, Esq. Jocelyn M. Arel, Esq.
Richard G. Costello, Esq. Testa, Hurwitz & Thibeault, LLP
Hale and Dorr LLP 125 High Street
60 State Street Boston, Massachusetts 02110
Boston, Massachusetts 02109 Telephone: (617) 248-7000
Telephone: (617) 526-6000 Telecopy: (617) 248-7100
Telecopy: (617) 526-5000
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Approximate date of commencement of proposed sale to the public: As soon as
practicable after the Registration Statement becomes effective.
If any of the securities being registered on this form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act,
check the following box. [_]
If this form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, check the following box and
list the Securities Act registration statement number of the earlier effective
registration statement for the same offering. [_]
If this form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]
If this form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration statement number of the earlier effective registration statement
for the same offering. [_]
If delivery of the prospectus is expected to be made pursuant to Rule 434,
check the following box. [_]
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CALCULATION OF REGISTRATION FEE
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Title of each Class of Proposed Maximum Aggregate Amount of
Securities to be Registered Offering Price(1) Registration Fee
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Common Stock, par value
$0.00001 per share....... $100,000,000 $26,400
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(1) Estimated solely for the purpose of calculating the amount of the
registration fee pursuant to Rule 457(o) under the Securities Act of 1933,
as amended.
The Registrant hereby amends this Registration Statement on such date or
dates as may be necessary to delay its effective date until the Registrant
shall file a further amendment which specifically states that this Registration
Statement shall thereafter become effective in accordance with Section 8(a) of
the Securities Act of 1933 or until the Registration Statement shall become
effective on such date as the Securities and Exchange Commission, acting
pursuant to said Section 8(a), may determine.
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+The information in this prospectus is not complete and may be changed. We may +
+not sell these securities until the registration statement filed with the +
+Securities and Exchange Commission is effective. This prospectus is not an +
+offer to sell these securities and it is not soliciting an offer to buy these +
+securities in any state where the offer or sale is not permitted. +
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
SUBJECT TO COMPLETION, DATED SEPTEMBER 28, 2000
Shares
Common Stock
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Prior to this offering, there has been no public market for our common stock.
The initial public offering price of our common stock is expected to be between
$ and $ per share. We have applied to list our common stock on The Nasdaq
Stock Market's National Market under the symbol "CVNI".
The underwriters have an option to purchase a maximum of additional
shares to cover over-allotments of shares.
Investing in our common stock involves risks. See "Risk Factors" on page 5.
Underwriting Proceeds
Discounts to
Price to and Convergent
Public Commissions Networks
-------- ------------ ----------
Per Share.................................. $ $ $
Total...................................... $ $ $
Delivery of the shares of common stock will be made on or about , 2000.
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if
this prospectus is truthful or complete. Any representation to the contrary is
a criminal offense.
Credit Suisse First Boston
J.P. Morgan & Co.
U.S. Bancorp Piper Jaffray
The date of this prospectus is , 2000.
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TABLE OF CONTENTS
Page
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Prospectus Summary.................. 1
Risk Factors........................ 5
Special Note Regarding Forward-
Looking Statements................. 16
Use of Proceeds..................... 17
Dividend Policy..................... 17
Capitalization...................... 18
Dilution............................ 19
Selected Consolidated Financial
Data............................... 20
Management's Discussion and Analysis
of Financial Condition and Results
of Operations...................... 21
Business............................ 27
Management.......................... 38
Page
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Related Party Transactions........ 50
Principal Stockholders............ 53
Description of Capital Stock...... 55
Shares Eligible for Future Sale... 57
U.S. Federal Tax Consequences to
Non-United States Holders........ 59
Underwriting...................... 63
Notice to Canadian Residents...... 66
Legal Matters..................... 67
Experts........................... 67
Where You Can Find More
Information...................... 67
Index to Consolidated Financial
Statements....................... F-1
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You should rely only on the information contained in this document or to
which we have referred you. We have not authorized anyone to provide you with
information that is different. This document may only be used where it is legal
to sell these securities. The information in this document may only be accurate
on the date of this document.
Dealer Prospectus Delivery Obligation
Until , 2000 (25 days after the commencement of this offering), all
dealers that effect transactions in these securities, whether or not
participating in this offering, may be required to deliver a prospectus. This
is in addition to the dealer's obligation to deliver a prospectus when acting
as an underwriter and with respect to unsold allotments or subscriptions.
PROSPECTUS SUMMARY
You should read this prospectus summary together with the more detailed
information contained in this prospectus, including the risk factors and
financial statements and the notes to the financial statements.
Convergent Networks, Inc.
We are a leading provider of broadband voice infrastructure products for the
new public network. We design, develop and market a new generation of carrier-
class switching equipment and software that enable service providers to deliver
voice and data services over high-speed, or broadband, networks. Our target
customers are new and established communications service providers, including
local exchange and long distance carriers and operators of foreign telephone
networks.
We believe that two dramatic developments in the telecommunications
industry--deregulation and the Internet--are now revolutionizing the public
telephone network worldwide. Service providers are responding to increased
competition and the dramatic growth of Internet use by building packet-based
networks. Packet-based networks divide information into small units called
packets for the efficient transmission of both voice and data, and will be the
core technology for the new public network. By enabling service providers to
deliver voice and data services over broadband packet-based networks, we
believe our products are laying the foundation for the new public network.
Our products provide the reliability, voice service quality and scalability
of today's public telephone network, while offering improved economics for
service providers to profitably deliver large amounts of voice and data
traffic. Our products also enable service providers to increase revenues and
profits by rapidly delivering new and innovative services to meet evolving end-
user demand. Our Cohesion product family includes the ICS2000 broadband switch,
which enables voice traffic to be transported over broadband packet-based
networks, the ICServiceWorks softswitch and service creation software, which
control and manage voice calls and services between the traditional telephone
network and a broadband packet-based network, and the ICView network management
system. Our customers include leading communications service providers
including BT, Broadwing, Focal and Global NAPs. We sell our products primarily
through a direct sales force and intend to complement it with strategic
distribution relationships with leading technology partners.
Our objective is to be the leading supplier of broadband voice
infrastructure products for the new public network. We intend to achieve this
by:
. leveraging our solutions-oriented approach;
. broadening our customer base though expanded product offerings;
. increasing our global sales and marketing capabilities;
. delivering superior customer service and support; and
. pursuing strategic alliances and acquisitions.
We were incorporated in May 1998. We have a limited operating history and we
have not reported an operating profit for any period since our incorporation.
We expect to continue to incur net losses for the foreseeable future. Our
principal executive offices are located at 900 Chelmsford Street, Lowell,
Massachusetts, 01851, and our telephone number is (978) 323-3300. Our website
address is www.convergentnet.com. Information contained in our website is not
incorporated by reference into this prospectus, and you should not consider
information contained in our website as part of this prospectus.
1
Recent Developments
On July 31, 2000, we completed our acquisition of Hemisphere Investments and
its wholly owned subsidiaries, including Technology Control Services,
collectively TCS. TCS developed softswitch and service creation software and
network-based service applications, such as unified messaging and calling card
services, which will be part of our ICServiceWorks product. We issued an
aggregate of 10,106,845 shares of our common stock in consideration for all of
the outstanding capital stock of TCS, reserved an aggregate of 1,229,436 shares
of our common stock in connection with the assumption of outstanding options to
purchase capital stock of TCS and assumed approximately $5.5 million of TCS
debt, which we repaid immediately upon closing the transaction. We have
accounted for the acquisition of TCS as a purchase.
On September 22, 2000, we sold 4,803,926 shares of Series D convertible
preferred stock in a private placement for net proceeds of $73.8 million. These
shares of Series D convertible preferred stock will automatically convert into
4,803,926 shares of our common stock upon the closing of this offering.
2
The Offering
Common stock offered........................... shares
Common stock to be outstanding after this
offering...................................... shares
Use of proceeds................................ For general corporate purposes
Proposed Nasdaq National Market symbol......... CVNI
The number of shares to be outstanding after this offering is based on
shares outstanding as of September 25, 2000 and excludes:
. 4,160,472 shares of common stock issuable upon exercise of options
outstanding as of September 25, 2000 at a weighted average exercise
price of $5.36 per share;
. 240,000 shares of common stock issuable upon exercise of warrants
outstanding as of September 25, 2000 at a weighted average exercise
price of $14.54 per share;
. 10,000,000 shares of common stock available for issuance under our 2000
stock incentive plan; and
. 5,000,000 shares of common stock available for issuance under our 2000
employee stock purchase plan.
Unless indicated otherwise, all information in this prospectus assumes:
. the conversion of all shares of convertible preferred stock into an
aggregate of 28,757,453 shares of common stock upon the completion of
this offering;
. the effectiveness of our amended and restated certificate of
incorporation; and
. that the underwriters do not exercise their over-allotment option.
Convergent Networks, the Convergent Networks logo, Cohesion, ICS,
ICServiceWorks, ICSG, ICSX, ICView and The Voice of Broadband Networking are
our trademarks. All other trade names referred to in this prospectus are the
property of their respective owners.
3
Summary Consolidated Financial Data
(in thousands, except per share data)
Period from
Inception Six Months Ended
(May 6, 1998) to Year Ended June 30,
December 31, December 31, -----------------
1998 1999 1999 2000
---------------- ------------ ------- --------
(unaudited)
Consolidated Statement of
Operations Data:
Revenues..................... $ -- $ -- $ -- $ 1,827
Loss from operations......... (2,628) (21,409) (5,422) (11,672)
Net loss..................... (2,528) (21,272) (5,382) (10,750)
Net loss attributable to
common stockholders......... (2,783) (22,339) (5,656) (12,919)
Net loss per share:
Basic and diluted.......... $ (4.87) $ (7.47) $ (2.79) $ (2.75)
Pro forma basic and
diluted................... (1.11) (0.38)
Shares used in computing net
loss per share:
Basic and diluted.......... 572 2,991 2,028 4,696
Pro forma basic and
diluted................... 19,168 28,610
June 30, 2000
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Pro Forma
Actual Pro Forma As Adjusted
----------- ----------- -----------
(unaudited) (unaudited) (unaudited)
Consolidated Balance Sheet Data:
Cash, cash equivalents and marketable
securities............................... $ 24,663 $ 94,175
Working capital........................... 23,628 84,079
Total assets.............................. 30,848 226,479
Notes payable and capital lease
obligations, net of current portion...... 695 909
Redeemable convertible preferred stock.... 58,309 --
Total stockholders' equity (deficit)...... (32,556) 207,819
Pro forma basic and diluted net loss per share have been calculated assuming
the conversion of all outstanding shares of convertible preferred stock into
shares of common stock, as if the shares had converted immediately upon
issuance.
The pro forma balance sheet data give effect to:
. our acquisition of TCS as if it had occurred on June 30, 2000;
. our sale of 4,803,926 shares of Series D convertible preferred stock on
September 22, 2000 and our receipt of net proceeds of approximately
$73.8 million from the sale; and
. the conversion into common stock of all outstanding convertible
preferred stock upon the closing of this offering.
The pro forma as adjusted balance sheet data give further effect to our
receipt of the net proceeds from the sale of the shares of common stock
offered by us at the assumed initial public offering price of $ per share,
after deducting estimated underwriting discounts and commissions and estimated
offering expenses.
4
RISK FACTORS
Investing in our common stock involves a high degree of risk. You should
consider carefully the following risk factors and all other information
contained in this prospectus before purchasing our common stock.
Risks Related to Our Financial Results
We have a limited operating history and have operated as a consolidated company
for a short period of time, which will make it difficult for you to predict our
future operating results.
We have a limited operating history and have operated as a consolidated
company for a short period of time. We were incorporated in May 1998. We only
began to recognize revenues during the second quarter of fiscal 2000. We
acquired TCS in July 2000. Due to our limited operating history, it is
difficult to predict our future operating results. You should consider our
business and prospects in light of the risks and difficulties typically
encountered by companies like us in their early stages of development,
particularly those that are in the process of consolidating different lines of
business and that are in rapidly evolving and intensely competitive markets.
We have incurred significant losses and negative cash flows since our inception
and we expect to continue to incur significant losses and negative cash flows
for the foreseeable future, and we may never achieve profitability.
We have incurred significant losses and negative cash flow for our entire
history, and we expect to continue to incur significant losses and negative
cash flow for the foreseeable future. As of June 30, 2000, we had an
accumulated deficit of $38.1 million. We have incurred and will continue to
incur significant expenses for research and development, sales and marketing,
customer support and general and administrative expenses as we expand our
business. We will need to generate significantly higher revenues to achieve
profitability, and we may never be able to achieve or sustain profitability.
Our revenues and operating results are likely to fluctuate significantly and as
a result our stock price could significantly decline.
Our quarterly revenues and operating results are likely to fluctuate
significantly in the future due to a variety of factors, many of which are
beyond our control. If our quarterly or annual operating results do not meet
the expectations of investors or securities analysts, our common stock price
could significantly decline. Some of the factors that could affect our
quarterly or annual revenues and operating results include:
. the timing and size of sales of our products;
. the speed with which our customers deploy our products in their
networks;
. variations in the capital spending budgets of communications service
providers;
. the ability of service providers to fund network equipment purchases;
. announcements, new product introductions and reductions in the prices of
products offered by our competitors;
. our ability to develop, manufacture, introduce, ship and support our
current product lines as well as new products and product enhancements;
and
. our ability to obtain sufficient supplies of sole or limited source
components for our products.
In addition, based on the experience of other communications equipment
providers, we believe we may recognize a substantial portion of our revenues in
a given quarter from sales booked and shipped in the last weeks of that
quarter. As a result, any delay in fulfillment of a customer order is likely to
result in a delay in shipment and recognition of revenues beyond the end of a
given quarter, which would have a significant impact on our operating results
for that quarter.
5
We plan to increase significantly our operating expenses to fund greater
levels of research and development, expand our sales and marketing operations,
broaden our customer support capabilities and develop new distribution
channels. We also plan to expand our general and administrative functions to
address the increased reporting and other administrative demands related to
being a publicly traded company and the increasing size of our business. Our
operating expenses are largely based on anticipated revenue trends, and a high
percentage of our expenses are and will continue to be fixed in the short term.
As a result, a delay in generating or recognizing revenues could cause
significant variations in our operating results from quarter to quarter and
could result in substantial operating losses.
We expect to rely on sales of our Cohesion family of products for our future
revenues, and if these products fail to achieve market acceptance we may never
achieve profitability.
Our future growth depends upon market acceptance of our Cohesion family of
products. We expect to derive nearly all of our revenues for the foreseeable
future from sales of our ICS2000 broadband switch, ICService Works softswitch
and service creation software and ICView Network Management System. If we are
unable to sell sufficient quantities of our products at acceptable prices, we
may not achieve or maintain profitability.
We may need additional capital to fund our existing and future operations. If
we are unable to obtain additional capital, we may be required to reduce the
scope of our planned product development and sales and marketing efforts, which
would harm our business.
The development and marketing of new products and the expansion of our
direct sales operation and associated support personnel is expected to require
a significant commitment of resources. We may incur significant operating
losses or expend significant amounts of capital if:
. the market for our products develops more slowly than anticipated;
. we fail to establish market share or generate revenues;
. our capital expenditure forecasts change or prove inaccurate; or
. we need to respond to unforeseen challenges or take advantage of
unanticipated opportunities.
As a result, we may need to raise substantial additional capital. To the
extent that we raise additional capital through the sale of equity or
convertible debt securities, the issuance of those securities could result in
dilution to our existing shareholders. If additional funds are raised through
the issuance of debt securities, the terms of the debt could impose additional
restrictions on our operations. Additional capital, if required, may not be
available on acceptable terms, or at all. If we are unable to obtain additional
capital, we may be required to reduce the scope of our planned product
development and sales and marketing efforts, which would harm our business.
Risks Related to Our Customers
If our customers are unable to raise sufficient capital to finance the
development of new networks, our business would be harmed.
We focus our sales and marketing efforts on next-generation communications
service providers. Many of these companies were recently formed, and few have
achieved profitability to date. As a result, some of these companies may not
have sufficient capital to finance the necessary infrastructure to build a
packet-based network. To date, we have not offered to finance customer
purchases of our products. To the extent that our competitors offer vendor
financing, we may not be able to successfully compete in selling our products
to next-generation service providers. If our customers are unable to raise
necessary capital, demand for our products from these companies would be
reduced, and our business and operating results would suffer.
6
We will not be successful if we do not expand our customer base beyond our
initial few customers.
Our future success will depend on our ability to attract additional
customers beyond our current limited number. To date, we have shipped our
products to a limited number of customers. We expect that in the foreseeable
future, substantially all of our revenues will depend on sales of our products
to a limited number of customers. Many of the customers to which we have
shipped products are currently using our products in laboratory testing and
internal trials. Customers still in the test and trial process may not deploy
our products in their commercial networks on a timely basis, or at all. The
loss of one or more of our current customers, a reduction in sales to them,
cancellation of or delays in orders placed by our customers or the failure to
sell our products to additional service providers would significantly reduce
our revenues. None of our contracts require our customers to make minimum
purchase commitments. Sales to Global NAPs, an affiliate of which is an
investor in our company, accounted for 100% of our revenues for the six months
ended June 30, 2000.
The long and variable sales and deployment cycles for our products may cause
our revenues and operating results to vary significantly.
Our products have lengthy sales cycles and we may incur substantial sales
and marketing expenses and expend significant management effort without making
a sale. A customer's decision to purchase our products often involves a
significant commitment of its resources and a lengthy product evaluation and
qualification process. Some potential customers may require an extended
technical pre-qualification process, which may cause the initial sales cycle to
be over a year. Even after making the decision to purchase our products, our
customers often have a lengthy deployment process. Timing of deployment can
vary widely and depends on:
. the size of the network deployment;
. the complexity of our customers' network environments;
. our customers' in-house skill sets;
. the hardware and software configuration and customization necessary to
deploy our products; and
. our customers' ability to finance their purchases of our products.
As a result, it is difficult for us to predict the quarter in which our
customers may purchase or deploy our products and our revenues and operating
results may vary significantly from quarter to quarter.
If our products fail to interoperate with our customers' networks, demand for
our products will be reduced and substantial product returns could occur, which
could harm our business and our reputation.
Many of our customers require that our products be designed to interoperate
with their existing networks, each of which may have different specifications
and use multiple standards. Our customers' networks may contain multiple
generations of products from different vendors that have been added over time
as their networks have grown and evolved. Our products must interoperate with
these products as well as with future products in order to meet our customers'
requirements. In some cases, we may be required to modify our product designs
to achieve a sale, which may result in a longer sales cycle, increased research
and development expense, and reduced operating margins. If our products do not
interoperate with existing equipment in our customers' networks, installations
could be delayed, orders for our products could be canceled or our products
could be returned. This could harm our business, reputation and operating
results.
If we fail to develop and sell new products that meet the evolving needs of our
customers, or if our new products or enhancements fail to achieve market
acceptance, our business and operating results would be harmed.
Our success depends on our ability to anticipate our customers' evolving
needs and to develop and market products that address those needs. We are
currently in the process of developing enhancements to our broadband voice
infrastructure products, including voice-over Internet Protocol, or IP,
enhancements to our ICS
7
2000 broadband switch, to meet the growing demands of communications service
providers for carrier-class applications. The timely development of these new
or enhanced products is a complex and uncertain process. We may experience
design, manufacturing, marketing and other difficulties that could delay or
prevent our development, introduction or marketing of these and other new
products and enhancements. We may not have sufficient resources to anticipate
successfully and accurately technological and market trends, or to manage
successfully long development cycles. We may also be required to collaborate
with third parties, or to license or purchase third-party software or hardware,
to develop our products, and may not be able to do so on a timely and cost-
effective basis, if at all. If we are not able to develop new products or
enhancements to existing products on a timely and cost-effective basis, or if
our new products or enhancements fail to achieve market acceptance, our ability
to continue to sell our products and grow our business would be harmed.
If we fail to capitalize on opportunities to win contracts from our target
customers, we may not be able to sell products to those customers for an
extended period of time.
We believe that our customers deploy and upgrade their networks infrequently
and in large increments. As a result, if we fail to win a purchase contract
from a target customer, we may not have an opportunity to sell products to that
customer for an extended period of time. In addition, if we fail to win
contracts from target customers that are at an early stage in their network
design cycle, we may never be able to sell products to these customers because
they may prefer to continue purchasing products from the first vendor selected
at the design stage. Because we rely on a limited number of customers for our
sales, our failure to capitalize on opportunities to win contracts with these
customers would harm our business and operating results.
Consolidation among communications services providers may cause a reexamination
of strategic and purchasing decisions by our current and potential customers,
which could harm our business.
Consolidation among communications service providers may cause delays in the
purchase of our products and cause a reexamination of strategic and purchasing
decisions by our current and potential customers. In addition, we may lose
valuable relationships with key personnel of a customer of ours due to budget
cuts, layoffs or other disruptions following, or during, a consolidation.
Risks Related to Our Industry
Intense competition and consolidation in the markets in which we compete could
prevent us from increasing or sustaining our revenues and prevent us from
achieving or sustaining profitability.
The market for voice infrastructure products is highly competitive. We
compete directly with numerous companies, including Cisco Systems, Lucent
Technologies, Nortel Networks and Sonus Networks. In the future, we expect that
additional companies will enter the market with competitive solutions. Many of
our current and potential competitors have longer operating histories, larger
customer bases, significantly greater selling and marketing, technical,
financial and customer support resources and broader product offerings than we
do. As a result, these competitors may be able to devote greater resources to
the development, promotion, sale and support of their products. In addition,
these companies may adopt aggressive pricing policies and leverage their
customer bases and broader product offerings to gain market share. We believe
that competitive pressures are likely to result in price reductions and reduced
margins, which would harm our operating results. Our competitors may foresee
market and technological developments earlier or more accurately than we do and
could develop new technologies that compete with our products or even render
our products obsolete.
The markets in which we compete are characterized by increasing
consolidation. We cannot predict how industry consolidation will affect our
competitors, and we may not be able to compete successfully in an increasingly
consolidated industry. Our competitors that have large market capitalizations
or significant cash reserves are better positioned than we are to acquire other
companies, thereby obtaining new technologies or products that may displace our
product lines. Any of these acquisitions could give our competitors a strategic
advantage that would harm our business.
8
If usage of packet-based networks does not continue to grow as expected or the
migration of communications services to packet-based networks is not widely
accepted, our business could be harmed.
Packet-based technology may not be widely accepted as the core technology
for the new public network. If the use of packet-based technology does not grow
significantly, or the migration to, and the market acceptance of, packet-based
technology as the core technology for the new public network does not occur, or
occurs more slowly than expected, we may not be able to sell our products in
significant volumes. Many factors beyond our control may limit the increased
use of packet-based networks or delay the migration of communications services
to packet-based networks, including:
. inadequate demand for broadband voice and data services from business
and consumer users;
. the development of legislation and regulations related to the new public
network;
. installation, space and power constraints at service provider central
offices; and
. evolving industry standards for broadband access, voice switching and
other technologies.
If we fail to respond to technological changes or to evolving industry
standards, our products could fail to achieve market acceptance.
The market for our products for the new public network is characterized by
rapid technological change and, in the future, will likely require frequent new
product introductions and enhancements. We may be unable to respond quickly or
effectively to these developments. Currently, our products support asynchronous
transfer mode, or ATM, packet technology. We intend to deliver voice-over IP
packet technology, in future versions of our existing products. We may
experience difficulties with hardware design or manufacturing or software
development that could delay or prevent our introduction of new products and
enhancements. The introduction of new products by competitors, the market
acceptance of products based on new or alternative technologies or the
emergence of new industry standards, particularly with respect to networking
technologies such as ATM or IP, could render our existing or future products
obsolete. If industry standards adopted in the future are different from those
that we have chosen to support, market acceptance of our products may be
significantly reduced or delayed.
Communications service providers are subject to governmental regulation, and
changes in current or future laws or regulations that negatively impact
communications service providers could harm our business.
The jurisdiction of the Federal Communications Commission, or FCC, extends
to the entire communications industry, including communications service
providers. Future FCC regulations affecting the Internet, communications
service providers or their service offerings may harm our business. For
example, FCC regulatory policies that affect the availability of data and
Internet services may impede communications service providers' penetration into
some markets or affect the prices that they are able to charge. In addition,
domestic and international regulatory bodies, such as the Federal Trade
Commission and the European Commission, are beginning to adopt standards and
regulations for the Internet. These domestic and foreign standards and
regulations address various aspects of Internet use, including issues regarding
invasion of privacy, the security of data transmitted over the Internet and
taxation of e-commerce. Resulting standards and regulations could adversely
affect the development of e-commerce and other uses of the Internet. To the
extent communications service providers are adversely affected by laws or
regulations regarding their business, products or service offerings, this could
harm our business.
Risks Associated With Our Products
We depend on ACT Manufacturing and other contract manufacturers to manufacture
our products and are vulnerable to disruptions in the manufacture and delivery
of our products.
We rely on ACT Manufacturing and other contract manufacturers to manufacture
our products according to our specifications and to fill orders on a timely
basis. We do not have internal manufacturing capabilities.
9
ACT provides comprehensive manufacturing services, including assembly of our
products and procurement of materials. Other contract manufacturers, including
Celestica, Sanmina and SMTC, manufacture sub-assemblies and other components of
our products. With the exception of ACT, we do not have contracts with our
contract manufacturers. Our reliance on ACT and our other contract
manufacturers involves a number of risks, including the absence of adequate
capacity, the unavailability of, or interruptions in access to, process
technologies and reduced control over component availability, delivery
schedules, manufacturing yields and costs. Each of our contract manufacturers
also builds products for other companies and may not always have sufficient
quantities of inventory available to fill our orders, or may not allocate its
internal resources to fill these orders on a timely basis. The process of
qualifying a new contract manufacturer and commencing commercial-scale
production is expensive and time consuming, and could result in a significant
interruption in the supply of our products. If a change in contract
manufacturers results in delays of our fulfillment of customer orders or if ACT
or any other contract manufacturer fails to make timely delivery of products or
key sub-assemblies or components, we may lose revenues and suffer damage to our
customer relationships.
If we fail to accurately predict our component or manufacturing requirements,
we could incur additional costs or experience manufacturing delays.
We currently provide forecasts of our demand to ACT and our sub-assembly and
component suppliers months prior to scheduled delivery of products to our
customers. Lead times for the materials and components that we order vary
significantly and depend on numerous factors, including the specific supplier,
contract terms and demand for a component at a given time. If we overestimate
our component requirements, ACT may purchase excess inventory on our behalf.
For those parts that are unique to our products, we could be required to pay
for these excess parts and recognize related inventory write-down costs. If we
underestimate our requirements, ACT may have an inadequate inventory, which
could interrupt the assembly of our products and result in delays in shipments
and revenues, or could cause us to purchase materials and components from third
parties at higher costs.
We depend on sole source and limited source suppliers for some of our key
components, and if we are unable to obtain these components on a timely basis,
we will not be able to deliver our products to our customers.
We currently purchase several key components of our products from single or
limited sources, including Lattice Semiconductor, Lucent, Mitel, PMC-Sierra and
Texas Instruments. We purchase these components on a purchase order basis. In
the past, there have been shortages of individual components from time to time.
Similar shortages are likely to occur in the future. To the extent shortages
occur in the future, we could be required to hold excess inventory or our
ability to manufacture our products could be disrupted. We currently do not
have guaranteed supply contracts with our component suppliers and they are not
required to supply us with products for any specified periods, in any specified
quantities or at any set price, except as may be specified in a particular
purchase order. In addition, any of our sole-source suppliers could be acquired
by, or enter into exclusive arrangements with, our competitors or stop selling
their products or components to us at commercially reasonable prices, or at
all. In the event of a disruption or delay in supply, we may not be able to
develop an alternate source in a timely manner or at favorable prices, or at
all. A failure to find acceptable alternative sources could hurt our ability to
deliver products to our customers and negatively affect our revenues and
operating results.
Because our products are complex, they may have errors or defects that we find
only after initial deployment, which could harm our business and our
reputation.
Our products are complex and are designed to be deployed in large,
sophisticated communications networks. Because of the nature of our products,
they can only be fully tested when deployed in large networks with high volumes
of traffic. In addition, our customers may use our products in conjunction with
products
10
from other vendors. As a result, if problems occur, it may be difficult to
identify the source of these problems. Any defects or errors in our products
discovered in the future, or failures of our customers' networks, whether
caused by our products or another vendor's products, could result in:
. loss of, or delay in, revenues and loss of market share;
. loss of customers;
. negative publicity regarding us and our products;
. increased service and warranty costs; and
. costly and time-consuming legal actions by our customers.
Claims based on errors in our products or in performing product-related
services could result in costly litigation against us.
Because our products are designed to provide critical communications
services, we may be subject to significant liability claims under contracts
with our customers. Our insurance may not, or may not be sufficient to, cover
us against these liabilities or may not continue to be available to us.
Liability claims could also require us to spend significant time and money in
litigation. As a result, any of these claims, whether or not successful, could
seriously damage our reputation and harm our business and operating results.
Risks Associated With Other Aspects of Our Business
If we fail to manage the growth of our operations and integration of our recent
acquisition, our future growth will be limited.
We have rapidly and significantly expanded our operations, by means of both
internal growth and our recent acquisition of TCS. We are still in the process
of completing the integration of the TCS operations with our operations. From
August 31, 1999 to August 31, 2000, we increased the number of our employees
from 64 to 235. Our rapid growth has placed, and our anticipated growth will
continue to place, a significant strain on our management systems and
resources. Our ability to successfully develop and market our products and to
implement our business plan in a rapidly evolving market requires effective
planning and management processes. We expect that we will need to continue to
upgrade and improve our financial, managerial and manufacturing controls and
reporting systems, and will need to continue to expand, train and manage our
work force. If we fail to implement adequate control systems in an efficient
and timely manner, our costs may be increased and our growth could be impaired.
In addition, we are still in the process of integrating managerial and other
personnel. In particular, John C. Thibault, our Chairman, President and Chief
Executive Officer, joined our company in February 2000. Our Chief Financial
Officer, Pamela F. Lenehan, joined our company in March 2000. Brian R.
Fitzgerald, our Vice President of Worldwide Sales, joined our company in May
2000. Our Vice President of Worldwide Customer Support, Ronald J. Rando, joined
us in August 2000.
If we make any acquisitions or strategic investments in the future, our
business could be disrupted and our financial condition could be harmed.
In July 2000, we acquired TCS. We are still in the process of integrating
the operations of TCS into our operations. Although we have no current
agreements or negotiations underway with respect to any other acquisitions or
strategic investments, we may acquire or make investments in businesses,
products or technologies in the future. The acquisition of TCS, and any future
acquisition and strategic investment, may entail numerous risks, including:
. difficulties in assimilating acquired operations, customers,
technologies or products;
. diversion of management's attention from our core business concerns;
11
. risks of entering markets in which we have no or limited prior
experience;
. substantial dilution of our current stockholders' ownership;
. incurrence of substantial debt;
. incurrence of significant amortization expenses related to goodwill and
other intangible assets; and
. incurrence of significant immediate write-offs.
Any of these risks could harm our business, financial condition and
operating results.
Our executive officers and key personnel are critical to our business and the
loss of their services could disrupt our operations and our customer
relationships.
Our success depends to a significant degree upon the continued contributions
of the principal members of our management, many of whom would be difficult to
replace. In particular, we rely on the services of each of John C. Thibault,
our Chairman, President and Chief Executive Officer, Pamela F. Lenehan, our
Vice President and Chief Financial Officer, Bing Yang, our Senior Vice
President and Chief Technology Officer and Brian R. Fitzgerald, our Vice
President, Worldwide Sales. The loss of the services of Mr. Thibault, Ms.
Lenehan, Mr. Yang or Mr. Fitzgerald or any other key personnel, particularly
senior management, sales personnel and engineers, could harm our operations and
our customer relationships.
If we are unable to retain and hire the qualified personnel we require, our
future growth may be limited.
Competition for highly skilled engineering, sales, marketing and support
personnel is particularly intense in the New England area and in the
communications equipment industry. Our failure to attract, assimilate or retain
qualified personnel to fulfill our current or future needs could impair our
growth. The support of our products requires highly trained customer support
and professional services personnel. Once we hire them, they typically require
extensive training. If we are unable to hire, train and retain our research and
development, customer support and professional services personnel, we may not
be able to continue our product development efforts or increase sales of our
products.
If we cannot obtain necessary third-party technology, our product development
efforts may be hampered.
We have incorporated third-party licensed technology into our current
products, and expect to continue to do so in the future to develop new products
and product enhancements. However, third-party licenses may not be available or
continue to be available to us on commercially reasonable terms. Our inability
to maintain or renew any third-party licenses required in our current products,
or to obtain any new third-party licenses to develop new products and product
enhancements could require us to obtain substitute technology of lower quality
or at greater cost, and delay or prevent us from making these products or
enhancements, any of which could seriously harm our business.
Our business could be harmed if we are unable to protect our intellectual
property.
We rely on a combination of patent, copyright, trademark and trade secret
laws and restrictions on disclosure to protect our intellectual property
rights. To date, we have one issued patent and two patent applications pending
in the United States. Additionally, we have several related non-U.S. patent
applications pending, relating to the design and operation of our products. Our
pending patent applications may not result in the issuance of any patents. If
any patent is issued, it may be invalidated or circumvented or may otherwise
fail to provide us with any meaningful protection. We do not conduct
comprehensive patent searches to determine whether the technology used in our
products infringes any patents held by third parties.
We have applied for federal trademark registration of Cohesion, Convergent
Networks, ICS, ICServiceWorks, ICSG, ICSX, ICView and The Voice of Broadband
Networking. We also claim common law protections for other marks we use in our
business. We have received a notice from another company with
12
a similar name demanding that we change our name. We may not be able to
continue using our name and our trademark applications may not be granted.
If we were to discover that any of our products violated the intellectual
property rights of a third party, we might be unable to redesign our product to
avoid violating those rights, and we might be unable to obtain a license on
commercially reasonable terms to use the third-party intellectual property. In
addition, we might be prevented from continuing to sell that product, which
could cause us to lose sales.
Despite our efforts to protect our proprietary rights, unauthorized parties
may attempt to copy or otherwise obtain and use our products or technology.
Monitoring unauthorized use of our products is difficult and we cannot be sure
that the steps we have taken will prevent unauthorized use of our technology,
particularly in foreign countries where the laws may not protect our
proprietary rights as fully as in the United States. If competitors are able to
use our technology, our ability to compete effectively would be harmed.
If we become subject to intellectual property rights litigation, we could incur
significant costs and we may be forced to stop selling our products.
We may become involved in litigation as a result of allegations by third
parties that we infringe their intellectual property rights. If a third party
asserted that our products infringed upon their proprietary rights, we would be
forced to defend ourselves and possibly our customers or contract manufacturers
against the alleged infringement. These claims and any resulting lawsuit, if
successful, could subject us to significant liability for damages and could
result in the invalidation of our proprietary rights. Any potential
intellectual property litigation also could force us to do one or more of the
following:
. stop selling or using our products that use the challenged intellectual
property;
. obtain from the owner of the infringed intellectual property a license
to sell or use the relevant technology, which license might not be
available on reasonable terms, or at all; or
. attempt to redesign those products that use any allegedly infringing
technology, which might not be successful.
Any lawsuits regarding intellectual property rights, regardless of their
ultimate outcome, would be time consuming and expensive to resolve and would
divert our management's time and attention.
We face risks associated with our international expansion that could harm our
financial condition and operating results.
The market for our products is global and we expect to market, sell and
service our products in the United States and internationally. We intend to
expand our international operations and enter new international markets. This
expansion will require management attention and financial resources to develop
direct and indirect international sales and support channels.
We have limited experience in marketing and distributing our products
internationally. In addition, our international operations may be subject to
risks including:
. certification requirements and differing regulatory and industry
standards;
. difficulties and costs of staffing and managing foreign operations;
. reduced protection for intellectual property rights;
. fluctuations in currency exchange rates; and
. import or export licensing requirements.
13
Additional Risks that May Affect Our Stock Price
Our stock price may be volatile and you may not be able to resell our shares at
or above the price you paid, or at all.
There has previously not been a public market for our common stock. We
cannot predict the extent to which investor interest in our stock will lead to
the development of a trading market or how liquid that market might become. The
initial public offering price for the shares will be determined by negotiations
between us and the representatives of the underwriters and may not be
indicative of prices that will prevail in the trading market. The trading price
of our common stock could be subject to wide fluctuations in response to
factors such as:
. actual or anticipated variations in quarterly operating results;
. failure to meet analysts' predictions and projections;
. changes in market valuations of communications service providers and
communications equipment companies;
. new products or services offered by us or our competitors; and
. our sales of common stock or other securities in the future.
In addition, stock markets in general, and the Nasdaq Stock Market's
National Market and technology companies in particular, have experienced
extreme price and volume fluctuations that have often been unrelated or
disproportionate to the operating performance of the companies. These broad
market and industry factors may harm the market price of our common stock,
regardless of our actual operating performance.
In addition, in the past, following periods of volatility in the overall
market and the market price of a company's securities, securities class action
litigation has often been instituted against that company. This type of
litigation, if instituted against us, could result in substantial costs and a
diversion of our management's attention and resources, which would harm our
business, financial condition and operating results.
Future sales by existing stockholders and option holders could depress the
market price of our common stock.
Once a trading market develops for our common stock, many of our
stockholders and option holders will have an opportunity to sell their common
stock for the first time. Sales of a substantial number of shares of common
stock in the public market after this offering, or the threat that substantial
sales might occur, could cause the market price of our common stock to
decrease. Based on shares outstanding as of , upon completion of this
offering, we will have approximately shares of outstanding common stock.
Other than the shares of common stock sold in this offering, approximately
shares will immediately be eligible for sale in the public market.
Substantially all of our stockholders will be subject to agreements with the
underwriters or us that restrict their ability to transfer their stock for 180
days from the date of this prospectus, subject to a number of exceptions. For a
detailed description of these exceptions, please see "Underwriting." After
these agreements expire, an additional shares will be eligible for sale in
the public market. For a description of the shares eligible for future sale,
please see "Shares Eligible for Future Sale."
Our management may use the proceeds of this offering in ways that may not
increase our profitability or our market value.
Our management will have considerable discretion in how we use the net
proceeds from this offering, and you will not have the opportunity, as part of
your investment decision, to assess whether the proceeds are being used
appropriately. The net proceeds may be used for corporate purposes that do not
increase our profitability or our market value. Pending application of the
proceeds, they may be placed in investments that do not produce income or that
lose value.
14
After this offering, our management and directors will exercise significant
control over our company, and this could limit your ability to influence the
outcome of important company decisions, including potential changes of control.
We expect that, after this offering, our executive officers and directors,
including their affiliated entities, will, in the aggregate, beneficially own
approximately % of our outstanding common stock, after giving effect to the
conversion of all of our outstanding preferred stock. These stockholders, if
acting together, would be able to influence all matters requiring approval by
our stockholders, including the election of directors and the approval of
mergers or other business combination transactions, which may have the effect
of delaying, deferring or preventing a change in control of our company or of
discouraging a potential acquirer from attempting to obtain control of us,
which could harm the market price of our common stock.
Our charter documents and Delaware law may have anti-takeover effects that
could prevent a change of control that might otherwise be beneficial to our
stockholders.
Provisions of our amended and restated certificate of incorporation, amended
and restated by-laws and Delaware law may deter an unsolicited offer to
purchase our company. For example, our board of directors will be divided into
three classes, only one of which will be elected at each annual meeting. These
factors could make it more difficult for a third party to acquire us, even if
doing so might allow our stockholders to recognize a significant premium on
their common stock.
You will incur immediate dilution because the initial public offering price of
a share of our common stock will exceed its tangible book value.
The initial public offering price of our common stock will be substantially
higher than the tangible book value per share of the outstanding common stock
immediately after the completion of this offering. Based upon an assumed
initial offering price of $ , if you purchase common stock in this offering,
you will incur immediate dilution of approximately $ in the book value per
share of the common stock from the price you pay.
15
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This prospectus contains forward-looking statements. In some cases, you can
identify forward-looking statements by terminology--for example, the words may,
will, should, expect, plan, anticipate, believe, estimate, predicts, potential
or continue, the negative of these terms, or other comparable terminology.
These statements are only predictions. Actual events or results may differ
materially. In evaluating these statements, you should specifically consider
various factors, including the risks outlined in the risk factors section.
These factors may cause our actual results to differ materially from any
forward-looking statement. Although we believe that the expectations reflected
in the forward-looking statements are reasonable, we cannot guarantee future
results, levels of activity, performance or achievements. Moreover, neither we
nor any other person assumes responsibility for the accuracy and completeness
of the forward-looking statements. We are under no duty to update any of the
forward-looking statements after the date of this prospectus to conform these
statements to actual results or to changes in our expectations.
16
USE OF PROCEEDS
We will receive net proceeds of approximately $ million from the sale of
shares in this offering at an assumed initial public offering price of $
per share and after deducting estimated underwriting discounts and commissions
and estimated offering expenses. If the underwriters exercise their over-
allotment option in full, our net proceeds will be approximately $ million.
The principal purposes of this offering are to obtain additional capital, to
create a public market for our common stock and to facilitate our future access
to public equity markets. We have not allocated the net proceeds of this
offering for specific uses. We expect to use the proceeds for general corporate
purposes, including working capital. We may also use a portion of the net
proceeds for acquisitions of businesses, products and technologies that
complement our business. We have no present plans, commitments or current
negotiations with respect to any acquisitions.
Pending our use of the net proceeds from this offering, we intend to invest
the proceeds in interest-bearing, investment-grade securities.
DIVIDEND POLICY
We have never declared or paid any cash dividends on our capital stock. We
presently intend to retain future earnings, if any, to finance the expansion of
our business and do not expect to pay any cash dividends in the foreseeable
future. Payment of future cash dividends, if any, will be at the discretion of
our board of directors after taking into account various factors, including our
financial condition, operating results, current and anticipated cash needs and
plans for expansion.
17
CAPITALIZATION
The following table sets forth our capitalization as of June 30, 2000:
. on an actual basis;
. on a pro forma basis to give effect to
. our acquisition of TCS as if it had occurred on June 30, 2000,
. our sale of 4,803,926 shares of Series D convertible preferred stock
on September 22, 2000 and our receipt of net proceeds of
approximately $73.8 million from the sale, and
. the conversion into common stock of all outstanding convertible
preferred stock upon the closing of this offering; and
. on a pro forma as adjusted basis to reflect our receipt of the estimated
net proceeds from our sale of shares of common stock in this
offering, at an assumed initial public offering price of $ per share,
after deducting the estimated underwriting discounts and commissions and
estimated offering expenses.
June 30, 2000
-------------------------------
Pro Pro Forma
Actual Forma As Adjusted
-------- -------- -----------
(in thousands, except share
data)
(unaudited)
Cash and cash equivalents...................... $ 24,663 $ 94,175
======== ======== =======
Notes payable and capital lease obligations,
net of current portion........................ $ 695 $ 909
-------- -------- -------
Redeemable convertible preferred stock, $0.01
par value; 17,700,000 shares authorized,
16,977,527 issued and outstanding actual; no
shares authorized, issued or outstanding, pro
forma and pro forma as adjusted............... 58,309 -- --
-------- -------- -------
Stockholders' equity (deficit):
Preferred Stock, $0.01 par value; 10,000,000
shares authorized, no shares issued or
outstanding................................. -- --
Common Stock, $0.00001 par value; 50,000,000
shares authorized, 19,425,100 shares issued
actual; 400,000,000 shares authorized,
pro forma and pro forma as adjusted;
58,289,398 shares issued pro forma;
shares issued pro forma as adjusted......... -- 1
Additional paid-in capital................... 26,537 298,685
Treasury stock, at cost: 2,903,500 shares.... (160) (160)
Accumulated deficit.......................... (38,110) (65,854)
Deferred compensation........................ (14,735) (18,765)
Stock subscriptions receivable............... (6,088) (6,088)
-------- -------- -------
Total stockholders' equity (deficit)....... (32,556) 207,819
-------- -------- -------
Total capitalization..................... $ 26,448 $208,728
======== ======== =======
The data in the table above excludes:
. 4,160,472 shares of common stock issuable upon exercise of options
outstanding as of September 25, 2000 at a weighted average exercise
price of $5.36 per share;
. 240,000 shares of common stock issuable upon exercise of warrants
outstanding as of September 25, 2000 at a weighted average exercise
price of $14.54 per share;
. 10,000,000 shares of common stock available for issuance under our 2000
stock incentive plan; and
. 5,000,000 shares of common stock available for issuance under our 2000
employee stock purchase plan.
18
DILUTION
If you invest in our common stock, your ownership interest will be diluted
by the difference between the public offering price per share of our common
stock and the pro forma as adjusted net tangible book value per share of
common stock upon the completion of this offering.
Our pro forma net tangible book value at was approximately $ , or
$ per share of common stock. Pro forma net tangible book value per share
represents the amount of our total tangible assets less total liabilities,
divided by the pro forma number of shares of common stock outstanding at
and assumes the conversion of our currently outstanding shares of preferred
stock into common stock upon the closing of this offering. Dilution in pro
forma net tangible book value per share represents the difference between the
amount per share paid by investors in this offering and the pro forma net
tangible book value per share of our common stock immediately after the
completion of this offering. After giving effect to the sale of shares of
our common stock in this offering at an assumed initial public offering price
of $ per share and after deducting the estimated underwriting discounts and
commissions and estimated offering expenses, our pro forma net tangible book
value at would have been approximately $ million, or approximately
$ per share of common stock. This represents an immediate increase in net
tangible book value of $ per share to our existing stockholders and an
immediate dilution in net tangible book value of $ per share to new
investors, or approximately % of the assumed initial public offering price of
$ per share. The following table illustrates this per share dilution:
Assumed initial public offering price per share.................... $
Pro forma net tangible book value per share at .............. $
Increase per share attributable to this offering.................
---
Pro forma net tangible book value per share after this offering....
----
Dilution per share to new investors................................ $
====
The following table shows, on a pro forma basis at , after giving
effect to the conversion of all outstanding shares of preferred stock into
common stock upon the closing of this offering, the total number of shares of
common stock purchased from us, the total consideration paid to us and the
average price per share paid to us by existing stockholders and by new
investors before deducting the estimated underwriting discounts and
commissions and estimated offering expenses, at an assumed initial public
offering price of $ per share:
Total
Shares Issued Consideration
------------------ ----------------- Average Price
Numbers Percentage Amount Percentage Per Share
------- ---------- ------ ---------- -------------
Existing stockholders........ % $ % $
New investors................
--- --- ---- ---
Total...................... % $ %
=== === ==== ===
The foregoing discussions and tables exclude:
. 4,160,472 shares of common stock issuable upon exercise of options
outstanding as of September 25, 2000 at a weighted average exercise
price of $5.36 per share;
. 240,000 shares of common stock issuable upon exercise of warrants
outstanding as of September 25, 2000 at a weighted average exercise
price of $14.54 per share;
. 10,000,000 shares of common stock available for issuance under our 2000
stock incentive plan; and
. 5,000,000 shares of common stock available for issuance under our 2000
employee stock purchase plan.
To the extent outstanding options and warrants are exercised, there will be
further dilution to new investors.
19
SELECTED CONSOLIDATED FINANCIAL DATA
This information should be read in conjunction with the financial statements
and related notes included elsewhere in this prospectus and "Management's
Discussion and Analysis of Financial Condition and Results of Operations." The
table below sets forth our selected financial data. The consolidated financial
data as of December 31, 1999 and for the period from May 6, 1998, date of
inception, through December 31, 1998 and the year ended December 31, 1999 are
derived from our audited consolidated financial statements included elsewhere
in this prospectus. The consolidated financial data as of and for the six
months ended June 30, 2000 are derived from our unaudited consolidated
financial statements included elsewhere in this prospectus. We believe that the
unaudited consolidated financial statements include all adjustments, consisting
only of normal recurring adjustments, necessary for the fair presentation of
our financial condition and our operating results for such periods and as of
such dates. Operating results for the six months ended June 30, 2000 are not
necessarily indicative of the results that may be expected for the year ending
December 31, 2000 or for any future period. Pro forma basic and diluted net
loss per share have been calculated assuming the conversion of all outstanding
shares of convertible preferred stock into shares of common stock, as if the
shares had converted immediately upon issuance.
Period from Six Months Ended
Inception Year Ended June 30,
(May 6, 1998) to December 31, -----------------
December 31, 1998 1999 1999 2000
----------------- ------------ ------- --------
(unaudited)
(in thousands, except per share data)
Consolidated Statement of
Operations Data:
Revenues.................... $ -- $ -- $ -- $ 1,827
Cost of revenues............ -- -- -- 1,303
------- -------- ------- --------
Gross profit.............. -- -- -- 524
Operating expenses:
Research and development.. 2,182 13,067 4,036 5,268
Selling and marketing..... 163 3,523 936 2,990
General and
administrative........... 283 1,273 350 1,226
Stock-based compensation.. 3,546 100 2,712
------- -------- ------- --------
Total operating
expenses............... 2,628 21,409 5,422 12,196
------- -------- ------- --------
Loss from operations........ (2,628) (21,409) (5,422) (11,672)
Interest income (expense),
net........................ 100 137 40 922
------- -------- ------- --------
Net loss.................... (2,528) (21,272) (5,382) (10,750)
Accretion of dividends on
preferred stock............ (255) (1,067) (274) (2,168)
------- -------- ------- --------
Net loss attributable to
common stockholders........ $(2,783) $(22,339) $(5,656) $(12,918)
======= ======== ======= ========
Net loss per share:
Basic and diluted......... $ (4.87) $ (7.47) $ (2.79) $ (2.75)
Pro forma basic and
diluted (unaudited)...... (1.11) (0.38)
Shares used in computing net
loss per share:
Basic and diluted......... 572 2,991 2,028 4,696
Pro forma basic and
diluted (unaudited)...... 19,168 28,610
December 31,
----------------- June 30,
1998 1999 2000
------- -------- -----------
(unaudited)
(in thousands)
Consolidated Balance Sheet Data:
Cash, cash equivalents and marketable
securities.................................... $ 4,746 $ 21,508 $ 24,663
Working capital................................ 4,006 16,509 23,628
Total assets................................... 5,085 24,370 30,848
Notes payable and capital lease obligations,
net of current portion........................ -- 943 695
Convertible preferred stock.................... 7,131 40,891 58,309
Total stockholders' deficit.................... (2,787) (22,789) (32,556)
20
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with our
financial statements and the related notes included elsewhere in this
prospectus.
Overview
We are a leading provider of broadband voice infrastructure products for the
new public network. We design, develop and market a new generation of carrier-
class switching equipment and software that enable service providers to deliver
voice and data services over broadband networks. Our target customers are new
and established communications service providers, including local exchange and
long distance carriers and operators of foreign telephone networks.
From our inception on May 6, 1998 through early 2000, our operations
consisted primarily of start-up activities, including raising capital,
recruiting personnel, conducting research and development, establishing the
market for our initial products and purchasing operating assets. In addition,
we developed our final product assembly and testing capabilities, arranged
manufacturing with third parties and began development of our sales, marketing,
customer service and administrative organizations. We first began recognizing
revenues from sales of our products during the second quarter of 2000. We sell
our products through our direct sales force to service providers in North
America and Europe. In the future, we anticipate expanding our sales through
domestic and international distribution partners and resellers.
A small number of customers have accounted for our revenues to date, and we
expect this concentration to continue in the future. Global NAPs, an affiliate
of which is an investor in our company, accounted for all of our revenues for
the six months ended June 30, 2000. Our agreement with Global NAPs does not
obligate it to make any minimum purchases of our products.
Revenues. We recognize product revenues at the time of shipment, provided
there are no uncertainties regarding acceptance, persuasive evidence of an
arrangement exists, the sales price is fixed or determinable and collection of
the related receivable is probable. If uncertainties exist, we recognize
revenues when those uncertainties are resolved. We recognize revenues from
support and maintenance contracts ratably over the terms of the contracts.
Amounts billed or collected prior to satisfying our revenue recognition
criteria are reflected as deferred revenues. Additionally, we have supplied
products to potential customers for use in field trials. We do not recognize
revenues from field trials since customers can typically return the products
with no payment or further obligation to us.
Cost of Revenues. Cost of revenues consists of payments to our contract
manufacturers, costs associated with in-house systems integration and testing,
customer service and estimated warranty costs.
Research and Development. Research and development expenses consist
primarily of salaries and related personnel and recruiting costs, and prototype
costs related to the design, development, testing and enhancement of our
products. We expense research and development costs as they are incurred. Some
aspects of our research and development efforts require material short-term
expenditures, which can cause significant quarterly fluctuations. We believe
that research and development is critical in achieving current and strategic
product objectives. We expect that our research and development expenses will
significantly increase in absolute dollars in the future as we continue to
enhance our existing products and develop new products.
Selling and Marketing. Selling and marketing expenses consist primarily of
salaries and related expenses for personnel engaged in sales and marketing, and
promotional and other marketing expenses. We expect that selling and marketing
expenses will increase substantially in absolute dollars in the future as we
increase our direct sales efforts by expanding our domestic and international
sales offices, hiring additional marketing personnel and initiating additional
marketing programs.
21
General and Administrative. General and administrative expenses consist
primarily of salaries and related expenses for executive, finance, legal,
information systems and human resources personnel, professional fees and other
general corporate expenses. We expect that general and administrative expenses
will increase in absolute dollars as we add personnel and incur additional
costs related to the growth of our business and our operations as a public
company.
Stock-based Compensation Expense. We recorded deferred compensation of
approximately $2.3 million for 1999 and $16.9 million for the six months ended
June 30, 2000. We expect to record additional deferred compensation of
approximately $8.9 million for the third quarter of 2000. These amounts
represent the aggregate difference between the exercise or purchase price of
stock options granted or stock sold to our employees and the deemed fair value
of our stock at the time of grant or sale. We are amortizing these amounts over
the vesting period of the options and stock awards, which is generally four to
five years. We recorded total stock-based compensation expense of $3.5 million
for 1999, of which $1.8 million related to amortization of deferred
compensation, and $2.7 million for the six months ended June 30, 2000, all of
which relates to deferred compensation expense. We also expect to record
compensation expense relating to these options and stock awards of
approximately $8.7 million in 2000, $8.9 million in 2001, $5.0 million in 2002,
$2.7 million in 2003, $1.0 million in 2004 and $100,000 in 2005. It is possible
that the amount of our total deferred compensation, and therefore the amount of
expense we incur each year, may increase as a result of factors such as the
grant of additional options and stock awards with an exercise or purchase
price, as applicable, below the deemed fair market value of our common stock.
In addition, on December 17, 1999, we issued shares of Series C convertible
preferred stock to an affiliate of Global NAPs in consideration for research
and development and other services performed for us by Global NAPs. The related
compensation charge of $1.7 million was recorded in December 1999.
Historically, we have incurred significant losses. As of June 30, 2000, we
had an accumulated deficit of $38.1 million. We expect to incur substantial
losses for the foreseeable future. We plan to increase significantly our
operating expenses. As a result, we will need to generate significant revenues
to achieve and maintain profitability. We may never achieve profitability.
Recent Transactions
Acquisition. On July 31, 2000, we completed our acquisition of TCS. We
issued an aggregate of 10,106,845 shares of our common stock in consideration
for all of the outstanding capital stock of TCS, reserved an aggregate of
1,229,436 shares of our common stock in connection with our assumption of
outstanding options to purchase capital stock of TCS and assumed $5.5 million
of TCS debt, which we repaid immediately upon closing the transaction. However,
1,516,025 of the shares of common stock issued to stockholders of TCS are
currently held in escrow to secure indemnification obligations of TCS and some
of its stockholders. With the completion of this acquisition, we have secured
intellectual property and engineering expertise for the development of software
products. We have accounted for the acquisition as a purchase. Accordingly, the
operating results of TCS will be included in our financial results from the
date of the acquisition. The allocation of the purchase price to the fair value
of the assets acquired and liabilities assumed will be based on an independent
analysis of the fair value of the assets and liabilities of TCS. It is expected
that approximately $23 million of the purchase price will be recorded as in-
process technology in the third quarter of 2000. Goodwill and other intangibles
of approximately $115 million will be amortized on a straight-line basis over
three years.
TCS provided service bureau and systems integration services that entailed
selling services, custom software and associated hardware. We have refocused
the efforts of TCS to provide standard software products, have organized the
acquired operations under the name Applications Technology Group, and are
phasing out the service bureau and the resale of hardware products. As a
result, we expect that the TCS operations will generate revenues significantly
lower than those generated by TCS in prior periods.
22
Series D Financing. On September 22, 2000, we sold 4,803,926 shares of
Series D convertible preferred stock in a private placement for net proceeds of
$73.8 million. These shares of Series D convertible preferred stock will
automatically convert into 4,803,926 shares of our common stock upon the
closing of this offering.
Warrants. On August 4, 2000, we issued a warrant to purchase 100,000 shares
of our common stock at $12.00 per share to a customer. The warrant was fully
vested and exercisable on the date it was issued and the warrant will expire on
the earlier of two years from the date of issue or the acquisition of our
company. On August 30, 2000, we entered into a master purchase and license
agreement with this customer, under which the customer has the ability but not
the obligation to purchase products from us. Although the master purchase and
license agreement does not contain any minimum purchase requirements, the
customer has issued purchase orders for our products. In September 2000, we
issued warrants to purchase an aggregate of 140,000 shares of common stock at
$16.35 per share to two potential customers. The warrants were fully vested and
exercisable on the date of issue and the warrants will expire on the earlier of
two years from the date of issue or the acquisition of our company. On
September 15, 2000, we entered into a master purchase agreement with one of the
potential customers, pursuant to which, the potential customer has the ability
but not the obligation to purchase equipment from us. Although the master
purchase agreement does not contain any minimum purchase requirements, the
potential customer has issued purchase orders for the Company's products. Each
of the warrants was valued using the Black-Scholes option pricing model using
the following assumptions: 100% volatility, 5.5% risk-free interest rate, 0.0%
dividend yield and a two-year expected life. As a result of the warrants being
fully vested and exercisable and not contingent upon future minimum purchases,
the aggregate value of the warrants, $1.9 million, will be expensed in the
third quarter of fiscal 2000.
Results of Operations
Six months ended June 30, 2000 and June 30, 1999
Revenues. Revenues were $1.8 million for the six months ended June 30, 2000.
We first began recognizing revenues from shipment of our products during the
second quarter of 2000. All of our revenues were from product shipments to
Global NAPs, an affiliate of which is an investor in our company. We had no
revenues in the six months ended June 30, 1999.
Cost of Revenues. Cost of revenues for the six months ended June 30, 2000
was $1.3 million. There was no cost of revenues in the six months ended June
30, 1999.
Research and Development. Research and development expenses increased $1.3
million to $5.3 million for the six months ended June 30, 2000 from $4.0
million for the six months ended June 30, 1999. The increase primarily
reflected increased salaries and related benefits for new personnel, offset in
part by lower prototype expenses.
Selling and Marketing. Selling and marketing expenses increased $2.1 million
to $3.0 million for the six months ended June 30, 2000 from $936,000 for the
six months ended June 30, 1999. The increase was due to costs associated with
the establishment of a sales and marketing group, and increased advertising,
marketing and other costs associated with sales and support activities.
General and Administrative. General and administrative expenses increased
$850,000 to $1.2 million for the six months ended June 30, 2000 from $350,000
for the six months ended June 30, 1999. The increase was due primarily to an
increase in salaries and related benefits due to the hiring of additional
personnel.
Stock-based Compensation Expense. Stock-based compensation expense increased
$2.6 to $2.7 million for the six months ended June 30, 2000 from $100,000 for
the six months ended June 30, 1999.
Interest Income (Expense), Net. Interest income consists of interest earned
on our cash balances and marketable securities. Interest expense consists of
interest incurred on our equipment line of credit. Interest income, net of
interest expense increased $881,000 to $921,000 for the six months ended June
30, 2000 from $40,000 for the six months ended June 30, 1999. The increase was
primarily attributable to higher invested cash balances from the proceeds of
private financings and interest on promissory notes to executive officers,
partially offset by an increase of interest expense from incurred borrowings.
23
Year ended December 31, 1999 and Period from May 6, 1998 (Inception) to
December 31, 1998
Revenues. We recognized no revenues in either period.
Research and Development. Research and development expenses increased $10.9
million to $13.1 million for 1999 from $2.2 million for the period from
inception to December 31, 1998. The increase reflected increased salaries and
related benefits due to the hiring of additional personnel and increased
prototype and laboratory expenses.
Selling and Marketing. Selling and marketing expenses increased $3.3 million
to $3.5 million for 1999 from $163,000 for the period from inception to
December 31, 1998. The increase was due to costs associated with the
establishment of a sales and marketing group, and increased advertising,
marketing and other costs associated with sales and support activities.
General and Administrative. General and administrative expenses increased
$1.0 million to $1.3 million for 1999 from $283,000 for the period from
inception to December 31, 1998. The increase was due primarily to salaries and
related benefits related to the hiring of additional general and administrative
personnel, as well as increased professional fees.
Stock-based Compensation Expense. During 1999, we recorded deferred stock-
based compensation expense of $2.3 million relating to stock options granted or
stock sold to employees. We had no deferred stock compensation relating to
stock options granted to employees in the period from inception to December 31,
1998. We recorded stock-based compensation expense of $3.5 million for 1999,
including $1.7 million in stock-based compensation expense related to the
issuance of 264,853 shares of Series C convertible preferred stock to an
affiliate of Global NAPs in exchange for services performed by Global NAPs.
There was no stock-based compensation expense recorded in the period from
inception to December 31, 1998.
Interest Income (Expense), Net. Interest income, net of interest expense
increased $37,000 to $137,000 for 1999 from $100,000 for the period from
inception to December 31, 1998. The increase was primarily attributable to
higher invested cash balances from the proceeds of private financings,
partially offset by an increase of interest expense from incurred borrowings.
Liquidity and Capital Resources
Since inception, we have financed our operations primarily through private
sales of convertible preferred stock. As of June 30, 2000, cash and cash
equivalents were $24.7 million. On September 22, 2000, we completed the sale of
4,803,926 shares of our Series D convertible preferred stock, for net proceeds
of approximately $73.8 million.
For the six months ended June 30, 2000, we used $11.1 million of cash for
operations primarily due to our net loss of $10.8 million and an increase in
inventory of $3.1 million. For 1999, we used $13.2 million of cash for
operations due to our net loss of $21.3 million, which was partially offset by
a $3.5 million stock-based compensation charge as well as a $2.4 million
increase in accrued expenses and a $1.4 million increase in accounts payable.
We used $1.7 million of cash for operations for the period from inception to
December 31, 1998 due primarily to the net loss of $2.5 million, partially
offset by an increase in accounts payable and accrued expenses.
For the six months ended June 30, 2000, our investing activities included
the purchase of $1.1 million of property and equipment. For 1999, our investing
activities included the purchase of $2.3 million of property and equipment. For
the period from inception to December 31, 1998, our investing activities
included the purchase of $416,000 of property and equipment.
Cash provided by financing activities for the six months ended June 30, 2000
was $15.4 million, primarily due to the receipt in the first quarter of 2000 of
a $15.0 million stock subscription receivable. Cash provided by financing
activities for 1999 was $32.9 million, primarily from the private sales of
convertible preferred stock. Cash provided by financing activities for the
period from inception to December 31, 1998 was $6.9 million, primarily from the
private sales of convertible preferred stock.
24
We previously had a $1.5 million bank equipment line of credit. On November
30, 1999, this line of credit converted into a 36-month term loan, which we are
repaying at a rate of $123,000 each fiscal quarter through the fourth quarter
of 2002. The loan is secured by substantially all of our assets, and bears
interest at the bank's prime rate plus 0.75%. We are required to comply with
financial and restrictive covenants set forth in the loan, and as of June 30,
2000, we were in compliance with these covenants.
As of December 31, 1999, we were obligated to pay lease payments of $9.6
million over the lease periods of our operating leases, with $1.1 million due
in 2000.
We expect our cash requirements will increase significantly in 2001, as we
continue our research and development efforts, hire and expand our sales,
support, marketing and product development organizations, grow our
administrative support activities and expand our leased facilities. As our
business volumes grow we anticipate a significant cash requirement for working
capital growth and capital expenditures. The amount and timing of cash
requirements will depend on market acceptance of our products and the resources
we devote to researching and developing, marketing, selling and supporting our
products. We believe that our current cash and cash equivalents on hand should
be sufficient to fund our operations for at least the next 12 months. However,
any material acquisition of complementary businesses, products or technologies
or any joint ventures could require us to obtain additional equity or debt
financing. Thereafter, if current sources are not sufficient to meet our needs,
we may seek additional equity or debt financing. Additional financing may not
be available on acceptable terms, if at all. If we raise additional funds
through the issuance of equity securities, the percentage ownership of our
stockholders would be reduced. If we are unable to raise sufficient funds on
acceptable terms we may not succeed in executing our strategy and achieving our
business objectives. In particular, we could be forced to reduce personnel and
limit our product development, sales and marketing activities, forego
attractive business opportunities, and be unable to respond to competitive
pressures.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board, or the FASB, issued
Statement of Financial Accounting Standards, or SFAS, No. 133, Accounting for
Derivative Instruments and Hedging Activities. This statement established
accounting and reporting standards for derivative instruments and hedging
activities. SFAS 133, as amended by SFAS 137, will be effective for our
financial reporting beginning in the first quarter of 2001. SFAS 133 will
require that we recognize all derivatives as either assets or liabilities in
the balance sheet and measure those instruments at fair value. The accounting
for gains and losses from changes in the fair value of a particular derivative
will depend on the intended use of that derivative. We believe the adoption of
this statement will not have a significant impact on our financial position,
operating results or cash flows.
In December 1999, the SEC issued Staff Accounting Bulletin No. 101, Revenue
Recognition. This bulletin summarizes some views of the staff on applying
accounting principles generally accepted in the United States to revenue
recognition in financial statements. We believe that our current revenue
recognition policy complies with the SEC guidelines.
In March 2000, the FASB issued Interpretation No. 44, Accounting for Certain
Transactions Involving Stock Compensation--an Interpretation of APB Opinion No.
25. The interpretation clarifies the application of APB Opinion No. 25 to
accounting for stock issued to employees. The interpretation is effective July
1, 2000, but covers events occurring during the period between December 15,
1998 and the effective date.
25
Quantitative and Qualitative Disclosures About Market Interest Rate Sensitivity
The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we may
invest in may be subject to market risk. This means that a change in prevailing
interest rates may cause the principal amount of the investment to fluctuate.
For example, if we hold a security that was issued with a fixed interest rate
at the then-prevailing rate and the prevailing interest rate later rises, the
principal amount of our investment will probably decline. To minimize this risk
in the future, we intend to maintain our portfolio of cash equivalents and
short-term investments in a variety of securities, including commercial paper,
money market funds, and government and investment grade non-government debt
securities. In general, money market funds are not subject to market risk
because the interest paid on these funds fluctuates with the prevailing
interest rate. As of June 30, 2000, all of our cash and cash equivalents were
in a cash reserves money market fund or in an operating checking fund.
26
BUSINESS
Overview
Convergent Networks is a leading provider of broadband voice infrastructure
solutions for the new public network. We design, develop and market a new
generation of carrier-class switching equipment and software applications that
enable voice and data services to be delivered over broadband networks. Our
Cohesion product family offers service providers an integrated broadband voice
infrastructure solution, which consists of the ICS2000 broadband switch, the
ICServiceWorks softswitch and service creation software and the ICView network
management system. Compared with traditional alternatives, our products
significantly reduce the cost to build and operate a network that is capable of
providing both voice and high-speed data services. Our products are also
compatible with existing circuit-based networks. Our target customers are new
and established communications service providers, including local exchange and
long distance carriers and operators of foreign telephone networks. We believe
that these service providers require a solution that enables the creation and
delivery of both traditional and advanced end-user services to generate
incremental revenues and attract and retain customers. By enabling service
providers to deliver voice and high-speed data services over broadband packet-
based networks, we believe our products will help lay the foundation for the
new public network.
Industry Background
The public telephone network has been heavily regulated for most of its
century-old existence. As a result, the public telephone network's underlying
circuit-switched technology has evolved slowly and, until recently, service
providers have experienced little market pressure to deploy innovative end-user
services and applications. We believe that two dramatic developments in the
telecommunications industry--deregulation and the Internet--are now
revolutionizing the public telephone network worldwide.
Market deregulation has increased competition among service providers
Deregulation of the telecommunications industry worldwide has accelerated
dramatically in the last decade. In the United States, the Telecommunications
Act of 1996 removed traditional barriers that once restricted service providers
to a specific geography or service offering, enabling thousands of new service
providers to enter the telephony services market. Intense competition between
existing and emerging service providers has driven down prices for basic
telephone service, and eroded profit margins for service providers. In
response, service providers are seeking next-generation infrastructure products
and solutions to decrease infrastructure and operating costs, and to increase
revenues by selling innovative new service offerings. Internationally, similar
deregulation forces have led to new entrants and increased demand for next-
generation infrastructure solutions offering differentiated services.
Internet usage is increasing data traffic on unoptimized and overburdened
circuit networks
The Internet has become a critical communications medium for many businesses
and consumers, leading to dramatic growth in data traffic. The Internet, email,
electronic commerce, telecommuting and online entertainment have all driven
this increase in data traffic. New applications such as streaming audio and
video will continue to drive this data growth in the future.
Today, a significant portion of this data traffic is carried over the
traditional circuit-switched public telephone network. However, the circuit-
switched public network was originally built to support voice services and is
very inefficient for carrying data traffic, particularly in high volumes.
Circuit-switched networks operate by establishing a dedicated path, or circuit,
between the calling and the called party that is reserved during the entire
length of a call. This approach is inefficient because the circuit requires
dedicated network capacity during the entire call, even when there is nothing
to be transmitted, such as during pauses in a conversation. The inefficiency is
even greater when transmitting data traffic, which is characterized by bursts
of traffic, followed by long periods of inactivity. These bursts of data
traffic can at times also exceed the capacity of the transmitting circuit,
resulting in slow transfer rates or dropped connections. As a result, service
providers have begun to rapidly deploy new packet-based infrastructure capable
of supporting high-speed data services.
27
There are significant benefits in combining voice and data traffic into a
single packet-based network
Because voice traffic is currently carried over traditional circuit-switched
networks, and data traffic carried over evolving packet networks, service
providers face the expense and complexity of building and maintaining separate
voice and data networks. Service providers can eliminate duplicate equipment
costs and reduce network operating costs associated with managing two separate
networks by converging voice and data traffic on a packet-based network.
A packet-based network aggregates voice and data from multiple sources and
transports it over shared network connections. Information is broken down into
packets which are channeled through the network and reassembled at their
destination. The aggregation of packets from multiple sources enables service
providers to better utilize network capacity, further reducing equipment,
network and operating costs.
Data traffic volume on communications networks now exceeds that of voice
traffic. Nonetheless, the majority of service provider revenues still are
generated from voice services delivered on circuit-switched networks.
Consequently, service providers are seeking to protect their profits derived
from voice services, particularly custom calling features such as caller ID and
call forwarding, while transitioning to packet-based networks that can handle
voice and data traffic efficiently. These requirements have driven the
emergence of the new public network--a network based on packet technology
capable of delivering integrated voice and high-speed data services to end
users, with improved efficiencies and economics as well as performance
advantages compared to the traditional circuit-switched telephone system.
Converging voice services with data over a packet-based network also creates
opportunities for service providers to provide new, high-margin service
offerings such as unified messaging.
Requirements for Voice Infrastructure Products for the New Public Network
We believe that broadband packet-based products are laying the foundation of
the new public network delivering both voice and high-speed data communications
and services to consumers and businesses. The new public network must match the
reliability, voice service quality and scalability of today's public telephone
network, while offering improved economics for service providers to profitably
deliver large amounts of voice and data traffic. The network must also enable
service providers to increase revenues and profits by rapidly delivering new
and innovative services to meet evolving end user demands. To meet these
requirements, new infrastructure products must be able to offer the following
benefits:
Reliable and High Quality Voice Services. Today's public voice network has
set high user expectations for reliability and voice service quality. The new
packet-based networks must provide the same service quality and reliability
provided to users by traditional circuit-based networks.
Compatibility and Interoperability. Due to their substantial investment in
circuit-switched networks, traditional service providers are continuing to use
their legacy networks as they migrate over time to new packet-based networks.
Next-generation service providers are building new networks based on packet
technology that must interoperate with the legacy networks of traditional
service providers. As a result, new infrastructure equipment and software must
support a full range of voice and data networking standards and interfaces to
interoperate with software and equipment from multiple vendors. Networking
standards include Signaling System 7, or SS7, a set of call control standards
and protocols used by service providers to enable integration with the global
public network for basic and advanced voice service delivery, as well as data
networking standards, such as ATM and IP, voice coding standards and common
optical network interfaces.
Low Cost. Packet-based networks must deliver a compelling economic advantage
over circuit-based networks in equipment and facilities costs to encourage
service providers to invest in the new public network.
Scalable, High-Capacity and High-Speed. The new public network must be
capable of efficiently and effectively delivering voice and high-speed data
services to meet consumer demand for Internet access, audio and video
streaming, video conferencing, online entertainment and other new bandwidth-
intensive services. The infrastructure solutions for the new public network
must also scale to accommodate thousands of users making simultaneous
connections while delivering the reliability and quality of traditional
circuit-based networks.
Open Service Creation Architecture, Rapid Service Delivery. As competition
increases, service providers must differentiate themselves by offering their
customers not only traditional voice services but also enhanced,
28
value-added services. An open architecture will allow service providers and
third-party software companies to write applications, enabling the rapid
creation and delivery of both traditional voice services as well as new value-
added services and applications.
Network-Based, Service-Enabling Applications. Service providers generate
revenues by delivering value-added services ranging from traditional call
waiting and call forwarding features to advanced applications such as unified
messaging. Because price competition has driven down revenues from providing
basic call services, service providers are seeking to increase revenues by
delivering full-featured and competitive service offerings to their customers.
The ability to quickly deploy new service applications is particularly
important for emerging carriers that generally do not have the time or
resources necessary to develop service applications in-house. Meanwhile,
incumbent carriers will require traditional service applications to be readily
available to ensure the seamless migration of their existing voice services to
packet-based networks.
Convergent Networks' Solution
We design, develop and market a new generation of carrier-class switching
equipment and software that enable service providers to deliver voice and data
services over broadband networks.
Our Cohesion family of broadband voice infrastructure solutions consists of
the following products:
. ICS2000 Broadband Switch
. ICServiceWorks comprised of:
. ICSX Softswitch
. ICSG Signaling Gateway
. ICServiceWorks Application Modules
. ICView Network Management System
[A graphic depiction of the ICView Management System appears here. A large
rectangle labelled ICServiceWorks Service Creation Softswitch occupies the top
half of the graphic.
A cluster of three clouds appears to the right of the rectangle labelled
ICS2000 Broadband Switch. The clouds are individually labelled Packet, Internet
and Public Telephone Network, and are each connected by a solid line to the
rectangle labelled ICS2000 Broadband Switch. The six smaller rectangles are
arranged in two rows with four rectangles over two rectangles. The four top
rectangles, from left to right, read as follows: ICService Works Class 5
Module; ICService Works Calling Card Module; ICService Works Unified Messaging
Module; and ICService Works Future Application Module. These four rectangles
are connected by dotted lines to another small rectangle labelled ICSX
Softswitch located in the bottom center of the larger rectangle. The ICSX
Softswitch rectangle is connected by a dotted line to another small rectangle
labelled ICSG Signaling Gateway.
A solid line extends downward from the ICSX Softswitch rectangle, crossing
over the boundary of the large rectangle, and connects to a rectangle labelled
ICS2000 Broadband Switch. This rectangle has four solid lines extending left to
four small rectangles stacked vertically. The top rectangle is labelled Modem
and is connected to the ICS2000 Broadband Switch by a line labelled ISDN PRI.
The second rectangle is labelled Traditional Circuit Switch and is connected to
the ICS2000 Broadband Switch by a line labelled Inter Machine Trunk, or IMT.
The third rectangle is labelled Integrated Access Device and is connected to
the ICS2000 Broadband Switch by a line labelled ATM or xDSL. The bottom
rectangle is labelled Private Branch Exchange and is connected to the ICS2000
Broadband Switch by a line labelled ISDN PRI.]
29
Our products can be offered together as an integrated solution or
individually as elements of a multi-vendor solution. Our Cohesion family of
products is designed to offer the following key advantages:
Carrier-Class Reliability and Voice Service Quality. Our products are
designed for the stringent reliability and performance standards, including
99.999% availability, required by incumbent local exchange carriers, long
distance carriers and competitive local exchange carriers. The ICS2000 is
designed to support the same high level of voice quality over packet-based
networks as is provided by today's circuit-based networks. The specific
reliability capabilities include:
. hardware designed and certified for network equipment building
standards, or NEBS, Level 3 compliance;
. full equipment redundancy, including hot standby for the common
equipment and redundancy for network interfaces;
. non-disruptive software upgrades, which allow software upgrades to be
made while the switch is in use;
. sophisticated network management and web-based configuration
capabilities; and
. a complete set of serviceability features and remote diagnostics
designed to ease maintenance.
Interoperability with Existing Infrastructure. Our products are designed to
interface with legacy circuit switches, supporting the switching of calls
between broadband packet-based and traditional circuit-based networks. This
allows service providers to migrate to the new public network while preserving
their investment in traditional circuit-based networks. Our products are also
designed to be fully compatible with all major voice and data networking
standards and interfaces, including SS7 signaling protocol, ATM data networking
standards, voice coding standards and all widely deployed, high-speed
interfaces, including DS3, OC-3, OC-12, ISDN PRI and Inter Machine Trunks, or
IMTs.
High Port Density and Efficient Space Usage. The cost-effectiveness of our
broadband switching solution is realized through the lower central office space
costs, lower power and cooling requirements, and reduced capital equipment
investment required to deploy our solution as opposed to traditional circuit-
based networks. Our ICS2000 broadband switch has been designed to handle high
voice port density, particularly when compared to legacy circuit switches. The
ICS2000 can switch up to 36,000 voice ports and three ICS2000's stacked in a
standard telecommunications bay can switch up to 108,000 voice ports in a 24 x
24 inch footprint. This represents a fraction of the space needed for
traditional circuit switches, allowing service providers to deploy our
equipment in central office locations where space is limited and where
traditional circuit switches may not be an option due to their expansive space
requirements.
Broadband Performance and Scalability. By leveraging a high-capacity packet
switch architecture and call control software, the ICS2000 delivers high-
performance switching of calls over broadband packet-based networks. Together,
the ICS2000 and ICSG signaling gateway can process up to 500,000 voice calls in
one hour. To meet a service provider's expanding network demands, the solution
can be scaled by aggregating up to 20 ICS2000s and connecting them to an ATM
core switch. The resulting virtual switch can support in excess of 300,000
voice ports and can process up to ten million voice calls in one hour.
Additionally, a single redundant ICSG signaling gateway can support up to 20
geographically distributed ICS2000 switches, minimizing the need for multiple
and costly SS7 signaling links for each switch.
Open Architecture, Flexible Call Control and Service Creation. The
ICServiceWorks software is designed to provide call control, SS7 signaling and
an open service creation environment allowing third parties to create network-
based service applications. Today, ICServiceWorks works with some switching
products offered by Cisco and Lucent for service applications such as calling
card services. Because ICServiceWorks will control and manage calls and
services for the ICS2000 by using the industry standard Media Gateway Control
Protocol, or MGCP, future releases will be compatible with other vendors'
switching equipment using this industry standard. Additionally, ICServiceWorks
will include an application programming interface, allowing third parties to
create new service applications, including end-user subscription services for
businesses and consumers, as well as future advanced voice applications.
30
Network-Based Service Applications. Our ICServiceWorks solution includes
service-enabling applications such as prepaid and postpaid calling card
services and unified messaging. Unified messaging provides capabilities for
voicemail, interactive voice response, follow-me/find-me, voice recognition and
text-to-speech. Our service-enabling applications allow our customers to
differentiate their service offerings and generate increased revenues.
Convergent Networks' Strategy
Our objective is to be the leading supplier of broadband voice
infrastructure solutions for the new public network. Our strategy to achieve
this goal includes the following key elements:
Leverage Our Solutions-Oriented Approach
We intend to aggressively expand the market we serve by providing an
integrated and open solution, which includes broadband switching products,
softswitch and service creation software and network-based service
applications. We believe that our solution will enable our customers to rapidly
deploy next-generation network infrastructure and offer revenue-generating
services. By providing an integrated product line, we are offering service
providers a single vendor solution to their network requirements. In addition,
we are developing our softswitch with an industry-standard interface, which
will allow it to be used on other vendors' hardware. We intend to make
available an application programming interface to encourage third-party
development of new, network-based service applications. This strategy will
allow service providers with legacy equipment to migrate to next-generation
networks, as well as enabling next-generation service providers to build new
networks.
Broaden Our Customer Base Though Expanded Product Offerings
We intend to continue to expand our product offerings to provide value-added
network solutions to our current and potential customers. Our Internet offload
product routes modem calls from Internet users off of the circuit-switched
network to the packet-based network, which saves expensive and overloaded
circuit-based network and equipment resources. Our broadband network access
product will enable service providers to deliver high-speed Internet access
coupled with voice services over xDSL or ATM networks to small business and
residential users. Our broadband trunking solution will allow service providers
to expand and compete in the long distance market by switching voice and data
traffic between local access networks over next-generation ATM and IP core
backbone networks.
Increase Our Global Sales and Marketing Capabilities
We are rapidly expanding our sales, sales engineering and marketing
personnel to increase our worldwide presence. We have recently opened regional
sales offices and hired additional sales personnel in the United States to
increase our direct sales force capabilities. Our recent acquisition of TCS has
provided us with a sales office in the United Kingdom. We expect to increase
our international presence by opening additional offices in Europe and Asia,
and we plan to augment our direct sales force through international
distribution partners.
Deliver Superior Customer Service and Support
Because our products are a critical element of our customers' networks, we
will continue to seek to increase customer satisfaction and strengthen customer
loyalty through our quality service offerings. We believe that delivering
superior customer service and support is essential to winning and retaining
business. We offer comprehensive customer service and support, including
consulting, training, software upgrades, and 24 by 7 on-line and telephone
support. We intend to continue improving our customer support services and
devoting significant resources to our customers to help them fully utilize the
benefits of our products.
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Pursue Strategic Alliances and Acquisitions
We intend to expand our product offerings by aggressively pursuing strategic
alliances with leading communications infrastructure providers that have
complementary technology and products. These may include vendors of access
equipment and customer premise equipment, as well as application development
companies. Our intention is to provide greater value to our customers by
providing solutions to their network issues and, if necessary, we will partner
with other companies to provide the best result for our customers. We also
intend to establish sales and distribution relationships with third parties
that will resell, integrate or support our products. We will continue to
participate in industry standards-making forums to ensure the long-term
interoperability of our products with evolving industry standards. We also
intend to selectively pursue acquisitions of companies or technologies that
complement our product family and our business.
Products
[A graphic depiction of Convergent Networks' Cohesion Product Family in the
New Public Network appears here. In the center is a cloud labelled Packet
Backbone. This cloud appears in front of a larger oval cloud. Below the Packet
Backbone cloud appears an item labelled ICView. Appearing in clockwise order
around the center cloud are depictions of the ICS2000, ICServiceWorks ICSG,
ICServiceWorks ICSX, ICServiceWorks Applications Server and ICS2000,
representing the family of Convergent Networks' Cohesion products. Each of these
items is connected by a solid line to the center cloud.
In the upper right corner of the graphic is a small cloud labelled Public
Telephone Network which is connected to the ICS2000. To the right of the Public
Telephone Network cloud is a telephone and a workstation. In the lower right
corner of the graphic is a small oval labelled ATM which is connected by a solid
line to the ICS2000. Within that oval is a telephone, a workstation and modem
representing peripheral equipment using ATM interfaces.
In the upper left corner of the graphic appears a cloud within an oval
labelled Internet Service Provider which is also connected by a solid line to
the ICS2000. In the lower left corner of the graphic, is an oval which is also
connected by a solid line to the ICS2000. Within that oval is a telephone, a
workstation and a modem, representing peripheral equipment using xDSL
interfaces.
Above the depiction labelled ICServiceWorks ICSG, connected by a solid line,
is an oval cloud labelled SS7.]
ICS2000 Broadband Switch
The ICS2000 broadband switch is designed to enable voice traffic to be
transported over broadband packet-based networks, such as ATM, xDSL and IP.
Today, the ICS2000 supports both circuit-based and ATM packet-based interfaces,
and is designed to support IP packet-based interfaces, which will be available
in a future release. The ICS2000 consists of a single chassis, designed
specifically for service providers' central offices, with 20 slots and a 10
Gigabit packet switch architecture, which is configured as two 5 Gigabit
redundant switches. The switch architecture provides dedicated bandwidth to
each slot in a non-blocking configuration. Two of the slots are dedicated to
the redundant switching architecture and control processor, while the remaining
18 slots are available for DS3, OC-3 or OC-12 interfaces, as well as new
feature modules. The new feature modules which will be supported will provide
additional value-added functions that will be dynamically assignable to any
interface, including high-density ATM AAL2 user switching, echo cancellation
conforming to the latest G.168 standard, G.711 and G.726 voice compression and
full tone generation and detection capabilities. The ICS2000 can be initially
deployed with only two slots occupied and capacity and features can be added by
inserting additional cards into the open slots, providing a flexible solution
for next-generation network developers. A single ICS2000 can switch up to
36,000 voice ports and three ICS2000s
32
stacked in a telecommunications bay can switch up to 108,000 voice ports in a
24 x 24 inch footprint. Up to 20 geographically distributed ICS2000s can also
be linked together to provide a scalable solution for service providers
managing heavy network demands.
The ICS2000 is designed for carrier-class reliability, including 99.999%
availability, and has received full NEBS Level 3 certification. The ICS2000
also supports optional full redundancy, including hot standby for the common
equipment, redundancy for the network interfaces and new feature modules. All
optical interfaces support Automatic Protection Switching for increased
resiliency, and the system is designed to support non-disruptive upgrades to
the software.
In the current version of the ICS2000, voice calls are controlled and
managed using softswitch technology that resides in the ICS2000 and ICSG. With
the addition of the industry-standard MGCP protocol, future releases of the
ICS2000 will be controlled by the ICServiceWorks MGCP-based ICSX softswitch, as
well as any MGCP-compliant softswitch offered by other vendors.
ICServiceWorks Service Creation Softswitch
ICServiceWorks is advanced softswitch and service creation software that
controls and manages voice calls in packet-based networks. It includes the call
control, or ICSX, and SS7 signaling, or ICSG, components, and an open service
creation environment with network-based service applications. Today, the
ICServiceWorks ICSG SS7 signaling gateway works in conjunction with the
ICS2000's call control functionality to provide a cost-effective SS7 signaling
solution to interconnect the traditional public telephone network with a
network of ICS2000 switches, allowing service providers to preserve their
existing infrastructure investment and offer a range of traditional network
services, such as 800 number lookup and local number portability, in a packet-
based voice network. With the addition of industry-standard MGCP protocol,
future releases of the ICServiceWorks ICSX softswitch will control and manage
calls for the ICS2000, and will allow network-based service applications, such
as traditional custom calling features as well as enhanced applications,
including unified messaging and calling card services, to be supported in an
ICS2000 network. Additionally, future releases of ICServiceWorks will include
an application programming interface that will enable the rapid delivery of
additional advanced services by next-generation service providers.
Today, the ICServiceWorks ICSX softswitch is compatible with some switching
products offered by Cisco and Lucent for service applications such as calling
card services. With the introduction of MGCP, future releases will also be
compatible with other vendors' switching equipment using this industry
standard.
ICView Network Management System
ICView is a suite of management tools for element management, billing and
subscriber management. ICView provides a Java-based element manager with
service provisioning capabilities that can be accessed anywhere in the network
via a web browser. ICView allows network managers to monitor and control their
deployed ICS2000s and can remotely manage fault, configuration, asset,
performance and security functions. ICView presents information critical to
business and operational decisions by collecting and analyzing alarms and
statistics on circuit-based and packet-based networks, and by processing call
traffic for both real-time and historical reporting. It also simplifies
configuration by providing automated tools to help network managers make
changes and backups from a central location. The system also interfaces with
service providers' billing systems.
33
Customers
Our target market includes emerging and incumbent carriers such as
competitive local exchange carriers, incumbent local exchange carriers, inter-
exchange carriers and national telephone companies and competitive
telecommunications carriers internationally. Each of the following customers
has entered into an agreement with us and is either using our products in
commercial applications or evaluating them in internal trials:
. BT
. Broadwing
. Duro Communications
. Focal Communications
. Global NAPs
. Missouri Telecom
. Stonehenge Telecom
. WanTel
. Warwick Valley
For the six months ended June 30, 2000, Global NAPs, an affiliate of which
is an investor in our company, accounted for all of our revenues.
Sales and Marketing
We sell and market our products through a direct sales force made up of
sales professionals with experience in selling carrier-class products. In
addition, we intend to establish a strategic distribution relationship with a
global technology partner to provide sales and support of our products and
services outside of the United States, in order to better serve customers in
specific geographic regions.
We maintain thirteen sales offices; twelve in the United States and one in
the United Kingdom. Our direct sales account managers are responsible for a
market on primarily a geographic basis and work as a team with a dedicated
system engineer. Our system engineers consult with and assist our customers in
deploying our products and identifying features required for specific
applications. We believe that through this direct interaction we can more fully
understand the business models and product requirements of our customers.
We have a number of marketing programs to drive demand for our products in
broadband packet-based network applications. These programs include
comprehensive sales tools, pricing strategies, sales training, competitive
information, product collateral, application notes, customer deployment
information and customer support programs. We work actively with major industry
publications and industry analysts to help educate service providers on the
benefits of broadband packet-based network technology. In addition, we
participate in and monitor the activities of industry consortiums and standards
organizations, including the Internet Engineering Task Force, the International
Telecommunications Union, the ATM Forum, the DSL Forum, the International
Softswitch Consortium and the Optical Domain Service Interconnect.
Customer Service and Support
We are committed to delivering the products and resources that will
contribute to the growth and success of our customers' businesses. We offer
comprehensive customer support and professional services delivered by a team of
support experts. These services include the planning, design and installation
of our customers' networks. We have established a technical assistance center
at our worldwide headquarters in Lowell, Massachusetts, which supports our
customers 24 hours a day, seven days a week. We believe that our customer
service and support offerings help ensure a customer's success with our
products.
34
Our customers can purchase contractual support and services to gain access
to comprehensive software and hardware services, training services and
implementation services. Software and hardware service contracts provide
extended coverage beyond the end of the standard warranty periods, customer
access to new releases of previously licensed software features, and
alternatives regarding advanced replacement or return to factory for hardware
repair. Training services offer comprehensive training for installation,
operations and maintenance personnel. Implementation services include design
validation, site survey, on-site installation, certification, testing and
acceptance and documentation of initial configuration records.
Research and Development
Our future success depends on our ability to increase the performance of our
products, to develop and introduce new products and product enhancements and to
effectively respond to our customers' changing needs. Our research and
development team is primarily responsible for, and is currently working on,
meeting these objectives. We have made, and will continue to make, a
substantial investment in research and development. Research and development
expenses were $13.1 million for 1999 and $5.3 million for the six months ended
June 30, 2000. In addition to developing our platforms, we are in the process
of developing products to meet the growing demands of communications service
providers. We conduct our research and development at our facilities in Lowell,
Massachusetts and Ft. Lauderdale, Florida.
Manufacturing
We maintain only limited in-house manufacturing capability for final system
integration and testing of our products. Our internal manufacturing expertise
is focused on product design for testability, design for manufacturability and
the transfer of products from development to manufacturing.
We have established a contract manufacturing relationship with ACT
Manufacturing. Using a contract manufacturer allows us to reduce our capital
expenditures, achieve purchasing economies of scale and reduce inventory
warehousing. Under our manufacturing services agreement with ACT, ACT
manufactures our ICS2000 broadband switch and provides related services to us.
This agreement is for an initial one-year term and automatically renews at the
end of the term for additional one-year terms. At any time after the initial
term, either party can terminate the agreement on 180 days' prior notice. Other
manufacturers, including Celestica, Sanmina and SMTC, manufacture sub-
assemblies and other components of our products on a purchase order basis. If
ACT or any other contract manufacturer fails to make timely delivery of
products or key sub-assemblies or components, our ability to make timely
product deliveries may be disrupted.
We currently purchase several key components of our products from single or
limited sources, including Lattice Semiconductor, Lucent, Mitel, PMC-Sierra and
Texas Instruments. We purchase these components on a purchase order basis. In
the past, there have been shortages of individual components from time to time.
Similar shortages are likely to occur in the future. To the extent shortages
occur in the future, we could be required to hold excess inventory or our
ability to manufacture our products could be disrupted.
Competition
The market for voice infrastructure products for the new public network is
intensely competitive, subject to rapid technological changes and significantly
affected by new product introductions and other market activities. We encounter
strong competition from large suppliers, such as Cisco, Lucent and Nortel, who
offer a broad range of products across multiple service areas, are
substantially larger than we are and have significantly greater financial,
sales, marketing, distribution, technical, manufacturing and other resources.
This makes them better positioned to acquire other companies, thereby obtaining
new technologies or products that may displace our product lines. We also
compete with Sonus Networks in the next-generation voice switching market, and
several other companies in the same market. We also compete with single product
companies which offer or will offer solutions that compete with one of our
product areas. In the future, we expect that additional companies will enter
the market with competitive solutions.
35
The principal competitive factors in our markets include, or are likely to
include:
. product performance and price;
. features and reliability;
. technical support and service;
. compliance with industry standards; and
. sales and distribution capabilities.
Intellectual Property
Our success and ability to compete are dependent on our ability to develop
and maintain the proprietary aspects of our technology. We rely on a
combination of trademark, copyright and trade secret laws, employee and third-
party nondisclosure agreements and licensing arrangements to protect our
intellectual property. These legal protections afford only limited protection
for our technology. We cannot assure you that others will not develop
technologies that are similar or superior to our technology. We have applied
for federal trademark registration of Cohesion, Convergent Networks, ICS,
ICServiceWorks, ICSG, ICSX, ICView and The Voice of Broadband Networking. We
also claim common law protections for other marks we use in our business. We
have received a notice from another company with a similar name demanding that
we change our name. We may not be able to continue using our name and our
trademark applications may not be granted.
To date, we have one issued patent and two patent applications pending in
the United States. Additionally, we have several related non-U.S. patent
applications pending, relating to the design and operation of our products. Our
pending patent applications may not result in the issuance of any patents. If
any patent is issued, it may be invalidated or circumvented or may otherwise
fail to provide us with any meaningful protection. We do not conduct
comprehensive patent searches to determine whether the technology used in our
products infringes any patents held by third parties. If we were to discover
that any of our products violated the intellectual property rights of a third
party, we might be unable to redesign our product to avoid violating their
rights, and we might be unable to obtain a license on commercially reasonable
terms to use the third-party intellectual property. In addition, we might be
prevented from continuing to sell that product, which could cause us to lose
sales.
We have incorporated third-party licensed technology into our current
products. From time to time, we may be required to license additional
technology from third parties to develop new products or product enhancements.
Third-party licenses may not be available or continue to be available to us on
commercially reasonable terms. The inability to maintain or re-license any
third-party licenses required in our current products, or to obtain any new
third-party licenses to develop new products and product enhancements could
require us to obtain substitute technology of lower quality or performance
standards or at greater cost, and delay or prevent us from making these
products or enhancements, any of which could seriously harm the competitiveness
of our products.
Employees
As of September 15, 2000, we had a total of 243 employees. Of the total, 114
were in research and development, 45 in sales and marketing, 31 in customer
support and professional services, 20 in manufacturing and 33 in finance and
administration. None of our employees is subject to a collective bargaining
agreement and we believe that our relations with our employees are good.
36
Facilities
We are headquartered in Lowell, Massachusetts where we lease approximately
72,000 square feet under a lease which expires in August 2006. We have also
entered into a sublease for approximately 24,090 square feet in Sunrise,
Florida, which expires in January 2004. We also lease approximately 9,680
square feet in Fort Lauderdale, Florida under a lease which expires in July
2003. We intend to sublease to a third party the Fort Lauderdale premises as
soon as we move our Florida operations to the Sunrise premises. We believe our
current facilities will be adequate to meet our near-term space requirements.
Legal Proceedings
On May 27, 1999, MCIWorldcom filed a lawsuit in the Circuit Court of the
17th Judicial Circuit in the State of Florida alleging breach of contract and
unjust enrichment by Technology Control Services and breach of guaranty by its
parent company Hemisphere Investments. On July 31, 2000, we acquired Hemisphere
and its wholly owned subsidiaries, including Technology Control Services,
collectively TCS. MCI alleges that TCS breached two contracts and was unjustly
enriched by failing to pay for telecommunications services allegedly rendered
by MCI in connection with TCS' discontinued business of the resale of voice
traffic. MCI is seeking up to $3,227,487 in damages, as well as costs and
attorneys' fees. We intend to defend ourselves vigorously against MCI's claim.
TCS has also filed counter-claims against MCI for breach of contract and
intentional interference with business relationships for an unspecified sum.
However, there can be no assurance that we will be successful in the defense of
this litigation. We may consider settlement due to the costs and uncertainties
associated with litigation in general, and the diversion of the time and
attention of some members of our management. In connection with our acquisition
of TCS, fifteen percent of the shares of our common stock issued to
stockholders of TCS have been held in escrow to secure specified
indemnification obligations of TCS and its stockholders, including any damages
we might incur as a result of the MCI litigation.
From time to time, we may be involved in litigation relating to claims
arising out of our operations in the normal course of business.
37
MANAGEMENT
Executive Officers, Directors and Key Employees
Our executive officers, directors and key employees and their respective
ages and positions as of September 20, 2000, are as follows:
Name Age Position
---- --- --------
John C. Thibault................ 46 Chairman of the Board, President and Chief
Executive Officer and Director
Bing Yang....................... 38 Senior Vice President and Chief Technology
Officer and Director
Pamela F. Lenehan............... 48 Vice President and Chief Financial Officer
Sally J. Bament................. 38 Vice President, Marketing
Brian R. Fitzgerald............. 40 Vice President, Worldwide Sales
Kenneth MacLure................. 42 Vice President, Operations
Ronald J. Rando................. 56 Vice President, Worldwide Customer Support
Todd A. Dagres (1)(2)........... 40 Director
David E. Schantz (2)............ 34 Director
William E. Foster (1)(2)........ 56 Director
- ---------------------
(1) Member of the compensation committee.
(2) Member of the audit committee.
John C. Thibault has served as our President and Chief Executive Officer,
Chairman of the Board of Directors and a Director since February 2000. Mr.
Thibault served as Senior Vice President for the Applications Technology Group
of Cisco Systems, a provider of networking solutions, delivering customer
contact software solutions for enterprise and service provider environments
from June 1999 to December 1999. Before joining Cisco, Mr. Thibault was
President and Chief Executive Officer of GeoTel Communications, a provider of
software solutions for distributed voice call centers for enterprise and
service provider customers, from December 1993 to June 1999 when GeoTel was
acquired by Cisco Systems. Before founding GeoTel Communications, Mr. Thibault
served as President and Chief Executive Officer of Coral Network, which
designed, developed and marketed a backbone router for enterprise network
applications, from 1991 to 1993. He was Senior Vice President and General
Manager of the Codex division of Motorola, a provider of integrated
communications solutions and embedded electronic solutions, from 1988 to 1991.
Mr. Thibault was at Wang Laboratories, a global network and desktop integrating
and services company, from 1975 to 1988.
Bing Yang co-founded Convergent Networks in May 1998 after serving more than
14 years in the data communication and telecommunications industries. Most
recently, Mr. Yang served as Vice President of Engineering and Technology at
XCOM Technology, a New England-based communications service provider, from
January 1998 to May 1998, where he developed the company's Internet SS7 gateway
product. He founded Cadia Networks, a manufacturer of ATM access equipment,
which was later acquired by FORE Systems, a manufacturer of ATM access and
switching equipment, where he managed system development for the company's
multi-service ATM access solution from March 1996 to January 1998. Mr. Yang
worked from 1994 to March 1996 at Cascade Communications, a manufacturer of
carrier frame relay and ATM switching equipment, where he was responsible for
ATM switch development, and at Cabletron Systems, a manufacturer of data
networking products and services, from March 1991 to April 1994, where he
managed an application-specific integrated circuit design team for next-
generation hub development.
Pamela F. Lenehan has served as our Vice President and Chief Financial
Officer since March 2000. Prior to joining Convergent Networks, Ms. Lenehan
served as Senior Vice President, Corporate Development and Treasurer for Oak
Industries, a manufacturer of highly engineered communications components, from
February 1995 until Oak Industries' acquisition by Corning, a manufacturer of
fiber optic cable and components, in January 2000. Previously, Ms. Lenehan was
at Credit Suisse First Boston from June 1981 to December 1994, most recently as
Managing Director, Investment Banking, where she handled equity and debt
financings and mergers and acquisitions for technology companies. Before
joining Credit Suisse First Boston, Ms. Lenehan served as a lending officer at
the Chase Manhattan Bank from 1974 to 1981.
38
Sally J. Bament has served as our Vice President, Marketing since February
1999. From June 1994 to February 1999, Ms. Bament was at Bay Networks, now
Nortel Networks, a provider of telephone, data and wireless wireline solutions
for the Internet, most recently as Vice President of Product Management, where
she was responsible for establishing strategic direction and executing short-
and long-term product plans for the company's routing products divisions. From
June 1991 to June 1994, she was Director of Marketing at Coral Network, which
was later acquired by Synoptics, a manufacturer of enterprise local area
network equipment. Ms. Bament spent four years from September 1987 to June 1991
with Motorola, with senior product management and marketing responsibilities
for the company's ATM, Frame Relay, STDM and X.25 products. She was with
British Petroleum from 1983 to 1987, in both London and New York, where she
worked as a software engineer in data networking.
Brian R. Fitzgerald has served as our Vice President, Worldwide Sales since
May 2000. From March 1997 to May 2000 he was at Lucent Technologies, a provider
of communications systems, products, technologies and support, most recently as
Senior Director of Global Accounts, with responsibility for sales and systems
engineering teams for Enterprise Internetworking Systems. Prior to that, he was
Senior Director of Original Equipment Manufacturers Sales for Agile Networks, a
division of Lucent, where he managed the worldwide Original Equipment
Manufacturers sales organization. Mr. Fitzgerald also held several senior-level
sales positions with Racal Data Group, a manufacturer of telecommunications
equipment, from March 1990 to March 1997, including Vice President of Original
Equipment Manufacturers Sales. From 1982 to February 1990 he held various sales
positions with Digital Communications Associates, a manufacturer of data
communications equipment, Exxon Office Systems, a manufacturer of word
processing office equipment, and Procter & Gamble, a provider of consumer
products and services.
Kenneth MacLure has served as our Vice President, Operations since September
1998. Prior to that, from November 1997 to August 1998, Mr. MacLure was
Director of Manufacturing at Aptis Communications, a manufacturer of a carrier-
class access switch designed for network service providers, which was acquired
by Nortel Networks. From 1994 to October 1997, he was Director of Operations
Technology at Cascade Communications. From 1991 to 1994, Mr. MacLure was
Manager of Operations at Supernetics, a startup manufacturer of integrated
services digital network products. Prior to that, Mr. MacLure spent 13 years at
Motorola in various engineering positions for wide area network, local area
network and wireless technologies.
Ronald J. Rando has served as our Vice President, Worldwide Customer Support
since August 2000. From December 1998 to August 2000, Mr. Rando was Vice
President Global Service and Support at Cabletron Systems. From December 1996
to December 1998, Mr. Rando was Vice President, Customer Services of the
Computer Systems Division of NEC, a provider of information and communications
systems and equipment. From 1994 to December 1996 and from 1974 to 1984, Mr.
Rando held various management positions at Digital Equipment Corporation, a
supplier of high performance web-based computing solutions, most recently Vice
President, Americas' Customer Service and Support, Personal Computer Business
Unit.
Todd A. Dagres has served on our board of directors since May 1998. Mr.
Dagres is a General Partner of Battery Ventures, a venture capital firm, which
he joined in August 1995. From 1994 to August 1995, he worked at Montgomery
Securities, where he was a Principal and Senior Technology Analyst focusing on
the networking industry. Prior to Montgomery, he was a Senior Technology
Analyst and Vice President of a division of Smith Barney. Mr. Dagres also held
positions as Vice President of Communications Research at The Yankee Group, a
provider of industry analysis and research, and Business Development Manager
for Networking at Digital Equipment Corporation. Mr. Dagres serves on the
boards of directors of Akamai Technologies, Edgix, Equipe Communications, Focal
Communications, Inventa, Predictive Networks and RiverDelta Networks.
David E. Schantz has served on our board of directors since May 1998. Mr.
Schantz is a General Partner of Matrix Partners, a venture capital firm, which
he joined in January 1998. From June 1996 to January 1998, he was Director of
Product Management and Marketing and was a member of the founding team at Cadia
Networks, which was acquired by FORE Systems. Prior to that, Mr. Schantz served
as Product Line Manager of the Service Provider Products Division at Bay
Networks, now Nortel Networks, from 1993 to
39
June 1996. He was a member of the Technical Staff and a Product Manager in the
Data Communications Business Unit at AT&T Bell Laboratories, a systems and
technology research and development company, which is now Lucent, from 1988 to
1993. Mr. Schantz serves on the boards of directors of Airvana, Appian
Communications, Cereva Networks, Crossbeam Systems, Sandburst and Silverback
Technologies.
William E. Foster has served on our board of directors since August 2000.
Mr. Foster has over 17 years of experience in the computer and
telecommunications industries. Mr. Foster co-founded Stratus Computer, a
designer of fault-tolerant computer systems for online transaction processing
and communications controls, and served as Chief Executive Officer from 1980 to
May 1997 and as Chairman from 1980 to October 1998 when Stratus Computer was
acquired by Ascend Communications, a manufacturer of telecommunications
equipment, which was subsequently acquired by Lucent. Prior to that time, Mr.
Foster spent 14 years in the computer industry at Data General as Vice
President of Software, and at Hewlett-Packard, where he held several management
and technical positions. Mr. Foster is currently a private investor and serves
on the board of directors of Natural MicroSystems.
Executive Officers
Each officer serves at the discretion of our board of directors and holds
office until his successor is elected and qualified or until his earlier
resignation or removal. There are no family relationships among any of our
directors or executive officers.
Election of Directors
Following this offering, the board of directors will be divided into three
classes, with members of each class serving for a staggered three-year term.
Messrs. Schantz and Thibault will serve in the class whose term expires in
2001, Messrs. Foster and Yang will serve in the class whose term expires in
2002, and Mr. Dagres will serve in the class whose term expires in 2003. At
each annual meeting of stockholders, a class of directors will be elected for a
three-year term to succeed the directors of the same class whose terms are then
expiring.
Compensation of Directors
We reimburse directors for reasonable out-of-pocket expenses incurred in
attending meetings of the board of directors. On August 28, 2000, we granted an
option to purchase 200,000 shares of common stock at an exercise price of
$10.00 per share to Mr. Foster. Twenty-five percent of the shares subject to
the option vest on August 28, 2001, and the remaining shares vest evenly over
the next 12 quarters.
Board Committees
The board of directors has established a compensation committee and an audit
committee. The compensation committee, which consists of Messrs. Dagres and
Foster, reviews executive salaries, administers bonuses, incentive compensation
and stock plans, and approves the salaries and other benefits of our executive
officers. In addition, the compensation committee consults with our management
regarding our benefit plans and compensation policies and practices.
The audit committee, which consists of Messrs. Dagres, Foster and Schantz,
reviews the professional services provided by our independent accountants, the
independence of our accountants, our annual financial statements and our system
of internal accounting controls. The audit committee also reviews other matters
with respect to our accounting, auditing and financial reporting practices and
procedures as it may find appropriate or may be brought to its attention.
Compensation Committee Interlocks and Insider Participation
Messrs. Dagres and Foster are the members of our compensation committee.
Neither Mr. Dagres nor Mr. Foster is an executive officer of Convergent
Networks, nor has either received any compensation from us within the last two
years other than in his capacity as a director. Mr. Thibault served on the
compensation committee from February 2000 until September 2000. From January
1999 through April 1999, Mr. Yang served
40
on the compensation committee. Messrs. Thibault and Yang did not participate in
deliberations regarding their own compensation. No interlocking relationship
exists between any member of our board of directors or our compensation
committee and any member of the board of directors or compensation committee of
any other company, and no such interlocking relationships have existed in the
past.
Executive Compensation
The following table sets forth the total compensation paid or accrued for
the fiscal year ended December 31, 1999 for Messrs. Karl May, our former
President and Chief Executive Officer, Bing Yang, our Senior Vice President and
Chief Technical Officer and formerly our President, Sally J. Bament, our Vice
President, Marketing, and Kenneth MacLure, our Vice President, Operations, who
were the only executive officers whose salary and bonus for the fiscal year
were in excess of $100,000. We refer to all of these officers collectively as
our "named executive officers."
Summary Compensation Table
Long-Term
Annual Compensation Compensation
--------------------------- ------------------------
Restricted Securities
Name and Principal Other Annual Stock Underlying All Other
Position Salary Bonus Compensation Awards Options Compensation
------------------ -------- ----- ------------ ---------- ---------- ------------
Bing Yang............... $141,019 -- -- -- -- --
President, Executive
Vice President and
Chief Technical
Officer(1)
Hwang-Ruey Wang......... 140,429 -- -- -- -- $ 18,038(3)
Vice President,
Engineering(2)
Sally J. Bament......... 134,344 -- -- 640,000 -- --
Vice President,
Marketing
Kenneth MacLure......... 102,060 -- -- -- 20,000 --
Vice President,
Operations
Karl May................ 105,942 -- $21,875(5) 2,540,000(6) -- 100,000(7)
Former Chief Executive
Officer and
President(4)
- ---------------------
(1) Mr. Yang served as our President from January 1, 1999 to March 22, 1999 and
from November 5, 1999 through January 31, 2000. Mr. Yang served as our
Executive Vice President and Chief Technical Officer from April 10, 1999
through April 13, 2000, and since that time has been our Senior Vice
President and Chief Technical Officer.
(2) Since April 13, 2000, Mr. Wang has been our Senior Vice President,
Engineering.
(3) Represents payments related to relocation expenses reported as income to
Mr. Wang.
(4) Mr. May was appointed our President and Chief Executive Officer on March
22, 1999 and ceased to be our Chief Executive Officer and President as of
November 5, 1999.
(5) Represents a severance payment to Mr. May in connection with the
termination of his employment with us.
(6) Upon termination of Mr. May's employment, we repurchased 2,032,000 shares
of common stock at a purchase price of $0.05 per share, the original
purchase price per share paid by Mr. May.
(7) Represents the difference between the fair market value of the 100,000
shares of Series A convertible preferred stock that Mr. May purchased from
us in March 1999 and the price paid for these shares.
Option Grants in Last Fiscal Year
The following table provides information concerning grants of options to
purchase shares of our common stock made during the fiscal year ended December
31, 1999 to each of the named executive officers. These options vest over a
five-year period as to 20% of the total number of shares on the first
anniversary of the date
41
of grant and as to 5% of the total number of shares every three months
thereafter. The exercise price per share of each option was equal to the fair
market value of the common stock on the date of grant, as determined by our
board of directors.
The potential realizable values are based on an assumption that the price of
our common stock will appreciate at the compounded annual rate shown from the
date of grant until the end of the option term. These values do not take into
account amounts required to be paid as income taxes under the Internal Revenue
Code and any applicable state laws or option provisions providing for
termination of an option following termination of employment. These amounts are
calculated based on the requirements promulgated by the Securities and Exchange
Commission and do not reflect our estimate of future price growth of shares of
our common stock.
Individual Grants
--------------------------------------------
Potential Realizable
Number of % of Total Value at Assumed
Securities Options Exercise Annual Rates of Stock
Underlying Granted to or Base Price Appreciation
Options Employees in Price Expiration for Option Term
Name Granted Fiscal Year Per Share Date 5% 10%
- ---- ---------- ------------ --------- ---------- ---------- ----------
Bing Yang............... -- -- -- -- -- --
Hwang-Ruey Wang......... -- -- -- -- -- --
Sally J. Bament......... -- -- -- -- -- --
Kenneth MacLure......... 20,000 0.6% $0.25 6/29/09 $3,144 $7,969
Karl May................ -- -- -- -- -- --
Aggregated Option Exercises in Last Fiscal Year and Fiscal Year-End Option
Values
The following table sets forth information regarding exercisable and
unexercisable stock options held as of December 31, 1999 by each of the named
executive officers. During fiscal 1999, no stock appreciation rights were
granted or outstanding.
Number of Securities
Underlying Unexercised Value of Unexercised In-
Options at Fiscal Year- the-Money Options at
Securities End Fiscal Year-End
Acquired Value ------------------------- -------------------------
on Exercise Realized Exercisable Unexercisable Exercisable Unexercisable
----------- -------- ----------- ------------- ----------- -------------
Bing Yang............... -- -- -- -- -- --
Hwang-Ruey Wang......... -- -- -- -- -- --
Sally J. Bament......... -- -- -- -- -- --
Kenneth MacLure......... 20,000(1) $0 -- -- -- --
Karl May................ -- -- -- -- -- --
- ---------------------
(1) As of December 31, 1999, the shares remained subject to repurchase.
Employee Benefit Plans
2000 Stock Incentive Plan
Our 2000 stock incentive plan was adopted by our board of directors in
September 2000, subject to stockholder approval. The 2000 stock incentive plan
authorizes the issuance of up to a total of 10,000,000 shares of common stock
to eligible employees, plus an annual increase of shares beginning in 2001 and
ending in 2010 equal to the lesser of:
.15,000,000 shares;
.4% of the outstanding shares of our common stock on the date of the
increase; or
.an amount determined by the board.
42
The 2000 stock incentive plan provides for the grant of incentive stock
options intended to qualify under Section 422 of the Internal Revenue Code,
nonstatutory stock options, restricted stock awards and other stock-based
awards. Our employees, officers, directors, consultants and advisors and those
of our subsidiaries are eligible to receive awards under the 2000 stock
incentive plan. Under present law, however, incentive stock options may be
granted only to employees. Under the 2000 stock incentive plan, no participant
may receive an award for more than 1,000,000 shares, subject to adjustment in
the event of stock splits and other similar events, in any calendar year.
Optionees may pay the exercise price of their options by cash, check or
delivery of shares of our common stock owned by the optionee for at least six
months prior to their delivery, valued at their fair market value as determined
by our board of directors. Our board of directors, in its discretion, may
permit payment of the option exercise price by delivery of an irrevocable
undertaking by a creditworthy broker, delivery by the optionee of a copy of
irrevocable instructions to a creditworthy broker, delivery of a promissory
note of the option holder, payment of other lawful consideration, or any
combination of the permitted forms of payment.
Our board of directors administers the 2000 stock incentive plan. Our board
of directors has the authority to adopt, amend and repeal the administrative
rules, guidelines and practices relating to the 2000 Stock incentive plan and
to interpret its provisions. Our board may delegate authority under the 2000
stock incentive plan to one or more of its committees and, subject to various
limitations, to one or more of our executive officers. Our board of directors
has authorized the compensation committee to administer the 2000 stock
incentive plan, including the granting of options to our executive officers.
Subject to any applicable limitations contained in the 2000 stock incentive
plan, our board of directors, our compensation committee or any other committee
or executive officer to whom our board of directors delegates authority, as the
case may be, selects the recipients of awards and determines:
. the number of shares of common stock covered by options and the dates
upon which the options become exercisable;
. the duration of options;
. the exercise price of options; and
. the number of shares of common stock subject to any restricted stock or
other stock-based awards and the terms and conditions of the awards,
including the conditions for repurchase, issue price and repurchase
price.
Our board of directors may at any time provide for the acceleration of the
vesting of any options, the removal of restrictions on any restricted stock
awards and the acceleration of the vesting of or the removal of restrictions on
any other stock-based awards, as the case may be.
For purposes of the 2000 stock incentive plan, a reorganization event means
a merger, consolidation or share exchange transaction, and a change in control
event means:
. the acquisition of 50% or more of either:
. the outstanding shares of our common stock; or
. the voting power of our outstanding securities entitled to vote in
the election of our directors;
. the consummation of a merger, consolidation, reorganization,
recapitalization or share exchange, unless specified conditions are
satisfied; or
. the sale of all our assets, unless specified conditions are satisfied.
In the event of a reorganization event that is not also a change in control
event, our board of directors shall provide that all outstanding options under
this plan be assumed or substituted for by the acquiror. If the acquiror does
not agree to this assumption or substitution, then all outstanding options will
become exercisable in full.
In the event of a reorganization event that is also a change in control
event, options shall accelerate in an amount equal to not more than 30% of the
number of shares originally subject to option, with the remaining unvested
shares to vest in accordance with the original vesting schedule.
43
If the acquiror does not agree to assume or substitute for all unexercised
options, all unexercised options will become exercisable in full.
In the event of a change in control event that is not also a reorganization
event, options shall accelerate in an amount equal to not more than 30% of the
number of shares originally subject to option, with the remaining unvested
shares to vest in accordance with the original vesting schedule.
In the event of a reorganization event that is not a change in control
event, our rights under outstanding restricted stock awards shall inure to the
benefit of our successor. In the event of a change in control event, the
vesting schedule of all outstanding restricted stock awards shall be
accelerated so that an amount equal to no more than 30% of the number of shares
originally subject to restriction shall immediately become free from
conditions, with the remaining unvested shares to become free from conditions
in accordance with the original vesting schedule.
The board of directors may amend, suspend or terminate the 2000 stock
incentive plan or any portion thereof at any time, except that, no award
granted after an amendment to the 2000 stock incentive plan and designated as
subject to Section 162(m) of the Internal Revenue Code by our board of
directors shall become exercisable, realizable or vested, to the extent an
amendment was required to grant an award, unless and until an amendment is
approved by our stockholders.
2000 Employee Stock Purchase Plan
Our 2000 employee stock purchase plan was adopted by our board of directors
in September 2000, subject to stockholder approval. The 2000 employee stock
purchase plan authorizes the issuance to participating employees of up to a
total of 5,000,000 shares of common stock.
All of our employees, whose customary employment is more than 20 hours per
week, including our directors who are employees, and all employees of any
participating subsidiaries, are eligible to participate in the 2000 employee
stock purchase plan. Employees who would immediately after the grant own five
percent or more of the total combined voting power or value of our stock or any
subsidiary are not eligible to participate. As of September 15, 2000,
approximately 240 of our employees were eligible to participate in the 2000
employee stock purchase plan.
On the first day of a designated payroll deduction period, the offering
period, we will grant to each eligible employee who has elected to participate
in the 2000 employee stock purchase plan an option to purchase shares of common
stock as follows: the employee may authorize up to 10% of his or her base pay
to be deducted by us from his or her base pay during the offering period. On
the last day of the offering period, the employee is deemed to have exercised
the option, at the option exercise price, to the extent of accumulated payroll
deductions. Under the terms of the 2000 employee stock purchase plan, the
option price is an amount equal to 85% of the average market price per share of
the common stock on either the first day or the last day of the offering
period, whichever is lower. In no event may an employee purchase in any one
offering period a number of shares which exceeds the number of shares
determined by dividing the product of the number of full months in the offering
period and $2,083 by the closing market price of a share of common stock on the
commencement date of the offering period or another lower number as may be
determined by the board prior to the commencement date of the offering period.
Under current federal tax law, an employee may not purchase more than $25,000
of stock per year, based on the fair market value of the stock at the start of
the purchase period, under a tax-advantaged employee stock purchase plan. The
compensation committee may, in its discretion, choose an offering period of six
months or less for each offering and may choose a different offering period for
each offering.
An employee who is not a participant on the last day of the offering period
is not entitled to exercise any option, and the employee's accumulated payroll
deductions will be refunded. However, upon termination of employment because of
death, the employee's beneficiary has rights to elect to exercise the option to
purchase the shares that the accumulated payroll deductions in the
participant's account would purchase at the date of death.
44
Because participation in the 2000 employee stock purchase plan is voluntary,
currently we cannot determine the number of shares of common stock to be
purchased by any particular current executive officer, by all current executive
officers as a group or by non-executive employees as a group.
1998 Stock Option Plan
Our 1998 stock option plan was adopted by our board of directors in November
1998 and approved by our stockholders in November 1999. The aggregate number of
shares of our common stock that may be issued under the plan is 16,195,000
shares, subject to adjustment in the event of any stock split and other similar
events, less that number of shares issued under our 1998 restricted stock
purchase plan. As of September 25, 2000, options to purchase an aggregate of
3,052,094 shares of common stock were outstanding under this plan. We are no
longer granting options under this plan.
The 1998 stock option plan provides for the grant of options intended to
qualify as incentive stock options under Section 422 of the Internal Revenue
Code, and nonstatutory stock options. We may grant incentive stock options only
to our employees including those of our subsidiaries and nonstatutory stock
options to our officers, directors, employees, consultants and advisors
including those of our subsidiaries. No nonstatutory stock options may be
granted at less than 50% of the fair market value of the common stock on the
date of grant.
The board of directors has designated the compensation committee to
administer this plan. Decisions of the compensation committee as to all
questions of interpretation and application of this plan are final, binding and
conclusive. Subject to any applicable limitations contained in this plan, the
compensation committee:
. has the authority to adopt, amend and rescind these rules and
regulations as it deems advisable in the administration of the plan;
. may correct any defect or supply any omission or reconcile any
inconsistency in the plan or in any option agreement granted thereunder;
. determines the eligibility for and selects the recipients of option
grants; and
. determines the terms and conditions of each option, including the number
of shares subject to each option and the grant date.
In general, options granted under our 1998 stock option plan expire ten
years after the original grant date. Options granted from November 1998 to May
2000 generally vest over a five-year period at the rate of 20% of the total
number of shares on the first anniversary of the grant date and 5% of the total
number of shares every three months thereafter. Options granted since May 16,
2000 generally vest over a four-year period at the rate of 25% of the total
number of shares on the first anniversary of the grant date and 6.25% of the
total number of shares every three months thereafter. In addition, the vesting
schedule contained in some option agreements is tied to our achievement of
specified performance goals during the applicable fiscal year.
Notwithstanding the foregoing, options granted prior to May 15, 2000 are
immediately exercisable by the holder thereof upon his execution of a stock
repurchase agreement approved by the compensation committee that provides for
the lapse of our right to repurchase the shares of restricted stock purchased
by these option holders at the same rate that the option would have vested.
These shares of restricted stock are held in escrow by us under the terms of
individual escrow agreements and are released from escrow in accordance with
the applicable vesting schedule.
Upon a change of control, unexercisable but outstanding options to purchase
shares of our common stock will become vested and immediately exercisable as to
an additional number of shares of common stock equal to 30% of the total number
of shares underlying options. Alternatively, upon a change in control, any
purchaser of our assets or stock may in its discretion deliver to the holders
of outstanding options the same kind of consideration that is delivered to our
stockholders in connection with the transaction equal to the value of the
45
shares of stock the option holder would have received had the option been
exercised prior to the transaction, less the option exercise price, or the
equivalent in cash. Upon receipt of the consideration by the option holder, his
option will immediately terminate. Notwithstanding the foregoing, our board of
directors may in its discretion accelerate the vesting of unexercisable options
at any time, including upon a change of control.
1998 Restricted Stock Purchase Plan
Our 1998 restricted stock purchase plan was adopted by our board of
directors and approved by our stockholders in August 1998. The aggregate number
of shares of our common stock that may be issued under the plan is 16,195,000
shares, subject to adjustment in the event of any stock split and other similar
events, less that number of shares issued or reserved for issuance under our
1998 stock option plan. We are no longer issuing shares of common stock under
this plan.
The 1998 restricted stock purchase plan provides for the grant of rights to
purchase shares of our common stock, or share purchase rights, to our
directors, officers, consultants and other key personnel. The board of
directors has designated the compensation committee to administer this plan.
Subject to any applicable limitations contained in this plan, the compensation
committee:
. has the authority to adopt, amend and rescind these rules and
regulations as it deems advisable in the administration of the plan;
. may correct any defect or supply any omission or reconcile any
inconsistency in the plan or in any offer made thereunder;
. determines the eligibility for and selects the recipients of share
purchase rights; and
. determines the terms and conditions of each offer, including the number
of shares covered by the offer, the purchase price per share and any
related repurchase and escrow rights.
Restricted stock granted under the 1998 restricted stock purchase plan
generally vests over a five-year period at the rate of 20% of the total number
of shares on the first anniversary of the grant date and 5% of the total number
of shares every three months thereafter. Any shares that are not vested remain
subject to repurchase by us at the original purchase price paid by the
participant. Certificates representing unvested shares are held in escrow until
we exercise our repurchase right or our repurchase right lapses with respect to
these unvested shares. Subject to our repurchase rights, restricted stock
issued under this plan may not be sold or transferred.
Upon a change of control, an additional number of shares equal to 30% of the
total number of shares originally issued to a participant shall immediately
vest and no longer be subject to our repurchase right. Notwithstanding the
foregoing, our board of directors may in its discretion specifically provide a
different vesting schedule for restricted stock issued under this plan or
accelerate the vesting thereof.
TCS Third Amended and Restated 1996 Employee Stock Option Incentive Plan
In connection with our merger with TCS in July 2000, we assumed the
obligations of TCS under its third amended and restated 1996 employee stock
option incentive plan. As of September 25, 2000, options to purchase an
aggregate of 1,108,378 shares of common stock were outstanding under this plan.
We are no longer granting options under this plan.
The plan provides for the grant of incentive stock options intended to
qualify under Section 422 of the Internal Revenue Code to employees of ours or
any of our subsidiaries, and nonstatutory stock options to employees, officers,
directors or persons or service companies that provide services to us or any of
our subsidiaries.
The compensation committee of our board of directors administers this plan
and has sole discretion to determine the terms and provisions of all options
granted thereunder. However, all options outstanding under the plan were
granted by the board of directors of Hemisphere Investments prior to our
assumption of the plan.
46
Stock options granted under this plan have terms not in excess of ten years
and vest at the rate specified in each option agreement, which generally
specify vesting ratably over four years. No participant in the plan may receive
incentive stock options vesting in a calendar year having a fair market value
at the time of grant having a value in excess of $100,000.
401(k) Plan
In August 1998, we adopted an employee savings and retirement plan,
qualified under Section 401(a) of the Internal Revenue Code, covering all of
our employees. Under the 401(k) plan, employees may elect to reduce their
current compensation by up to the statutorily prescribed annual limit and have
the amount of the reduction contributed to the 401(k) plan. We may make
matching or additional contributions to the 401(k) plan in amounts to be
determined annually by our board of directors. We have made no contributions to
the 401(k) plan to date.
Agreements with Executive Officers
In September 2000, we entered into an employment agreement with John C.
Thibault which provides for his employment as our President and Chief Executive
Officer from September 1, 2000 until March 31, 2002. Under the terms of this
agreement, Mr. Thibault receives a base salary of $200,000 per year, which will
increase to $250,000 on January 1, 2001.
Mr. Thibault's employment agreement also provides for a payment of $275,000
payable within 90 days of the consummation of this offering and a payment of
$275,000 on April 1, 2001 in the event our board of directors determines that
we have met specified financial targets for fiscal year 2000. Mr. Thibault is
also eligible to receive a payment of up to $300,000 in the event we meet
financial targets for fiscal 2001 as determined by our board of directors. If
we terminate Mr. Thibault's employment without cause, he will be entitled to
the balance of his salary through March 31, 2002.
In connection with his employment with us, Mr. Thibault purchased an
aggregate of 3,482,000 shares of restricted stock on February 15, 2000, for
which he paid $3,482,000 in the form of three recourse promissory notes. Mr.
Thibault's employment agreement provides us with the right to repurchase his
unvested restricted stock at the original purchase price paid by Mr. Thibault,
or $1.00 per share, subject to the vesting described below. Mr. Thibault's
restricted stock vests as to 100,000 shares on February 15, 2000, as to 180,125
shares for each full three-month period beginning March 15, 2000 through March
15, 2002 during which he is employed by us and for an additional 1,441,000
shares on March 31, 2002, provided he is employed by us at that time. Upon
consummation of this offering, Mr. Thibault's restricted stock will immediately
vest as to 250,000 shares, provided he is employed by us at that time. Mr.
Thibault's restricted stock will vest as to an additional 250,000 shares on
January 31, 2005, or on April 1, 2001 if we meet specified financial targets
for fiscal year 2000 as determined by our board of directors, provided Mr.
Thibault is employed by us through December 31, 2000. If we terminate Mr.
Thibault's employment with or without cause on or before September 1, 2001, 50%
of his unvested restricted stock will immediately vest. Mr. Thibault's stock
will vest in full in the event of a change in control or sale of our company or
if we terminate his employment with or without cause after September 1, 2001.
Additionally, Mr. Thibault's employment agreement limits his ability to
transfer this restricted stock, except to members of his family or to a trust
for their benefit.
The promissory notes issued by Mr. Thibault to purchase the 3,482,000 shares
of restricted stock are unsecured and bear interest at a rate of 6.8% per year,
and are payable as to $250,000 of the principal amount upon the closing of this
offering and as to $3,232,000 of the principal amount and all accrued interest
upon the earlier of March 31, 2002 or termination of Mr. Thibault's employment.
As of August 31, 2000, the aggregate amount of principal and interest
outstanding under these notes was $3,610,257. Mr. Thibault's employment
agreement provides that if he continues his employment with us through
September 1, 2001 and we have completed an initial public offering prior to
January 1, 2002, $745,000 of the principal amount under the notes
47
will be forgiven. If Mr. Thibault continues his employment with us through
January 1, 2002 an additional $745,000 of the principal amount under the notes
will be forgiven. If Mr. Thibault continues his employment with us through
March 31, 2002, an additional $1,492,000 of the principal amount will be
forgiven. All principal under Mr. Thibault's notes will be forgiven upon our
change of control.
In March 2000, we entered into an employment letter agreement with Pamela F.
Lenehan which provides for her employment as Vice President and Chief Financial
Officer. Under the terms of this agreement, Ms. Lenehan receives a base salary
of $155,000 per year. Under the terms of an employment termination agreement
with us, if we terminate Ms. Lenehan's employment without cause, she will be
entitled to receive a severance payment of $100,000 payable in lump sum within
30 days of termination.
In connection with her employment with us, Ms. Lenehan purchased an
aggregate of 450,000 shares of restricted stock on March 31, 2000 under the
1998 restricted stock purchase plan, for which she paid $900,000, $100,000 in
cash and $800,000 in the form of a recourse promissory note. We have the right
to repurchase the restricted stock at the original purchase price paid by Ms.
Lenehan, or $2.00 per share, until the shares vest. Of the 450,000 shares sold
to Ms. Lenehan, 25,000 shares will vest upon the consummation of this offering.
Another 25,000 shares will vest on March 31, 2005, or on April 1, 2001 if our
board of directors determines we have met specified financial targets for
fiscal 2000, provided Ms. Lenehan is employed with us at that time. The
remaining 400,000 shares will vest as to 100,000 shares on March 31, 2001 and
25,000 shares will vest at the end of each full three-month period thereafter
during which Ms. Lenehan is employed by us so as to be fully vested on March
31, 2004. Upon a change of control of our company, 135,000 shares of Ms.
Lenehan's then unvested shares will vest, and, if, in connection with our
change of control, her employment is terminated, she is required to relocate or
the resulting company fails to offer her a position with compensation and
responsibilities comparable to her employment with us, all of Ms. Lenehan's
shares will vest.
The promissory note in the principal amount of $800,000 issued by Ms.
Lenehan to purchase the 400,000 shares of our common stock is unsecured and
bears interest at a rate of 6.8% per year, and is payable upon the earlier of
March 31, 2004 or the termination of Ms. Lenehan's employment. As of August 31,
2000, the aggregate amount of principal and interest outstanding under this
note was $822,667.
On July 13, 2000, we granted Ms. Lenehan an option to purchase 100,000
shares of our common stock at an exercise price of $5.00 per share. These
options vest and become exercisable as to 25,000 shares on July 13, 2001 and as
to 6,250 additional shares each three-month period thereafter. Upon our change
of control, 30,000 of Ms. Lenehan's then unvested shares will vest, and, if in
connection with our change of control, her employment is terminated, she is
required to relocate, or the resulting company fails to offer her a position
with compensation and responsibilities comparable to her employment with us,
all of Ms. Lenehan's shares will vest.
In May 2000, we entered into an employment letter agreement with Brian
Fitzgerald which provides for his employment as our Vice President, Worldwide
Sales. Under the terms of this agreement, Mr. Fitzgerald receives a base salary
of $150,000 per year, and is eligible to receive a cash bonus of up to $150,000
upon meeting sales and revenue goals. Mr. Fitzgerald has also received an
option to purchase up to 25,000 shares of our common stock, which will vest on
May 15, 2004 or on April 1, 2001 if our board of directors determines we have
met specified financial targets for fiscal 2000, provided Mr. Fitzgerald is
employed with us at that time. Mr. Fitzgerald has also received an option to
purchase up to 25,000 shares of our common stock, which will vest on May 15,
2004 or on April 1, 2002 depending on whether we meet financial targets for
fiscal 2001, which are to be determined by our board of directors, and provided
he is employed by us at that time. If we terminate Mr. Fitzgerald's employment
without cause, he is entitled to a severance payment of $120,000 and
continuation of medical benefits payable by us over a period of six months from
the date of his termination.
In connection with his employment with us, Mr. Fitzgerald purchased 600,000
shares of restricted stock on May 15, 2000 under the 1998 restricted stock
purchase plan, for which he paid $1,800,000 in the form of a recourse
promissory note. We have the right to repurchase the restricted stock at the
original purchase price paid by Mr. Fitzgerald, or $3.00 per share, until the
shares vest. Of the 600,000 shares, 150,000 shares will vest
48
on May 15, 2001 and 37,500 will vest at the end of each full three-month period
thereafter during which Mr. Fitzgerald is employed by us so as to be fully
vested by May 15, 2004. Upon a change of control of our company, 180,000 shares
of Mr. Fitzgerald's then unvested shares will become vested, and, if, in
connection with our change in control, his employment with us is terminated, he
is required to relocate or the resulting company fails to offer him a position
with comparable compensation and responsibilities to his employment with us,
all of Mr. Fitzgerald's shares will vest.
The promissory note issued by Mr. Fitzgerald to purchase the 600,000 shares
of restricted stock is unsecured and bears interest at a rate of 6.8% per year,
and is payable upon the earlier of May 15, 2004 or termination of Mr.
Fitzgerald's employment with us. As of August 31, 2000, the aggregate amount of
principal and interest outstanding under this note was $1,855,218.
In August 2000, we entered into an employment letter agreement with Ron
Rando which provides for his employment as our Vice President, Worldwide
Customer Support. Under the terms of this agreement, Mr. Rando receives a base
salary of $160,000 per year. Mr. Rando received an option to purchase up to
400,000 shares of our common stock, which will vest as to 100,000 shares on
August 23, 2001 and as to an additional 25,000 shares each full three-month
period thereafter during which Mr. Rando is employed with us. Mr. Rando also
received an option to purchase up to 15,000 shares of our common stock, which
will become exercisable on August 23, 2004, or on April 1, 2000 if our board of
directors determines we have met specified financial targets for fiscal 2000
and Mr. Rando is employed with us through April 1, 2000. Mr. Rando also
received an option to purchase up to 25,000 shares of our common stock, which
will vest on August 23, 2004 or on April 1, 2002 depending on whether we meet
financial targets for fiscal 2001, which are to be determined by our board of
directors, and provided he is employed by us at that time. Upon a change of
control of our company, 120,000 shares of Mr. Rando's then unvested shares will
become vested, and, if, in connection with our change of control, his
employment with us is terminated, he is required to relocate or the resulting
company fails to offer him a position with comparable compensation or
responsibilities, all of Mr. Rando's shares will vest. If we terminate Mr.
Rando's employment without cause, he is entitled to a severance payment of
$80,000 and continuation of medical benefits payable by us over a period of six
months from the date of his termination.
On September 21, 1998, Kenneth MacLure entered into an agreement to purchase
126,000 shares of restricted stock for a total purchase price of $630. These
shares vested as to 20% of the original number of shares on October 5, 1999,
and vest as to 5% of the original number of shares for each full three-month
period thereafter during which he is employed by or consulting with us so as to
be fully vested on October 5, 2003. On August 4, 1999, Mr. MacLure purchased
20,000 shares of restricted stock through the early exercise of an option
granted to him under the 1998 stock option plan for a total purchase price of
$5,000. These shares vested as to 20% of the original number of shares on June
29, 2000, and vest as to 5% of the original number of shares thereafter on a
quarterly basis so as to be fully vested on June 29, 2004. Mr. MacLure's stock
will vest as to an additional 37,800 shares in the event of a change of control
of our company.
On March 11, 1999, Sally J. Bament entered into an agreement to purchase
640,000 shares of restricted stock for a total purchase price of $32,000. The
restricted stock held by Ms. Bament vested as to 20% of the original number of
shares on February 17, 2000, and vests as to 5% of the original number of
shares for each full three-month period thereafter during which she is employed
by or consulting with us so as to be fully vested on February 17, 2004. Ms.
Bament's stock will vest as to an additional 192,000 shares in the event of a
change of control of our company.
49
RELATED PARTY TRANSACTIONS
Preferred Stock Issuances
Series A Preferred Stock. In July 1998 and March 1999, we issued an
aggregate of 6,976,000 shares of Series A convertible preferred stock at a
price of $1.00 per share, for an aggregate offering price of $6,976,000. In
this private placement, we sold 2,625,000 shares to Battery Ventures IV, L.P.
and Battery Investment Partners IV, LLC, or the Battery entities, which
beneficially own more than five percent of our outstanding common stock and
have a representative on our board, 2,625,000 shares to Matrix Partners, L.P.
and Matrix V Entrepreneurs Fund, L.P., or the Matrix entities, which
beneficially own more than five percent of our outstanding common stock and
have a representative on our board, 1,250,000 shares to North Bridge Venture
Partners II, L.P which beneficially owns more than five percent of our
outstanding common stock, 100,000 shares to Bing Yang, a director and our
Senior Vice President and Chief Technology Officer, and 100,000 shares to
Hwang-Ruey Wang, our Vice President, Engineering.
Series B Preferred Stock. In July 1999, we issued an aggregate of 4,133,892
shares of Series B convertible preferred stock at a price of $2.39 per share,
for an aggregate offering price of $9,880,002. In this private placement, we
sold 1,574,477 shares to the Battery entities, 1,574,477 shares to the Matrix
entities, 749,791 shares to North Bridge Venture Partners II, L.P., 59,833
shares to Mr. Yang and 59,833 shares to Mr. Wang.
Series C Preferred Stock. In December 1999 and March 2000, we issued an
aggregate of 5,602,782 shares of Series C convertible preferred stock at a
purchase price of $6.47 per share, for an aggregate offering price of
$36,250,000. In this private placement, we sold 298,065 shares to the Battery
entities, 298,065 shares to the Matrix entities, 141,938 shares to North Bridge
Venture Partners II, L.P., 3,091,189 shares to VantagePoint Communications
Partners, L.P., VantagePoint Venture Partners III (Q), L.P. and VantagePoint
Venture Partner III, L.P., or the VantagePoint entities, which beneficially own
more than five percent of our outstanding common stock, 19,976 shares to Mr.
Yang and 38,640 shares to Pamela F. Lenehan, our Vice President and Chief
Financial Officer.
Series D Preferred Stock. In September 2000, we issued an aggregate of
4,803,926 shares of Series D convertible preferred stock at a price of $16.35
per share, for an aggregate offering price of $78,544,190. In this private
placement, we sold 183,486 shares to the VantagePoint entities, 122,324 shares
to the Battery entities, 122,324 shares to the Matrix entities, 122,324 shares
to North Bridge Venture Partners II, L.P., 61,162 shares to William E. Foster,
a director, 6,116 shares to Christian S. Zousas, John Thibault's brother-in-
law, 10,000 shares to Despena Zousas, Mr. Thibault's mother-in-law, 9,174
shares to Ms. Linda Thoa Phan, Mr. Yang's wife, and 12,232 shares to
Dr. Lawrence F. Geuss, Jr., Ms. Lenehan's husband.
Common Stock Purchases by Executive Officers and Key Employees
On May 15, 1998, each of Bing Yang and Hwang-Ruey Wang purchased 2,540,000
shares of common stock for a purchase price of $150 each. On July 14, 1998, we
entered into stock restriction agreements with each of Mr. Yang and Mr. Wang
providing us with the right to repurchase unvested shares of restricted stock
at a per share price of $.005 if Mr. Yang's or Mr. Wang's employment with us
terminates prior to July 14, 2002. The restricted stock held by each of Mr.
Yang and Mr. Wang vests as to 20% of the original number of shares on July 14,
1998, and 5% of the original number of shares for each full three-month period
thereafter during which Mr. Yang or Mr. Wang, as applicable, is employed by us
so as to be fully vested on July 14, 2002. In January 1999, both of these stock
restriction agreements were amended to provide that an additional number of
shares equal to 30% of the total shares originally issued to them will vest
upon the acquisition of our business by merger, sale of our assets or
otherwise, with the remaining unvested shares to vest at a quarterly rate of 5%
of the restricted stock that was originally issued. Upon an acquisition, 100%
of the restricted stock originally issued to Mr. Wang and Mr. Yang will vest,
unless the acquiring corporation agrees that the original vesting schedule
shall continue in effect and that all unvested shares shall become vested if
Mr. Wang's or Mr. Yang's employment with the acquiring corporation is
terminated without cause or if Mr. Wang or Mr. Yang terminates his employment
with the acquiring corporation for good reason, in either case, within 12
months after the acquisition.
50
Investor Rights Agreement
We have entered into an amended and restated investor rights agreement with
some of our executive officers and stockholders, including the Battery
entities, the Matrix entities, North Bridge Venture Partners II, L.P., the
VantagePoint entities, William Foster, John Thibault, Bing Yang, Hwang-Ruey
Wang and Pamela F. Lenehan. The holders of at least 35% of the shares of common
stock issued upon conversion of our preferred stock can request that we
register all or a portion of their shares under the Securities Act. Those
stockholders must also request registration of enough shares so that the
offering would have an anticipated aggregate offering price of $5.0 million. We
are only required to effect up to two of these demand registrations.
Beginning 180 days after the closing of this offering, if we propose to
register shares of common stock under the Securities Act, the parties to the
investor rights agreement will have the right to receive notice of the proposed
registration and to include their shares in the registration statement.
At any time we become eligible to file a registration statement on Form S-3
under the Securities Act, upon the request of the holders of shares of common
stock issued upon conversion of our preferred stock, we must effect a
registration statement on Form S-3. However, the registration must have a
minimum anticipated aggregate offering price of $1.0 million.
These registration rights are subject to conditions and limitations,
including, in the case of an underwritten public offering, the right of the
managing underwriter to limit the number of shares of common stock to be
included in the registration. We are generally required to bear all the
expenses of registrations under the investor rights agreement, except
underwriting discounts and commissions. The investor rights agreement also
contains our commitment to indemnify the holders of registration rights for
specified losses they incur in connection with registrations under the
agreement. These registration rights terminate ten years after the closing of
this offering and do not apply to any shares that are sold under Rule 144 under
the Securities Act. All holders of registration rights have agreed not to
exercise their registration rights until 180 days following the date of this
prospectus without the consent of Credit Suisse First Boston Corporation.
Other Material Transactions
For the six months ended June 30, 2000, Global NAPs accounted for all of our
revenues. On December 17, 1999, BABP, L.L.C., an affiliate of Global NAPs,
purchased 155,147 shares of our Series C convertible preferred stock, at a
price of $6.47 per share, for aggregate consideration of $1,003,801. In
addition, we issued 264,853 shares of Series C convertible preferred stock to
BABP in consideration for research and development and other related services
performed for us by Global NAPs.
On September 22, 2000, we sold 183,486 shares of Series D convertible
preferred stock to BABP at a price of $16.35 per share, for aggregate
consideration of $2,999,996.
Under an agreement dated December 17, 1999 by and among us, Global NAPs and
BABP, BABP granted an irrevocable proxy to our President to vote all shares of
our capital stock held by BABP in favor of any stockholder action in which the
holders of a majority of our capital stock have voted either to:
. sell all of their shares of our capital stock;
. enter into a transaction to merge with another entity; or
. enter into a transaction to sell all or substantially all of our assets.
On August 4, 2000, we issued a warrant to purchase 100,000 shares of our
common stock at $12.00 per share to Focal Communications. On August 30, 2000,
we entered into a master purchase and license agreement with Focal. Todd
Dagres, one of our directors, is also a director of Focal.
51
Agreements with Executive Officers
We have entered into agreements with some of our executive officers relating
to employment compensation. See "Management -- Agreements with Executive
Officers."
All future transactions, including loans between us and our officers,
directors, principal stockholders and their affiliates will be approved by a
majority of the board of directors, including a majority of the independent and
disinterested directors on the board of directors, and will be on terms no less
favorable to us than could be obtained from unaffiliated third parties.
52
PRINCIPAL STOCKHOLDERS
The following table sets forth information regarding beneficial ownership of
our common stock as of September 25, 2000 and as adjusted to reflect the sale
of our common stock offered in this prospectus by:
. each person we know to own beneficially more than 5% of our common stock;
. each of our directors and named executive officers; and
. all directors and executive officers as a group.
The number of shares of common stock deemed outstanding prior to this
offering includes 55,444,894 shares of common stock outstanding as of September
25, 2000, assuming conversion of all outstanding shares of convertible
preferred stock into common stock. The number of shares of common stock deemed
outstanding after this offering includes the shares that are being offered
for sale by us in this offering.
Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission, and includes voting and investment power
with respect to shares. Unless otherwise indicated below, each person named in
the table has sole voting and investment power, or shares such power with his
or her spouse, with respect to all shares of capital stock listed as owned by
such person. Shares issuable upon exercise of options that are currently
outstanding or will become exercisable within 60 days of September 25, 2000 are
considered outstanding for the purposes of computing the percentage ownership
of the person holding such option but are not considered outstanding for
purposes of computing the percentage ownership of any other person.
Unless otherwise indicated below, the address of each stockholder listed is
c/o Convergent Networks, Inc., 900 Chelmsford Road, Lowell, Massachusetts
01851.
Percentage of Shares
Outstanding
------------------------
Name and Address of Number of Shares After
Beneficial Owner Beneficially Owned Before Offering Offering
------------------- ------------------ --------------- --------
Battery Ventures IV, L.P. (1)..... 7,244,866 13.1%
Matrix Partners V, L.P. (2)....... 7,244,866 13.1
North Bridge Venture Partners II,
L.P. (3)......................... 3,514,053 6.3
VantagePoint Venture Partners III
(Q), L.P. (4).................... 3,274,676 5.9
John C. Thibault (5).............. 3,482,000 6.3
Bing Yang (6)(7).................. 2,819,809 5.1
Hwang-Ruey Wang (7)............... 2,799,833 5.0
Sally J. Bament (8)............... 640,000 1.2
Kenneth MacLure (9)............... 146,000 *
Karl May.......................... 708,000 1.3
Todd Dagres (10).................. 7,244,866 13.1
David Schantz (11)................ 7,244,866 13.1
William E. Foster................. 61,162 *
All executive officers and
directors as a group
(10 persons) (12)................ 21,638,703 39.0
- ---------------------
* Less than 1%
(1) Also includes 108,673 shares held by Battery Investment Partners IV, LLC.
The address for both of these entities is 20 William Street, Wellesley, MA
02481.
53
(2) Also includes 199,486 shares held by Matrix V Entrepreneurs Fund, L.P. The
address for both of these entities is Bay Colony Corporate Center, 1000
Winter Street, Suite 4500, Waltham, MA 02451.
(3) The address for North Bridge Venture Partners II, L.P. is 950 Winter
Street, Suite 4600, Waltham, MA 02451.
(4) Also includes 1,091,604 shares held by VantagePoint Communications
Partners, L.P. and 240,206 shares held by VantagePoint Venture Partners
III, L.P. The address for the VantagePoint entities is 1001 Bayhill Drive,
Suite 100, San Bruno, CA 94066.
(5) Includes 3,109,250 shares of restricted stock that are subject to our right
of repurchase. Includes 25,000 shares held by Susan C. Thibault, 25,000
shares held by Cynthia B. Thibault and 50,000 shares held by Elaine Zouzas.
Mr. Thibault disclaims beneficial ownership of the shares held by Susan C.
Thibault, Cynthia B. Thibault and Elaine Zouzas.
(6) Includes 200,000 shares held by the Nikki Mei-Hui Yang Trust, 200,000
shares held by the Caroline Yang Trust and 200,000 shares held by the Troy
Yang Trust. Mr. Yang disclaims beneficial ownership of the shares held by
these trusts.
(7) Includes 1,016,000 shares of restricted stock that are subject to our right
of repurchase.
(8) Includes 448,000 shares of restricted stock that are subject to our right
of repurchase.
(9) Includes 97,900 shares of restricted stock that are subject to our right of
repurchase.
(10) Consists of 7,136,193 shares held by Battery Ventures IV, L.P. and 108,673
shares held by Battery Investment Partners IV, LLC. Battery Ventures IV,
L.P. is the managing member of Battery Investment Partners IV, LLC. Todd
A. Dagres, one of our directors, is a general partner of Battery Ventures
IV, L.P. and may be deemed to be the beneficial owner of shares held,
directly or indirectly, by these two entities. Mr. Dagres disclaims
beneficial ownership of the shares held by these two entities. The address
for Mr. Dagres is c/o Battery Ventures IV, L.P., 20 William Street,
Wellesley, MA 02481.
(11) Consists of 7,045,380 shares held by Matrix Partners V, L.P. and 199,486
shares held by Matrix V Entrepreneurs Fund, L.P. David Schantz is a
managing member of Matrix V Management Co., L.L.C., the general partner of
Matrix Partners V, L.P. and Matrix V Entrepreneurs Fund, L.P. Mr. Schantz
has sole voting and dispositive power over the shares held by both Matrix
entities. Mr. Schantz disclaims beneficial ownership of the shares held by
both Matrix entities, except to the extent of his pecuniary interest as a
managing member of Matrix V Management Co., L.L.C. The address for Mr.
Schantz is c/o Matrix Partners, Bay Colony Corporate Center, 1000 Winter
Street, Suite 4500, Waltham, MA 02451.
(12) Includes 5,721,150 shares of restricted stock that are subject to our
right of repurchase.
54
DESCRIPTION OF CAPITAL STOCK
Effective upon the closing of this offering and the filing of our amended
and restated certificate of incorporation, our authorized capital stock will
consist of 400,000,000 shares of common stock, $0.00001 par value per share,
and 10,000,000 shares of preferred stock, $0.01 par value per share.
The following summary description of our capital stock, as of the closing of
this offering, may not contain all the information that is important to you.
You should also refer to the provisions of applicable law and to our amended
and restated certificate of incorporation and amended and restated by-laws
filed as exhibits to the registration statement of which this prospectus is a
part.
Common Stock
As of September 25, 2000, there were 55,444,894 shares of common stock
outstanding and held of record by 266 stockholders, after giving effect to the
conversion of all outstanding shares of convertible preferred stock upon the
closing of this offering. Based upon the number of shares outstanding as of
September 25, 2000 and giving effect to the issuance of the shares of common
stock offered by us in this offering, there will be shares of common stock
outstanding upon the closing of this offering. In addition, as of September 25,
2000, there were outstanding stock options for the purchase of a total of
4,160,472 shares of common stock.
Holders of our common stock are entitled to one vote per share for each
share held of record on all matters submitted to a vote of stockholders and do
not have cumulative voting rights. Our directors are elected by a plurality of
the votes of the shares present in person or by proxy at the meeting. The
holders of common stock are entitled to receive ratably lawful dividends as may
be declared by our board of directors. However, these dividends are subject to
preferences that may be applicable to the holders of any outstanding shares of
preferred stock. In the event of our liquidation, dissolution or winding up of
our affairs, whether voluntarily or involuntarily, the holders of common stock
will be entitled to receive pro rata all of our remaining assets available for
distribution to our stockholders. Any pro rata distribution would be subject to
the rights of the holders of any outstanding shares of preferred stock. The
common stock has no preemptive, redemption, conversion or subscription rights.
All outstanding shares of common stock are fully paid and nonassessable. The
shares of common stock to be issued by us in this offering will be fully paid
and nonassessable. The rights, powers, preferences and privileges of holders of
common stock are subject to, and may be adversely affected by, the rights of
the holders of shares of any series of preferred stock that we may designate
and issue in the future. Upon the closing of this offering, there will be no
shares of preferred stock outstanding.
Preferred Stock
Our board of directors will be authorized, subject to any limitations
prescribed by Delaware law, without further stockholder approval, to issue from
time to time up to an aggregate of 10,000,000 shares of preferred stock, in one
or more series. Each share of preferred stock would be entitled to no more than
one vote per share. Our board of directors is also authorized, subject to the
limitations prescribed by Delaware law, to establish the number of shares to be
included in each series and to fix the voting powers, preferences,
qualifications and special or relative rights or privileges of each series. Our
board of directors is authorized to issue preferred stock with conversion and
other rights and preferences that could adversely affect the voting power or
other rights of the holders of common stock.
We have no current plans to issue any preferred stock. However, the issuance
of preferred stock or of rights to purchase preferred stock could have the
effect of making it more difficult for a third party to acquire, or of
discouraging a third party from attempting to acquire, a majority of the shares
of our outstanding common stock.
Warrants
As of September 25, 2000, there were warrants outstanding for purchase of up
to 240,000 shares of our common stock at exercise prices of ranging from $12.00
per share to $16.35 per share. The warrants terminate on the earlier of two
years from the date of issuance or our acquisition by another company.
55
Registration Rights
Pursuant to a first amended and restated investor rights agreement dated
September 22, 2000 among us and some of our stockholders, these stockholders
have participation registration rights with respect to the registration of
37,719,453 shares of our common stock, and demand registration rights with
respect to 28,757,453 of those shares. See "Related Party Transactions" for a
description of the rights and obligations under this agreement. In addition,
the former stockholders of TCS, who collectively hold 10,106,845 shares of our
common stock, have the right to participate in any future registrations of
securities by us. All holders of registration rights have agreed not to
exercise their registration rights until 180 days following the date of this
prospectus without the consent of Credit Suisse First Boston Corporation.
Section 203 of the Delaware General Corporation Law
Our certificate of incorporation contains a provision expressly electing not
to be governed by Section 203 of the Delaware General Corporation Law. In
general, Section 203 restricts some business combinations involving interested
stockholders, defined as any person or entity that is the beneficial owner of
at least 15% of a corporation's voting stock or is an affiliate or associate of
the corporation or the owner of 15% or more of the outstanding voting stock of
the corporation at any time in the past three years, or their affiliates.
Because of this election, Section 203 will not apply to us.
Limitation of Liability and Indemnification
Our certificate of incorporation provides that none of our directors shall
be personally liable to us or to our stockholders for monetary damages for
breach of fiduciary duty as a director, except to the extent that the
elimination or limitation of this liability is not permitted by Delaware
General Corporation Law as it exists or may later be amended.
Our certificate of incorporation further provides for the indemnification of
our directors and officers to the fullest extent permitted by Section 145 of
the Delaware General Corporation Law, including circumstances in which
indemnification is otherwise discretionary.
Transfer Agent and Registrar
The transfer agent and registrar for our common stock is .
56
SHARES ELIGIBLE FOR FUTURE SALE
Effect of Sales of Shares
Prior to this offering, no public market existed for our common stock, and
we can make no prediction as to the effect, if any, that sales of shares of our
common stock or the availability of shares of our common stock for sale will
have on the market price of the common stock prevailing from time to time.
Nevertheless, sales of substantial amounts of our common stock in the public
market, or the perception that sales occur, could cause the market price of our
common stock to decrease and could impair our future ability to raise capital
through an offering of our equity securities.
Sale of Restricted Shares
Upon completion of this offering, based upon the number of shares
outstanding as of , we will have an aggregate of shares of common
stock outstanding, assuming no exercise of the underwriters' over-allotment
option and no exercise of outstanding options. Of these outstanding shares, the
shares sold in this offering will be freely tradable without restriction or
further registration under the Securities Act, except that any shares purchased
by our "affiliates," as that term is defined in Rule 144 under the Securities
Act, generally only may be sold in compliance with the limitations of Rule 144
described below. All of the remaining shares of common stock that will be
outstanding after this offering will be "restricted securities" as that term is
defined under Rule 144. Restricted securities may be sold in the public market
only if they qualify for an exemption from registration under Rule 144,
including Rule 144(k), or Rule 701 under the Securities Act. Upon expiration of
the lock-up agreements described in "Underwriting," of these restricted
shares will be immediately available for resale in the public market.
In general, under Rule 144, commencing 90 days after the date of this
prospectus, a person who has beneficially owned shares of our common stock for
at least one year is entitled to sell within any three-month period a number of
shares that does not exceed the greater of:
. 1% of the number of shares our common stock then outstanding, which is
expected to be approximately shares upon completion of this
offering; or
. the average weekly trading volume of our common stock on The Nasdaq
Stock Market's National Market during the four calendar weeks preceding
the filing of a notice on Form 144 with respect to a sale, subject to
the restrictions specified in Rule 144.
Sales under Rule 144 are also subject to manner of sale provisions and
notice requirements and to the availability of current public information about
us.
Under Rule 144(k), a person who is not one of our affiliates at any time
during the three months preceding a sale and who has beneficially owned the
shares proposed to be sold for at least two years is entitled to sell their
shares under Rule 144(k) without complying with the manner of sale, public
information, volume limitation or notice provisions of Rule 144. As a result,
unless otherwise restricted, Rule 144(k) shares may be sold immediately upon
completion of this offering. Immediately upon completion of this offering, no
outstanding shares may be sold under Rule 144(k).
Options
Rule 701 provides that the shares of common stock acquired upon the exercise
of options outstanding as of September 25, 2000 or under other rights granted
under our stock plans may be resold, to the extent not subject to the lock-up
agreements, by persons, other than affiliates, beginning 90 days after the date
of this prospectus, subject only to the manner of sale provisions of Rule 144,
and by affiliates under Rule 144, without compliance with its one-year minimum
holding period, subject to limitations. As of September 25, 2000, options to
purchase a total of 4,160,472 shares of common stock were outstanding, 649,147
of which are exercisable. Of the total shares issuable upon the exercise of
these options, shares are subject to the lock-up agreements described in
"Underwriting."
57
We intend to file one or more registration statements on Form S-8 under the
Securities Act following the offering to register up to shares of common
stock which are issuable under our stock option and stock purchase plans. These
registration statements are expected to become effective upon filing. Shares
covered by these registration statements will thereupon be eligible for sale in
the public markets, subject to the lock-up agreements, to the extent applicable
and to Rule 144 limitations applicable to affiliates.
Lock-up Agreements
Substantially all of our stockholders and option holders have entered into
the lock-up agreements described in "Underwriting."
Registration Rights
Following this offering, under specified circumstances and subject to
specified conditions, holders of our common stock will have the right to
require us to register their shares of common stock under the Securities Act
and to participate in any future registrations of securities by us. All holders
of registration rights have agreed not to exercise their registration rights
until 180 days following the date of this prospectus without the consent of
Credit Suisse First Boston Corporation. See "Related Party Transactions" and
"Description of Capital Stock."
58
UNITED STATES FEDERAL TAX CONSEQUENCES
TO NON-UNITED STATES HOLDERS
The following is a general discussion of the material U.S. federal income
and estate tax consequences of the ownership and disposition of our common
stock by a non-U.S. holder. As used in this discussion, the term non-U.S.
holder means a beneficial owner of our common stock that is not, for U.S.
federal income tax purposes:
. an individual who is a citizen or resident of the United States;
. a corporation, an entity taxable as a corporation, or a partnership
created or organized in or under the laws of the United States or of any
political subdivision of the United States, other than a partnership
treated as foreign under U.S. Treasury regulations;
. an estate whose income is includible in gross income for U.S. federal
income tax purposes regardless of its source; or
. a trust, in general, if a U.S. court is able to exercise primary
supervision over the administration of the trust and one or more U.S.
persons have authority to control all substantial decisions of the
trust.
An individual may be treated as a resident of the United States in any
calendar year for U.S. federal income tax purposes, instead of a nonresident,
by, among other ways, being present in the United States on at least 31 days in
that calendar year and for an aggregate of at least 183 days during a three-
year period ending on December 31 of the current calendar year. For purposes of
this calculation, you would count all of the days present in the current year,
one-third of the days present in the immediately preceding year and one-sixth
of the days present in the second preceding year. Residents are taxed for U.S.
federal income purposes as if they were U.S. citizens.
This discussion does not consider:
. U.S. state and local or non-U.S. tax consequences;
. specific facts and circumstances that may be relevant to a particular
non-U.S. holder's tax position, including, if the non-U.S. holder is a
partnership or trust that the U.S. tax consequences of holding and
disposing of our common stock may be affected by certain determinations
made at the partner or beneficiary level;
. the tax consequences for the stockholders, partners or beneficiaries of
a non-U.S. holder;
. special tax rules that may apply to particular non-U.S. holders, such as
financial institutions, insurance companies, tax-exempt organizations,
U.S. expatriates, broker-dealers, and traders in securities; or
. special tax rules that may apply to a non-U.S. holder that holds our
common stock as part of a straddle, hedge, conversion transaction,
synthetic security or other integrated investment.
The following discussion is based on provisions of the U.S. Internal Revenue
Code of 1986, as amended, applicable U.S. Treasury regulations and
administrative and judicial interpretations, all as in effect on the date of
this prospectus, and all of which are subject to change, retroactively or
prospectively. The following summary assumes that a non-U.S. holder holds our
common stock as a capital asset for U.S. federal tax purposes. EACH NON-U.S.
HOLDER SHOULD CONSULT A TAX ADVISOR REGARDING THE U.S. FEDERAL, STATE, LOCAL
AND NON-U.S. INCOME, ESTATE, GIFT AND OTHER TAX CONSEQUENCES OF ACQUIRING,
HOLDING AND DISPOSING OF SHARES OF OUR COMMON STOCK.
Dividends
We do not anticipate paying cash dividends on our common stock in the
foreseeable future. In the event, however, that we pay dividends on our common
stock, we will have to withhold a U.S. federal withholding tax at a rate of
30%, or a lower rate under an applicable income tax treaty, from the gross
amount of the dividends paid to a non-U.S. holder. Non-U.S. holders should
consult their tax advisors regarding their entitlement to benefits under a
relevant income tax treaty.
59
Dividends that are effectively connected with a non-U.S. holder's conduct of
a trade or business in the United States and, in the event that an income tax
treaty applies, are also attributable to a permanent establishment maintained
by the non-U.S. holder in the United States, are taxed on a net income basis at
the regular graduated rates and in the manner applicable to U.S. persons. In
that case, we will not have to withhold U.S. federal withholding tax if the
non-U.S. holder complies with applicable certification and disclosure
requirements. In addition, a branch profits tax may be imposed at a 30% rate,
or a lower rate under an applicable income tax treaty, on dividends received by
a foreign corporation that are effectively connected with such foreign
corporation's conduct of a trade or business in the United States.
Dividends paid prior to 2001 to an address in a foreign country are
presumed, absent actual knowledge to the contrary, to be paid to a resident of
such country for purposes of the withholding discussed above and for purposes
of determining the applicability of an income tax treaty rate. For dividends
paid after 2000, a non-U.S. holder who claims the benefit of an applicable
income tax treaty rate generally will be required to satisfy applicable
certification and other requirements. However,
. in the case of common stock held by a foreign partnership, the
certification requirement will generally be applied to the partners of
the partnership and the partnership will be required to provide certain
information;
. in the case of common stock held by a foreign trust, the certification
requirement will generally be applied to the trust or the beneficial
owners of the trust depending on whether the trust is a foreign complex
trust, foreign simple trust, or foreign grantor trust as defined in the
U.S. Treasury regulations; and
. look-through rules will apply for tiered partnerships, foreign simple
trusts and foreign grantor trusts.
A non-U.S. holder which is a foreign partnership or a foreign trust is urged
to consult its own tax advisor regarding its status under these U.S. Treasury
regulations and the certification requirements applicable to it.
A non-U.S. holder that is eligible for a reduced rate of U.S. federal
withholding tax under an income tax treaty may obtain a refund or credit of any
excess amounts withheld by filing an appropriate claim for a refund with the
U.S. Internal Revenue Service.
Gain on Disposition of Common Stock
A non-U.S. holder generally will not be taxed on gain recognized on a
disposition of our common stock unless:
. the gain is effectively connected with the non-U.S. holder's conduct of
a trade or business in the United States and, in the event that an
income tax treaty applies, is also attributable to a permanent
establishment maintained by the non-U.S. holder in the United States; in
these cases, the gain will be taxed on a net income basis at the regular
graduated rates and in the manner applicable to U.S. persons, unless an
applicable treaty provides otherwise, and, if the non-U.S. holder is a
foreign corporation, the branch profits tax described above may also
apply;
. the non-U.S. holder is an individual who holds our common stock as a
capital asset, is present in the United States for more than 182 days in
the taxable year of the disposition and meets other requirements; or
. we are or have been a U.S. real property holding corporation for U.S.
federal income tax purposes at any time during the shorter of the five-
year period ending on the date of disposition or the period that the
non-U.S. holder held our common stock.
60
Generally, a corporation is a U.S. real property holding corporation if the
fair market value of its U.S. real property interests equals or exceeds 50% of
the sum of the fair market value of its worldwide real property interests plus
its other assets used or held for use in a trade or business. The tax relating
to stock in a U.S. real property holding corporation generally will not apply
to a non-U.S. holder whose holdings, direct and indirect, at all times during
the applicable period, constituted 5% or less of our common stock, provided
that our common stock was regularly traded on an established securities market.
We believe that we are not currently, and we do not anticipate becoming in the
future, a U.S. real property holding corporation.
Federal Estate Tax
Common stock owned or treated as owned by an individual who is a non-U.S.
holder at the time of death will be included in the individual's gross estate
for U.S. federal estate tax purposes, unless an applicable estate tax or other
treaty provides otherwise and, therefore, will be subject to U.S. federal
estate tax.
Information Reporting and Backup Withholding Tax
We must report annually to the U.S. Internal Revenue Service and to each
non-U.S. holder the amount of dividends paid to that holder and the tax
withheld from those dividends. Copies of the information returns reporting
those dividends and withholding may also be made available to the tax
authorities in the country in which the non-U.S. holder is a resident under the
provisions of an applicable income tax treaty or agreement.
Under some circumstances, U.S. Treasury regulations require additional
information reporting and backup withholding at a rate of 31% on some payments
on our common stock. Under currently applicable law, non-U.S. holders generally
will be exempt from these additional information reporting requirements and
from backup withholding on dividends paid prior to 2001 if we either were
required to withhold a U.S. federal withholding tax from those dividends or we
paid those dividends to an address outside the United States. After 2000,
however, the gross amount of dividends paid to a non-U.S. holder that fails to
certify its non-U.S. holder status in accordance with applicable U.S. Treasury
regulations generally will be reduced by backup withholding at a rate of 31%.
The payment of the proceeds from the disposition of our common stock by a
non-U.S. holder to or through the U.S. office of a broker generally will be
reported to the U.S. Internal Revenue Service and reduced by backup withholding
at a rate of 31% unless the non-U.S. holder either certifies its status as a
non-U.S. holder under penalties of perjury or otherwise establishes an
exemption and the broker has no actual knowledge to the contrary. The payment
of the proceeds from the disposition of our common stock by a non-U.S. holder
to or through a non-U.S. office of a non-U.S. broker will not be reduced by
backup withholding or reported to the U.S. Internal Revenue Service unless the
non-U.S. broker is a U.S. related person. In general, the payment of the
proceeds from the disposition of our common stock by or through a non-U.S.
office of a broker that is a U.S. person or a U.S. related person will be
reported to the U.S. Internal Revenue Service and, after 2000, may in limited
circumstances be reduced by backup withholding at a rate of 31%, unless the
broker receives a statement from the non-U.S. holder, signed under penalties of
perjury, certifying its non-U.S. status or the broker has documentary evidence
in its files that the holder is a non-U.S. holder and the broker has no actual
knowledge to the contrary. For this purpose, a U.S. related person is
generally:
. a controlled foreign corporation for U.S. federal income tax purposes;
. a foreign person 50% or more of whose gross income from all sources for
the three-year period ending with the close of its taxable year
preceding the payment, or for such part of the period that the broker
has been in existence, is derived from activities that are effectively
connected with the conduct of a U.S. trade or business; or
61
. effective after 2000, a foreign partnership if, at any time during the
taxable year, at least 50% of the capital or profits interest in the
partnership is owned by U.S. persons or the partnership is engaged in a
U.S. trade or business.
Non-U.S. holders should consult their own tax advisors regarding the
application of the information reporting and backup withholding rules to them,
including changes to these rules that will become effective after 2000.
Any amounts withheld under the backup withholding rules from a payment to a
non-U.S. holder will be refunded, or credited against the holder's U.S. federal
income tax liability, if any, provided that the required information or
appropriate claim for refund is furnished to the U.S. Internal Revenue Service.
62
UNDERWRITING
Under the terms and subject to the conditions contained in an underwriting
agreement dated , 2000, we have agreed to sell to the underwriters named
below, for whom Credit Suisse First Boston Corporation, J.P. Morgan Securities
Inc. and U.S. Bancorp Piper Jaffray Inc. are acting as representatives, the
following respective numbers of shares of common stock:
Number
Underwriter of Shares
----------- ---------
Credit Suisse First Boston Corporation............................
J.P. Morgan Securities Inc........................................
U.S. Bancorp Piper Jaffray Inc....................................
---
Total...........................................................
===
The underwriting agreement provides that the underwriters are obligated to
purchase all the shares of common stock in the offering if any are purchased,
other than those shares covered by the over-allotment option described below.
The underwriting agreement also provides that if an underwriter defaults the
purchase commitments of non-defaulting underwriters may be increased or the
offering may be terminated.
We have granted to the underwriters a 30-day option to purchase on a pro
rata basis up to additional shares from us at the initial public offering
price less the underwriting discounts and commissions. The option may be
exercised only to cover any over-allotments of common stock.
The underwriters propose to offer the shares of common stock initially at
the public offering price on the cover page of this prospectus and to selling
group members at that price less a selling concession of $ per share. The
underwriters and selling group members may allow a discount of $ per share
on sales to other broker/dealers. After the initial public offering, the public
offering price and concession and discount to broker/dealers may be changed by
the representatives.
The following table summarizes the compensation and estimated expenses we
will pay:
Per Share Total
----------------------------- -----------------------------
Without With Without With
Over-allotment Over-allotment Over-allotment Over-allotment
-------------- -------------- -------------- --------------
Underwriting Discounts
and
Commissions paid by
us..................... $ $ $ $
Expenses payable by us.. $ $ $ $
The representatives have informed us that the underwriters do not expect
discretionary sales to exceed 5% of the shares of common stock being offered.
We have agreed that we will not offer, sell, contract to sell, pledge or
otherwise dispose of, directly or indirectly, or file with the Securities and
Exchange Commission a registration statement under the Securities Act of 1933
relating to, any shares of our common stock or securities convertible into or
exchangeable or exercisable for any shares of our common stock, or publicly
disclose the intention to make any such offer, sale, pledge, disposition or
filing, without the prior written consent of Credit Suisse First Boston
Corporation for a period of 180 days after the date of this prospectus, subject
to exceptions set forth in the underwriting agreement.
63
Our officers, directors and substantially all of our stockholders and option
holders have agreed that they will not offer, sell, contract to sell, pledge or
otherwise dispose of, directly or indirectly, any shares of our common stock or
securities convertible into or exchangeable or exercisable for any shares of
our common stock, enter into a transaction that would have the same effect, or
enter into any swap, hedge or other arrangement that transfers, in whole or in
part, any of the economic consequences of ownership of our common stock,
whether any of these transactions are to be settled by delivery of our common
stock or other securities, in cash or otherwise, or publicly disclose the
intention to make any offer, sale, pledge or disposition, or to enter into any
of these types of transactions, swaps, hedges or other arrangements, without,
in each case, the prior written consent of Credit Suisse First Boston
Corporation for a period of 180 days after the date of this prospectus. If the
reported last sale price of our common stock on The Nasdaq Stock Market's
National Market is at least twice the offering price per share for 20 of the 30
trading days ending on the last trading day preceding the 90th day after the
date of this prospectus, then 25% of the shares of our common stock owned by
the officers, directors and stockholders described above and subject to the
180-day restriction described above, or shares, will be released from these
restrictions. The release of these shares will occur on one of the following
dates:
. if we publicly release our financial results for the above-mentioned
fiscal quarter prior to the 88 days after the date of this prospectus,
it will occur on the 91st day after the date of this prospectus; or
. if such release occurs on or after the 88th day after the date of this
prospectus, it will occur on the second trading day following the public
release of our financial results for the above-mentioned fiscal quarter.
The underwriters have reserved for sale, at the initial public offering
price, up to % of the shares of common stock offered pursuant to this
prospectus for employees, directors and other persons associated with us who
have expressed an interest in purchasing common stock in the offering. The
number of shares available for sale to the general public in the offering will
be reduced to the extent these persons purchase the reserved shares. Any
reserved shares not so purchased will be offered by the underwriters to the
general public on the same terms as the other shares.
We have agreed to indemnify the underwriters against liabilities under the
Securities Act, or contribute to payments that the underwriters may be required
to make in that respect.
We have applied to list the shares of common stock on The Nasdaq Stock
Market's National Market under the symbol "CVNI".
In connection with its services as placement agent for the Series D
convertible preferred stock financing, Credit Suisse First Boston Corporation
received a placement agent fee of approximately $4.4 million. In addition,
affiliates of Credit Suisse First Boston Corporation beneficially own an
aggregate of 179,370 shares of our Series D convertible preferred stock. These
shares will automatically convert into 179,370 shares of common stock upon the
closing of this offering.
Before this offering, there has been no public market for our common stock.
The initial public offering price will be determined by negotiation between the
representatives and us. The principal factors to be considered in determining
the public offering price include:
. the information in this prospectus or available to the underwriters;
. the history and the prospects for the industry in which we will
complete;
. the ability of our management;
. the prospects for our future earnings;
. the present state of our developments and our current financial
condition;
. the general condition of the securities markets at the time of this
offering; and
. the recent market prices of, and the demand for, publicly traded common
stock of generally comparable companies.
64
We cannot be sure that the initial offering price will correspond to the
price at which the common stock will trade in the public market following this
offering or that an active trading market for the common stock will develop and
continue after this offering.
In connection with this offering, the underwriters may engage in stabilizing
transactions, over-allotment transactions, syndicate covering transactions and
penalty bids in accordance with Regulation M under the Securities Exchange Act
of 1934.
. Stabilizing transactions permit bids to purchase the underlying security
so long as the stabilizing bids do not exceed a specified maximum.
. Over-allotment involves sales by the underwriters of shares in excess of
the number of shares the underwriters are obligated to purchase, which
creates a syndicate short position. The short position may be either a
covered short position or a naked short position. In a covered short
position, the number of shares over-allotted by the underwriters is not
greater than the number of shares that they may purchase in the over-
allotment option. In a naked short position, the number of shares
involved is greater than the number of shares in the over-allotment
option. The underwriters may close out any short position by either
exercising their over-allotment option or purchasing shares in the open
market.
. Syndicate covering transactions involve purchases of the common stock in
the open market after the distribution has been completed in order to
cover syndicate short positions. In determining the source of shares to
close out the short position, the underwriters will consider, among
other things, the price of shares available for purchase in the open
market as compared to the price at which they may purchase shares
through the over-allotment option. If the underwriters sell more shares
than could be covered by the over-allotment option -- a naked short
position -- the position can only be closed out by buying shares in the
open market. A naked short position is more likely to be created if the
underwriters are concerned that there could be downward pressure on the
price of the shares in the open market after pricing that could
adversely affect investors who purchase in the offering.
. Penalty bids permit the representatives to reclaim a selling concession
from a syndicate member when the common stock originally sold by the
syndicate member is purchased in a stabilizing or syndicate covering
transaction to cover syndicate short positions.
These stabilizing transactions, syndicate covering transactions and penalty
bids may have the effect of raising or maintaining the market price of the
common stock or preventing or retarding a decline in the market price of the
common stock. As a result, the price of the common stock may be higher than the
price that might otherwise exist in the open market. These transactions may be
effected on The Nasdaq Stock Market's National Market or otherwise and, if
commenced, may be discontinued at any time.
A prospectus in electronic format may be made available on the web sites
maintained by one or more of the underwriters participating in this offering.
The representatives may agree to allocate a number of shares to underwriters
for sale to their online brokerage account holders. Internet distributions will
be allocated by the underwriters that will make internet distributions on the
same basis as other allocations.
65
NOTICE TO CANADIAN RESIDENTS
Resale Restrictions
The distribution of the common stock in Canada is being made only on a
private placement basis exempt from the requirement that we prepare and file a
prospectus with the securities regulatory authorities in each province where
trades of common stock are made. Any resale of the common stock in Canada must
be made under applicable securities laws which will vary depending on the
relevant jurisdiction, and which may require resales to be made under available
statutory exemptions or under a discretionary exemption granted by the
applicable Canadian securities regulatory authority. Purchasers are advised to
seek legal advice prior to any resale of the common stock.
Representations of Purchasers
By purchasing common stock in Canada and accepting a purchase confirmation,
a purchaser is representing to us and the dealer from whom the purchase
confirmation is received that:
. the purchaser is entitled under applicable provincial securities laws to
purchase the common stock without the benefit of a prospectus qualified
under those securities laws,
. where required by law, the purchaser is purchasing as principal and not
as agent, and
. the purchaser has reviewed the text above under Resale Restrictions.
Rights of Action (Ontario Purchasers)
The securities being offered are those of a foreign issuer and Ontario
purchasers will not receive the contractual right of action prescribed by
Ontario securities law. As a result, Ontario purchasers must rely on other
remedies that may be available, including common law rights of action for
damages or rescission of rights of action under the civil liability provisions
of the U.S. federal securities laws.
Enforcement of Legal Rights
All of the issuer's directors and officers as well as the experts named
herein may be located outside of Canada and, as a result, it may not be
possible for Canadian purchasers to effect service of process within Canada
upon the issuer or such persons. All or a substantial portion of the assets of
the issuer and such persons may be located outside of Canada and, as a result,
it may not be possible to satisfy a judgment against the issuer or such persons
in Canada or to enforce a judgment obtained in Canadian courts against such
issuer or persons outside of Canada.
Notice to British Columbia Residents
A purchaser of common stock to whom the Securities Act (British Columbia)
applies is advised that such purchaser is required to file with the British
Columbia Securities Commission a report within ten days of the sale of any
common stock acquired by the purchaser pursuant to this offering. The report
must be in the form attached to British Columbia Securities Commission Blanket
Order BOR #95/17, a copy of which may be obtained from us. Only one report must
be filed for common stock acquired on the same date and under the same
prospectus exemption.
Taxation and Eligibility for Investment
Canadian purchasers of common stock should consult their own legal and tax
advisors with respect to the tax consequences of an investment in the common
stock in their particular circumstances and about the eligibility of the common
stock for investment by the purchaser under relevant Canadian legislation.
66
LEGAL MATTERS
The validity of the common stock offered hereby will be passed upon for us
by Hale and Dorr LLP, Boston, Massachusetts. H&D Investments 2000, a fund
affiliated with Hale and Dorr LLP, owns 6,116 shares of our Series D
convertible preferred stock. Legal matters for the underwriters will be passed
upon by Testa, Hurwitz & Thibeault, LLP, Boston, Massachusetts.
EXPERTS
The audited consolidated financial statements as of December 31, 1998 and
1999 and for the period from inception, May 6, 1998, to December 31, 1998 and
the year ended December 31, 1999, included in this prospectus and elsewhere in
the registration statement have been audited by Arthur Andersen LLP,
independent public accountants, as indicated in their report dated January 13,
2000 with respect thereto, and are included herein in reliance upon the
authority of said firm as experts in giving said report.
The consolidated financial statements of Hemisphere Investments, Inc. at
December 31, 1998 and 1999 and for each of the three years in the period ended
December 31, 1999, appearing in this prospectus and registration statement have
been audited by Ernst & Young LLP, independent auditors, as set forth in their
report thereon appearing elsewhere herein, and are included in reliance upon
such report given on the authority of such firm as experts in accounting and
auditing.
WHERE YOU CAN FIND MORE INFORMATION
We have filed with the Securities and Exchange Commission a registration
statement on Form S-1, including the exhibits and schedules to the registration
statement, under the Securities Act with respect to the shares to be sold in
this offering. This prospectus does not contain all the information set forth
in the registration statement. For further information with respect to us and
the shares to be sold in this offering, reference is made to the registration
statement. Statements contained in this prospectus as to the contents of any
contract, agreement or other document referred to, are not necessarily
complete, and in each instance reference is made to the copy of each contract,
agreement or other document filed as an exhibit to the registration statement.
You may read and copy all or any portion of the registration statement or
any reports, statements or other information we file at the Commission's public
reference room at Room 1024, Judiciary Plaza, 450 Fifth Street, N.W.,
Washington, D.C. 20549 and at the regional offices of the Commission located at
Seven World Trade Center, 13th Floor, New York, New York 10048 and 500 West
Madison Street, Suite 1400, Chicago, Illinois 60661. You can request copies of
these documents upon payment of a duplicating fee, by writing to the
Commission. Please call the Commission at 1-800-SEC-0330 for further
information on the operation of the public reference rooms. Our Commission
filings, including the registration statement, will also be available to you on
the Commission's Internet site (http://www.sec.gov).
67
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Convergent Networks, Inc. and Subsidiaries:
Report of Independent Public Accountants................................ F-2
Consolidated Balance Sheets as of December 31, 1998 and 1999, June 30,
2000 (Unaudited) and Pro Forma June 30, 2000 (Unaudited)............... F-3
Consolidated Statements of Operations for the Period from Inception (May
6, 1998) to December 31, 1998, for the Year Ended December 31, 1999 and
for the Six Months Ended June 30, 1999 and 2000 (Unaudited)............ F-4
Consolidated Statements of Redeemable Convertible Preferred Stock and
Stockholders' Equity (Deficit) for the Period from Inception (May 6,
1998) to December 31, 1998, for the Year Ended December 31, 1999, for
the Six Months Ended June 30, 2000 (Unaudited) and Pro Forma June 30,
2000 (Unaudited)....................................................... F-5
Consolidated Statements of Cash Flows for the Period from Inception (May
6, 1998) to December 31, 1998, for the Year Ended December 31, 1999 and
for the Six Months Ended June 30, 1999 and 2000 (Unaudited)............ F-6
Notes to Consolidated Financial Statements.............................. F-7
Hemisphere Investments, Inc. and Subsidiaries:
Report of Independent Auditors.......................................... F-24
Consolidated Balance Sheets as of June 30, 2000 (unaudited) and December
31, 1999 and 1998...................................................... F-25
Consolidated Statements of Operations for the six months ended June 30,
2000 and 1999 (unaudited) and for the years ended December 31, 1999,
1998 and 1997.......................................................... F-26
Consolidated Statements of Stockholders' Equity for the six months ended
June 30, 2000 (unaudited) and for the years ended December 31, 1999,
1998 and 1997.......................................................... F-27
Consolidated Statements of Cash Flows for the six months ended June 30,
2000 and 1999 (unaudited) and for the years ended December 31, 1999,
1998 and 1997.......................................................... F-29
Notes to Consolidated Financial Statements.............................. F-30
Convergent Networks, Inc. and Subsidiaries Unaudited Pro Forma Financial
Data:
Introduction to Pro Forma Financial Data................................ F-44
Pro Forma Condensed Consolidated Balance Sheet as of June 30, 2000
(Unaudited)............................................................ F-45
Pro Forma Condensed Consolidated Statement of Operations for the Year
Ended December 31, 1999 and for the Six Months Ended June 30, 2000
(Unaudited)............................................................ F-46
Notes to Unaudited Pro Forma Financial Data............................. F-48
F-1
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Stockholders and Board of Directors of
Convergent Networks, Inc.:
We have audited the accompanying consolidated balance sheets of Convergent
Networks, Inc. (a Delaware Corporation) and subsidiaries as of December 31,
1998 and 1999 and the related consolidated statements of operations, redeemable
convertible preferred stock and stockholders' equity (deficit), and cash flows
for the period from inception (May 6, 1998) to December 31, 1998 and the year
ended December 31, 1999. These financial statements are the responsibility of
Convergent Networks, Inc.'s management. Our responsibility is to express an
opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. 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 financial statements referred to above present fairly,
in all material respects, the financial position of Convergent Networks, Inc.
and subsidiaries as of December 31, 1998 and 1999 and the results of their
operations and their cash flows for the period from inception (May 6, 1998) to
December 31, 1998 and the year ended December 31, 1999 in conformity with
accounting principles generally accepted in the United States.
Boston, Massachusetts Arthur Andersen LLP
January 13, 2000
F-2
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31, Pro Forma
------------------------- June 30, June 30,
1998 1999 2000 200
----------- ------------ ------------ ------------
(unaudited) (unaudited)
Assets
Current assets:
Cash and cash
equivalents.......... $ 4,746,450 $ 21,507,673 $ 24,663,206 $ 98,463,206
Restricted
investments.......... -- 150,000 150,000 150,000
Inventory............. -- -- 3,094,484 3,094,484
Prepaid expenses and
other current
assets............... 1,000 176,282 120,641 120,641
----------- ------------ ------------ ------------
Total current
assets............. 4,747,450 21,833,955 28,028,331 101,828,331
Property and equipment,
net.................... 337,824 2,036,330 2,320,003 2,320,003
----------- ------------ ------------ ------------
Restricted investments.. -- 500,000 500,000 500,000
----------- ------------ ------------ ------------
$ 5,085,274 $ 24,370,285 $ 30,848,334 $104,648,334
=========== ============ ============ ============
Liabilities, Redeemable
Convertible Preferred
Stock and Stockholders'
Equity (Deficit)
Current liabilities:
Notes payable......... $ -- $ 564,409 $ 492,144 $ 492,144
Accounts payable...... 155,540 1,526,729 986,260 986,260
Accrued expenses...... 585,878 2,982,033 2,217,177 2,217,177
Deferred rent......... -- 192,213 432,770 432,770
Deferred revenue...... -- 59,789 271,496 271,496
----------- ------------ ------------ ------------
Total current
liabilities........ 741,418 5,325,173 4,399,847 4,399,847
----------- ------------ ------------ ------------
Notes payable, net of
current portion........ -- 943,285 695,446 695,446
----------- ------------ ------------ ------------
Commitments and
contingencies (Note 4)
Redeemable convertible
preferred stock, $0.01
par value:
Authorized--17,700,000
shares actual; none
pro forma............
Issued and
outstanding--
6,876,000, 16,938,887
and 16,977,527 shares
as of December 31,
1998 and 1999 and
June 30, 2000,
respectively; none
pro forma (at
redemption value).... 7,130,729 55,891,126 58,309,311 --
Preferred stock
subscriptions
receivable.......... -- (15,000,000) -- --
----------- ------------ ------------ ------------
7,130,729 40,891,126 58,309,311 --
----------- ------------ ------------ ------------
Stockholders' equity
(deficit):
Preferred stock, $0.01
par value:
authorized--
10,000,000 shares,
pro forma............ -- -- -- --
Common stock, $0.00001
par value--
Authorized--
50,000,000 shares
actual and
400,000,000 shares
pro forma...........
Issued--8,458,000,
14,426,000 and
19,425,100 shares as
of December 31, 1998
and 1999 and June
30, 2000,
respectively
and 48,182,553
shares pro forma.... 84 144 194 481
Additional paid-in
capital.............. 17,106 3,068,588 26,536,443 163,389,657
Treasury stock--
159,000, 2,791,000
and 2,903,500 shares
at cost as of
December 31, 1998 and
1999 and June 30,
2000, respectively
and 2,903,500 shares
pro forma............ (795) (132,395) (160,520) (160,520)
Accumulated deficit... (2,803,268) (25,191,230) (38,109,763) (42,853,953)
Deferred
compensation......... -- (512,531) (14,734,999) (14,734,999)
Common stock
subscriptions
receivable........... -- (21,875) (6,087,625) (6,087,625)
----------- ------------ ------------ ------------
Total stockholders'
equity (deficit)... (2,786,873) (22,789,299) (32,556,270) 99,553,041
----------- ------------ ------------ ------------
$ 5,085,274 $ 24,370,285 $ 30,848,334 $104,648,334
=========== ============ ============ ============
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Period from
Inception
(May 6, Six Months Ended June
1998) to Year Ended 30,
December 31, December 31, -------------------------
1998 1999 1999 2000
------------ ------------ ----------- ------------
(unaudited) (unaudited)
Revenues................ $ -- $ -- $ -- $ 1,826,739
Cost of revenues(1)..... -- -- -- 1,302,936
----------- ------------ ----------- ------------
Gross profit........ -- -- -- 523,803
----------- ------------ ----------- ------------
Operating expenses:
Research and
development(1)....... 2,181,884 13,067,158 4,035,543 5,268,144
Selling and
marketing(1)......... 163,121 3,522,903 936,397 2,990,181
General and
administrative(1).... 283,024 1,273,363 350,013 1,225,595
Stock-based
compensation......... -- 3,545,710 100,000 2,711,637
----------- ------------ ----------- ------------
Total operating
expenses........... 2,628,029 21,409,134 5,421,953 12,195,557
----------- ------------ ----------- ------------
Loss from
operations......... (2,628,029) (21,409,134) (5,421,953) (11,671,754)
Interest income......... 99,576 204,551 61,129 987,521
Interest expense........ -- 67,139 20,946 66,115
----------- ------------ ----------- ------------
Net loss............ (2,528,453) (21,271,722) (5,381,770) (10,750,348)
Accretion of dividends
on preferred stock..... (254,729) (1,066,817) (274,029) (2,168,185)
----------- ------------ ----------- ------------
Net loss
attributable to
common
stockholders....... $(2,783,182) $(22,338,539) $(5,655,799) $(12,918,533)
=========== ============ =========== ============
Basic and diluted net
loss per common share.. $ (4.87) $ (7.47) $ (2.79) $ (2.75)
=========== ============ =========== ============
Pro forma basic and
diluted net loss per
common share........... $ (1.11) $ (0.38)
============ ============
Weighted average common
shares outstanding:
Basic and diluted..... 571,500 2,991,313 2,028,025 4,695,592
=========== ============ =========== ============
Pro forma basic and
diluted.............. 19,168,342 28,610,480
============ ============
(1) Excludes non-cash,
stock-based
compensation as
follows:
Cost of revenues...... $ -- $ -- $ -- $ --
Research and
development.......... -- 1,713,599 -- 286,727
General and
administrative....... -- 276,242 100,000 2,006,386
Selling and
marketing............ -- 1,555,869 -- 418,524
----------- ------------ ----------- ------------
$ -- $ 3,545,710 $ 100,000 $ 2,711,637
=========== ============ =========== ============
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND
STOCKHOLDERS EQUITY (DEFICIT)
For the Period from Inception (May 6, 1998) to December 31, 1998 the Year
Ended December 31, 1999 and for the Six Months Ended June 30, 2000 and Pro
Forma June 30, 2000 (unaudited)
Stockholders' Equity (Deficit)
---------------------------------------------------------------------------------
Redeemable Convertible
Preferred Stock Common Stock Treasury Stock
------------------------- ------------------- --------------------
Carrying $0.00001 Additional
Amount, Par Paid-in Accumulated Deferred
Shares Net Shares Value Capital Shares Cost Deficit Compensation
----------- ------------ ---------- -------- ------------ ---------- --------- ------------ ------------
Inception (May 6,
1998)............ -- $ -- -- $-- $ -- -- $ -- $ -- $ --
Sale of common
stock........... -- -- 8,458,000 84 17,106 -- -- -- --
Sale of Series A
redeemable
convertible
preferred stock,
net of issuance
costs of
$20,086......... 6,876,000 6,876,000 -- -- -- -- -- (20,086) --
Repurchase of
common stock.... -- -- -- -- -- 159,000 (795) -- --
Accretion of
dividends on
redeemable
convertible
preferred
stock........... -- 254,729 -- -- -- -- -- (254,729) --
Net loss........ -- -- -- -- -- -- -- (2,528,453) --
----------- ------------ ---------- ---- ------------ ---------- --------- ------------ ------------
Balance, December
31, 1998......... 6,876,000 7,130,729 8,458,000 84 17,106 159,000 (795) (2,803,268) --
Sale of common
stock........... -- -- 3,530,000 36 344,164 -- -- -- --
Exercise of
common stock
options......... -- -- 2,438,000 24 362,676 -- -- -- --
Sale of Series A
redeemable
convertible
preferred
stock........... 100,000 100,000 -- -- -- -- -- -- --
Sale of Series B
redeemable
convertible
preferred stock,
net of issuance
costs of
$9,423.......... 4,133,892 9,879,998 -- -- -- -- -- (9,423) --
Sale of Series C
redeemable
convertible
preferred stock,
net of issuance
costs of
$40,000......... 5,564,142 20,999,983 -- -- -- -- -- (40,000) --
Issuance of
Series C
redeemable
convertible
preferred stock
in exchange for
services
received........ 264,853 1,713,599 -- -- -- -- -- -- --
Collection of
stock
subscriptions
receivable...... -- -- -- -- -- -- -- -- --
Deferred
compensation
related to stock
options and
capital stock... -- -- -- -- 2,344,642 -- -- -- (2,344,642)
Amortization of
deferred
compensation.... -- -- -- -- -- -- -- -- 1,832,111
Repurchase of
common stock.... -- -- -- -- -- 2,632,000 (131,600) -- --
Accretion of
dividends on
redeemable
convertible
preferred
stock........... -- 1,066,817 -- -- -- -- -- (1,066,817) --
Net loss........ -- -- -- -- -- -- -- (21,271,722) --
----------- ------------ ---------- ---- ------------ ---------- --------- ------------ ------------
Balance, December
31, 1999......... 16,938,887 40,891,126 14,426,000 144 3,068,588 2,791,000 (132,395) (25,191,230) (512,531)
Sale of common
stock
(unaudited)..... -- -- 4,544,500 45 6,151,955 -- -- -- --
Exercise of
common stock
options
(unaudited)..... -- -- 454,600 5 381,795 -- -- -- --
Sale of Series C
redeemable
convertible
preferred stock
(unaudited)..... 38,640 250,000 -- -- -- -- -- -- --
Collection of
stock
subscriptions
receivable
(unaudited)..... -- 15,000,000 -- -- -- -- -- -- --
Deferred
compensation
related to stock
options and
capital stock
(unaudited)..... -- -- -- -- 16,934,105 -- -- -- (16,934,105)
Amortization of
deferred
compensation
(unaudited)..... -- -- -- -- -- -- -- -- 2,711,637
Repurchase of
common stock
(unaudited)..... -- -- -- -- -- 112,500 (28,125) -- --
Accretion of
dividends on
redeemable
convertible
preferred stock
(unaudited)..... -- 2,168,185 -- -- -- -- -- (2,168,185) --
Net loss
(unaudited)..... -- -- -- -- -- -- -- (10,750,348) --
----------- ------------ ---------- ---- ------------ ---------- --------- ------------ ------------
Balance, June 30,
2000
(unaudited)...... 16,977,527 58,309,311 19,425,100 194 26,536,443 2,903,500 (160,520) (38,109,763) (14,734,999)
Sale of Series D
redeemable
convertible
preferred stock;
net of estimated
issuance costs
of $4,744,190
(unaudited)..... 4,803,926 78,544,190 -- -- -- -- -- (4,744,190) --
Conversion of
redeemable
convertible
preferred stock
into common
stock
(unaudited)..... (21,781,453) (136,853,501) 28,757,453 287 136,853,214 -- -- -- --
----------- ------------ ---------- ---- ------------ ---------- --------- ------------ ------------
Pro Forma
Balance, June
30, 2000
(unaudited)..... -- $ -- 48,182,553 $481 $163,389,657 2,903,500 $(160,520) $(42,853,953) $(14,734,999)
=========== ============ ========== ==== ============ ========== ========= ============ ============
Stock Total
Subscrip- Stockholders'
tions Equity
Receivable (Deficit)
------------ --------------
Inception (May 6,
1998)............ $ -- $ --
Sale of common
stock........... -- 17,190
Sale of Series A
redeemable
convertible
preferred stock,
net of issuance
costs of
$20,086......... -- (20,086)
Repurchase of
common stock.... -- (795)
Accretion of
dividends on
redeemable
convertible
preferred
stock........... -- (254,729)
Net loss........ -- (2,528,453)
------------ --------------
Balance, December
31, 1998......... -- (2,786,873)
Sale of common
stock........... (45,000) 299,200
Exercise of
common stock
options......... -- 362,700
Sale of Series A
redeemable
convertible
preferred
stock........... -- --
Sale of Series B
redeemable
convertible
preferred stock,
net of issuance
costs of
$9,423.......... -- (9,423)
Sale of Series C
redeemable
convertible
preferred stock,
net of issuance
costs of
$40,000......... -- (40,000)
Issuance of
Series C
redeemable
convertible
preferred stock
in exchange for
services
received........ -- --
Collection of
stock
subscriptions
receivable...... 23,125 23,125
Deferred
compensation
related to stock
options and
capital stock... -- --
Amortization of
deferred
compensation.... -- 1,832,111
Repurchase of
common stock.... -- (131,600)
Accretion of
dividends on
redeemable
convertible
preferred
stock........... -- (1,066,817)
Net loss........ -- (21,271,722)
------------ --------------
Balance, December
31, 1999......... (21,875) (22,789,299)
Sale of common
stock
(unaudited)..... (6,082,000) 70,000
Exercise of
common stock
options
(unaudited)..... -- 381,800
Sale of Series C
redeemable
convertible
preferred stock
(unaudited)..... -- --
Collection of
stock
subscriptions
receivable
(unaudited)..... 16,250 16,250
Deferred
compensation
related to stock
options and
capital stock
(unaudited)..... -- --
Amortization of
deferred
compensation
(unaudited)..... -- 2,711,637
Repurchase of
common stock
(unaudited)..... -- (28,125)
Accretion of
dividends on
redeemable
convertible
preferred stock
(unaudited)..... -- (2,168,185)
Net loss
(unaudited)..... -- (10,750,348)
------------ --------------
Balance, June 30,
2000
(unaudited)...... (6,087,625) (32,556,270)
Sale of Series D
redeemable
convertible
preferred stock;
net of estimated
issuance costs
of $4,744,190
(unaudited)..... -- (4,744,190)
Conversion of
redeemable
convertible
preferred stock
into common
stock
(unaudited)..... -- 136,853,501
------------ --------------
Pro Forma
Balance, June
30, 2000
(unaudited)..... $(6,087,625) $ 99,553,041
============ ==============
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Period from
Inception Six Months Ended June
(May 6, 1998) to Year Ended 30,
December 31, December 31, -------------------------
1998 1999 1999 2000
---------------- ------------ ----------- ------------
(unaudited) (unaudited)
Cash flows from
operating activities:
Net loss.............. $(2,528,453) $(21,271,722) $(5,381,770) $(10,750,348)
Adjustments to
reconcile net loss to
net cash used in
operating
activities--
Depreciation and
amortization....... 78,336 698,154 190,682 859,356
Stock-based
compensation....... -- 3,545,710 100,000 2,711,637
Changes in assets
and liabilities--
Inventory......... -- -- -- (3,094,484)
Prepaid expenses
and other current
assets........... (1,000) (175,282) (3,173) 55,641
Accounts payable.. 155,540 1,371,189 420,748 (540,469)
Accrued expenses.. 585,878 2,396,155 671,640 (764,856)
Deferred rent..... -- 192,213 -- 240,557
Deferred revenue.. -- 59,789 -- 211,707
----------- ------------ ----------- ------------
Net cash used in
operating
activities..... (1,709,699) (13,183,794) (4,001,873) (11,071,259)
----------- ------------ ----------- ------------
Cash flows from
investing activities:
Purchase of property
and equipment........ (416,160) (2,296,660) (807,405) (1,143,029)
Increase in restricted
investments.......... -- (650,000) -- --
----------- ------------ ----------- ------------
Net cash used in
investing
activities..... (416,160) (2,946,660) (807,405) (1,143,029)
----------- ------------ ----------- ------------
Cash flows from
financing activities:
Proceeds from sale of
redeemable
convertible preferred
stock, net of
issuance costs....... 6,855,914 30,930,558 100,000 250,000
Proceeds from sale of
common stock and
exercise of common
stock options........ 17,190 661,900 234,550 451,800
Proceeds from the
collection of
subscriptions
receivable........... -- 23,125 -- 15,016,250
Purchase of treasury
stock................ (795) (131,600) -- (28,125)
Borrowings on notes
payable.............. -- 1,472,665 848,125 --
Payments on notes
payable.............. -- (64,971) -- (320,104)
----------- ------------ ----------- ------------
Net cash
provided by
financing
activities..... 6,872,309 32,891,677 1,182,675 15,369,821
----------- ------------ ----------- ------------
Net increase (decrease)
in cash and cash
equivalents............ 4,746,450 16,761,223 (3,626,603) 3,155,533
Cash and cash
equivalents, beginning
of period.............. -- 4,746,450 4,746,450 21,507,673
----------- ------------ ----------- ------------
Cash and cash
equivalents, end of
period................. $ 4,746,450 $ 21,507,673 $ 1,119,847 $ 24,663,206
=========== ============ =========== ============
Supplemental disclosure
of noncash investing
and financing
activities:
Equipment acquired
with note payable.... $ -- $ 100,000 $ -- $ --
=========== ============ =========== ============
Common stock issued
for subscriptions
receivables.......... $ -- $ 45,000 $ -- $ 6,082,000
=========== ============ =========== ============
Accretion of dividends
on preferred stock... $ 254,729 $ 1,066,817 $ 274,029 $ 2,168,185
=========== ============ =========== ============
Series C preferred
stock issued for
subscriptions
receivable........... $ -- $ 15,000,000 $ -- $ --
=========== ============ =========== ============
Supplemental disclosure
of cash flow
information:
Cash paid during the
period for interest.. $ -- $ 67,139 $ 20,946 $ 66,115
=========== ============ =========== ============
The accompanying notes are an integral part of these consolidated financial
statements.
F-6
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(including data applicable to unaudited periods)
(1) Operations and Significant Accounting Policies
Convergent Networks, Inc. (the Company) was incorporated as a Delaware
corporation on May 6, 1998. The Company provides broadband voice infrastructure
products for the new public network. The Company designs, develops and markets
a new generation of carrier-class switching equipment and software that enable
service providers to deliver voice and data services over high-speed or
broadband networks. The Company's target customers are new and established
communications service providers, including local exchange and long distance
carriers and operators of foreign telephone networks.
The Company incurred net losses of approximately $2.5 million, $21.3 million
and $10.8 million for the period from inception (May 6, 1998) to December 31,
1998 and for the year ended December 31, 1999 and the six months ended June 30,
2000, respectively. At June 30 2000, the Company has an accumulated deficit of
approximately $38.1 million. During the six month ended June 30, 2000 the
Company commenced commercial shipment of its products and emerged from the
development stage. Although no longer in the development stage, the Company
continues to be subject to the risks and challenges similar to other companies
in a similar stage of development. These risks include, but are not limited to,
dependence on key individuals, dependence on contract manufacturers and key
suppliers of integral components, successful development and marketing of
products, the ability of next-generation service providers to raise sufficient
capital to purchase the Company's products, the ability to obtain adequate
financing to support growth, technological change and competition from
substitute products and larger companies with greater financial, technical,
management and marketing resources.
The accompanying consolidated financial statements reflect the application
of certain significant accounting policies as described in this note and
elsewhere in these notes to consolidated financial statements.
(a) Principles of Consolidation
The accompanying consolidated financial statements reflect the operations
and include the accounts of the Company and its wholly owned subsidiaries. All
significant intercompany transactions and balances have been eliminated in
consolidation.
(b) Unaudited Interim Financial Information
The financial statements as of June 30, 2000, and for the six months ended
June 30, 1999 and 2000 are unaudited but include all adjustments, consisting of
only normal recurring adjustments, that in the opinion of management are
necessary for a fair presentation of the Company's financial position,
operating results, and cash flows for such periods. Operating results for the
six-month period ended June 30, 2000 are not necessarily indicative of results
to be expected for the full fiscal year of 2000 or any future period. The
information disclosed in the notes to consolidated financial statements for
these periods is unaudited.
(c) Unaudited Pro Forma Presentation
The unaudited pro forma consolidated balance sheet as of June 30, 2000,
reflects the following:
. The automatic conversion of all outstanding shares of Series A, B and C
redeemable convertible preferred stock into 23,953,527 shares of common
stock which will occur upon the closing of the Company's proposed
initial public offering; and
. The sale of 4,803,926 shares of Series D redeemable convertible
preferred stock in September 2000, the receipt of approximately $73.8
million in net proceeds and the automatic conversion of those shares
into 4,803,926 shares of the Company's common stock upon the closing of
the Company's proposed initial public offering.
F-7
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
(d) Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States requires management to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
(e) Revenue Recognition
The Company recognizes revenue from product sales upon product shipment
provided that there are no uncertainties regarding acceptance, there is
persuasive evidence of an arrangement, the sales price is fixed or
determinable and collection of the related receivable is probable. If
uncertainties exist, the Company recognizes revenues when those uncertainties
are resolved. Revenues from support and maintenance contracts are recognized
ratably over the terms of the contracts. Amounts collected or billed prior to
satisfying the above revenue recognition criteria are reflected as deferred
revenue.
Warranty costs are estimated and recorded by the Company at the time of
product revenue recognition.
(f) Single Source Suppliers and Contract Manufacturers
Several key components of the Company's products are currently available
from single or limited sources. If the Company is unable to obtain sufficient
quantities of these components, it would be unable to manufacture and ship its
products on a timely basis. This could result in lost or delayed revenues,
damage to the Company's reputation and increased manufacturing costs.
The Company currently subcontracts the manufacturing and assembly of its
products and procurement of materials to independent manufacturers. The
Company does not have internal manufacturing capabilities. The Company's
reliance on contract manufacturers exposes it to a number of risks, including
reduced control over manufacturing capacity and component availability,
product completion and delivery times, product quality, manufacturing costs
and inadequate or excess inventory levels which could lead to product shortage
or charges for excess or obsolete inventory.
(g) Cash and Cash Equivalents
The Company considers all highly liquid investments purchased with an
original maturity of 90 days or less to be cash equivalents. The Company
accounts for its cash equivalents and short-term investments in accordance
with Statement of Financial Accounting Standards (SFAS) No. 115, Accounting
for Certain Investments in Debt and Equity Securities. All cash equivalents
are classified as held-to-maturity and are recorded at their amortized cost,
which approximates market.
F-8
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
(h) Inventory
Inventory is stated at the lower of cost (first-in, first-out) or market and
consists of the following at June 30, 2000 (unaudited):
Raw materials................................................... $ 94,812
Work-in-progress................................................ 1,266,046
Finished goods.................................................. 1,733,626
----------
$3,094,484
==========
(i) Property and Equipment
Property and equipment consists of the following:
December 31,
-------------------- June 30,
1998 1999 2000
-------- ---------- -----------
(unaudited)
Asset
Computer and office equipment........... $144,920 $ 897,837 $ 1,366,464
Furniture and fixtures.................. 101,315 262,184 225,497
Technology license...................... 136,319 195,053 195,053
Engineering equipment................... 33,606 1,457,746 2,168,835
-------- ---------- -----------
Cost.................................. 416,160 2,812,820 3,955,849
Accumulated depreciation and
amortization........................... (78,336) (776,490) (1,635,846)
-------- ---------- -----------
Property and equipment, net........... $337,824 $2,036,330 $ 2,320,003
======== ========== ===========
(j) Depreciation and Amortization
The Company provides for depreciation and amortization by charges to
operations on a straight-line basis in amounts estimated to allocate the cost
of the assets over their estimated useful lives, as follows:
Estimated
Asset Classification Useful Life
-------------------- -----------
Computer and office equipment.................................. 2 years
Furniture and fixtures......................................... 3 years
Technology license............................................. 2 years
Engineering equipment.......................................... 2 years
(k) Accrued Expenses
Accrued expenses consisted of the following:
December 31,
------------------- June 30,
1998 1999 2000
-------- ---------- -----------
(Unaudited)
Accrued accounts payable..................... $446,807 $1,410,708 $ 456,066
Accrued payroll and related expenses......... 78,034 883,985 799,851
Accrued professional fees.................... 44,130 280,953 280,300
Other........................................ 16,907 406,387 680,960
-------- ---------- ----------
$585,878 $2,982,033 $2,217,177
======== ========== ==========
F-9
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
(l) Software Development Costs
The Company accounts for its software development costs in accordance with
SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased
or Otherwise Marketed. Accordingly, the costs for the development of new
software and substantial enhancements to existing software are expensed as
incurred until technological feasibility has been established, at which time
any additional costs are capitalized. The Company believes technological
feasibility has been established at the time at which a working model of the
software has been completed. Because the Company believes its current process
for developing software is essentially completed concurrently with the
establishment of technological feasibility, no costs have been capitalized to
date.
(m) Concentration of Credit Risk and Significant Customers
Financial instruments that potentially expose the Company to concentrations
of credit risk consist mainly of cash and cash equivalents and accounts
receivable. The Company maintains its cash and cash equivalents principally in
domestic financial institutions of high credit standing. At December 31, 1998
and 1999 and June 30, 2000 the Company did not have any accounts receivable.
During the period from inception (May 6, 1998) to December 31, 1998 and for the
year ended December 31, 1999 the Company had no revenues. For the six months
ended June 30, 2000, the Company had one customer that accounted for 100% of
revenues and an affiliate of that customer is an investor in the Company.
(n) Fair Value of Financial Instruments
The Company's financial instruments consist mainly of cash and cash
equivalents, subscriptions receivable, accounts payable and a term loan. The
carrying amounts of these instruments approximate their fair value.
(o) Comprehensive Income (Loss)
The Company has adopted SFAS No. 130, Reporting Comprehensive Income. SFAS
No. 130 requires disclosure of all components of comprehensive income (loss),
on an annual and interim basis. Comprehensive income (loss) is defined as the
change in equity of a business enterprise during a period from transactions and
other events and circumstances from nonowner sources. Comprehensive net loss is
the same as the reported net loss for all periods presented.
(p) Net Loss Per Share
Basic and diluted net loss per share are presented in conformity with SFAS
No. 128, Earnings Per Share, for all periods presented. In accordance with SFAS
No. 128, basic and diluted net loss per share have been computed by dividing
the net loss attributable to common stockholders by the weighted-average number
of shares of common stock outstanding during the period, less shares subject to
repurchase. Basic and diluted net loss per share are the same because all
outstanding common stock options have been excluded as they are antidilutive
since the Company has incurred net losses for all periods presented. Options to
purchase a total of 1,003,200 and 1,251,600 common shares have been excluded
from the computations of diluted weighted average shares outstanding for the
year ended December 31, 1999, and for the six months ended June 30, 2000,
respectively. Shares of common stock issuable upon the conversion of
outstanding shares of redeemable convertible preferred stock have also been
excluded for all periods presented.
F-10
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
In accordance with Securities and Exchange Commission (SEC) Staff Accounting
Bulletin (SAB) No. 98, Earnings Per Share in a Public Offering, the Company has
determined that it has not had any issuances or grants for nominal
consideration.
The Company's historical capital structure is not indicative of its capital
structure after the proposed initial public offering due to the automatic
conversion of all shares of preferred stock into common stock concurrent with
the closing of the Company's proposed initial public offering. Accordingly, pro
forma net loss per share is presented for the year ended December 31, 1999 and
for the six months ended June 30, 2000, assuming the conversion of all
outstanding shares of Series A, B and C redeemable convertible preferred stock
into common stock upon the closing of the Company's initial public offering
using the if-converted method from the respective dates of issuance.
The following table reconciles the weighted average common shares
outstanding to the shares used in the computation of pro forma basic and
diluted net loss per share:
For the Year For the
Ended Six Months
December 31, Ended June 30,
1999 2000
------------ --------------
Weighted-average shares of common stock
outstanding.................................... 2,991,313 4,695,592
Assumed conversion of Series A, B and C
redeemable convertible preferred stock from the
date of issuance............................... 16,177,029 23,914,888
---------- ----------
Weighted-average shares used in computing pro
forma basic and diluted net loss per share..... 19,168,342 28,610,480
========== ==========
Pro forma basic and diluted loss per share have been computed by dividing
the Company's net loss by the above calculated weighted average shares
outstanding.
(q) Segment and Geographic Information
SFAS No. 131, Disclosures About Segments of an Enterprise and Related
Information established standards for reporting information about operating
segments in annual financial statements and requires companies to report
selected segment information in interim financial reports to stockholders. To
date the Company has viewed its operations and manages its business as one
segment. The Company had no revenues from customers outside of the United
States for the period from inception (May 6, 1998) to December 31, 1998, for
the year ended December 31, 1999 and for the six months ended June 30, 2000.
(r) Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133
establishes methods of accounting for derivative financial instruments and
hedging activities related to those instruments as well as other hedging
activities. The Company will be required to adopt SFAS No. 133 for its year
ending December 31, 2001. However, because the Company currently does not
utilize derivative financial instruments, the Company does not believe the
impact of SFAS No. 133 will be material to its financial position, results of
operations, or cash flows.
In December 1999, the SEC released SAB No. 101, Revenue Recognition in
Financial Statements. This bulletin summarizes some views of the staff on
applying accounting principles generally accepted in the United States to
revenue recognition in financial statements. The Company believes that its
current revenue recognition policy complies with SAB No. 101.
F-11
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
In March 2000, the FASB issued Interpretation No. 44, Accounting for Certain
Transactions Involving Stock Compensation--an Interpretation of APB Opinion No.
25. This interpretation clarifies the application of APB Opinion No. 25 in
certain situations, as defined. The interpretation is effective July 1, 2000,
but covers certain events occurring during the period after December 15, 1998
but before the effective date.
(2) Income Taxes
The Company accounts for federal and state income taxes in accordance with
SFAS No. 109, Accounting for Income Taxes. Under the liability method specified
by SFAS No. 109, deferred tax assets and liabilities are determined based on
the differences between the financial statement and tax bases of assets and
liabilities, using currently enacted tax rates.
No provision for federal or state income taxes has been recorded, as the
Company has incurred net operating losses for all periods presented.
As of December 31, 1999, the Company had federal and state net operating
loss carryforwards and research and development credits available of
approximately $20,800,000 and $88,000, respectively, to offset future taxable
income, if any. These carryforwards expire through 2019 and are subject to
review and possible adjustment by the Internal Revenue Service.
The U.S. Internal Revenue Code of 1986, as amended (the Code), contains
provisions that may limit the U.S. net operating loss and tax credit
carryforwards available to be used in any given year upon the occurrence of
certain events, including significant changes in the ownership interests, as
defined.
The components of the Company's net deferred tax assets are approximately as
follows:
December 31,
-----------------------
1998 1999
---------- -----------
Net operating loss carryforwards.................... $1,010,000 $ 8,362,000
Tax credit carryforwards............................ -- 88,000
Other temporary differences......................... (27,000) 488,000
---------- -----------
983,000 8,938,000
Valuation allowance................................. (983,000) (8,938,000)
---------- -----------
$ -- $ --
========== ===========
The Company has recorded a 100% valuation allowance against its gross
deferred tax assets at December 31, 1998 and 1999 because the future
realizability of such assets is uncertain.
(3) Notes Payable
(a) Equipment Line of Credit
During 1998, the Company entered into a $1,500,000 equipment line of credit
with a bank. All outstanding borrowings bear interest at the prime rate (8.50%
at December 31, 1999) plus 0.75% and are collateralized by substantially all
assets of the Company. In addition, the Company is required to comply with
certain financial and restrictive covenants regarding minimum levels of
tangible net worth. As of December 31, 1999 and June 30, 2000, the Company was
in compliance with all such covenants.
F-12
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
All equipment advances outstanding as of December 31, 1999 had been
converted into a term loan payable in 36 consecutive equal monthly principal
installments of $41,012. As of December 31, 1999, the Company has included
approximately $492,000 in current liabilities and approximately $943,000 in
long-term liabilities.
(b) Notes Payable
In October 1999, the Company purchased $100,000 of equipment from a vendor
in exchange for a $100,000 note payable. The note bears interest at a rate of
10% per annum, payable monthly. Final payment of the note was made in March
2000. As of December 31, 1999, the balance on this note was $72,265 and is
included in current liabilities.
(4) Commitments and Contingencies
(a) Operating Leases
The Company conducts its operations in leased facilities and is obligated
to pay monthly rent through August 2006. Rental expense charged to operations
in 1998, 1999 and for the six months ended June 30, 1999 and 2000 was
approximately $89,000, $519,000, $86,000 and $428,000, respectively.
Additionally, the Company maintains letters of credit totaling $650,000 as a
condition of its facility leases. The letters of credit have been fully
collateralized by certificates of deposit maintained at the bank that issued
the letters of credit. The certificates of deposit have been classified as
restricted investments in the accompanying consolidated balance sheet.
Future minimum rental payments under the lease as of December 31, 1999 are
approximately as follows:
Year Amount
---- ----------
2000............................................................ $1,107,000
2001............................................................ 1,332,000
2002............................................................ 1,404,000
2003............................................................ 1,477,000
2004............................................................ 1,549,000
Thereafter...................................................... 2,736,000
----------
Total......................................................... $9,605,000
==========
(b) Trade Name Infringement Claim
The Company received a letter from the counsel of Convergent Communications
on January 6, 2000 alleging that the Company's use of the name Convergent
Networks and the convergentnet.com domain name is an infringement of
Convergent Communications trademarks. The Company believes an adverse outcome
of this matter would not have a material impact on its financial condition or
results of operations.
(5) Redeemable Convertible Preferred Stock
At December 31, 1999 and June 30, 2000, the Company had 17,700,000
authorized shares of redeemable convertible preferred stock of which
7,000,000, 4,200,000 and 6,500,000 shares have been designated as Series A,
Series B and Series C redeemable convertible preferred stock, respectively.
F-13
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
During 1998, the Company sold 6,876,000 shares of Series A redeemable
convertible preferred stock (Series A Preferred Stock) at $1.00 per share,
resulting in net proceeds to the Company of approximately $6,856,000. In 1999,
the Company sold an additional 100,000 shares of Series A Preferred Stock for
net proceeds of $100,000.
During 1999, the Company sold 4,133,892 shares of Series B redeemable
convertible preferred stock (Series B Preferred Stock) at $2.39 per share
resulting in net proceeds to the Company of approximately $9,871,000.
In December 1999, the Company sold 5,564,142 shares of Series C redeemable
convertible preferred stock (Series C Preferred Stock) at $6.47 per share,
resulting in net cash proceeds to the Company of approximately $20,960,000 and
a note receivable of $15,000,000 which was paid in January 2000. In addition,
during 1999, the Company issued 264,853 shares of Series C Preferred Stock to
an affiliate of a customer in consideration for research and development and
other related services performed for us by that customer. These shares were
fully vested upon issuance. Accordingly, the Company has charged the fair
value of these shares, approximately $1,714,000, to its consolidated statement
of operations for the year ended December 31, 1999. In March 2000, the Company
sold an additional 38,640 shares of Series C Preferred Stock at $6.47 per
share for net proceeds of $250,000.
In September 2000, the Company sold 4,803,926 shares of Series D redeemable
convertible preferred stock at $16.35 per share for net proceeds of
approximately $73.8 million. (See Note 9(e).)
Redeemable convertible preferred stock outstanding consists of the
following:
December 31,
---------------------- June 30,
1998 1999 2000
---------- ----------- -----------
(Unaudited)
Series A, $0.01 par value--7,000,000
shares authorized, 6,876,000, 6,976,000
and 6,976,000 shares issued and
outstanding at December 31, 1998 and
1999 and June 30, 2000 (at redemption
value)................................. $7,130,729 $ 7,786,048 $ 8,062,795
Series B, $0.01 par value--4,200,000
shares authorized, 0, 4,133,892 and
4,133,892 shares issued and outstanding
at December 31, 1998 and 1999 and June
30, 2000 (at redemption value)......... -- 10,275,778 10,667,730
Series C, $0.01 par value--6,500,000
shares authorized, 0, 5,828,995 and
5,867,638 shares issued and outstanding
at December 31, 1998 and 1999 and June
30, 2000 (at redemption value)......... -- 37,829,300 39,578,786
---------- ----------- -----------
$7,130,729 $55,891,126 $58,309,311
========== =========== ===========
The rights, preferences and privileges of the Series A, Series B and Series
C Preferred Stock are listed below.
Dividends
The Company shall not declare or pay any dividends on shares of common
stock unless the holders of the Series A, Series B and Series C Preferred
Stock then outstanding receive an amount equal to the dividends declared or
paid on common stock.
Voting Rights
The Series A, Series B and Series C Preferred Stockholders are entitled to
vote on all matters with the common stockholders as if they were one class of
stock. The Series A, Series B and Series C Preferred
F-14
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
Stockholders are entitled to the number of votes equal to the number of shares
of common stock into which each share of the Series A, Series B and Series C
Preferred Stock is then convertible.
Liquidation
In the event of any voluntary or involuntary liquidation, dissolution or
winding-up of the corporation, as defined, the holders of the Series A, Series
B and Series C Preferred Stock then outstanding will be entitled to be paid an
amount equal to $1.00, $2.39 and $6.47 per share, respectively, plus any
dividends declared but unpaid on such shares prior to any payment to common
stockholders. Amounts remaining after the preference payment to the Series A,
Series B and Series C Preferred Stockholders, if any, will be shared on a
proportional basis among all stockholders, including the Series A, Series B and
Series C Preferred Stockholders, whose portion will be determined based on the
number of shares of common stock into which the Series A, Series B and Series C
Preferred Stock is convertible, provided however, that if on an as converted
basis, the holders of Series C Preferred Stock would receive more than $12.94
per share as their participation amount, then such holders would not be
entitled to receive their liquidation amount.
Conversion
Each share of Series A Preferred Stock is convertible at the option of the
holder, at any time, into two shares of common stock, adjusted for certain
dilutive events, as defined. Each share of Series B and Series C Preferred
Stock is convertible at the option of the holder, at any time, into one share
of common stock, adjusted for certain antidilutive events, as defined. In
addition, all shares of Series A, Series B and Series C Preferred Stock shall
be automatically converted into shares of common stock upon the closing of an
underwritten public offering in which the per share price to the public is not
less than $10.00 and the aggregate net proceeds are not less than $15 million
(See Note 9(e)).
Redemption Rights
The Company will be required to redeem, subject to certain conditions, on
July 1, 2004, July 1, 2005 and July 1, 2006 (each a Mandatory Redemption Date)
the percentage of Series A, Series B and Series C Preferred Stock, as listed in
the following table, at a price equal to $1.00, $2.39 and $6.47 per share,
respectively, plus an amount equal to 8% per annum from the original issue date
to the mandatory redemption date per share.
Mandatory Redemption
Date Portion of Shares of Preferred Stock to be Redeemed
-------------------- ---------------------------------------------------
July 1, 2004............ 33 1/3%
July 1, 2005............ 50%
July 1, 2006............ All shares then held
(6) Stockholders' Equity
(a) Common Stock
The Company has authorized 50,000,000 shares of common stock at June 30,
2000 (See Note 9).
(b) Stock Split
On June 29, 1999, the Company's Board of Directors approved a two-for-one
stock split of the Company's outstanding $0.00001 par value common stock, to be
effected in the form of a stock dividend payable on July 1, 1999 to
stockholders of record at the close of business on June 30, 1999. All share and
per share amounts for all periods presented have been retroactively adjusted to
reflect the two-for-one stock split.
F-15
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
(c) Reserved Shares
The Company has reserved the following number of shares of common stock for
the conversion of preferred stock:
Series A Preferred Stock........................................ 14,000,000
Series B Preferred Stock........................................ 4,200,000
Series C Preferred Stock........................................ 6,500,000
----------
24,700,000
==========
(d) Founders Shares
In 1998, the Company sold 2,540,000 shares of restricted common stock to its
senior vice president and 2,540,000 shares to another founding employee at
$0.00001 per share, which represented the fair value of the common stock. The
Company entered into stock repurchase agreements with its senior vice president
and the founding employee that provide for the immediate vesting to each
founder of 508,000 of these shares. In the event that the senior vice
president's or other founding employee's employment is terminated, the Company
has the right to repurchase, at $0.00001 per share through October 14, 2002,
the total number of shares that have not vested. The repurchase right on the
4,064,000 shares will lapse at the rate of 127,000 shares for each founder per
quarter beginning on October 14, 1998. As of June 30, 2000, 2,286,000 of these
shares were subject to repurchase.
(7) The 1998 Restricted Stock Purchase Plan and the 1998 Stock Option Plan
In July 1998, the Company's Board of Directors approved the 1998 Restricted
Stock Purchase Plan (the 1998 Stock Plan), which provides for the sale of
common stock to directors, officers, consultants and other key personnel.
Additionally, in July 1998, the Company's Board of Directors approved the 1998
Stock Option Plan, which provides for the granting of incentive stock options
(ISOs) and nonqualified stock options to employees, officers, directors,
advisors and consultants of the Company. The Company reserved an aggregate of
16,195,000 shares of common stock pursuant to these plans.
(a) Restricted Common Stock
Under the 1998 Stock Plan, the Board of Directors may authorize the sale of
common stock to key employees, directors and consultants of the Company. The
purchase price shall be determined by the Board of Directors. In addition, for
each grant, the Board of Directors will determine the terms under which the
Company may repurchase such shares.
During 1998 and 1999, the Company sold a total of 6,908,000 shares of
restricted common stock to various employees under the 1998 Stock Plan. The
6,908,000 shares were sold at prices ranging from $0.005--$0.50 per share. All
of these shares are subject to repurchase restrictions, which generally expire
over four to five years, except that upon a change of control, as defined,
approximately 30% of the original shares purchased are subject to acceleration
provisions. During 1998 and 1999, the Company repurchased 159,000 and 2,032,000
shares, respectively under the 1998 stock plan as a result of employee
terminations.
During 1999, the Company issued 180,000 shares of restricted common stock
under the 1998 Restricted Stock Purchase Plan to two employees in exchange for
recourse promissory notes in the amount of $45,000. As of December 31, 1999 and
June 30, 2000, the balance on these notes totaled $21,875 and $5,625,
respectively and is included in the accompanying consolidated financial
statements as stock subscriptions receivable.
F-16
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
During the six months ended June 30, 2000, the Company sold a total of
4,532,000 shares of restricted common stock to various employees at prices
ranging from $1.00--$3.00 per share. The Company received $100,000 in cash and
recourse promissory notes in the amount of $6,082,000 in consideration for
these shares. The promissory notes bear interest at a rate of 6.8% per year.
The promissory notes are due on the earlier of four years from the date of
employment or termination of employment, except with respect to $3,482,000 of
the promissory notes. (See Note 8(b)). The repurchase restrictions related to
1,050,000 shares generally expire over four years, except that upon a change of
control, as defined, approximately 30% of the original shares purchased are
subject to acceleration provisions. See Note 8(b) for repurchase restrictions
on 3,482,000 shares. The Company also repurchased 112,500 shares under the 1998
Stock Plan as a result of employee terminations.
As of June 30, 2000, 7,200,925 of the shares issued under the 1998 Stock
Plan were subject to repurchase by the Company at the original purchase price.
(b) Stock Options
Under the 1998 Stock Option Plan, the Board of Directors may grant ISO's and
nonqualified stock options to officers, employees, directors, consultants and
advisors of the Company. ISO's may be granted only to employees who do not own
stock representing more than 10% of the voting power or more than 10% of the
value of all classes of stock of the Company, unless the purchase price is at
least 110% of its fair value at the time the option is granted and the option
is not exercisable more than five years from the grant date. Nonqualified stock
options may be granted to officers, employees, consultants and advisors of the
Company. The Board shall determine the option price for nonqualified stock
options. All stock options issued under the 1998 Stock Option Plan expire 10
years from the date of grant.
Activity under the 1998 Stock Option Plan is summarized as follows:
Weighted
Average
Exercise
Price
Number of Price per per
Shares Share Share
---------- ----------- --------
Outstanding, May 6, 1998.................... -- $ -- $ --
Granted................................... 160,000 0.05 0.05
---------- ----------- -----
Outstanding, December 31, 1998.............. 160,000 0.05 0.05
Granted................................... 3,353,200 0.05--1.00 0.24
Exercised................................. (2,438,000) 0.05--0.50 0.15
Canceled.................................. (72,000) 0.05--0.50 0.19
---------- ----------- -----
Outstanding, December 31, 1999.............. 1,003,200 0.05--1.00 0.42
Granted................................... 845,000 1.00--4.00 3.15
Exercised................................. (454,600) 0.25--3.00 0.84
Canceled.................................. (143,000) 0.50--3.00 0.50
---------- ----------- -----
Outstanding, June 30, 2000.................. 1,250,600 $0.05--4.00 $2.10
========== =========== =====
Exercisable, June 30, 2000................ 971,100 $0.05--4.00 $1.55
========== =========== =====
Exercisable, December 31, 1999............ 985,200 $ 0.42 $0.42
========== =========== =====
Exercisable, December 31, 1998............ 160,000 $ 0.05 $0.05
========== =========== =====
Options granted under the 1998 Stock Option Plan generally vest over four to
five years, except that upon a change of control, as defined, approximately 30%
of the original stock options granted are subject to acceleration provisions.
Certain option grants are fully vested but shares of common stock issued
pursuant to such option exercises are subject to repurchase restrictions which
generally expire over four to five years, except that upon a change of control,
as defined, approximately 30% of the original shares purchased are subject to
acceleration provisions. During
F-17
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
1999, the Company repurchased 600,000 shares issued under the 1998 stock option
plan for $30,000. As of June 30, 2000, 1,698,000 shares are subject to
repurchase by the Company. As of June 30, 2000, the Company had 3,729,300
shares available for future grant under the 1998 Stock Option Plan.
The range of exercise prices for options outstanding and options exercisable
at June 30, 2000 are as follows:
Options Outstanding Options Exercisable
--------------------------------------------- ----------------------------
Range of Weighted Average
Exercise Options Remaining Weighted Average Options Weighted Average
Prices Outstanding Contractual Life Exercise Price Exercisable Exercise Price
-------- ----------- ---------------- ---------------- ----------- ----------------
$0.05--0.25 200,000 8.97 years $0.23 971,100 $1.55
0.50--3.00 564,100 9.43 years 1.11 -- --
4.00 486,500 9.95 years 4.00 -- --
----------- --------- ---------- ----- ------- -----
$0.05--4.00 1,250,600 9.56 years $2.10 971,100 $1.55
=========== ========= ========== ===== ======= =====
SFAS No. 123, Accounting for Stock-Based Compensation, which requires the
measurement of the fair value of stock options or warrants to be included in
the statement of operations or disclosed in the notes to the financial
statements. The Company has determined that it will account for stock-based
compensation for employees under Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and elect the disclosure-only
alternative under SFAS No. 123. Options granted have been valued for disclosure
purposes using the Black-Scholes option pricing model prescribed by SFAS No.
123. The weighted average assumptions used are as follows:
Six Months Ended
December 31, June 30,
-------------------- -------------------
1998 1999 1999 2000
--------- --------- -------- ---------
(unaudited)
Risk-free interest rate........... 4.65-4.78% 4.80-6.38% 4.8-6.05% 6.05-6.79%
Expected dividend yield........... 0.00% 0.00% 0.00% 0.00%
Expected lives.................... 7 years 7 years 7 years 7 years
Expected volatility............... 0.00% 0.00% 0.00% 0.00%
The effects of applying SFAS No. 123 would have been as follows:
Six Months Ended
December 31, June 30,
------------------------- -------------------------
1998 1999 1999 2000
----------- ------------ ----------- ------------
(unaudited)
Net loss--
As reported......... $(2,528,453) $(21,271,722) $(5,381,770) $(10,750,348)
Pro forma........... (2,548,506) (21,437,894) (5,391,208) (12,612,006)
The weighted average fair value of options granted during the period ended
December 31, 1998, the year ended December 31, 1999 and the six months ended
June 30, 2000 under the 1998 Stock Option Plan is $0.03, $.27 and $4.04 per
share, respectively. As of December 31, 1998 and 1999 and for the six months
ended June 30, 2000, the weighted average remaining contractual life of
outstanding options under the 1998 Stock Option Plan is 9.9 years, 9.6 years
and 9.6 years, respectively.
F-18
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
The Black-Scholes option pricing model was developed for use in estimating
the fair value of traded options that have no vesting restrictions and are
fully transferable. In addition, option pricing models require the input of
highly subjective assumptions, including expected stock price volatility.
Because the Company's stock options have characteristics significantly
different from those of traded options and because changes in the subjective
input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its stock options.
(c) Stock-based Compensation
In connection with certain stock option grants and stock sales during the
year ended December 31, 1999 and the six months ended June 30, 2000, the
Company recorded deferred compensation in the accompanying statements of
stockholders' equity (deficit) of $2,344,642 and $16,934,105, respectively. The
Company expects to record additional deferred compensation during the quarter
ending September 30, 2000 of approximately $8,944,000. The deferred
compensation represents the aggregate difference between the deemed fair value
of the Company's stock and the exercise price of stock options granted or the
selling price of stock sold, as applicable. The deferred compensation will be
recognized as an expense over the vesting period of the underlying common stock
and stock options using the accelerated method prescribed under FASB
Interpretation No. 28, Accounting for Stock Appreciation Rights and Other
Variable Stock Option or Award Plans--An Interpretation of APB Opinion Nos. 15
and 25.
The Company accelerated the vesting on two stock awards during the year
ended December 31, 1999 and recorded stock-based compensation expense of
approximately $1,639,740 as of the new measurement date, which occurred as a
result of the modification of the original stock award. During 1999, the
Company also recorded stock-based compensation expense of $100,000 in
connection with the sale of 100,000 shares of Series A Preferred Stock, which
represents the aggregate difference between the purchase price and the fair
market value of the preferred stock and approximately $1,714,000 in connection
with the issuance of 264,853 shares of Series C Preferred Stock to a related
party in exchange for services received.
The Company recorded total stock-based compensation expense of $3,545,710
and $2,711,637 in the year ended December 31, 1999 and the six months ended
June 30, 2000, respectively. The Company expects to record the following stock-
based compensation expense related to the above stock option grants and stock
sales during the period from July 1, 2000 to December 31, 2000 and during the
years ending December 31:
2000........................................................... $ 6,040,480
2001........................................................... 8,864,124
2002........................................................... 4,997,707
2003........................................................... 2,746,611
2004........................................................... 960,939
2005........................................................... 69,547
-----------
$23,679,408
===========
(8) Other Employee Arrangements
(a) Employee Benefit Plan
In August 1998, the Company adopted a 401(k) retirement plan (the 401(k)
Plan) for eligible employees, as defined. Each participant may elect to
contribute up to 12% of his or her compensation for the plan year, subject to
certain IRS limitations. At this time, the Company has decided not to make any
discretionary contributions to the 401(k) Plan during all periods presented.
F-19
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
(b) Employment Agreements
In September 2000, the Company entered into an employment agreement with its
Chief Executive Officer (CEO). The agreement provides for bonus and salary as
follows: base annual salary of $200,000, which will increase to $250,000 on
January 1, 2001; cash bonus of $275,000 upon consummation of an initial public
offering prior to January 1, 2002; and a cash bonus of up to $275,000 and
$300,000, if certain financial targets are met for fiscal years 2000 and 2001,
respectively.
In connection with the CEO's employment, the CEO purchased 3,482,000 shares
of restricted common stock, subject to vesting terms, as defined below. The
Company received recourse promissory notes in the amount of $3,482,000 in
consideration for these shares. The promissory notes bear interest at a rate of
6.8% per year and are payable as to $250,000 of the principal on the closing of
an initial public offering and as to $3,232,000 of the principal amount and all
accrued interest upon the earlier of March 31, 2002 or the termination of the
CEO's employment. The employment agreement provides that if the Company
completes an initial public offering prior to January 1, 2002 and the CEO
continues employment with the Company the principal on the promissory notes
will be forgiven as follows: $745,000 on September 1, 2001, $745,000 on January
1, 2002 and $1,492,000 on March 31, 2002. All principal on the promissory notes
will be forgiven upon a change of control, as defined.
The restricted stock vests as to 100,000 shares on February 15, 2000, as to
180,125 shares for each full three-month period beginning March 15, 2000
through March 15, 2002 during which the CEO is employed by the Company and for
an additional 1,441,000 shares on March 31, 2002, provided he is employed by
the Company at that time. Upon the completion of an initial public offering
before January 1, 2002, the restricted stock will immediately vest as to
250,000 shares, provided that the CEO is employed by the Company at that time
and the Company will record stock-based compensation expense of approximately
$465,000. The restricted stock will vest as to an additional 250,000 shares on
January 31, 2005, or on April 1, 2001 if the Company meets specified financial
targets for fiscal year 2000 as determined by the board of directors, provided
that the CEO is employed by us through December 31, 2000. If this occurs the
Company will record stock-based compensation expense of approximately $465,000.
If the Company terminates his employment with or without cause on or before
September 1, 2001, 50% of his unvested restricted stock will immediately vest.
The restricted stock will vest in full in the event of a change in control or
sale of the Company or if the Company terminates his employment with or without
cause after September 1, 2001.
Certain other officers of the Company have purchased restricted stock
subject to repurchase agreements or have been granted options to purchase
common stock, which provide for accelerated vesting upon the completion of an
initial public offering or the achievement of certain operating results for the
year ended December 31, 2000. If the Company completes its proposed initial
public offering, 25,000 shares of restricted common stock will vest immediately
and the Company will record stock-based compensation expense of approximately
$64,000. If the Company achieves certain operating results for the year ended
December 31, 2000, 25,000 shares of restricted common stock and options to
purchase 200,000 shares of common stock will immediately vest and the Company
will record stock-based compensation expense of approximately $922,000.
(9) Subsequent Events
(a) Acquisition
On July 31, 2000, the Company acquired Hemisphere Investments, Inc. and its
wholly owned subsidiaries including, Technology Control Services, Inc.
(collectively, TCS) for an aggregate of 10,106,845 shares of common stock in
consideration for all the outstanding capital stock of TCS, and reserved an
aggregate of 1,229,436 shares of the Company's common stock in connection with
the assumption of outstanding options to purchase capital stock of TCS and
assumed approximately $5.5 million of TCS debt, which was repaid upon
F-20
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
closing the transaction. 1,516,025 shares of common stock issued to
stockholders of TCS are currently held in escrow to secure certain
indemnification obligations of TCS and certain of its stockholders. The
acquisition was accounted for using the purchase method of accounting in
accordance with APB No. 16, Business Combinations. Accordingly, the operating
results of TCS will be included in the Company's financial results from the
date of the acquisition. The allocation of the purchase price to the fair value
of the assets acquired and liabilities assumed will be based on an independent
analysis of the fair value of the assets and liabilities of TCS. It is expected
that approximately $23 million of the purchase price will be recorded as
acquired in process technology in the third quarter of fiscal 2000. Goodwill
and other intangible assets of approximately $115 million will be amortized on
a straight-line basis over three years. Such allocations have been made based
upon currently available information and management estimates and accordingly,
the amounts presented here are subject to change.
The Company does not believe that pro forma operating results are indicative
of the future combined operating results. TCS provided service bureau and
systems integration services that entailed selling services, custom software
and associated hardware. The Company has refocused the efforts of TCS to
provide standard software products, has organized the acquired operations under
the name Applications Technology Group, and is phasing out the service bureau
and the resale of hardware products. As a result, the Company expects that the
acquired TCS operations will generate revenues significantly lower than those
generated by TCS in prior periods.
The unaudited pro forma combined results of operations are as follows:
Year Ended Six Months
December 31, Ended June
1999 30, 2000
------------ ------------
Revenues..................................... $ 7,109,574 $ 7,701,972
============ ============
Loss from continuing operations available to
common stockholders......................... $(71,305,246) $(36,478,252)
============ ============
Basic and diluted net loss per share......... $ (5.44) $ (2.46)
============ ============
On May 27, 1999, MCIWorldcom filed a lawsuit in the Circuit Court of the
17th Judicial Circuit in the State of Florida alleging breach of contract and
unjust enrichment by Technology Control Services and breach of guaranty by its
parent company Hemisphere Investments. MCI alleges that TCS breached two
contracts and was unjustly enriched by failing to pay for telecommunications
services allegedly rendered by MCI in connection with TCS' discontinued
business of the resale of voice traffic. MCI is seeking up to $3,227,487 in
damages, as well as costs and attorneys' fees. The Company intends to defend
itself vigorously against MCI's claim. TCS has also filed counter-claims
against MCI for breach of contract and intentional interference with business
relationships for an unspecified sum. However, there can be no assurance that
the Company will be successful in the defense of this litigation. The Company
may consider settlement due to the costs and uncertainties associated with
litigation in general, and the diversion of the time and attention of some
members of its management. In connection with the acquisition of TCS, fifteen
percent of the shares of common stock issued to stockholders of TCS have been
held in escrow to secure specified indemnification obligations of TCS and its
stockholders, including any damages the Company might incur as a result of the
MCI litigation.
(b) Warrants
On August 4, 2000 the Company issued a warrant to purchase 100,000 shares of
common stock at $12.00 per share to a potential customer. The warrant was fully
vested and exercisable on the date of issue and the warrant will expire on the
earlier of two years or the acquisition of the Company. On August 30, 2000, the
F-21
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
Company entered into a master purchase and license agreement with the potential
customer, pursuant to which, the potential customer has the ability but not the
obligation to purchase equipment from the Company. Although the master purchase
and license agreement does not contain any minimum purchase requirements, the
potential customer has issued purchase orders for the Company's products.
On September 18, 2000, the Company issued a warrant to purchase 50,000
shares of common stock at $16.35 per share to a potential customer. The warrant
was fully vested and exercisable on the date of issuance and will expire on the
earlier of two years or the acquisition of the Company. On September 15, 2000
the Company entered into a master purchase agreement with the potential
customer, pursuant to which, the potential customer has the ability but not the
obligation to purchase equipment from the Company. Although the master purchase
agreement does not contain any minimum purchase requirements, the potential
customer has issued purchase orders for the Company's products.
On September 22, 2000, the Company issued a warrant to purchase 90,000
shares of common stock at $16.35 per share to a potential customer. The warrant
was fully vested and exercisable on the date of issuance and will expire on the
earlier of two years or the acquisition of the Company.
The warrants were valued using the Black-Scholes option pricing model using
the following assumptions: 100% volatility, 5.5% risk-free interest rate, 0.0%
dividend yield and a 2 year expected life. As a result of the warrants being
fully vested and exercisable and not contingent upon future minimum purchases,
the value of the warrants, approximately $1,908,000, will be expensed in the
third quarter of fiscal 2000.
(c) 2000 Stock Incentive Plan
In September 2000, the Company's Board of Directors adopted the 2000 Stock
Incentive Plan (the 2000 Plan), subject to stockholder approval. The 2000 Plan
authorizes the issuance of up to 10,000,000 shares of common stock plus an
annual increase of shares beginning in 2001 equal to the lesser of:
. 15,000,000 shares;
. 4% of the outstanding shares of the Company's common stock on the date
of the increase; or
. an amount determined by the Board of Directors.
The 2000 Plan provides for the grant of ISO's, nonstatutory stock options,
restricted stock awards and other stock-based awards. Incentive stock options
may be granted under the 2000 Plan only to employees. Under the 2000 Plan, no
participant may receive an award for more than 1,000,000 shares, subject to
adjustment in the event of stock splits and other similar events, in any
calendar year.
The 2000 Plan is administered by the Board of Directors. The Board of
Directors approves the individuals to whom options will be granted and
determines the option exercise price and other terms of each award, subject to
the provisions of the 2000 Plan.
(d) 2000 Employee Stock Purchase Plan
In September 2000, the Company's Board of Directors adopted the 2000
Employee Stock Purchase Plan (the Stock Purchase Plan), subject to stockholder
approval. The Stock Purchase Plan authorizes the issuance of up to a total of
5,000,000 shares of the Company's common stock.
F-22
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(including data applicable to unaudited periods)
Under the terms of the Stock Purchase Plan, all employees, whose customary
employment is more than 20 hours per week, including directors who are
employees, and all employees of any participating subsidiaries, are eligible to
participate in the Stock Purchase Plan. Employees whom immediately after the
grant, own five percent or more of the total combined voting power or value of
all classes of stock of the Company or any subsidiary are not eligible to
participate in the Stock Purchase Plan.
The right to purchase common stock under the Stock Purchase Plan is made
available through a series of offerings. On the first day of an offering
period, the Company will grant to each eligible employee who has
elected to participate in the Stock Purchase Plan an option to purchase shares
of common stock. The employee may authorize between 1% and 10% of his or her
base pay to be deducted from his or her base pay during the offering period. On
the last day of the offering period, the employee will be deemed to have
exercised the option, at the option exercise price, to the extent of
accumulated payroll deductions. Under the terms of the Stock Purchase Plan, the
option price is an amount equal to 85% of the average market price per share of
the common stock on either the first day or last day of the offering period,
whichever is lower.
The Stock Purchase Plan is administered by the compensation committee of the
Board of Directors. The compensation committee may, in its discretion, choose
an offering period of six months or less for each offering and may choose a
different offering period for each offering.
(e) Series D Redeemable Convertible Preferred Stock
In September 2000, the Company issued 4,803,926 shares of Series D
redeemable convertible preferred stock (Series D Preferred Stock) at a price of
$16.35 per share, for net proceeds of approximately $73.8 million. In
connection with the issuance of the Series D Preferred Stock, the Company
amended its articles of Incorporation such that all shares of Series A, B, C
and D Preferred Stock shall be automatically converted into shares of common
stock upon the closing of an underwritten public offering in which the price
per share to the public is not less than $20.44 and the aggregate net proceeds
are not less than $50 million.
(f) Increase in Authorized Shares
On September 18, 2000, the Board of Directors approved an increase in the
number of shares of $0.01 par value redeemable convertible preferred stock from
17,700,000 shares to 22,600,000 shares and designated 4,900,000 shares as
Series D Preferred Stock.
On September 22, 2000, the Board of Directors approved an increase in the
number of common shares authorized to 400,000,000. In addition, 10,000,000
shares of $0.01 par value preferred stock were authorized.
(g) 1998 Stock Plan and 1998 Stock Option Plan
On September 22, 2000, the Board of Directors resolved that no additional
shares of common stock will be issued under the 1998 Stock Plan and that no
additional options to purchase common stock will be granted under the 1998
Stock Option Plan.
F-23
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors and Stockholders
of Hemisphere Investments, Inc.
We have audited the accompanying consolidated balance sheets of Hemisphere
Investments, Inc. and subsidiaries (the "Company") as of December 31, 1999 and
1998, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1999. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. 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 consolidated financial position
of Hemisphere Investments, Inc. and subsidiaries at December 31, 1999 and 1998,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 1999 in conformity with
accounting principles generally accepted in the United States.
The accompanying consolidated financial statements have been prepared
assuming that the Company will continue as a going concern. As discussed in
Note 2 to the financial statements, the Company's recurring operating losses
and working capital deficiencies raise substantial doubt about its ability to
continue as a going concern. Management's plans in regard to these matters,
which include raising additional capital, are also described in Note 2. The
financial statements do not include any adjustments to reflect the possible
future effects on the recoverability and classification of assets or the
amounts and classification of liabilities that might result from the outcome of
this uncertainty.
Ernst & Young LLP
Atlanta, Georgia
July 7, 2000
F-24
HEMISPHERE INVESTMENTS, INC.
CONSOLIDATED BALANCE SHEETS
December 31,
June 30, ------------------------
2000 1999 1998
----------- ----------- -----------
Assets: (Unaudited)
Current assets:
Cash and cash equivalents.............. $ 1,611,858 $ 1,064,252 $ 3,944,916
Trade accounts receivable, net of
allowance for doubtful accounts of
$78,185 at June 30, 2000 (unaudited)
and $23,919 and $42,780 at December
31, 1999 and 1998, respectively....... 1,396,859 877,861 541,561
Loan origination fees.................. -- -- 1,898,250
Uninstalled equipment.................. 2,255,950 460,126 370,446
Balance receivable on sale of
discontinued operation................ 273,107 273,107 --
Prepaid expenses and other current
assets................................ 332,954 468,680 206,129
----------- ----------- -----------
Total current assets.................... 5,870,728 3,144,026 6,961,302
Property and equipment:
Computer and telephone equipment....... 13,842,478 11,743,198 9,210,370
Furniture and equipment................ 388,179 382,573 334,095
Leasehold improvements................. 590,252 583,902 557,002
----------- ----------- -----------
14,820,909 12,709,673 10,101,467
Accumulated depreciation............... (8,097,736) (6,358,602) (3,431,469)
----------- ----------- -----------
6,723,173 6,351,071 6,669,998
Development costs, net of accumulated
amortization of $98,335 at June 30,
2000 (unaudited) and $32,709 at
December 31, 1999...................... 294,165 359,791 --
Other assets............................ 31,340 99,472 169,047
----------- ----------- -----------
Total assets............................ $12,919,406 $ 9,954,360 $13,800,347
=========== =========== ===========
Liabilities and stockholders' equity
(deficit)
Current liabilities:
Accounts payable....................... $ 4,908,938 $ 3,184,118 $ 1,824,976
Deferred revenue....................... 3,568,995 2,698,574 --
Accrued expenses....................... 2,220,684 2,123,205 886,167
Accrued future operating losses on
discontinued operations............... -- -- 4,600,000
Current installments of long-term
debt.................................. 4,029,029 3,773,205 2,007,552
Current installments of obligations to
related parties....................... 3,500,000 -- 5,000,000
Current installments of obligations
under capital leases.................. 543,853 399,032 260,076
----------- ----------- -----------
Total current liabilities............... 18,771,499 12,178,134 14,578,771
Long-term debt, excluding current
portion................................ 59,862 59,862 3,875,057
Obligations to related parties.......... -- 5,000,000 --
Obligations under capital leases,
excluding current portion.............. 153,467 320,113 216,842
----------- ----------- -----------
Total liabilities....................... 18,984,828 17,558,109 18,670,670
Commitments and contingencies
Stockholders' equity (deficit):
Preferred stock $.001 par value;
25,000,000 shares authorized;
5,856,488 shares issued and
outstanding at June 30, 2000
(unaudited) and December 31, 1999;
$1.14 per share liquidation
preference............................ 5,856 5,856 --
Common stock $.001 par value;
60,000,000 shares authorized;
36,186,230, 31,337,321 and 30,317,203
issued and outstanding at June 30,
2000 (unaudited), December 31, 1999
and 1998, respectively................ 36,186 31,337 30,317
Additional paid in capital............. 64,051,779 57,317,356 50,475,188
Deferred compensation.................. (1,375,000) -- --
Accumulated other comprehensive loss... (76,546) (66,385) (83,015)
Accumulated deficit.................... (68,707,697) (64,891,913) (55,105,697)
----------- ----------- -----------
(6,065,422) (7,603,749) (4,683,207)
Treasury stock, 70,000 shares at cost.. -- -- (187,116)
----------- ----------- -----------
Total stockholders' equity (deficit).... (6,065,422) (7,603,749) (4,870,323)
----------- ---------- -----------
Total liabilities and stockholders'
equity (deficit)....................... $12,919,406 $9,954,360 $13,800,347
=========== ========== ===========
See accompanying notes.
F-25
HEMISPHERE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
Six months ended June 30, Years ended December 31,
-------------------------- --------------------------------------
2000 1999 1999 1998 1997
------------ ------------ ----------- ------------ -----------
(Unaudited)
Net sales.............. $ 5,875,233 $ 3,072,838 $ 7,109,574 $ 6,093,164 $15,403,934
Cost of services....... 1,053,713 1,895,185 3,978,567 5,794,548 13,742,817
------------ ------------ ----------- ------------ -----------
Gross profit........... 4,821,520 1,177,653 3,131,007 298,616 1,661,117
General and
administrative........ 1,157,593 709,912 1,340,325 8,603,072 6,783,741
Research and
development........... 3,913,171 3,942,197 6,678,306 2,867,691 --
Selling and marketing.. 1,687,182 71,063 133,560 253,590 358,405
Depreciation and
amortization.......... 1,365,704 1,790,235 2,964,755 1,572,036 1,088,532
------------ ------------ ----------- ------------ -----------
Operating loss......... (3,302,130) (5,335,754) (7,985,939) (12,997,773) (6,569,561)
Other income (expense):
Gain on settlement of
litigation........... -- 2,775,259 2,775,259 -- --
Interest income....... 16,720 45,568 105,089 254,107 107,346
Interest expense...... (530,374) (1,504,452) (3,029,895) (566,560) (327,200)
------------ ------------ ----------- ------------ -----------
Loss from continuing
operations before net
loss from discontinued
operations............ (3,815,784) (4,019,379) (8,135,486) (13,310,226) (6,789,415)
Net loss from
discontinued
operations............ -- -- -- (5,537,233) --
Loss on disposal of
discontinued
operations............ -- (1,650,730) (1,650,730) (20,172,686) --
------------ ------------ ----------- ------------ -----------
Net loss............... $ (3,815,784) $ (5,670,109) $(9,786,216) $(39,020,145) $(6,789,415)
============ ============ =========== ============ ===========
See accompanying notes.
F-26
HEMISPHERE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
Accumulated
Preferred Stock Common Stock Additional Other Treasury Stock
---------------- --------------------- Paid-in Deferred Comprehensive -------------------
Shares Par Value Shares Par Value Capital Compensation Income (loss) Shares Value
------ --------- ---------- --------- ---------- ------------ ------------- -------- ---------
Balance at January 1, 1997.. -- $ -- 18,066,850 $18,066 $8,589,284 $ -- $23,709 (705,000) $(499,295)
Net loss...... -- -- -- -- -- -- -- -- --
Foreign
currency
translation
adjustment... -- -- -- -- -- -- (75,541) -- --
Total
comprehensive
loss.........
Conversion of
note payable
to
stockholder
to common
stock........ -- -- 1,250,000 1,250 1,998,750 -- -- -- --
Sale of common
stock........ -- -- 4,701,090 4,701 14,718,643 -- -- -- --
Common stock
issued for
services..... -- -- 2,461 3 8,859 -- -- -- --
Noncash
compensation
expense ..... -- -- -- -- 200,750 -- -- -- --
Common stock
repurchase
and
retirement... -- -- (705,000) (705) -- -- -- 705,000 499,295
Exercise of
stock
options...... -- -- 421,560 422 3,794 -- -- -- --
Exercise of
warrants..... -- -- 100,000 100 15,900 -- -- -- --
------ ------ ---------- ------- ---------- ------ ------- -------- ---------
Balance at
December 31,
1997........... -- -- 23,836,961 23,837 25,535,980 -- (51,832) -- --
Net loss...... -- -- -- -- -- -- -- -- --
Foreign
currency
translation
adjustment... -- -- -- -- -- -- (31,183) -- --
Total
comprehensive
loss......... -- --
Issuance of
common stock
in connection
with
acquisition.. -- -- 2,334,688 2,335 8,402,540 -- -- -- --
Sale of common
stock........ -- -- 3,988,888 3,989 14,356,008 -- -- -- --
Warrants
issued in
connection
with debt.... -- -- -- -- 2,020,000 -- -- -- --
Noncash
compensation
expense...... -- -- -- -- 135,750 -- -- -- --
Common stock
repurchase... -- -- -- -- -- -- -- (70,000) (187,116)
Exercise of
stock
options...... -- -- 156,666 156 24,910 -- -- -- --
------ ------ ---------- ------- ---------- ------ ------- -------- ---------
Balance at December 31, 1998.. -- -- 30,317,203 30,317 50,475,188 -- (83,015) (70,000) (187,116)
Total
Accumulated Stockholders'
Deficit Equity
------------ -------------
Balance at January 1, 1997.. $(8,797,547) $ (665,783)
Net loss...... (6,789,415) (6,789,415)
Foreign
currency
translation
adjustment... -- (75,541)
-------------
Total
comprehensive
loss......... (6,864,956)
Conversion of
note payable
to
stockholder
to common
stock........ -- 2,000,000
Sale of common
stock........ -- 14,723,344
Common stock
issued for
services..... -- 8,862
Noncash
compensation
expense ..... -- 200,750
Common stock
repurchase
and
retirement... (498,590) --
Exercise of
stock
options...... -- 4,216
Exercise of
warrants..... -- 16,000
------------ -------------
Balance at
December 31,
1997........... (16,085,552) 9,422,433
Net loss...... (39,020,145) (39,020,145)
Foreign
currency
translation
adjustment... -- (31,183)
-------------
Total
comprehensive
loss......... (39,051,328)
Issuance of
common stock
in connection
with
acquisition.. -- 8,404,875
Sale of common
stock........ -- 14,359,997
Warrants
issued in
connection
with debt.... -- 2,020,000
Noncash
compensation
expense...... -- 135,750
Common stock
repurchase... -- (187,116)
Exercise of
stock
options...... -- 25,066
------------ -------------
Balance at December 31, 1998.. (55,105,697) (4,870,323)
F-27
HEMISPHERE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY--(Continued)
Accumulated
Preferred Stock Common Stock Additional Other Treasury Stock
------------------- --------------------- Paid-in Deferred Comprehensive -------------- Accumulated
Shares Par Value Shares Par Value Capital Compensation Income (loss) Shares Value Deficit
--------- --------- ---------- --------- ------------ ------------ ------------- ------ ------- ------------
Net loss........ -- -- -- -- -- -- -- -- -- (9,786,216)
Foreign currency
translation
adjustment..... -- -- -- -- -- -- 16,630 -- -- --
Total
comprehensive
loss...........
Conversion of
note payable to
preferred
stock.......... 1,470,523 1,470 -- -- 1,674,926 -- -- -- -- --
Sale of Series A
preferred
stock.......... 4,385,965 4,386 -- -- 4,922,046 -- -- -- -- --
Sale of common
stock.......... -- -- 39,474 40 44,960 -- -- -- -- --
Treasury stock
retirement..... -- -- (70,000) (70) (187,046) -- -- 70,000 187,116 --
Noncash
compensation
expense........ -- -- -- -- 370,126 -- -- -- -- --
Additional
common stock
issued to
shareholder.... -- -- 833,333 833 (833) -- -- -- -- --
Exercise of
stock options.. -- -- 217,311 217 17,989 -- -- -- -- --
--------- ------- ---------- ------- ------------ ------------ --------- ------ ------- ------------
Balance at
December 31,
1999........... 5,856,488 5,856 31,337,321 31,337 57,317,356 -- (66,385) -- -- (64,891,913)
Net loss
(unaudited).... -- -- -- -- -- -- -- -- -- (3,815,784)
Foreign currency
translation
adjustment
(unaudited).... -- -- -- -- -- -- (10,161) -- -- --
Total
comprehensive
loss
(unaudited).... -- -- -- -- -- -- -- -- -- --
Conversion of
note payable to
Common stock... -- -- 4,385,965 4,386 4,995,614 -- -- -- -- --
Deferred stock
compensation
(unaudited).... -- -- -- -- 1,375,000 (1,375,000) -- -- -- --
Noncash
compensation
expense
(unaudited).... -- -- -- -- 110,000 -- -- -- -- --
Exercise of
warrants
(unaudited).... -- -- 250,000 250 249,750 -- -- -- -- --
Exercise of
stock options
(unaudited).... -- -- 212,944 213 4,059 -- -- -- -- --
--------- ------- ---------- ------- ------------ ------------ --------- ------ ------- ------------
Balance at June
30, 2000
(unaudited).... 5,856,488 $ 5,856 36,186,230 $36,186 $ 64,051,779 $ (1,375,000) $ (76,546) -- $ -- $(68,707,697)
========= ======= ========== ======= ============ ============ ========= ====== ======= ============
Total
Stockholders'
Equity
--------------
Net loss........ (9,786,216)
Foreign currency
translation
adjustment..... 16,630
--------------
Total
comprehensive
loss........... (9,769,586)
Conversion of
note payable to
preferred
stock.......... 1,676,396
Sale of Series A
preferred
stock.......... 4,926,432
Sale of common
stock.......... 45,000
Treasury stock
retirement..... --
Noncash
compensation
expense........ 370,126
Additional
common stock
issued to
shareholder.... --
Exercise of
stock options.. 18,206
--------------
Balance at
December 31,
1999........... (7,603,749)
Net loss
(unaudited).... (3,815,784)
Foreign currency
translation
adjustment
(unaudited).... (10,161)
--------------
Total
comprehensive
loss
(unaudited).... (3,825,945)
Conversion of
note payable to
Common stock... 5,000,000
Deferred stock
compensation
(unaudited).... --
Noncash
compensation
expense
(unaudited).... 110,000
Exercise of
warrants
(unaudited).... 250,000
Exercise of
stock options
(unaudited).... 4,272
--------------
Balance at June
30, 2000
(unaudited).... $ (6,065,422)
==============
See accompanying notes
F-28
HEMISPHERE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Six months ended June 30, Year ended December 31,
-------------------------- --------------------------------------
2000 1999 1999 1998 1997
------------ ------------ ----------- ------------ -----------
Cash flows from operating
activities
Net loss................. $ (3,815,784) $ (5,670,109) $(9,786,216) $(39,020,145) $(6,789,415)
Adjustments to reconcile
net loss to net cash
used in continuing
operating activities:
Depreciation and
amortization.......... 1,804,760 1,790,235 3,155,755 1,572,036 1,088,532
Non-cash compensation
expense............... 110,000 310,277 370,126 135,750 200,750
Amortization of loan
origination cost...... -- 1,015,458 1,898,250 121,750 --
Loss (gain) on disposal
of property and
equipment............. -- 846,869 846,869 (16,571) 104,914
Loss from discontinued
operations -- -- -- 5,537,233 --
Loss on disposal of
discontinued
operation............. -- 1,650,730 1,650,730 20,172,686 --
Changes in assets and
liabilities:
Trade accounts
receivable.......... (518,998) 22,777 (336,300) 1,688,467 (1,174,116)
Uninstalled
equipment........... (1,795,824) (119,617) (89,680) (370,446) --
Balance receivable on
sale of discontinued
operation........... -- (273,107) (273,107) -- --
Prepaid expenses and
other current
assets.............. 135,726 (1,305,407) (262,551) 128,265 (103,012)
Other assets......... 68,132 (31,778) 69,575 (23,577) (22,597)
Accounts payable..... 1,724,820 1,395,078 1,359,142 (993,525) 1,548,676
Deferred revenue..... 870,421 75,000 2,698,574 -- --
Accrued expenses..... 97,479 22,814 1,269,996 (1,107,585) 520,833
Accrued future
operating losses on
discontinued
operations.......... -- (1,650,730) (4,600,000) -- --
------------ ------------ ----------- ------------ -----------
Net cash used in
operating activities.... (1,319,268) (1,921,510) (2,028,837) (12,175,662) (4,625,435)
Cash flows from investing
activities
Acquisition, net of cash
acquired................ -- -- -- (139,966) --
Proceeds from sale of
equipment............... -- -- -- 66,454 22,834
Purchase of property and
equipment............... (2,111,236) (709,878) (3,149,899) (3,371,630) (2,906,071)
Deferred development
costs................... -- -- (359,791) -- --
------------ ------------ ----------- ------------ -----------
Net cash used in
investing activities of
continuing operations... (2,111,236) (709,878) (3,509,690) (3,445,142) (2,883,237)
Cash flows from financing
activities
Proceeds from issuance of
preferred stock......... -- -- 4,926,432 -- 14,723,344
Proceeds from issuance of
common stock............ -- -- 45,000 14,359,997 20,216
Proceeds from stock
option exercise......... 4,272 12,800 18,206 25,066 --
Proceeds from exercise of
warrants................ 250,000 -- -- -- --
Proceeds from long-term
debt.................... 500,000 1,639,765 1,639,765 -- --
Proceeds from borrowings
from related parties.... 3,500,000 -- -- 5,000,000 --
Purchase of treasury
stock................... -- -- -- (187,116) --
Repayment of borrowings.. (266,001) (2,125,797) (2,371,655) (2,860,060) (1,020,554)
------------ ------------ ----------- ------------ -----------
Net cash provided by
(used in) financing
activities of continuing
operations.............. 3,988,271 (473,232) 4,257,748 16,337,887 13,723,006
Effect of exchange rate
fluctuation on cash..... (10,161) 34,870 50,845 (33,756) (75,541)
Net cash used by
discontinued
operations.............. -- (675,493) (1,650,730) (4,033,998) --
------------ ------------ ----------- ------------ -----------
Net increase (decrease)
in cash and cash
equivalents............. 547,606 (3,745,243) (2,880,664) (3,350,671) 6,138,793
Cash and cash equivalents
at beginning of period.. 1,064,252 3,944,916 3,944,916 7,295,587 1,156,794
------------ ------------ ----------- ------------ -----------
Cash and cash equivalents
at end of period........ $ 1,611,858 $ 199,673 $ 1,064,252 $ 3,944,916 $ 7,295,587
============ ============ =========== ============ ===========
See accompanying notes.
F-29
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
1. Organization and Nature of Business
Description of Business
Hemisphere Investments, Inc. (the "Company") was formed in 1994 to develop
telecommunications software applications to enhance functionality related to
programmable switching technology. Software applications focus on enhanced
telecommunications capabilities in the convergence of voice and data
communications.
The Company has historically derived its primary sources of revenue from
facilities-based resellers of long distance services. The Company charges
switching fees or transaction fees for each minute of traffic that its
facilities process. In 1999, the Company began releasing its software
applications into the marketplace. In 1999 and going forward, the majority of
the Company's revenue will be derived from software sales.
2. Summary of Significant Accounting Policies
Basis of Presentation
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries Interglobe Telecommunications
(International), Plc., Interglobe Telecommunications (International), Inc. (see
note 3), Technology Control Systems, Inc., Technology Control Services, Inc.,
Technology Control Services (UK), Inc., European International Teleconsultants,
Ltd., Technology Controls Services (Hong Kong), Limited and Nicom, Inc. All
significant intercompany transactions and accounts have been eliminated in
consolidation.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates and such differences may be
material to the financial statements.
The estimated fair value of financial instruments has been determined by the
Company using available market information and appropriate valuation
methodologies. However, considerable judgment is required in interpreting data
to develop the estimates of fair value. Accordingly, the estimates presented
herein are not necessarily indicative of the amounts that the Company could
realize in a current market exchange. The fair value estimates presented in the
balance sheets herein are based on pertinent information available to
management as of the respective balance sheet dates. Although management is not
aware of any factors that would significantly affect the estimated fair value
amounts, such amounts have not been comprehensively revalued for purposes of
these financial statements since that date and current estimates of fair value
may differ significantly from the amounts presented herein.
Interim Financial Information (Unaudited)
The accompanying financial statements at June 30, 2000 and for the six
months ended June 30, 1999 and 2000 are unaudited but include all adjustments
(consisting of normal recurring accruals), which, in the opinion of management,
are necessary for a fair statement of the financial position and the operating
results and cash flows for the interim date and periods presented. Results for
the interim period ended June 30, 2000 are not necessarily indicative of
results for the entire year or future periods.
F-30
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
2. Summary of Significant Accounting Policies (continued)
Revenue Recognition
The Company designs and manufactures an advanced softswitch platform that
provides both call control and an open service creation environment that
enables the rapid delivery of carrier-class services and enhanced applications
like unified messaging and pre-paid calling card services.
Revenues from sales of software products are recognized when persuasive
evidence of an arrangement exists, delivery has occurred, the fee is fixed or
determinable and collectibility is probable in accordance with Statement of
Position 97-2, Software Revenue Recognition, as amended.
Where customers require significant customization of the software products,
the license and service fees are recognized as long-term contracts in
conformity with Accounting Research Bulletin No. 45, Long Term Construction
Type Contracts and Statement of Position 81-1, Accounting for Performance of
Construction-Type and Certain Production-Type Contracts.
Revenue related to ongoing production support services following the
completion of the initial production launch of the software is recognized as
the work is performed. Revenue from maintenance services are recognized
ratably over the term of the maintenance contract. Deferred revenue represents
revenue from customers in advance of the revenue being earned.
Cash and Cash Equivalents
The Company considers all highly liquid investments with original
maturities of three months or less when purchased to be cash equivalents.
Loan Origination Fees
The Company capitalized costs to obtain a Facility Agreement. These amounts
were amortized over the life of the loan. See Note 3 for further information.
Uninstalled Equipment
Uninstalled equipment consists of equipment received for future
installation. This equipment is stated at cost.
Property and Equipment
Property and equipment are stated at cost. Depreciation and amortization is
provided for financial reporting purposes using the straight line method over
the following estimated useful lives:
Computer and telephone equipment 2-7 years
Furniture and equipment 5 years
Leasehold improvements Term of lease
Repairs and maintenance are expensed as incurred. Replacements and
betterments are capitalized. Amortization of assets recorded under capital
leases is included with depreciation and amortization expense. Property and
equipment are periodically reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount may not be recoverable.
Total depreciation expense for the six months ended June 30, 2000 and 1999 was
$1,739,000 and $1,790,000, respectively. Total depreciation expense for 1999,
1998 and 1997 was $3,123,000, $2,133,000 and $1,089,000, respectively.
F-31
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
2. Summary of Significant Accounting Policies (continued)
Effective January 1, 1999, the Company prospectively revised the estimated
useful lives of computer and telephone equipment from seven to three years. The
decision to change the estimated service period for these assets was to conform
to industry standards and more accurately reflect the useful period of these
assets. This change in accounting estimate resulted in a $397,000 and $794,000
increase in depreciation expense for the six months ended and the year ended
December 31, 1999, respectively.
Impairment of Long-Lived Assets
The Company evaluates impairment of long-lived assets pursuant to Statement
of Financial Accounting Standard No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, which requires
impairment losses to be recorded on long-lived assets used in operations when
events or changes in circumstances indicate that the carrying amount of an
asset may not be recoverable. Management periodically evaluates property and
equipment for impairment whenever events or changes in circumstances indicate
the assets may be impaired.
This evaluation consists of comparing estimated future cash flows
(undiscounted and without interest charges) over the remaining life of the
asset to its carrying value. When such evaluation results in a deficiency, the
asset is written down to its estimated fair value.
Research and Development Costs
The Company accounts for its software development costs in accordance with
Statement of Financial Accounting Standard No. 86, Accounting for the Costs of
Computer Software to Be Sold, Leased or Otherwise Marketed. Accordingly, the
costs for the development of new software that is included in the hardware
products and substantial enhancements to such existing software are expensed as
incurred until technological feasibility has been established, at which time
any additional costs are capitalized. Capitalized costs are amortized over the
greater of the amount computed using (a) the ratio that current gross revenues
for a product bear to the total of current anticipated future gross revenues
for that product or (b) the straight-line method over the estimated economic
life of the related product (currently not to exceed three years). During 1999,
the Company capitalized approximately $393,000. Amortization expense was
approximately $66,000 for the six months ended June 30, 2000 and $33,000 for
the year ended December 31, 1999.
The Company determines technological feasibility has been established at the
time at which a working model of the software has been completed. Research and
development expenses consist primarily of salaries, benefits, equipment and
allocable overhead for software engineers, pre-production quality assurance
personnel, program managers and technical writers.
In July 1999, pursuant to an agreement with its largest customer, the
Company received a $2,500,000 non-refundable license fee for the purchase and
installation of certain test beds required for continued custom software
development. The agreement provided for payment within 45 days of receipt of
invoice and requires the Company to maintain the test bed such that it is
capable of testing the current release of the Company's unified messaging
application. The Company recognized revenues of $294,000 for the six months
ended June 30, 2000 and $294,000 for the year ended December 31, 1999. The
agreement will terminate in October of 2003.
Advertising Costs
Advertising costs are expensed in the period incurred. Total advertising
expenses were $73,000 and $2,000 for the six months ended June 30, 2000 and
1999, respectively. Total advertising expenses were approximately $6,000,
$150,000 and $152,000 for the years ended December 31, 1999, 1998 and 1997,
respectively.
F-32
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
2. Summary of Significant Accounting Policies (continued)
Income Taxes
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Such amounts are
measured using enacted tax rates and laws that are expected to be in effect
when the differences reverse.
Statements of Cash Flows
In April and May 1999, the Company received proceeds from loans amounting in
total to approximately $1,650,000. In July 1999, the notes together with
accrued interest were converted to 1,470,523 shares of Series A Preferred
Stock.
In June 2000, obligations to related parties of $5,000,000 were converted to
4,385,965 shares of common stock.
The Company has entered into capital lease agreements aggregating
approximately $568,000 and $101,000 for the years ended December 31, 1999 and
1998, respectively. These non-cash transactions are excluded from the
statements of cash flows; however, depreciation expense from the assets
recorded under such capital leases is included in the statements of cash flows.
Interest paid for the six months ended June 30, 2000 and 1999 was
approximately $249,000 and $235,000, respectively and for the years ended
December 31, 1999, 1998 and 1997 was approximately $1,054,000, $248,000 and
$349,000, respectively.
Foreign Currency Translation
The Company's United Kingdom subsidiaries consider the British pound to be
their functional currency. The Company considers its functional currency to be
the U.S. dollar. The foreign subsidiary's assets and liabilities are translated
at year-end rates of exchange and revenues and expenses are translated at the
average rates of exchange during the year.
Gains and losses resulting from currency translation are accumulated as a
separate component of stockholders' equity. Gains and losses resulting from
foreign currency transactions are included in the results of operations.
Accounting for Employee Stock Options
In October 1995, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation ("Statement 123"). Under Statement 123, the Company may continue
following existing accounting rules or adopt a new fair value method of valuing
stock-based awards.
The Company elected to continue following the existing accounting rules
under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
to Employees ("APB 25"), and related interpretations in accounting for its
employee stock options. The pro forma effect on the accompanying consolidated
statements of operations of adopting Statement 123 is presented in Note 7.
F-33
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
2. Summary of Significant Accounting Policies (continued)
Concentrations of Credit Risk
The Company received approximately 66%, 68% and 83% of its revenue from its
two largest customers for the years ended December 31, 1999, 1998 and 1997,
respectively.
Reclassifications
Certain items in the prior year consolidated financial statements have been
reclassified to conform to the current presentation.
Liquidity
Since its existence, the Company has been developing its core technology,
which has resulted in working capital deficiencies and recurring losses through
December 1999. The activities engaged in by the Company involve a high degree
of risk and uncertainty. Successful implementation of the Company's strategy
will depend upon many factors including among others, the need for additional
financing, the dependence on technology, acceptance and pricing of the
Company's services, the ability to meet Federal Communication Commission's
requirements and the competitive environment in the Company's marketplace. The
Company's ability to develop these operations may be impacted by uncertainties
related to technological change and obsolescence, product development,
competition and government regulations. As a result of the aforementioned
factors and the related uncertainties, there can be no assurance of the
Company's future success.
The Company must raise additional funds during the next 12 months to
maintain its operations and meet its debt service obligations. Capital
requirements including costs of development and start-up activities for the
Company will be significant.
While the Company believes that sufficient capital will be raised so that
the Company can maintain its operations and meet its debt service obligations,
there can be no assurances that such funds will be secured or have favorable
terms. Depending on their extent and timing, these factors, individual or in
the aggregate, could have a material adverse effect on the Company's financial
condition.
As a result of the aforementioned factors and the related uncertainties,
there is substantial doubt about the Company's ability to continue as a going
concern. The financial statements do not include any adjustments relating to
the recoverability and classification of asset carrying amounts or the amount
and classification of liabilities that might result from the outcome of this
uncertainty.
3. Investment in Interglobe Telecommunications (International). Plc.
On March 31, 1998, the Company acquired all of the outstanding capital stock
of Interglobe Telecommunications (International), Plc. ("Interglobe"), a
London, England based telecommunications company principally engaged in
providing long distance services from the sale of prepaid and post paid calling
cards.
The acquisition was accounted for under the purchase method of accounting.
The purchase price of Interglobe was approximately $18,471,000 consisting
primarily of $8,090,000 in seller notes payable, liabilities in excess of
assets acquired of $1,714,000, acquisition costs of $262,000, and 2,334,688
shares of the Company's common stock. The shares were valued at approximately
$8,405,000 based on the board of directors' estimate of the fair value of the
stock in the absence of a trading market for the stock.
F-34
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
3. Investment in Interglobe Telecommunications (International). Plc.
(continued)
As a result of Interglobe's deteriorating operating results, the Company
formalized its plan to discontinue the business on January 8, 1999. Interglobe
has been accounted for as a discontinued operation and, accordingly, the
results of its operations have been excluded from continuing operations in the
consolidated statements of operations for 1999 and 1998.
The Company recorded an estimated loss on disposal of $20,172,686 in 1998
associated with the divestiture of Interglobe. The loss was based upon expected
operating losses of $4,600,000 to be incurred during the phase-out period and
upon management's estimate of net realizable value based on contract
negotiations. The Company completed the sale in February 2000 and will receive
approximately $273,000 in proceeds from the ultimate sale of Interglobe. Based
upon the actual results of operations and proceeds upon disposal, the estimated
loss on disposal was increased by $1,650,730 and is reflected in the 1999
statement of operations.
Operating results of Interglobe for the years ended December 31, 1999 and
1998 were:
1999 1998
----------- -----------
Revenues......................................... $ 8,834,371 $ 8,850,919
Cost of services................................. 4,955,755 5,311,753
Loss from operations............................. (5,693,333) (5,536,280)
Net loss......................................... (5,695,728) (5,537,233)
The net assets and liabilities of the discontinued operations consist of the
following at December 31, 1999 and 1998:
1999 1998
---------- ----------
Cash................................................ $ 325,406 $1,049,132
Accounts receivable................................. 1,200,826 2,748,777
Inventories......................................... 113,924 113,924
Other current assets................................ 157,870 185,853
---------- ----------
Total current assets................................ 1,798,026 4,097,686
Property and equipment.............................. 1,363,483 1,401,404
---------- ----------
Total assets........................................ $3,161,509 $5,499,090
========== ==========
Accounts payable.................................... $4,376,751 $5,887,393
Other current liabilities........................... 2,304,350 1,369,956
Long-term debt...................................... -- 288,488
---------- ----------
Total liabilities................................... $6,681,101 $7,545,837
========== ==========
Net liabilities..................................... $3,519,592 $2,046,747
========== ==========
F-35
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
4. Long-Term Debt
Long-term debt consists of the following:
June 30, December 31,
----------- ---------------------
2000 1999 1998
----------- ---------- ----------
(Unaudited)
Notes payable on March 31, 2000 with interest
at 8% per annum with quarterly interest
payments.................................... $3,529,029 $3,773,205 $3,815,195
Notes payable upon demand by holder after
September 30, 1998. Interest accrues at
5.25% per annum with quarterly interest
payments.................................... -- -- 2,007,552
Convertible note payable upon demand by
holder. Interest accrues at 10% per annum
with interest due upon maturity............. 500,000 -- --
Financing received for research and
development payable May 1, 2003 unless
certain financial criteria are met by the
Company. Interest accrues at prime plus 1%
(9.5% at December 31, 1999) per annum with
semi-annual interest payments............... 59,862 59,862 59,862
---------- ---------- ----------
Total........................................ 4,088,891 3,833,067 5,882,609
Less current portion......................... 4,029,029 3,773,205 2,007,552
---------- ---------- ----------
$ 59,862 $ 59,862 $3,875,057
========== ========== ==========
In connection with the purchase of Interglobe, the Company held notes
payable in the amount of $3,773,205 payable to the sellers of Interglobe ("Note
Holders"). The notes accrued interest of 8% per annum with quarterly interest
payments and were payable on March 31, 2000. An event of default due to non-
payment occurred on March 31, 2000 in respect of the notes between the Company
and the Note Holders. Pursuant to an extension agreement dated May 25, 2000,
the Note Holders agreed to forbear the event of default subject to a payment
plan and the issuance of warrants to purchase up to 99,600 shares of common
stock at the exercise price of $.01. The payment plan calls for periodic
payments by the Company through September 30, 2000 and restricts the Company
from borrowing additional funds without the Note Holders consent.
5. Obligations to Related Parties
On December 9, 1998, the Company executed a Facility Agreement with Nomura
International Plc., Ramot AG, and another shareholder for $5 million. The term
of the facility was for one year with a 12% per annum rate of interest.
Interest payments were due on December 9, 1999. Additionally, the lenders were
granted warrants to purchase an aggregate of 2,000,000 shares of Common Stock
at an exercise price of $.001 per share. Such warrants were immediately
exercisable with an expiration date five years from the executed date of the
agreement.
The warrants were granted at less than the fair market value of the stock as
determined by the Company. As a result, the Company recorded approximately $2.0
million of loan origination fees associated with the warrants in 1998 which
were amortized over the life of the loan. Under the terms of the Facility
Agreement, substantially all of the assets and stock of the Company have been
used to secure the debt. On January 13, 2000, the Company issued convertible
promissory notes to other investors (collectively, the "Holders") for a total
principal amount of $5,000,000 and used the principal received to repay the
existing bridge loan facility. Interest on the promissory notes accrued at the
rate of 12% per annum and the loan is payable on January 13, 2001. As
additional consideration, the Company issued the Holders warrants to purchase
up to 250,000 shares of Common Stock at an exercise price of $1.00. The Holders
have the right to convert all outstanding
F-36
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
5. Obligations to Related Parties (Continued)
principal debt to common stock of the Company upon the occurrence of certain
events at a purchase price per share determined in accordance with such
agreement. In accordance with the terms of the promissory notes, the Holders
elected to convert the $5 million principal amount into common stock of the
Company during June 2000. Upon such conversion, one of the Holders provided a
loan to the Company of an additional $2.5 million. Principal and interest on
the $2.5 million loan is not convertible. Interest accrued at the rate of 12%
per annum.
From April 27, 2000, to May 28, 2000, the Company entered into convertible
promissory notes with Portil AG and another shareholder for $1 million. The
notes were payable upon 30 days written notice and accrued interest at the rate
of 10% per annum. The notes were convertible at the election of the Lender. The
Lenders have elected to convert their Notes into shares of the Company's common
stock.
6. Income Taxes
The Company's deferred income tax assets and liabilities are as follows:
December 31
------------------------
1999 1998
----------- -----------
Deferred income tax liabilities:
Depreciation.................................... $ 179,155 $ 263,629
Deferred income tax assets:
Accrued bonus................................... 115,790 --
Deferred revenue................................ 808,511 --
Research & development credit................... 318,056 --
Net operating loss carryforwards................ 13,682,504 10,162,245
Other........................................... 394,526 634,526
----------- -----------
Total deferred income tax assets................. 15,319,387 10,796,771
Valuation allowance for deferred income tax
assets.......................................... (15,140,232) (10,533,142)
----------- -----------
Net deferred income tax assets................... 179,155 263,629
----------- -----------
Net deferred income taxes........................ $ -- $ --
=========== ===========
At December 31, 1999, the Company has U.S. and U.K. net operating loss
carryforwards for federal income tax purposes of approximately $32,495,000 and
$5,531,000, respectively, which are available to offset future federal taxable
income, if any, through 2018.
The actual income tax expense attributable to earnings from continuing
operations differed from the amounts computed by applying the statutory federal
income tax rate of 34% to pretax earnings from continuing operations as a
result of the following:
December 31
------------------------
1999 1998
----------- -----------
Federal income taxes at statutory rate............. $(2,766,065) $(4,525,477)
State tax, net of federal benefit.................. (244,065) (399,307)
Change in valuation allowance...................... 3,132,643 4,868,220
Research and development costs..................... (318,056) --
Other.............................................. 195,543 56,564
----------- -----------
$ -- $ --
=========== ===========
F-37
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
7. Stockholders' Equity
Preferred Stock Issuances
On July 7, 1999, the Company issued 4,385,965 shares of Series A Preferred
Stock for an aggregate amount of approximately $4,926,000, net of expenses of
$74,000. In conjunction to this transaction, debt of $1,676,396 including
accrued interest was converted into 1,470,523 shares of Series A Preferred
Stock.
Holders of shares of Series A Preferred Stock are entitled to the following:
(1) In the event of any liquidation, dissolution or winding up of the
corporation, receive, prior and in preference to any distribution of any of the
assets of the Corporation to the holders of Common Stock, an amount equal to
$1.14 for each outstanding share of preferred stock; (2) The merger,
consolidation or acquisition of the Corporation with or into another
corporation, which results in the exchange of outstanding shares for securities
or other consideration issued or paid shall be deemed to be a liquidation,
dissolution or winding up of the Corporation. The amount deemed distributed to
the holders of preferred stock shall be the cash or the value of the property,
rights and/or securities distributed to such holders by the acquiring party;
(3) Each preferred share shall be convertible, at the option of the holder, at
any time after the date of issuance of such share into such number of fully
paid and non-assessable shares of Common Stock as is determined by dividing (a)
the Original Series A Issue Price by (b) the conversion price, as defined,
applicable to such share, in effect on the date that the certificate is
surrendered for conversion; (4) There is automatic conversion into Common Stock
upon the earlier to occur of (a) the Corporation's sale of its common stock in
a firm commitment underwritten public offering in which the Corporation is to
receive aggregate cash proceeds in excess of $25 million and the public
offering price of which is not less than $5.50 per share or (b) the date
specified by written consent or agreement of the holders of a majority of the
then outstanding preferred stock; (5) The preferred stockholder shall have the
right to one vote for each share of Common Stock into which such Series A
preferred stock could then be converted, with powers equal to the voting rights
and powers of the holders of the Common Stock.
At December 31, 1999, warrants to purchase 75,000 shares of Series A
Preferred Stock were issued at an exercise price of $1.43 per share. The
warrants expire three years from the date of issuance.
Common Stock Issuances
During March through August 1998, the Company issued an aggregate of
3,988,888 shares of common stock at $3.60 per share. The proceeds to the
Company were $14,359,997. On August 21, 1999, the Company issued a further
833,333 shares of common stock in connection with this offering as a result of
certain financial and performance targets not being met.
Stock Option Plan
In October 1996, the Company adopted the 1996 Employee Stock Option
Incentive Plan ("the Plan"), which provides for the granting to directors,
officers, key employees and consultants up to 6,645,007 and 6,270,007 shares of
common stock at June 30, 2000 (unaudited) and December 31, 1999, respectively.
Options for 6,012,667 and 5,637,667 shares at June 30, 2000 (unaudited) and
December 31, 1999, respectively are governed by the Hemisphere Investments plan
under which grants of options may be incentive stock options and will be at
such exercise prices, in such amounts, and upon such terms and conditions, as
determined by the stock option committee under the Plan (such committee is
comprised of several members of the board of directors). In October 1996, the
Company's directors set aside 1,969,623 shares for issuance under
F-38
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
7. Stockholders' Equity (Continued)
Stock Option Plan (Continued)
the Plan. On April 20, 1998, the Company's Board of Directors increased the
number of options available under the Hemisphere Investments plan from
1,969,623 options to 3,343,198 options. On October 5, 1998, the Company's Board
of Directors increased the number of options available under the Hemisphere
Investments' plan from 3,343,198 options to 3,565,420 options. On September 16,
1999, the number of options available under the Hemisphere Investments' plan
was increased from 3,565,420 to 5,637,667. On June 12, 2000, the
number of options available under the Hemisphere Investments' plan was
increased from 5,637,667 to 6,012,667. Each of the foregoing increases to the
Plan were subsequently approved and ratified by a majority of the shareholders.
However, with respect to incentive stock options, the option exercise price may
not be less than 100 percent of the market value at the time of grant (110
percent if the incentive stock option is granted to a 10 percent or more
stockholder) and the term of any option may not exceed ten years.
The remaining 632,340 options are governed by the McCarthy plan under which
the grants of options will be at such exercise prices, in such amounts, and
upon such terms and conditions, as determined by the Stock Option committee
under the McCarthy Plan (such committee is comprised of those Directors of the
Board who represent McCarthy Corporation's interest in the Company). All
options available under the McCarthy Plan had been issued to members of the
stock option committee at a stock option exercise price of $0.01.
The following table summarizes all option activity:
Options Weighted-
Available Average
for Future Number of Exercise
Grant Shares Price
---------- --------- ---------
Balance as of December 31, 1996............ 804,623 1,797,340 $0.11
Granted................................... (684,000) 684,000 2.45
Exercised................................. -- (421,560) 0.04
Canceled/forfeited........................ 10,000 (10,000) 0.16
---------- --------- -----
Balance as of December 31, 1997............ 130,623 2,049,780 0.91
Additional shares reserved................ 1,595,797 -- --
Granted................................... (1,151,750) 1,151,750 3.20
Exercised................................. -- (156,667) 0.16
Canceled/forfeited........................ 417,833 (417,833) 1.91
---------- --------- -----
Balance as of December 31, 1998............ 992,503 2,627,030 1.79
Additional shares reserved................ 2,072,247 -- --
Granted................................... (3,210,500) 3,210,500 0.97
Exercised................................. -- (219,182) 0.08
Canceled/forfeited........................ 700,068 (700,068) 0.98
---------- --------- -----
Balance as of December 31, 1999............ 554,318 4,918,280 0.79
Additional shares reserved (unaudited).... 375,000 -- --
Granted (unaudited)....................... (1,085,500) 1,085,500 0.75
Exercised (unaudited)..................... -- (212,944) 0.02
Canceled/forfeited (unaudited)............ 163,338 (163,338) 1.00
---------- --------- -----
Balance as of June 30, 2000 (unaudited).... 7,156 5,627,498 $0.81
========== ========= =====
F-39
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
7. Stockholders' Equity (Continued)
Stock Option Plan (Continued)
The following table summarizes information about stock options outstanding
at December 31, 1999:
Options Outstanding Options Exercisable
------------------------------------- -----------------------
Number Weighted Number
Outstanding Weighted Average Exercisable Weighted
Range of at Average Remaining at Average
Exercise December Exercise Contractual December Exercise
Price 31, 1999 Price Life (Years) 31, 1999 Price
-------- ----------- -------- ----------- ----------- --------
$0.01 310,780 $0.01 7.63 210,780 $0.01
0.16 910,000 0.16 6.88 910,000 0.16
1.00 3,697,500 1.00 9.45 389,000 1.00
--------- ---------
4,918,280 1,509,780
========= =========
Compensation expense has been recognized for stock options granted at less
than market value in the amount of $1,485,000 and $59,850 for the six months
ended June 30, 2000 and 1999, respectively and $119,699, $135,750 and $200,750
for the years ended December 31, 1999, 1998 and 1997, respectively.
On February 9, 1999, the board of directors of Hemisphere Investments
resolved that all options granted under the 1996 Employee Stock Option Plan
with an exercise price greater than $1.00 per share would be repriced at $1.00
per share effective immediately. The repricing of the options qualified the
awards as variable under FASB Interpretation Number 44, Accounting for Certain
Transactions Involving Stock Compensation--an interpretation of APB Opinion No.
25 ("FIN 44"). As a result, additional compensation expense of $137,200 was
recognized during 1999.
Pro forma information regarding net income is required by Statement 123,
which also requires that the information be determined as if the Company has
accounted for its employee stock options granted subsequent to December 31,
1994 under the fair value method of that Statement. The fair value for these
options was estimated using the "minimum value" method which may be used by
nonpublic companies to value an award.
The "minimum value" of each option grant is estimated on the date of grant
as the excess of the fair value of the stock at the date of grant over the
present value of the exercise price using the following weighted-average
assumptions for grants in 1997, 1998 and 1999: a weighted average risk-free
interest rate of 5.98%, 5.47% and 5.71%; no anticipated dividends; no
volatility; and a weighted average expected life of the options of three years.
Had compensation cost for the Company's stock option plan been determined
based on the fair value at the grant dates for awards under those plans
consistent with the method prescribed by Statement 123, the Company's net loss
would have been changed to the pro forma amounts indicated below:
1999 1998 1997
----------- ------------ -----------
Net Loss
As Reported........................ $(9,786,216) $(39,020,145) $(6,789,415)
Pro Forma.......................... (9,841,777) (39,161,837) (6,775,897)
F-40
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
8. Reservations of Common Stock
A summary of the Company's shares of common stock reserved for future
issuance at December 31, 1999 is as follows:
Warrants........................................................ 2,000,000
Employee Options................................................ 5,472,598
Conversion of preferred stock................................... 5,856,488
----------
13,329,086
==========
9. Gain on Settlement of Litigation
Pursuant to a settlement agreement in April 1999 and in consideration for a
full release from future claims or liability, the Company recovered damages in
the amount of approximately $2.8 million, net of expenses of $1.2 million, for
unauthorized use of the Company's intellectual property.
10. Commitments and Contingencies
Leases
The Company leases its office space and certain equipment under terms of
non-cancelable operating leases. The Company also leases equipment under
various capital leases. The leases generally require that the Company pay
certain maintenance, insurance and other operating expenses. Rent expense under
operating leases was approximately $216,000 and $256,000 for the six months
ended June 30, 2000 and 1999, respectively and $551,000, $689,000 and $475,000
for the years ended December 31, 1999, 1998 and 1997, respectively.
At December 31, 1999, future minimum lease payments under capital leases and
non-cancelable operating leases with initial or remaining lease terms in excess
of one year are as follows:
Capital Operating
Leases Leases
-------- ---------
2000.................................................. $458,336 $242,178
2001.................................................. 308,308 207,808
2002.................................................. 33,250 207,604
2003.................................................. -- 125,314
-------- --------
Total minimum lease payments.......................... 799,894 $782,904
========
Less amounts representing interest at rates ranging
from 10% to 13%...................................... 80,749
--------
Present value of net minimum capital lease payments... 719,145
Less current installments of obligations under capital
leases............................................... 399,032
--------
Obligations under capital leases, excluding current
installments......................................... $320,113
========
F-41
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
10. Commitments and Contingencies
Leases (continued)
Property and equipment at year end include the following amounts for
capitalized leases:
1999 1998
---------- ----------
Computer and telephone equipment................... $1,475,734 $1,281,218
Less accumulated depreciation...................... (777,997) (794,070)
---------- ----------
$ 697,737 $ 487,148
========== ==========
Amortization of these assets is included in depreciation expense.
Legal Proceedings
In May 1999, MCI WorldCom filed a lawsuit against Hemisphere Investments,
Inc. and its subsidiary claiming breach of contract in the sum of $1.5 million.
In a subsequent amendment response to an interrogatory, additional invoices
were added increasing the balance to approximately $3.2 million. The Company
has filed an answer denying liability and instituted a counter-claim against
MCI WorldCom for an unspecified sum. At present both parties are in the process
of discovery. The Company has provided for any anticipated losses.
The Company is involved in other claims and legal actions which arose in the
ordinary course of business. In the option of management and outside legal
counsel the ultimate disposition of these matters will not have a material
adverse effect on the Company's consolidated financial position or results of
operations.
Employment Agreements
During 1999, the Company entered into employee agreements with the Company's
chief executive officer, president and chief financial officer. The Company
also has employee agreements with certain other senior management of the
Company. The amount of minimum commitment on the employment agreements is
approximately $1,086,660 through September 31, 2001. Each of the agreements
provides for certain benefits upon change of control or termination without
cause.
11. Impact of Recently Issued Accounting Pronouncements
In June 1998, the FASB issued Statement No. 133, Accounting for Derivative
Instruments and Hedging Activities ("Statement 133"), which establishes
accounting and reporting standards for derivative instruments, including
certain derivative instruments embedded in other contracts, and for hedging
activities. In June 1999, Statement 133 was amended by Statement No. 137,
Accounting for Derivative Instruments and Hedging Activities--Deferral of the
Effective Date of Statement 133 ("Statement 137"). As a result of this
amendment, Statement 133 is effective for all fiscal quarters of all fiscal
years beginning after June 15, 2000. In accordance with Statement 133, an
entity is required to recognize all derivatives as either assets or liabilities
in the statement of financial position and measure those instruments at fair
value. Statement 133 requires that changes in the derivative's fair value be
recognized currently in earnings unless specific hedge accounting criteria are
met. Special accounting for qualifying hedges allows a derivative's gains and
losses to offset related results on the hedged item in the income statement and
requires that a company formally document, designate and assess the
effectiveness of transactions that receive hedge accounting. The Company does
not expect the adoption of this statement to have a material effect on its
consolidated financial position or results of operations.
F-42
HEMISPHERE INVESTMENTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information subsequent to December 31, 1999 and pertaining to June 30, 2000
and
for the six months ended June 30, 1999 and 2000 is unaudited)
11. Impact of Recently Issued Accounting Pronouncements (Continued)
On December 3, 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 ("SAB 101"). SAB 101 summarizes certain areas of
the Staff's views in applying generally accepted accounting principles to
revenue recognition in financial statements. The Company believes that its
current revenue recognition policies comply with SAB 101.
12. Geographic Segment Disclosures
The Company operates in one industry: the development of telecommunications
software applications. The Company's segments are organized on the basis of
geographic location and include United States and Europe. The Company has no
material amounts of sales or transfers between its United States and European
territories and no significant United States export sales.
The following presents net sales for the six months ended June 30, 2000 and
1999 (unaudited) and for the years ended December 31, 1999, 1998 and 1997 and
long-lived assets as of June 30, 2000 (unaudited) and December 31, 1999 and
1998 by geographical territory:
Six months ended June
30, Years ended December 31,
--------------------- ---------------------------------
2000 1999 1999 1998 1997
---------- ---------- ---------- ---------- -----------
(Unaudited)
Net Sales
United States......... $5,113,538 $2,335,677 $5,074,734 $5,516,401 $14,870,223
Europe................ 761,695 737,161 2,034,840 576,763 533,711
---------- ---------- ---------- ---------- -----------
$5,875,233 $3,072,838 $7,109,574 $6,093,164 $15,403,934
========== ========== ========== ========== ===========
Long-lived Assets:
United States......... $6,043,737 $5,577,793 $5,555,556
Europe................ 679,436 773,278 1,114,442
---------- ---------- ----------
$6,723,173 $6,351,071 $6,669,998
========== ========== ==========
13. Subsequent Events -- Unaudited
Proposed Merger with Convergent Networks
On July 7, 2000, Convergent Networks, Inc. ("Convergent") entered into a
Purchase and Sale Agreement with the Company to acquire all of the outstanding
shares of Hemisphere Investments, Inc. On July 31, 2000 the transaction closed
and, the Company's stockholders received an aggregate of 10,106,845 Convergent
shares based on the fully diluted shares outstanding at closing.
F-43
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL DATA
The unaudited pro forma condensed consolidated financial data of Convergent
Networks, Inc and subsidiaries (the Company) were prepared to illustrate the
estimated effects of the Company's acquisition of Hemisphere Investments, Inc.
and its wholly owned subsidiaries, including Technology Control Services, Inc.
(collectively TCS) for balance sheet purposes as of June 30, 2000 and for
purposes of the results of operations for the year ended December 31, 1999 and
for the six months ended June 30, 2000. The unaudited pro forma condensed
consolidated balance sheet gives effect to the acquisition as if it occurred
on June 30, 2000 and the unaudited consolidated pro forma statements of
operations give effect to the acquisition as if it had occurred on January 1,
1999.
The unaudited pro forma consolidated financial data have been prepared
using the purchase method of accounting for the acquisition whereby the total
cost of the acquisition is allocated to the tangible and intangible assets
acquired and liabilities assumed based upon their respective fair values at
the effective date of the acquisition. Such allocation has been made based
upon currently available information and management's estimates. Final
allocations will be determined upon completion of the analysis of the assets
acquired and liabilities assumed and accordingly, the amounts presented herein
are subject to change.
The following unaudited pro forma condensed consolidated financial
statements are based on the audited consolidated financial statements of the
Company and TCS for the year ended December 31, 1999 and the unaudited
consolidated financial statements of the Company and TCS as of June 30, 2000
and for the six months then ended. The unaudited financial statements reflect
all adjustments, consisting of normal recurring adjustments, which in the
opinion of management are necessary for a presentation of results for the
respective periods in accordance with the basis of presentation described in
Note 1 of the notes to the Company's consolidated financial statements and
similar statements found in TCS's financial statements.
The unaudited pro forma condensed consolidated financial statements do not
purport to represent what the results of operations or the financial position
of the Company would actually have been if the acquisition had occurred on
such dates or to project the results of operations or the financial positions
of the Company for any future date or period. The Company does not believe
that pro forma operating results are indicative of the future combined
operating results. TCS provided service bureau and systems integration
services that entailed selling services, custom software and associated
hardware. The Company has refocused the efforts of TCS to provide standard
software products, has organized the acquired operations under the name
Applications Technology Group, and is phasing out the service bureau and the
resale of hardware products. As a result, the Company expects that TCS
operations will generate revenues significantly lower than those generated by
TCS in prior periods. The unaudited pro forma condensed consolidated balance
sheet and statements of operations set forth below should be read in
conjunction with the respective consolidated financial statements and notes
thereto of the Company and the respective consolidated financial statements
and notes thereto of TCS included elsewhere in this prospectus and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
F-44
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED BALANCE SHEET
As of June 30, 2000
Historical
--------------------------
Convergent Hemisphere
Networks, Investments,
Inc. Inc. Adjustments Pro Forma
------------ ------------ ------------ ------------
Assets
Current assets:
Cash and cash
equivalents.......... $ 24,663,206 $ 1,611,858 $ (5,900,000)(a) $ 20,375,064
Restricted
investments.......... 150,000 -- -- 150,000
Accounts receivable... -- 1,396,859 -- 1,396,859
Inventory............. 3,094,484 2,255,950 -- 5,350,434
Prepaid expenses and
other current
assets............... 120,641 637,401 -- 758,042
------------ ----------- ------------ ------------
Total current
assets............. 28,028,331 5,902,068 (5,900,000) 28,030,399
Property and equipment,
net.................... 2,320,003 6,723,173 -- 9,043,176
------------ ----------- ------------ ------------
Restricted investments.. 500,000 -- -- 500,000
------------ ----------- ------------ ------------
Intangible assets....... -- 294,165 114,811,062 (d) 115,105,227
------------ ----------- ------------ ------------
Total assets........ $ 30,848,334 $12,919,406 $108,911,062 $152,678,802
============ =========== ============ ============
Liabilities, Redeemable
Convertible Preferred
Stock and Stockholders'
Equity (Deficit)
Current liabilities:
Loans payable......... $ 492,144 $ 8,072,882 $ (5,420,000)(a) $ 3,145,026
Accounts payable...... 986,260 4,908,938 -- 5,895,198
Accrued expenses...... 2,217,177 2,220,684 -- 4,437,861
Deferred rent......... 432,770 -- -- 432,770
Deferred revenue...... 271,496 3,568,995 -- 3,840,491
------------ ----------- ------------ ------------
Total current
liabilities........ 4,399,847 18,771,499 (5,420,000) 17,751,346
Loans payable, net of
current portion........ 695,446 213,329 -- 908,775
------------ ----------- ------------ ------------
Commitments and
contingencies
Redeemable convertible
preferred stock net.... 58,309,311 -- -- 58,309,311
Stockholders' equity
(deficit)
Preferred stock....... -- 5,856 (5,856)(b) --
Common stock.......... 194 36,186 (36,085)(b) 295
Additional paid-in
capital.............. 26,536,443 64,051,779 71,243,816 (b) 161,832,038
Treasury stock........ (160,520) -- -- (160,520)
Accumulated deficit... (38,109,763) (68,784,243) 45,784,243 (b) (61,109,763)
Deferred
compensation......... (14,734,999) (1,375,000) (2,655,056)(c) (18,765,055)
Stock subscriptions
receivable........... (6,087,625) -- -- (6,087,625)
------------ ----------- ------------ ------------
Total stockholders'
equity (deficit)... (32,556,270) (6,065,422) 114,331,062 75,709,370
------------ ----------- ------------ ------------
Total liabilities,
redeemable
convertible
preferred stock and
stockholders'
equity (deficit)... $ 30,848,334 $12,919,406 $108,911,062 $152,678,802
============ =========== ============ ============
The accompanying notes are an integral part of these unaudited pro forma
condensed consolidated financial statements.
F-45
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the Year ended December 31, 1999
Historical
--------------------------
Convergent Hemisphere
Networks, Investments, Pro Forma
Inc. Inc. Adjustments Pro Forma
------------ ------------ ------------ ------------
Revenues................ $ -- $ 7,109,574 $ -- $ 7,109,574
Cost of revenues........ -- 3,978,567 -- 3,978,567
------------ ----------- ------------ ------------
Gross profit........ -- 3,131,007 -- 3,131,007
------------ ----------- ------------ ------------
Operating expenses:
Research and
development.......... 13,067,158 7,738,082 -- 20,805,240
Selling and
marketing............ 3,522,903 1,644,145 -- 5,167,048
General and
administrative....... 1,273,363 1,734,719 -- 3,008,082
Amortization of
intangible assets.... -- -- 38,368,409 (e) 38,368,409
Stock-based
compensation......... 3,545,710 -- 2,462,812 (f) 6,008,522
------------ ----------- ------------ ------------
Total operating
expenses........... 21,409,134 11,116,946 40,831,221 73,357,301
------------ ----------- ------------ ------------
Loss from operations.. (21,409,134) (7,985,939) (40,831,221) (70,226,294)
Gain on settlement of
litigation........... -- 2,775,259 -- 2,775,259
Interest income
(expense), net....... 137,412 (2,924,806) -- (2,787,394)
------------ ----------- ------------ ------------
Loss from continuing
operations......... (21,271,722) (8,135,486) (40,831,221) (70,238,429)
Accretion of dividends
on preferred stock..... (1,066,817) -- -- (1,066,817)
------------ ----------- ------------ ------------
Loss from continuing
operations
attributable to
common
stockholders....... $(22,338,539) $(8,135,486) $(40,831,221) $(71,305,246)
============ =========== ============ ============
Basic and diluted loss
from continuing
operations per common
share.................. $ (7.47) $ (5.44)
============ ============
Weighted average common
shares outstanding:
Basic and diluted..... 2,991,313 10,106,845 (g) 13,098,158
============ ============ ============
The accompanying notes are an integral part of these unaudited pro forma
condensed consolidated financial statements.
F-46
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
UNAUDITED PRO FORMA CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
For the Six Months ended June 30, 2000
Historical
--------------------------
Convergent Hemisphere
Networks, Investments, Pro Forma
Inc. Inc. Adjustments Pro Forma
------------ ------------ ------------ ------------
Revenues................ $ 1,826,739 $ 5,875,233 $ -- $ 7,701,972
Cost of revenues........ 1,302,936 1,053,713 -- 2,356,649
------------ ----------- ------------ ------------
Gross profit........ 523,803 4,821,520 -- 5,345,323
------------ ----------- ------------ ------------
Operating expenses:
Research and
development.......... 5,268,144 4,480,274 -- 9,748,418
Selling and
marketing............ 2,990,181 2,110,990 -- 5,101,171
General and
administrative....... 1,225,595 1,532,386 -- 2,757,981
Amortization of
intangible assets.... -- -- 19,184,205 (e) 19,184,205
Stock-based
compensation......... 2,711,637 -- 559,730 (f) 3,271,367
------------ ----------- ------------ ------------
Total operating
expenses........... 12,195,557 8,123,650 19,743,935 40,063,142
------------ ----------- ------------ ------------
Loss from operations.. (11,671,754) (3,302,130) (19,743,935) (34,717,819)
Interest income
(expense), net....... 921,406 (513,654) -- 407,752
------------ ----------- ------------ ------------
Loss from continuing
operations......... (10,750,348) (3,815,784) (19,743,935) (34,310,067)
Accretion of dividends
on preferred stock..... (2,168,185) -- -- (2,168,185)
------------ ----------- ------------ ------------
Loss from continuing
operations
attributable to
common
stockholders....... $(12,918,533) $(3,815,784) $(19,743,935) $(36,478,252)
============ =========== ============ ============
Basic and diluted loss
from continuing
operations per common
share.................. $ (2.75) $ (2.46)
============ ============
Weighted average common
shares outstanding:
Basic and diluted..... 4,695,592 10,106,845 (g) 14,802,437
============ ============ ============
The accompanying notes are an integral part of these unaudited pro forma
condensed consolidated financial statements.
F-47
CONVERGENT NETWORKS, INC. AND SUBSIDIARIES
NOTES TO UNAUDITED PRO FORMA CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
On July 31, 2000, the Company acquired Hemisphere Investments, Inc. and its
wholly owned subsidiaries, including Technology Control Services, Inc.
(collectively, TCS) for an aggregate of 10,106,845 shares of common stock in
consideration for all the outstanding capital stock of TCS, and reserved an
aggregate of 1,229,436 shares of the Company's common stock in connection with
the assumption of outstanding options to purchase capital stock of TCS and
assumed approximately $5.5 million of TCS debt, which was repaid upon closing
the transaction. 1,516,025 shares of common stock issued to stockholders of TCS
are currently held in escrow to secure certain indemnification obligations of
TCS and certain of its stockholders. The acquisition was accounted for using
the purchase method of accounting in accordance with APB No. 16, Business
Combinations. Accordingly, the operating results of TCS will be included in the
Company's financial results from the date of the acquisition. The allocation of
the purchase price to the fair value of the assets acquired and liabilities
assumed will be based on an independent analysis of the fair value of the
assets and liabilities of TCS. It is expected that approximately $23 million of
the purchase price will be recorded as acquired in process technology in the
third quarter of fiscal 2000. This charge has been excluded from the unaudited
pro forma condensed consolidated statements of operations due to its
nonrecurring nature but it is reflected as an increase in accumulated deficit
in the unaudited pro forma condensed consolidated balance sheet as of June 30,
2000. Goodwill and other intangible assets of approximately $115 million will
be amortized on a straight-line basis over three years. The current purchase
price allocation and the following pro forma condensed consolidated financial
statements are based upon a preliminary valuation and may change upon final
determination of the fair value of assets and liabilities acquired.
Accordingly, the amounts presented herein are subject to change.
The following adjustments have been reflected in the unaudited pro forma
consolidated balance sheet:
(a) The pro forma adjustment to reflect the estimated expenses incurred
by the Company in connection with the acquisition and the repayment of debt
assumed from TCS;
(b) The pro forma adjustment to stockholders' equity (deficit) reflects
the fair value of $121.3 million related to the issuance of 10,106,845
shares of common stock at a $12.00 fair value, the estimated fair value of
$6.3 million related to vested common stock options issued by the Company
in exchange for vested TCS common stock options and the excess of the
estimated fair value over the intrinsic value of $3.7 million related to
unvested common stock options issued by the Company in exchange for
unvested TCS common stock options;
(c) The pro forma adjustment reflects the deferred compensation (the
intrinsic value) related to unvested common stock options issued by the
Company in exchange for unvested TCS common stock options.
(d) The pro forma adjustment to intangible assets reflects the recording
goodwill and other intangible assets.
The following adjustments have been reflected in the unaudited pro forma
consolidated statements of operations:
(e) The pro forma adjustment to amortization of intangible assets
adjusts the amortization expense to reflect the acquisition of TCS as if it
occurred on January 1, 1999 and the amortization of intangible assets began
as of that date.
(f) The pro forma adjustment to stock-based compensation adjusts the
stock-based compensation expense to reflect compensation expense related to
the unvested common stock options exchanged in the acquisition.
(g) The pro forma adjustment to weighted average shares outstanding
adjusts the weighted average shares outstanding to reflect the shares
issued by the Company as if they were issued on January 1, 1999.
F-48
PART II
INFORMATION NOT REQUIRED IN THE PROSPECTUS
Item 13. Other Expenses of Issuance and Distribution.
Estimated expenses (other than underwriting discounts and commissions)
payable in connection with the sale of our common stock offered hereby are as
follows:
SEC registration fees............................................. $26,400
NASD filing fees.................................................. 10,500
Nasdaq National Market listing fee................................ *
Blue Sky fees and expenses........................................ *
Transfer Agent and Registrar fees................................. *
Accounting fees and expenses...................................... *
Legal fees and expenses........................................... *
Director and officer liability insurance.......................... *
Printing and mailing expenses..................................... *
Miscellaneous..................................................... *
-------
Total........................................................... $ *
=======
We will bear all expenses shown above.
- ---------------------
* To be completed by amendment.
Item 14. Indemnification of Directors and Officers.
Article EIGHTH of our amended and restated certificate of incorporation
provides that we will indemnify our directors and officers (a) against all
expenses (including attorneys' fees), judgments, fines and amounts paid in
settlement incurred in connection with any litigation or other legal proceeding
(other than an action by or in the right of us) brought against him by virtue
of his position as our director or officer if he acted in good faith and in a
manner he reasonably believed to be in, or not opposed to, our best interests,
and, with respect to any criminal action or proceeding, had no reasonable cause
to believe his conduct was unlawful and (b) against all expenses (including
attorneys' fees) and amounts paid in settlement incurred in connection with any
action by or in the right of us brought against him by virtue of his position
as our director or officer if he acted in good faith and in a manner he
reasonably believed to be in, or not opposed to, our best interests, except
that no indemnification shall be made with respect to any matter as to which
such person will have been adjudged to be liable to us, unless a court
determines that, despite such adjudication but in view of all of the
circumstances, he is entitled to indemnification of such expenses.
Notwithstanding the foregoing, to the extent that a director or officer has
been successful, on the merits or otherwise, including, without limitation, the
dismissal of an action without prejudice, we are required to indemnify him
against all expenses (including attorneys' fees) incurred in connection
therewith. Expenses shall be advanced to the director or officer at his
request, provided that he undertakes to repay the amount advanced if it is
ultimately determined that he is not entitled to indemnification for such
expenses.
Indemnification is required to be made unless we determine that the
applicable standard of conduct required for indemnification has not been met.
If we determine that the director or officer did not meet the applicable
standard of conduct required for indemnification, or if we fail to make an
indemnification payment within 60 days after such payment is claimed by such
person, such person is permitted to petition the court to make an independent
determination as to whether such person is entitled to indemnification.
As a condition precedent to the right of indemnification, the director or
officer must give us notice of the action for which indemnity is sought and we
have the right to participate in such action or assume the defense thereof.
II-1
Article EIGHTH of our amended and restated certificate of incorporation
further provides that the indemnification provided therein is not exclusive and
that if the Delaware General Corporation Law is amended to expand the
indemnification permitted to directors or officers, we must indemnify those
persons to the fullest extent permitted by such laws as so amended.
Article EIGHTH of the our amended and restated certificate of incorporation
provides that none of our directors will be personally liable for any monetary
damages for any breach of fiduciary duty as a director, except to the extent
that the Delaware General Corporation Law prohibits the elimination or
limitation of liability of directors for breach of fiduciary duty. We intend to
obtain a policy of directors and officers insurance that provides insurance
against certain expenses and liabilities which may be incurred by directors and
officers.
Under Section of the underwriting agreement, the underwriters are
obligated, under certain circumstances, to indemnify our directors and officers
against certain liabilities, including liabilities under the Securities Act.
Reference is made to the form of underwriting agreement filed as Exhibit 1.1
hereto.
Item 15. Recent Sales of Unregistered Securities.
Since our incorporation, we have issued the following securities that were
not registered under the Securities Act:
(a) Issuance of Capital Stock and Warrants
1. On July 14, 1998, the Registrant issued and sold an aggregate of
5,080,000 shares of its common stock to accredited investors for an aggregate
purchase price of approximately $300.
2. Between July 14, 1998 and March 31, 1998, the Registrant issued and sold
an aggregate of 6,976,000 shares of its Series A convertible preferred stock to
accredited investors for an aggregate purchase price of approximately
$6,976,000.
3. Since August 12, 1998, the Registrant issued and sold pursuant to stock
restriction agreements under the 1998 Restricted Stock Purchase Plan, as
amended, 6,950,500 shares of its common stock to 29 employees for an aggregate
purchase price of $726,530. In addition, under the same stock plan, the
Registrant issued 4,482,000 shares to three employees for aggregate
consideration of $6,082,000 in the form of promissory notes, 25,000 shares to a
consultant for a purchase price of $125 on August 14, 1998, and 17,500 shares
to a consultant in exchange for services with a value of $220,000.
4. On July 1, 1999, the Registrant issued and sold an aggregate of 4,133,892
shares of its Series B convertible preferred stock to accredited investors for
an aggregate purchase price of $9,879,998.
5. Between December 17, 1999 and March 31, 2000, the Registrant issued and
sold an aggregate of 5,602,782 shares of its Series C convertible preferred
stock to accredited investors for an aggregate purchase price of $36,249,984.
In December 1999, 264,853 shares were issued to a consultant in exchange for
services with a value of $1,714,599.
6. On July 31, 2000, the Registrant issued an aggregate of 10,106,845 shares
of common stock to the former shareholders of Hemisphere Investments, Inc. in
connection with the Registrant's acquisition of this company.
7. On August 4, 2000, the Registrant issued a warrant for the purchase of up
to 100,000 shares of common stock at an exercise price of $12.00 per share,
terminating on the earlier of August 4, 2002 or our acquisition by another
company.
8. On September 19, 2000, the Registrant issued a warrant for the purchase
of up to 50,000 shares of common stock at an exercise price of $16.35 per
share, terminating on the earlier of September 19, 2002 or our acquisition by
another company.
II-2
9. On September 22, 2000, the Registrant issued a warrant for the purchase
of up to 90,000 shares of common stock at an exercise price of $16.35 per
share, terminating on the earlier of September 22, 2002 or our acquisition by
another company.
10. On September 22, 2000, the Registrant issued and sold an aggregate of
4,803,926 shares of its Series D convertible preferred stock to accredited
investors for an aggregate price of $78,544,190.
(b) Grants and Exercises of Stock Options.
1. On July 31, 2000, the Registrant reserved an aggregate of 1,229,436
shares of common stock in connection with the assumption of outstanding options
to purchase capital stock issued to employees, directors and consultants of
Hemisphere Investments, Inc. The as converted exercise prices range from $.05
to $4.59 per share.
2. From inception through September 25, 2000, the Registrant granted under
the 1998 Stock Option Plan options to purchase 6,297,545 shares of common stock
at exercise prices ranging from $.05 to $13.20 per share to employees,
consultants and directors.
3. From inception through September 25, 2000, the Registrant issued and sold
an aggregate of 3,000,446 shares of its common stock pursuant to the exercise
of stock options to employees, consultants and directors for aggregate
consideration of $979,736.
No underwriters were involved in the foregoing sales of securities. Such
sales were made in reliance upon an exemption from the registration provisions
of the Securities Act set forth in Section 4(2) thereof relative to sales by an
issuer not involving any public offering or the rules and regulations
thereunder, or, in the case of options to purchase our common stock, Rule 701
under the Securities Act. All of the foregoing securities are deemed restricted
securities for purposes of the Securities Act.
Item 16. Exhibits and Financial Statements Schedules.
(a) Exhibits:
Exhibit No. Description
----------- -----------
1.1* Form of Underwriting Agreement
2.1 Agreement and Plan of Merger dated July 6, 2000 by and among
Convergent Networks, Inc., Hemisphere Acquisition Corporation and
Hemisphere Investments, Inc. and certain shareholders of
Hemisphere Investments, Inc.
3.1 Restated Certificate of Incorporation
3.2 Amended and Restated Certificate of Incorporation, to become
effective upon completion of this offering
3.3 By-laws
Amended and Restated By-Laws, to become effective upon completion
3.4 of this offering
4.1* Specimen certificate for shares of common stock
5.1* Opinion of Hale and Dorr LLP
10.1 1998 Stock Option Plan, as amended
10.2 1998 Restricted Stock Purchase Plan, as amended
10.3 Hemisphere Investments, Inc. Third Amended and Restated 1996
Employee Stock Option Incentive Plan
10.4 2000 Stock Incentive Plan
10.5 2000 Employee Stock Purchase Plan
10.6 Form of First Amended and Restated Investor Rights Agreement dated
September 22, 2000 by and among Convergent Networks, Inc. and the
individuals and entities listed on Attachment A and Attachment B
thereto
10.7 Lease between Cross Point Limited Partnership and Convergent
Networks, Inc. dated August 1999.
II-3
Exhibit No. Description
----------- -----------
10.8 Sublease Agreement dated as of September 1, 2000 between Nortel
Networks (CALA) Inc. and Convergent Networks, Inc.
10.9 Employment Agreement dated September 26, 2000 between Convergent
Networks, Inc. and John C. Thibault
10.10+ Purchase and License Agreement dated May 1, 2000 between Global
NAPs, Inc. and Convergent Networks, Inc.
21 Subsidiaries
23.1 Consent of Arthur Andersen LLP
23.2 Consent of Ernst & Young LLP
23.3* Consent of Hale and Dorr LLP (included in Exhibit 5.1)
Power of Attorney (included in the signature pages to this
24.1 registration statement)
27.1 Financial Data Schedule
- ---------------------
*To be filed by amendment.
+ We have sought confidential treatment from the Securities and Exchange
Commission for selected portions of this exhibit. The omitted portions will
be separately filed with the Securities and Exchange Commission.
Item 17. Undertakings.
Insofar as indemnification for liabilities arising under the Securities Act
may be permitted to directors, officers and controlling persons of the
registrant pursuant to the provisions described in Item 14 above, or otherwise,
the registrant has been advised that in the opinion of the Securities and
Exchange Commission such indemnification is against public policy as expressed
in the Securities Act and is, therefore, unenforceable. In the event that a
claim for indemnification against such liabilities (other than the payment by
the registrant of expenses incurred or paid by a director, officer or
controlling person of the registrant in the successful defense of any action,
suit or proceeding) is asserted by such director, officer or controlling person
in connection with the securities being registered, the registrant will, unless
in the opinion of its counsel the matter has been settled by controlling
precedent, submit to a court of appropriate jurisdiction the question whether
such indemnification by it is against public policy as expressed in the
Securities Act and will be governed by the final adjudication of such issue.
The undersigned registrant hereby undertakes:
(1) To provide to the underwriters at the closing specified in the
underwriting agreement, certificates in such denominations and registered
in such names as required by the underwriters to permit prompt delivery to
each purchaser.
(2) For purposes of determining any liability under the Securities Act,
the information omitted from the form of prospectus filed as part of this
registration statement in reliance upon Rule 430A and contained in a form
of prospectus filed by the registrant pursuant to Rule 424(b)(1) or (4) or
497(h) under the Securities Act shall be deemed to be part of this
registration statement as of the time it was declared effective.
(3) For the purpose of determining any liability under the Securities
Act, each post-effective amendment that contains a form of prospectus shall
be deemed to be a new registration statement relating to the securities
offered therein, and the offering of such securities at that time shall be
deemed to be the initial bona fide offering thereof.
II-4
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as amended, the
registrant has duly caused this registration statement to be signed on its
behalf by the undersigned, thereunto duly authorized, in Lowell, Massachusetts
on September 27, 2000.
Convergent Networks, Inc.
/s/ John C. Thibault
By: _________________________________
John C. Thibault
President and Chief Executive
Officer
POWER OF ATTORNEY AND SIGNATURES
We, the undersigned officers and directors of Convergent Networks, Inc.,
hereby severally constitute and appoint John C. Thibault and Pamela F. Lenehan,
and each of them singly, our true and lawful attorneys, with full power to them
and each of them singly, to sign for us in our names in the capacities
indicated below, any registration statement related to the offering that is to
be effective upon filing pursuant to Rule 462(b) under the Securities Act of
1933, as amended (a "462(b) Registration Statement"), any and all amendments
and exhibits to this registration statement or any 462(b) Registration
Statement, and any and all applications and other documents to be filed with
the Securities and Exchange Commission pertaining to the registration of the
securities covered hereby or thereby, and generally to do all things in our
names and on our behalf in such capacities to enable Convergent Networks, Inc.
to comply with the provisions of the Securities Act of 1933 and all
requirements of the Securities and Exchange Commission.
Pursuant to the requirements of the Securities Act of 1933, as amended, this
registration statement has been signed by the following persons in the
capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ John C. Thibault Chairman, President, Chief September 27, 2000
______________________________________ Executive Officer and
John C. Thibault Director (Principal
Executive Officer)
/s/ Pamela F. Lenehan Vice President and Chief September 27, 2000
______________________________________ Financial Officer
Pamela F. Lenehan (Principal Financial
Officer)
/s/ Karen L. Vergura Controller (Principal September 27, 2000
______________________________________ Accounting Officer)
Karen L. Vergura
/s Bing Yang Senior Vice President, Chief September 27, 2000
______________________________________ Technology Officer and
Bing Yang Director
/s/ Todd A. Dagres Director September 27, 2000
______________________________________
Todd A. Dagres
/s/ David E. Schantz Director September 27, 2000
______________________________________
David E. Schantz
/s/ William E. Foster Director September 27, 2000
______________________________________
William E. Foster
II-5
EXHIBIT INDEX
Exhibit No. Description
----------- -----------
1.1* Form of Underwriting Agreement
2.1 Agreement and Plan of Merger dated July 6, 2000 by and among
Convergent Networks, Inc. and Hemisphere Investments, Inc. and
certain shareholders of Hemisphere Investments, Inc.
3.1 Restated Certificate of Incorporation
3.2 Amended and Restated Certificate of Incorporation, to become
effective upon completion of this offering
3.3 By-laws
Amended and Restated By-Laws, to become effective upon completion
3.4 of this offering
4.1* Specimen certificate for shares of common stock
5.1* Opinion of Hale and Dorr LLP
10.1 1998 Stock Option Plan, as amended
10.2 1998 Restricted Stock Purchase Plan, as amended
10.3 Hemisphere Investments, Inc. Third Amended and Restated 1996
Employee Stock Option Incentive Plan
10.4 2000 Stock Incentive Plan
10.5 2000 Employee Stock Purchase Plan
10.6 Form of First Amended and Restated Investor Rights Agreement dated
September 22, 2000 by and among Convergent Networks, Inc. and the
individuals and entities listed on Attachment A and Attachment B
thereto
10.7 Lease between Cross Point Limited Partnership and Convergent
Networks, Inc. dated August 1999.
10.8 Sublease Agreement dated as of September 1, 2000 between Nortel
Networks (CALA) Inc. and Convergent Networks, Inc.
10.9 Employment Agreement dated September 26, 2000 between Convergent
Networks, Inc. and John C. Thibault
10.10+ Purchase and License Agreement dated May 1, 2000 between Global
NAPs, Inc. and Convergent Networks, Inc.
21 Subsidiaries
23.1 Consent of Arthur Andersen LLP
23.2 Consent of Ernst & Young LLP
23.3* Consent of Hale and Dorr LLP (included in Exhibit 5.1)
Power of Attorney (included in the signature pages to this
24.1 registration statement)
27.1 Financial Data Schedule
- ---------------------
*To be filed by amendment.
+ We have sought confidential treatment from the Securities and Exchange
Commission for selected portions of this exhibit. The omitted portions will
be separately filed with the Securities and Exchange Commission.