UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
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[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED DECEMBER 31, 2002
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 0-30903
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VIRAGE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 38-3171505
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
411 BOREL AVENUE, 100S
SAN MATEO, CALIFORNIA 94402-3116
(650) 573-3210
(Address, including zip code, and telephone number, including area code,
of the registrant's principal executive offices)
------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. [X] Yes [ ] No
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act). [ ] Yes [X] No
The number of outstanding shares of the registrant's Common Stock,
$0.001 par value, was 20,978,790 as of February 2, 2003.
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VIRAGE, INC.
INDEX
PAGE
PART I: FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited)
Condensed Consolidated Balance Sheets - December 31, 2002 and
March 31, 2002 ....................................................... 1
Condensed Consolidated Statements of Operations -- Three and
Nine Months Ended December 31, 2002 and 2001 ......................... 2
Condensed Consolidated Statements of Cash Flows -- Nine Months Ended
December 31, 2002 and 2001 ........................................... 3
Notes to Condensed Consolidated Financial Statements ................... 4
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations ......................................... 17
Item 3. Quantitative and Qualitative Disclosures About Market Risk ........ 37
Item 4. Controls and Procedures ........................................... 37
PART II: OTHER INFORMATION
Item 1. Legal Proceedings ................................................. 38
Item 2. Changes in Securities and Use of Proceeds ......................... 38
Item 3. Defaults Upon Senior Securities ................................... 39
Item 4. Submission of Matters to a Vote of Security Holders ............... 39
Item 5. Other Information ................................................. 39
Item 6. Exhibits and Reports on Form 8-K .................................. 40
Signature ................................................................. 41
Certifications ............................................................ 42
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
VIRAGE, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
December 31, March 31,
2002 2002
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents ........................ $ 2,923 $ 4,586
Short-term investments ........................... 15,949 26,108
Accounts receivable, net ......................... 2,037 2,366
Prepaid expenses and other current assets ........ 498 220
--------- ---------
Total current assets ......................... 21,407 33,280
Property and equipment, net ........................ 1,931 3,701
Other assets ....................................... 2,389 2,571
--------- ---------
Total assets ................................. $ 25,727 $ 39,552
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................. $ 444 $ 831
Accrued payroll and related expenses ............. 1,455 2,376
Accrued expenses ................................. 2,645 2,946
Deferred revenue ................................. 3,235 3,050
--------- ---------
Total current liabilities .................... 7,779 9,203
Deferred rent ...................................... -- 290
Commitments and contingencies
Stockholders' equity:
Preferred stock .................................. -- --
Common stock ..................................... 21 21
Additional paid-in capital ....................... 121,427 121,387
Deferred compensation ............................ (1,070) (2,425)
Accumulated deficit .............................. (102,430) (88,924)
--------- ---------
Total stockholders' equity ................... 17,948 30,059
--------- ---------
Total liabilities and stockholders' equity ... $ 25,727 $ 39,552
========= =========
See accompanying notes.
1
VIRAGE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
December 31, December 31,
--------------------------- ---------------------------
2002 2001 2002 2001
-------- -------- -------- --------
Revenues:
License revenues ..................................... $ 1,339 $ 1,478 $ 4,623 $ 6,292
Service revenues ..................................... 1,975 3,290 5,203 7,000
Other revenues ....................................... -- 20 -- 232
-------- -------- -------- --------
Total revenues ..................................... 3,314 4,788 9,826 13,524
Cost of revenues:
License revenues ..................................... 195 202 542 534
Service revenues(1) .................................. 1,090 2,122 3,308 7,059
Other revenues ....................................... -- 5 -- 153
-------- -------- -------- --------
Total cost of revenues ............................. 1,285 2,329 3,850 7,746
-------- -------- -------- --------
Gross profit ........................................... 2,029 2,459 5,976 5,778
Operating expenses:
Research and development(2) .......................... 1,781 2,117 6,607 6,934
Sales and marketing(3) ............................... 2,357 3,858 9,104 12,720
General and administrative(4) ........................ 963 1,284 3,174 3,946
Stock-based compensation ............................. 291 719 1,026 2,257
-------- -------- -------- --------
Total operating expenses ........................... 5,392 7,978 19,911 25,857
-------- -------- -------- --------
Loss from operations ................................... (3,363) (5,519) (13,935) (20,079)
Interest and other income, net ......................... 101 315 429 1,295
-------- -------- -------- --------
Net loss ............................................... $ (3,262) $ (5,204) $(13,506) $(18,784)
======== ======== ======== ========
Basic and diluted net loss per share ................... $ (0.16) $ (0.26) $ (0.65) $ (0.93)
======== ======== ======== ========
Shares used in computation of basic and
diluted net loss per share ........................... 20,899 20,366 20,786 20,249
======== ======== ======== ========
(1) Excluding $5 and $15 in amortization of employee deferred stock-based
compensation for the three and nine months ended December 31, 2002,
respectively ($56 and $199 for the three and nine months ended December
31, 2001, respectively).
(2) Excluding $24 and $70 in amortization of employee deferred stock-based
compensation for the three and nine months ended December 31, 2002,
respectively ($102 and $321 for the three and nine months ended
December 31, 2001, respectively).
(3) Excluding $28 and $83 in amortization of employee deferred stock-based
compensation for the three and nine months ended December 31, 2002,
respectively ($211 and $670 for the three and nine months ended
December 31, 2001, respectively).
(4) Excluding $234 and $858 in amortization of employee deferred
stock-based compensation for the three and nine months ended December
31, 2002, respectively ($350 and $1,067 for the three and nine months
ended December 31, 2001, respectively).
See accompanying notes.
2
VIRAGE, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine Months Ended
December 31,
----------------------------
2002 2001
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss ................................................................................... $(13,506) $(18,784)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization ............................................................ 1,870 2,223
Loss on disposal of assets ............................................................... 106 263
Amortization of deferred compensation related to
stock options and issuance of stock options to consultants ............................. 1,113 2,781
Amortization of technology right ......................................................... 27 26
Amortization of warrant fair values ...................................................... 11 657
Changes in operating assets and liabilities:
Accounts receivable .................................................................... 329 (30)
Prepaid expenses and other current assets .............................................. (278) 37
Other assets ........................................................................... 155 --
Accounts payable ....................................................................... (387) (167)
Accrued payroll and related expenses ................................................... (921) (372)
Accrued expenses ....................................................................... (301) 8
Deferred revenue ....................................................................... 185 (216)
Deferred rent .......................................................................... (290) 145
-------- --------
Net cash used in operating activities ...................................................... (11,887) (13,429)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment ......................................................... (206) (361)
Purchase of short-term investments ......................................................... (52,500) (53,508)
Sales and maturities of short-term investments ............................................. 62,659 53,837
-------- --------
Net cash provided by (used in) investing activities ........................................ 9,953 (32)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options, net of repurchases ................................ 80 3
Proceeds from employee stock purchase plan ................................................. 191 766
-------- --------
Net cash provided by financing activities .................................................. 271 769
-------- --------
Net decrease in cash and cash equivalents .................................................. (1,663) (12,692)
Cash and cash equivalents at beginning of period ........................................... 4,586 19,680
-------- --------
Cash and cash equivalents at end of period ................................................. $ 2,923 $ 6,988
======== ========
SUPPLEMENTAL DISCLOSURES OF NONCASH OPERATING, INVESTING AND FINANCING ACTIVITIES:
Book value of equipment write-downs ........................................................ $ 476 $ 506
Accumulated depreciation of equipment write-downs .......................................... $ 370 $ 243
Deferred compensation related to stock options ............................................. $ 69 $ 123
Reversal of deferred compensation upon employee termination ................................ $ 398 $ 761
See accompanying notes.
3
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2002
(unaudited)
1. Summary of Significant Accounting Policies
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with generally accepted accounting principles
for interim financial information and in accordance with the instructions to
Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all
of the information and footnotes required by generally accepted accounting
principles for complete financial statements. In the opinion of management, all
adjustments (consisting of normal recurring accruals) necessary for a fair
presentation of the financial statements at December 31, 2002 and for the three
and nine month periods ended December 31, 2002 and 2001 have been included.
The condensed consolidated financial statements include the accounts of
Virage, Inc. (the "Company") and its wholly-owned subsidiaries, Virage Europe,
Ltd. and Virage GmbH. All significant intercompany balances and transactions
have been eliminated in consolidation.
Results for the three and nine months ended December 31, 2002 are not
necessarily indicative of results for the entire fiscal year or future periods.
These financial statements should be read in conjunction with the consolidated
financial statements and the accompanying notes included in the Company's Annual
Report on Form 10-K, dated June 14, 2002 as filed with the United States
Securities and Exchange Commission. The accompanying balance sheet at March 31,
2002 is derived from the Company's audited consolidated financial statements at
that date.
Revenue Recognition
The Company enters into arrangements for the sale of licenses of
software products and related maintenance contracts, application services and
professional services offerings; and also receives revenues under U.S.
government agency research grants. Service revenues include revenues from
maintenance contracts, application services, and professional services. Other
revenues are primarily U.S. government agency research grants.
The Company's revenue recognition policy is in accordance with the
American Institute of Certified Public Accountants' ("AICPA") Statement of
Position No. 97-2 ("SOP 97-2"), "Software Revenue Recognition", as amended by
Statement of Position No. 98-4, "Deferral of the Effective Date of SOP 97-2,
"Software Revenue Recognition"" ("SOP 98-4"), and Statement of Position No.
98-9, "Modification of SOP No. 97-2 with Respect to Certain Transactions" ("SOP
98-9") and is also consistent with the Securities and Exchange Commission's
Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial
Statements." For each arrangement, the Company determines whether evidence of an
arrangement exists, delivery has occurred, the fee is fixed or determinable, and
collection is probable. If any of these criteria are not met, revenue
recognition is deferred until such time as all criteria are met. The Company
considers all arrangements with payment terms extending beyond twelve months and
other arrangements with payment terms longer than normal not to be fixed or
determinable. If collectibility is not considered probable, revenue is
recognized when the fee is collected. Generally, no customer has the right of
return.
4
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
Arrangements consisting of license and maintenance. For those contracts
that consist solely of license and maintenance, the Company recognizes license
revenues based upon the residual method after all elements other than
maintenance have been delivered as prescribed by SOP 98-9. The Company
recognizes maintenance revenues over the term of the maintenance contract as
vendor specific objective evidence of fair value for maintenance exists. In
accordance with paragraph ten of SOP 97-2, vendor specific objective evidence of
fair value of maintenance is determined by reference to the price the customer
will be required to pay when it is sold separately (that is, the renewal rate).
Customers that enter into maintenance contracts have the ability to renew such
contracts at the renewal rate. Maintenance contracts are typically one year in
duration. Revenue is recognized on a per copy basis for licensed software when
each copy of the license requested by the customer is delivered.
Revenue is recognized on licensed software on a per user or per server
basis for a fixed fee when the product master is delivered to the customer.
There is no right of return or price protection for sales to domestic and
international distributors, system integrators, or value added resellers
(collectively, "resellers"). In situations where the reseller has a purchase
order or other contractual agreement from the end user that is immediately
deliverable upon, the Company recognizes revenue on the shipment to the
reseller, if other criteria in SOP 97-2 are met, since the Company has no risk
of concessions. The Company defers revenue on shipments to resellers if the
reseller does not have a purchase order or other contractual agreement from an
end user that is immediately deliverable upon or other criteria in SOP 97-2 are
not met. The Company recognizes royalty revenues upon receipt of the quarterly
reports from the vendors.
When licenses and maintenance are sold together with professional
services such as consulting and implementation, license fees are recognized upon
shipment, provided that (1) the criteria in the previous paragraph have been
met, (2) payment of the license fee is not dependent upon the performance of the
professional services, and (3) the services do not include significant
alterations to the features and functionality of the software.
Should professional services be essential to the functionality of the
licenses in a license arrangement that contains professional services or should
an arrangement not meet the criteria mentioned above, both the license revenues
and professional service revenues are recognized in accordance with the
provisions of the AICPA's Statement of Position No. 81-1, "Accounting for
Performance of Construction Type and Certain Production Type Contracts" ("SOP
81-1"). When reliable estimates are available for the costs and efforts
necessary to complete the implementation services and the implementation
services do not include contractual milestones or other acceptance criteria, the
Company accounts for the arrangements under the percentage of completion
contract method pursuant to SOP 81-1 based upon input measures such as hours or
days. When such estimates are not available, the completed contract method is
utilized. When an arrangement includes contractual milestones, the Company
recognizes revenues as such milestones are achieved provided the milestones are
not subject to any additional acceptance criteria.
Application services. Application services revenues consist primarily
of web design and integration fees, video processing fees and application
hosting fees. Web design and integration fees are recognized ratably over the
contract term, which is generally six to twelve months. The Company generates
video processing fees for each hour of video that a customer deploys. Processing
fees are recognized as encoding, indexing and editorial services are performed
and are based upon time-based rates of video content. Application hosting fees
are generated by and based upon the number of video queries processed, subject
in most cases to monthly minimums. The Company recognizes revenues on
transaction fees that are subject to monthly minimums based upon the monthly
minimum rate since the Company has no further obligations, the payment terms are
normal and each month is a separate measurement period.
Professional Services. The Company provides professional services such
as consulting, implementation and training services to its customers. Revenues
from such services, when not sold in conjunction with product licenses, are
generally recognized as the services are performed provided all other revenue
recognition criteria are met.
5
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
Other revenues. Other revenues consist primarily of U.S. government
agency research grants that are best effort arrangements. The
software-development arrangements are within the scope of the Financial
Accounting Standards Board's ("FASB") Statement of Financial Accounting
Standards No. 68, "Research and Development Arrangements." As the financial
risks associated with the software-development arrangement rest solely with the
U.S. government agency, the Company is recognizing revenues as the services are
performed. The cost of these services are included in cost of other revenues.
The Company's contractual obligation is to provide the required level of effort
(hours), technical reports, and funds and man-hour expenditure reports.
Use of Estimates
The preparation of the accompanying unaudited condensed consolidated
financial statements requires management to make estimates and assumptions that
affect the amounts reported in these financial statements. Actual results could
differ from those estimates.
Cash Equivalents and Short-Term Investments
The Company invests its excess cash in money market accounts and debt
instruments and considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents. Investments
with an original maturity at the time of purchase of over three months are
classified as short-term investments regardless of maturity date, as all such
instruments are classified as available-for-sale and can be readily liquidated
to meet current operational needs. At December 31, 2002, all of the Company's
cash equivalents and short-term investments were classified as
available-for-sale and consisted of obligations issued by U.S. or state
government agencies and multinational corporations, maturing within one year.
Comprehensive Net Loss
The Company has adopted the FASB's Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income" ("FAS 130"). FAS 130
establishes standards for the reporting and display of comprehensive income
(loss) and its components in a full set of general purpose financial statements.
To date, unrealized gains and losses have been insignificant and the Company has
had no other significant comprehensive income (loss), and consequently, net loss
equals total comprehensive net loss.
Net Loss per Share
Basic and diluted net loss per share are computed in conformity with
the FASB's Statement of Financial Accounting Standards No. 128, "Earnings Per
Share" ("FAS 128"), for all periods presented, using the weighted average number
of common shares outstanding less shares subject to repurchase.
6
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
The following table presents the computation of basic and diluted net
loss per share (in thousands, except per share data):
Three Months Ended Nine Months Ended
December 31, December 31,
-------------------- --------------------
2002 2001 2002 2001
-------- -------- -------- --------
Net loss ....................... $ (3,262) $ (5,204) $(13,506) $(18,784)
======== ======== ======== ========
Weighted-average shares of
common stock outstanding ..... 20,902 20,474 20,797 20,400
Less weighted-average shares of
common stock subject to
repurchase ................... (3) (108) (11) (151)
-------- -------- -------- --------
Weighted-average shares used in
computation of basic and
diluted net loss per share ... 20,899 20,366 20,786 20,249
======== ======== ======== ========
Basic and diluted net loss per
share ........................ $ (0.16) $ (0.26) $ (0.65) $ (0.93)
======== ======== ======== ========
The Company has excluded all outstanding stock options, warrants and
shares subject to repurchase from the calculation of basic and diluted net loss
per share because these securities are antidilutive for all periods presented.
Such securities, had they been dilutive, would have been included in the
computation of diluted net loss per share using the treasury stock method.
Impact of Recently Issued Accounting Standards
In August 2001, the FASB issued Statement of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets ("FAS 144")," which addresses financial accounting and reporting for the
impairment or disposal of long-lived assets and supersedes FAS 121 and the
accounting and reporting provisions of Accounting Principles Board Opinion No.
30, "Reporting the Results of Operations for a Disposal of a Segment of a
Business." The Company adopted FAS 144 as of April 1, 2002 and, to date, the
adoption of this statement has not had a significant impact on the Company's
financial position and results of operations. The Company monitors its
long-lived assets, primarily its property and equipment, for impairment issues
as part of its on-going financial processes and the provisions of FAS 144 could
result in the Company recording additional charges in the future.
In November 2001, the FASB issued a Staff Announcement (the
"Announcement"), Topic D-103, which concluded that the reimbursement of
"out-of-pocket" expenses should be classified as revenue in the statement of
operations. The Company adopted the Announcement in its fiscal fourth quarter of
its year ended March 31, 2002 and the Announcement did not have a material
affect on the Company's operations, financial position or cash flows.
In July 2002, the FASB issued Statement of Financial Accounting
Standards No. 146, "Accounting for Costs Associated with Exit and Disposal
Activities ("FAS 146")." This statement revises the accounting for exit and
disposal activities under the FASB's Emerging Issues Task Force Issue 94-3,
"Liability Recognition for Certain Employee Termination Benefits and Other Costs
to Exit an Activity ("EITF 94-3")," by spreading out the reporting of expenses
related to restructuring activities. Commitment to a plan to exit an activity or
dispose of long-lived assets will no longer be sufficient to record a one-time
charge for most anticipated costs. Instead, companies will record exit or
disposal costs when they are "incurred" and can be measured at fair value, and
they will subsequently adjust the recorded liability for changes in estimated
cash flows. Companies may not restate previously issued financial statements for
the effect of the provisions of FAS 146 and liabilities that a company
previously recorded under EITF 94-3 are grandfathered.
7
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
During the three months ended December 31, 2002, the Company early
adopted FAS 146. The Company also adopted a plan that calls for the Company to
consolidate certain headquarters facilities in March 2003. As a result of this
early adoption of FAS 146, approximately $1,858,000 of charges related to the
Company's planned facility consolidation will be recorded as of the date the
Company ceases use of the space it intends to abandon (March 2003) instead of
the plan adoption date (December 2002) as prescribed under EITF 94-3. Based upon
the facts and circumstances around charges that the Company historically has
been required to record, the Company currently believes that the adoption of FAS
146 may affect the timing of, but ultimately will not have a materially
different impact on, its operations, financial position or cash flows.
In November 2002, a consensus was reached regarding the FASB's Emerging
Issues Task Force Issue 00-21, "Accounting for Revenue Arrangements with
Multiple Deliverables ("EITF 00-21")." EITF 00-21 prescribes that if
deliverables in a multi-element arrangement meet certain criteria, arrangement
consideration should be allocated among the separate units of accounting based
on each unit's relative fair values. Applicable revenue recognition criteria
should be considered separately for separate units of accounting. EITF 0-21 will
be applicable to agreements entered into in fiscal periods beginning after June
15, 2003. The Company does not believe EITF 00-21 will have a material effect on
its operations, financial position or cash flows.
In December 2002, the FASB issued Statement of Financial Accounting
Standards No. 148, "Accounting for Stock-Based Compensation--Transition and
Disclosure ("FAS 148")." FAS 148 amends Statement of Financial Accounting
Standards No. 123, "Accounting for Stock-Based Compensation ("FAS 123")," to
provide alternative methods of transition to FAS 123's fair value method of
accounting for stock-based employee compensation. FAS 148 also amends the
disclosure provisions of FAS 123 and Accounting Principles Board's Opinion No.
28, "Interim Financial Reporting," to require disclosure in the summary of
significant accounting policies of the effects of an entity's accounting policy
with respect to stock-based employee compensation on reported net income and
earnings (loss) per share in annual and interim financial statements. FAS 148
does not require companies to account for employee stock options using the fair
value method of accounting (ie. the expensing of stock option grants in a
company's statement of operations). The Company will adopt FAS 148 in its fiscal
fourth quarter of its year ended March 31, 2003. FAS 148 will not have a
material effect on the Company's operations, financial position or cash flows as
the Company will continue to account for employee stock options using the
intrinsic value method of accounting. However, the Company will be required to
provide additional disclosures with its interim and annual financial statements
regarding the impact of employee stock options as if it had accounted for
employee stock options using the fair value method of accounting.
In December 2002, the FASB issued Interpretation No. 45, "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others ("FIN 45")." FIN 45 elaborates on the
disclosures to be made by a guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it has issued. It
also clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in
issuing the guarantee. The Company has adopted the disclosure requirements of
FIN 45 as of December 31, 2002. In addition, the Company is required to adopt
the initial recognition and measurement of the fair value of the obligation
undertaken in issuing the guarantee on a prospective basis for all guarantees
issued or modified after December 31, 2002. The Company does not believe FIN 45
will have a material effect on the Company's operations, financial position or
cash flows.
8
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
2. Commitments and Contingencies
In the normal course of business, the Company is subject to commitments
and contingencies, including operating leases, restructuring liabilities and
litigation including securities-related litigation and other claims in the
ordinary course of business. The Company records accruals for such contingencies
based upon its assessment of the probability of occurrence and, where
determinable, an estimate of the liability. The Company considers many factors
in making these assessments including past history and the specifics of each
matter. The estimate of the liability necessarily requires assumptions to be
made with respect to certain internal and external variables, which may affect
the ultimate actual amount of liability. However, actual results may differ from
these estimates if such assumptions later prove inaccurate. The Company reviews
its assessment of the likelihood of loss on any outstanding contingencies as
part of its on-going financial processes.
Commitments
In December 2002, the Company amended its lease for its headquarters
(the "Lease Amendment"). The Lease Amendment reduces, from December 2002 until
December 2003, the Company's rent rate to half of what the rent rate was under
the original operating lease agreement. In December 2003, and on each annual
anniversary thereafter through the Amendment's termination date of September
2006, the Company's rent rate will be adjusted to fair market value as to be
mutually determined by the Company and its landlord, subject to a minimum rate
that is equivalent to the Lease Amendment's initial reduced rate discussed above
(the "Minimum Rate").
In addition, the Company and its landlord will use best efforts to have
the landlord lease, to a third party, certain space that the Company intends to
abandon in March 2003. If the space is leased to a third party, the space will
be excluded from the Lease Amendment as of the date an agreement for the third
party lease is executed, subject to the Company guaranteeing its landlord the
Minimum Rate for the leased space. This guarantee will continue for a minimum of
24 months after the date of execution for the leased space.
Furthermore, if the Company is acquired by an unrelated entity, the
acquiror may terminate the lease obligation for a termination fee equal to 67%
of the total minimum monthly rent payable for the remaining term of the lease
subsequent to such acquisition.
In consideration for the above, the Company issued its landlord a
warrant to purchase 200,000 shares of the Company's common stock at $0.57 per
share (see Note 3). In addition, the Company will pay its landlord $1,250,000 on
January 2, 2003. On March 30, 2003, the landlord will release back to the
Company $1,250,000 of $2,000,000 of restricted cash used to collateralize a
letter of credit. The Company will also forego approximately $240,000 of
security deposits by March 31, 2003. The $2,000,000 of restricted cash and
$240,000 of security deposits are classified as other assets on the Company's
condensed consolidated balance sheets as of December 31, 2002 and March 31,
2002.
The Company will be obligated to remit an additional $750,000 to its
landlord if its landlord is able to lease this excess space for the benefit of
the Company. Should this occur, the Company's landlord will cancel the Company's
letter of credit in its entirety and release the final $750,000 of restricted
cash back to the Company. The Company estimates it will also incur approximately
$325,000 of other various expenses relating to certain provisions set forth
within the Lease Amendment.
In addition, the landlord, under certain limited conditions and
exceptions specified in the Lease Amendment, may have the option to extend the
term of the Lease Amendment for an additional five (5) years, with the base rent
for the renewal term based on fair market value.
9
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
The Company began amortizing the $2,565,000 of payments and other
expenses described above as rent expense over the life of the lease in December
2002. In March 2003, the Company anticipates abandoning approximately half of
its headquarters facility to facilitate the leasing of the space to a third
party. As a result of this and the Company's early adoption of FAS 146 (see Note
1), the Company expects to incur charges of approximately $1,858,000 during the
three months ended March 31, 2003. The charges are related to the write-off of
approximately half of the unamortized portion of the $2,565,000 of anticipated
payments described above and the accrual of approximately $750,000 relating to
the expected leasing of the excess space to a third party at a rate that is
below the Minimum Rate guarantee.
At December 31, 2002, the Company has contractual and commercial
commitments not included on its balance sheet primarily for its San Mateo,
California facility that it has an obligation to lease through September 2006.
For the remainder of the fiscal year ended March 31, 2003, the Company's total
commitments amount to $2,290,000. Future full fiscal year commitments are as
follows: $3,166,000 in 2004, $1,972,000 in 2005, $1,715,000 in 2006 and
$1,057,000 in 2007 ($10,200,000 in total commitments as of December 31, 2002).
The aforementioned amounts include estimates of expected fair market rental
rates in fiscal years ending March 31, 2004 to March 31, 2007 and the payments
of cash and forfeiture of other collateral of $1,489,000 and $1,076,000 for the
years ending March 31, 2003 and 2004, respectively, pursuant to the Lease
Amendment described above.
Guarantees
The Company generally provides a warranty for its software products and
services to its customers for a period of 90 days and accounts for its
warranties under the FASB's Statement of Financial Accounting Standards No. 5,
"Accounting for Contingencies." The Company's software products' media are
generally warranted to be free of defects in materials and workmanship under
normal use and the products are also generally warranted to substantially
perform as described in certain Company documentation. The Company's services
are generally warranted to be performed in a professional manner and to
materially conform to the specifications set forth in a customer's signed
contract. In the event there is a failure of such warranties, the Company
generally will correct or provide a reasonable work around or replacement
product. The Company's warranty accrual as of December 31, 2002 and March 31,
2002 was not significant and, to date, the Company's product warranty expense
has not been significant.
At December 31, 2002 and March 31, 2002, the Company has two letters of
credit that collateralize certain operating lease obligations of the Company and
total approximately $2,018,000. The Company collateralizes these letters of
credit with cash deposits made with certain of its financial institutions and
has classified these cash deposits as other assets on the Company's balance
sheet as of December 31, 2002 and March 31, 2002. The Company's landlords are
able to withdraw on each respective letter of credit in the event that the
Company is found to be in default of its obligations under each of its operating
leases.
The Company generally does not enter into indemnification agreements
that contingently require the Company to make payments directly to a party that
is indemnified by the Company (an "Indemnified Party"). The Company's
indemnification agreements generally defend and indemnify an Indemnified Party
against adverse situations such as, for example, defense against plaintiffs in a
lawsuit brought by a third party. In all such cases the Company would make
payments to such third party and/or attorneys if such a third party were
successful in such litigation. Historically, the expenses relating to or arising
from the Company's indemnification agreements have not been significant.
10
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
Restructuring
During the three and nine months ended December 31, 2002, the Company
implemented additional restructuring programs to better align operating expenses
with anticipated revenues. The Company recorded a $940,000 restructuring charge
(the significant majority of which was recorded during the three months ended
June 30, 2002), which consisted of $834,000 in employee severance costs and
$106,000 in equipment write-downs across most of the expense line items in the
Company's consolidated statement of operations for the nine months ended
December 31, 2002. The restructuring programs resulted in a reduction in force
across all company functions of approximately 50 employees. At March 31, 2002,
the Company had $763,000 of accrued restructuring costs (the significant
majority of which were recorded during the three months ended March 31, 2002)
related to monthly rent for excess facility capacity, employee severance
payments and other exit costs. The Company expects to pay out all restructuring
amounts accrued as of December 31, 2002 over the course of the next 12 months.
During the three months ended December 31, 2002, the Company made an
adjustment of $66,000 to its accrued excess facilities costs, which affected its
results of operations for the three and nine months ended December 31, 2002. The
excess facility accrual was originally recorded pursuant to EITF 94-3. The
adjustment is a result of the Company's expectation that, in March 2003, it will
re-occupy certain space it had previously written-off and had not intended to
use until April 2003.
The following table depicts the restructuring activity during the nine
months ended December 31, 2002 (in thousands):
Balance at Expenditures Balance at
March 31, --------------------- December 31,
Category 2002 Additions Cash Non-cash Adjustments 2002
-------- ------ --------- ---- -------- ----------- ------
Excess facilities ........................ $ 460 $ -- $ 361 $ -- $ 66 $ 33
Employee severance ....................... 259 834 1,093 -- -- --
Equipment write-downs .................... -- 106 -- 106 -- --
Other exit costs ......................... 44 -- 9 -- -- 35
------ ------ ------ ------ ------ ------
Total .................................. $ 763 $ 940 $1,463 $ 106 $ 66 $ 68
====== ====== ====== ====== ====== ======
During the nine months ended December 31, 2001, the Company implemented
restructuring programs to better align operating expenses with anticipated
revenues. The Company recorded a $847,000 restructuring charge ($397,000 of
which was recorded during the three months ended June 30, 2001 and $450,000 of
which was recorded during the three months ended September 30, 2001), which
consisted of $345,000 in facility exit costs and $502,000 in employee severance
costs across most of the expense line items in the Company's consolidated
statement of operations for the nine months ended December 31, 2001. The
restructuring programs resulted in a reduction in force across all company
functions of approximately 45 employees. At December 31, 2001, the Company had
$148,000 of accrued restructuring costs related to monthly rent for excess
facility capacity, employee severance payments and other exit costs. The Company
paid these accrued amounts out over the course of the 12 months subsequent to
December 31, 2001.
The following table depicts the restructuring activity during the nine
months ended December 31, 2001 (in thousands):
Balance at
Cash December 31,
Category Additions Expenditures 2001
-------- --------- ---- ----
Excess facilities .................... $345 $284 $ 61
Employee severance ................... 502 415 87
---- ---- ----
Total .............................. $847 $699 $148
==== ==== ====
11
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
The Company has invested significant resources into developing and
marketing its recently introduced application products. The Company believes
that these application products broaden the value proposition to business
software application users and expects to derive future revenues as a result of
these product introductions. The market for the Company's application products
is in a relatively early stage. The Company cannot predict how the market for
its application products will develop, and part of its strategic challenge will
be to convince enterprise customers of the productivity, communications, cost
and other benefits of its application products. The Company's future revenues
and revenue growth rates will depend in large part on its success in creating
market acceptance for its application products. If the Company fails to do so,
its products and services will not achieve widespread market acceptance, and may
not generate significant revenues to offset its development, sales and marketing
costs, which will hurt its business. This could lead to the Company taking
additional restructuring actions in order to reduce costs and bring staffing in
line with then anticipated requirements.
Litigation
Beginning on August 22, 2001, purported securities fraud class action
complaints were filed in the United States District Court for the Southern
District of New York. The cases were consolidated and the litigation is now
captioned as In re Virage, Inc. Initial Public Offering Securities Litigation,
Civ. No. 01-7866 (SAS) (S.D.N.Y.), related to In re Initial Public Offering
Securities Litigation, 21 MC 92 (SAS) (S.D.N.Y.). On or about April 19, 2002,
plaintiffs electronically served an amended complaint. The amended complaint is
brought purportedly on behalf of all persons who purchased the Company's common
stock from June 28, 2000 through December 6, 2000. It names as defendants the
Company; one current and one former officer of the Company; and several
investment banking firms that served as underwriters of the Company's initial
public offering. The complaint alleges liability under Sections 11 and 15 of the
Securities Act of 1933 and Sections 10(b) and 20(a) of the Securities Exchange
Act of 1934, on the grounds that the registration statement for the offering did
not disclose that: (1) the underwriters had agreed to allow certain customers to
purchase shares in the offerings in exchange for excess commissions paid to the
underwriters; and (2) the underwriters had arranged for certain customers to
purchase additional shares in the aftermarket at predetermined prices. The
amended complaint also alleges that false analyst reports were issued. No
specific damages are claimed.
The Company is aware that similar allegations have been made in other
lawsuits filed in the Southern District of New York challenging over 300 other
initial public offerings and secondary offerings conducted in 1999 and 2000.
Those cases have been consolidated for pretrial purposes before the Honorable
Judge Shira A. Scheindlin. On July 15, 2002, the Company (and the other issuer
defendants) filed a motion to dismiss. This motion was heard on November 1,
2002. The Company believes that the allegations against it and the individual
defendants are without merit, and intends to contest them vigorously.
From time to time, the Company may become involved in litigation claims
arising from its ordinary course of business. The Company believes that there
are no claims or actions pending or threatened against it, the ultimate
disposition of which would have a material adverse effect on the Company's
consolidated financial position, results of operations or cash flows.
12
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
NASDAQ National Market Trading Requirements
The Company's stock is currently traded on the NASDAQ National Market.
Under NASDAQ's listing maintenance standards, if the closing bid price of the
Company's common stock is under $1.00 per share for 30 consecutive trading days,
NASDAQ may choose to notify the Company that it may delist its common stock from
the NASDAQ National Market. On October 31, 2002, the Company received notice
from NASDAQ that it is not in compliance with NASDAQ's listing maintenance
standards and that it has until January 29, 2003 to regain compliance. If at any
time before January 29, 2003 the bid price of the Company's common stock closes
at $1.00 per share or more for a minimum of 10 consecutive trading days, NASDAQ
will consider notifying the Company that it complies with the maintenance
standards. If the Company is unable to meet this minimum bid price requirement
by January 29, 2003, the Company expects to have the option of transferring to
the NASDAQ SmallCap Market, which makes available a 180 calendar day extended
grace period for the minimum $1.00 bid price requirement (instead of a 90 day
grace period as provided by the NASDAQ National Market). In addition, the
Company expects that it may also be eligible for an additional 180 calendar day
grace period on the NASDAQ SmallCap Market (ie. until October 27, 2003) provided
that the Company meets the other non-bid price related listing criteria. If the
Company transfers to the NASDAQ SmallCap Market, the Company expects that it may
be eligible to transfer back to the NASDAQ National Market if its bid price
maintains the $1.00 per share requirement for 30 consecutive trading days and it
has maintained compliance with all other continued listing requirements for the
NASDAQ National Market. There can be no assurance that the Company's common
stock will remain eligible for trading on the NASDAQ National Market or the
NASDAQ SmallCap Market. If the Company's stock were delisted, the ability of the
Company's stockholders to sell any of the Company's common stock at all would be
severely, if not completely, limited.
3. Stockholders' Equity
Voluntary Stock Option Cancellation and Re-grant Program
In February 2002, the Company offered a voluntary stock option
cancellation and re-grant program to its employees. The plan allowed employees
with stock options at exercise prices of $5.00 per share and greater to cancel a
portion or all of these unexercised stock options effective February 6, 2002, if
they so chose, provided that should an employee participate, any option granted
to that employee within the six months preceding February 6, 2002 was also
automatically cancelled. On February 6, 2002, 2,678,250 shares with a
weighted-average exercise price of $9.54 per share were cancelled pursuant to
this program. As a result of this program, the Company was required to grant its
employees stock options on August 7, 2002 at the closing market price as of that
date. On August 7, 2002, the Company issued 2,538,250 shares at $0.59 per share
to employees that participated in the Company's Voluntary Stock Option
Cancellation and Re-grant Program.
In addition, the Company had two employees that were eligible to
participate in this program that did not meet certain employee definitional
criteria pursuant to APB Opinion No. 25, "Accounting for Stock Issued to
Employees," as interpreted by the FASB's Interpretation No. 44, "Accounting for
Certain Transactions involving Stock Compensation, an interpretation of APB
Opinion No. 25." Accordingly, the Company had to account for the option grants
to these two participants as though they were non-employees pursuant to EITF
Issue 96-18, "Accounting for Equity Instruments That Are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services,"
resulting in the Company recording non-cash, stock-based charges of $87,000 for
the nine months ended December 31, 2002.
13
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
Warrants
In December 2002, the Company entered into an amendment for its
headquarters' operating lease (see Note 2) and issued an immediately
exercisable, non-forfeitable warrant to purchase 200,000 shares of common stock
at $0.57 per share. The warrant expires in December 2005. The value of the
warrant was estimated to be $86,000 and was based upon a Black-Scholes valuation
model with the following assumptions: risk free interest rate of 1.9%, no
dividend yield, volatility of 130%, expected life of three years, exercise price
of $0.57 and fair market value of $0.57. The non-cash amortization of the
warrant's value is being recorded as rent expense over the life of the lease.
During the three and nine months ended December 31, 2002, the Company recorded
$2,000 as rent expense related to this warrant.
In December 2000, the Company entered into a services agreement with a
customer and issued an immediately exercisable, non-forfeitable warrant to
purchase 200,000 shares of common stock at $5.50 per share. The warrant expires
in December 2003. The value of the warrant was estimated to be $648,000 and was
based upon a Black-Scholes valuation model with the following assumptions: risk
free interest rate of 7.0%, no dividend yield, volatility of 90%, expected life
of three years, exercise price of $5.50 and fair market value of $5.38. The
non-cash amortization of the warrant's value was recorded against service
revenues as revenues from services were recognized over the one-year services
agreement. During the three months and nine months ended December 31, 2001, the
Company recorded $216,000 and $648,000, respectively, as contra-service revenues
representing the pro-rata amortization of the warrant's value for the
aforementioned periods (none during the three or nine months ended December 31,
2002).
4. Segment Reporting
The Company has two reportable segments: the sale of software and
related software support services ("software") and the sale of its application
and professional services which includes set-up fees, professional services
fees, video processing fees, and application hosting fees ("application and
professional services"). The Company's Chief Operating Decision Maker ("CODM")
is the Company's Chief Executive Officer who evaluates performance and allocates
resources based upon total revenues and gross profit (loss). Discrete financial
information for each segment's profit and loss and each segment's total assets
is not provided to the Company's CODM, nor is it tracked by the Company.
14
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
Information on the Company's reportable segments for the three and nine
months ended December 31, 2002 and 2001 are as follows (in thousands):
Three Months Ended Nine Months Ended
December 31, December 31,
------------------ ------------------
2002 2001 2002 2001
------- ------- ------- -------
Software:
Total revenues .................... $ 2,002 $ 2,158 $ 6,635 $ 8,536
Total cost of revenues ............ 375 361 1,107 1,121
------- ------- ------- -------
Gross profit ...................... $ 1,627 $ 1,797 $ 5,528 $ 7,415
======= ======= ======= =======
Application and Professional Services:
Total revenues .................... $ 1,312 $ 2,630 $ 3,191 $ 4,988
Total cost of revenues ............ 910 1,968 2,743 (6,625)
------- ------- ------- -------
Gross profit (loss) ............... $ 402 $ 662 $ 448 $(1,637)
======= ======= ======= =======
The Company expects to incur a charge of $1,858,000 during the three
months ended March 31, 2003 related to a planned facility consolidation (see
Note 2). Of this amount, the Company expects that approximately $93,000 will
relate to the Company's software segment and approximately $261,000 will relate
to the Company's application and professional services segment.
5. Income Taxes
The Company has not recorded a provision for federal and state or
foreign income taxes for the three and nine months ended December 31, 2002 or
2001 because the Company has experienced net losses since inception, which have
resulted in deferred tax assets. The Company has recorded a valuation allowance
against all deferred tax assets as a result of uncertainties regarding the
realization of the balances, which only may occur through future taxable
profits.
15
VIRAGE, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (continued)
December 31, 2002
(unaudited)
6. Subsequent Events
NASDAQ National Market Trading Requirements
On January 30, 2003, the NASDAQ Stock Market submitted a proposal to
the U.S. Securities and Exchange Commission ("SEC") to extend its pilot program
governing bid price rules for all companies listed on the NASDAQ National Market
and also proposed additional bid price rules for all companies listed on the
NASDAQ SmallCap Market. Under the National Market proposal, NASDAQ will extend
the bid price grace period of its pilot program for all National Market issuers
from 90 calendar days to 180 calendar days. In addition, the NASDAQ Small Cap
Market has proposed to increase its pilot program by an additional 180 day grace
period to gain compliance with the minimum bid price listing requirements
(provided that certain other non-bid price related criteria are met by the
registrant). The SEC must approve all of the NASDAQ's proposals prior to the
proposals becoming effective.
As described in Note 2 above, the Company received a letter on October
31, 2002 that it was not in compliance with the NASDAQ's minimum bid price
listing requirement. Based upon NASDAQ's proposed changes, which still require
SEC approval, the Company believes that it may have until approximately April
29, 2003 to regain compliance with the minimum bid price listing requirement. If
the Company is unable to meet this minimum bid price listing requirement by
April 29, 2003, the Company expects that it may have the option of transferring
to the NASDAQ SmallCap Market. Based upon a separate NASDAQ proposal that also
requires SEC approval, the NASDAQ SmallCap market would make available up to two
additional 180 calendar day extended grace periods (ie. until approximately
April 23, 2004) to meet the minimum $1.00 bid price requirement provided the
Company is able to meet certain financial related criteria. If the Company
transfers to the NASDAQ SmallCap Market, the Company expects that it may be
eligible to transfer back to the NASDAQ National Market if its bid price
maintains the $1.00 per share requirement for 30 consecutive trading days and it
has maintained compliance with all other continued listing requirements for the
NASDAQ National Market.
Should the SEC not approve the NASDAQ's proposals and/or should the
Company receive a letter from NASDAQ informing the Company that it will be
delisted due to noncompliance with the National Market's minimum bid price
requirement, the Company believes it will have the opportunity to transfer to
the NASDAQ Small Cap Market. From the date of receipt of such a NASDAQ delisting
letter, the Company believes it would have 90 days to attempt to regain
compliance while trading on the NASDAQ SmallCap Market. In addition, the Company
expects that it may also be eligible for an additional 180 calendar day grace
period on the NASDAQ SmallCap Market provided that the Company meets the other
non-bid price related listing criteria.
There can be no assurance that the SEC will approve NASDAQ's proposals,
that the Company will comply with other non-bid price related listing criteria
or that the Company's common stock will remain eligible for trading on the
NASDAQ National Market or the NASDAQ SmallCap Market. If the Company's stock
were delisted, the ability of the Company's stockholders to sell any of the
Company's common stock at all would be severely, if not completely, limited.
16
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion and analysis of our financial condition and
results of operations should be read in conjunction with the "Selected
Consolidated Financial Data", the condensed consolidated financial statements
and related notes contained herein. This discussion contains forward-looking
statements within the meaning of Section 27A of the Securities Act and Section
21E of the Exchange Act. We may identify these statements by the use of words
such as "believe", "expect", "anticipate", "intend", "plan" and similar
expressions. These forward-looking statements involve several risks and
uncertainties. Our actual results may differ materially from those set forth in
these forward-looking statements as a result of a number of factors, including
those described under the caption "Risk Factors" herein. These forward-looking
statements speak only as of the date of this report, and we caution you not to
rely on these statements without also considering the risks and uncertainties
associated with these statements and our business as addressed elsewhere in this
report.
Virage, Inc. is a provider of software products, professional services
and application services that enable owners of rich-media and video assets to
more effectively communicate, manage, retrieve and distribute these rich-media
assets for improved productivity and communications. Depending on their
particular needs and resources, our customers may elect to license our software
products or employ our application or professional services. Our customers
include media and entertainment companies, other corporations, government
agencies and educational institutions.
Recent Events
Application Products
During the past year, we introduced new software application products
that are targeted toward a broadened user base within our key markets. VS
Publishing is an application that offers media and entertainment customers a
streamlined workflow for rich-media web publishing, including a simple editorial
control and greater website programming capabilities. VS Webcasting allows
corporations to self-produce live and on-demand webcasting events such as
executive communications, human resource broadcasts and webinars. Finally, VS
Production is an integrated software solution for media and entertainment
enterprises that automates the professional video production process from
acquisition to distribution.
Though we have sold each of these products to date, early demand is
strongest for our VS Webcasting product, particularly from our corporate
enterprise customers. However, our VS Publishing and VS Production products were
released at a later date than VS Webcasting, and we continue to monitor
anticipated market demand and sales success for these products as we evaluate
the allocation and prioritization of our available resources. We may discover
that the marketplace for our application products is not as robust as we had
expected and we may react to this by leaving the development of a product at an
early stage or combining key features of one or more of our application products
into a single product.
We continue to believe that the success of our application products,
particularly VS Webcasting, is critical to our future and have heavily invested
our resources in the development, marketing, and sale of them. The market for
our application products is in a relatively early stage. We cannot predict how
much the market for our application products will develop, and part of our
strategic challenge will be to convince enterprise customers of the
productivity, communications, cost, and other benefits of these products. Our
future revenues and revenue growth rates will depend in large part on our
success in creating market acceptance for one or more of our application
products.
17
Facility Lease Amendment
In December 2002, we amended our lease for our headquarters (the "Lease
Amendment"). The Lease Amendment reduces, from December 2002 until December
2003, our rent rate to half of what the rent rate was under our original
operating lease agreement. In December 2003, and on each annual anniversary
thereafter through the Amendment's termination date of September 2006, our rent
rate will be adjusted to fair market value as to be mutually determined by us
and our landlord, subject to a minimum rate that is equivalent to the Lease
Amendment's initial reduced rate discussed above (the "Minimum Rate").
In addition, we and our landlord will use best efforts to have our
landlord lease, to a third party, certain space that we intend to abandon in
March 2003. If the space is leased to a third party, the space will be excluded
from the Lease Amendment as of the date an agreement for the third party lease
is executed, subject to our guaranteeing our landlord the Minimum Rate for the
leased space. This guarantee will continue for a minimum of 24 months after the
date of execution for the leased space.
Furthermore, if we are acquired by an unrelated entity, the acquirer
may terminate the lease obligation for a termination fee equal to 67% of the
total minimum monthly rent payable for the remaining term of the lease
subsequent to such acquisition.
In consideration for the above, we issued our landlord a warrant to
purchase 200,000 shares of our common stock at $0.57 per share. In addition, we
will pay our landlord $1,250,000 on January 2, 2003. On March 30, 2003, our
landlord will release back to us $1,250,000 of $2,000,000 of restricted cash
used to collateralize a letter of credit. We will also forego approximately
$240,000 of security deposits by March 31, 2003. The $2,000,000 of restricted
cash and $240,000 of security deposits are classified as other assets on our
consolidated balance sheets as of December 31, 2002 and March 31, 2002.
We will also be obligated to remit an additional $750,000 to our
landlord if our landlord is able to lease this excess space for the benefit of
the Company. Should this occur, our landlord will cancel our letter of credit in
its entirety and release the final $750,000 of restricted cash back to us. We
estimate we will also incur approximately $325,000 of other various expenses
relating to certain provisions set forth within the Lease Amendment.
In addition, our landlord, under certain limited conditions and
exceptions specified in the Lease Amendment, may have the option to extend the
term of the Lease Amendment for an additional five (5) years, with the base rent
for the renewal term based on fair market value.
We began amortizing the $2,565,000 of payments and other expenses
described above as rent expense over the life of the lease in December 2002. As
noted above, in March 2003, we anticipate abandoning approximately half of our
headquarters facility to facilitate the leasing of the space to a third party.
As a result of this and the Company's early adoption of FAS 146, we expect to
incur charges of approximately $1,858,000 during the three months ended March
31, 2003. The charges are related to the write-off of approximately half of the
unamortized portion of the $2,565,000 of anticipated payments described above
and the accrual of approximately $750,000 relating to the expected leasing of
the excess space to a third party at a rate that is below the Minimum Rate
guarantee.
18
Business Restructuring Charges
During the nine months ended December 31, 2002, we re-evaluated our
cost structure and executed additional restructuring measures designed to reduce
and consolidate operations worldwide. We further reduced headcount and
infrastructure across all functional areas of the company in our continued
efforts to limit our expenses and more closely match our expense and short-term,
anticipated revenue levels. These headcount and infrastructure changes resulted
in a reduction in force of approximately 50 employees worldwide and the
recording of $940,000 in business restructuring charges during the nine months
ended December 31, 2002. A breakdown of our business restructuring charges
during the nine months ended December 31, 2002 and of the remaining
restructuring accrual is as follows:
Balance at Expenditures Balance at
March 31, ---------------------- December 31,
Category 2002 Additions Cash Non-cash Adjustments 2002
-------- ------ --------- ------ -------- ----------- ------
Excess facilities and other .............. $ 504 $ -- $ 370 $ -- $ 66 $ 68
Employee severance ....................... 259 834 1,093 -- -- --
Equipment write-downs .................... -- 106 -- 106 -- --
------ ------ ------ ------ ------ ------
Total .................................. $ 763 $ 940 $1,463 $ 106 $ 66 $ 68
====== ====== ====== ====== ====== ======
Excess Facilities and Other Exit Costs: Excess facilities and other
exit costs relate to lease obligations and closure costs associated with offices
we have vacated as a result of our cost reduction initiatives. Cash expenditures
for excess facilities and other exit costs during the nine months ended December
31, 2002 primarily represent contractual ongoing lease payments. Our management
reviews our facility requirements and assesses whether any excess capacity
exists as part of our on-going financial processes.
During the three months ended December 31, 2002, we made an adjustment
of $66,000 to our accrued excess facilities costs, which affected our results of
operations for the three and nine months ended December 31, 2002. The excess
facility accrual was originally recorded pursuant to the FASB's Emerging Issues
Task Force Issue 94-3, "Liability Recognition for Certain Employee Termination
Benefits and Other Costs to Exit an Activity ("EITF 94-3")." The adjustment is a
result of our expectation that, in March 2003, we will re-occupy certain space
we had previously written-off and had not intended to use until April 2003.
Employee Severance: Employee severance, which includes severance
payments, related taxes, outplacement and other benefits, totaled approximately
$834,000 during the nine months ended December 31, 2002 (representing
approximately 50 terminated employees), and $1,093,000 was paid in cash during
the nine months ended December 31, 2002. Personnel affected by the cost
reduction initiatives during the nine months ended December 31, 2002 include
employees in positions throughout the company in sales, marketing, services,
engineering, and general and administrative functions in all geographies.
Equipment Write-Downs: As part of our cost restructuring efforts, we
decided to substantially downsize our subsidiary in the United Kingdom,
primarily in response to weak market conditions in Europe. Pursuant to these
efforts, we reduced our European asset infrastructure by reducing assets
previously used by terminated employees. This resulted in a write-off of
approximately $106,000 of assets at net book value. Our management reviews its
equipment requirements and assesses whether any excess equipment exists as part
of our on-going financial processes.
19
Voluntary Stock Option Cancellation and Re-grant Program
In February 2002, we canceled 2,678,250 stock options of certain
employees who elected to participate in our voluntary stock option cancellation
and re-grant program. Many of our employees canceled stock options that had
significantly higher exercise prices in comparison to where our common stock
price currently trades. On August 7, 2002, we issued 2,538,250 stock options to
current employees who participated in the program with a new exercise price
equal to $0.59 per share.
We believe that this program has helped, and will continue to help, to
retain our employees and to improve our workforce morale. However, this program
may cause dilution to our existing stockholder base, which may cause our stock
price to fall.
Critical Accounting Policies & Estimates
The discussion and analysis of our financial position and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with generally accepted accounting principles in the
United States. The preparation of these consolidated financial statements
requires us to make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues, and expenses, and related disclosure of
contingent assets and liabilities. We base our estimates on historical
experience and on various other assumptions that are believed to be reasonable
under the circumstances, the results of which form the basis for making
judgments about the carrying values of assets and liabilities that are not
readily apparent from other sources. Estimates and assumptions are reviewed as
part of our management's on-going financial processes. Actual results may differ
from these estimates under different assumptions and conditions.
We believe our critical accounting policies and estimates include
accounting for revenue recognition and the accounting and related estimates for
our commitments and contingencies.
Revenue Recognition
We enter into arrangements for the sale of licenses of software
products and related maintenance contracts, application services and
professional services offerings; and also receive revenues under U.S. government
agency research grants. Service revenues include revenues from maintenance
contracts, application services, and professional services. Other revenues are
primarily U.S. government agency research grants.
Our revenue recognition policy is in accordance with the American
Institute of Certified Public Accountants' ("AICPA") Statement of Position No.
97-2 ("SOP 97-2"), "Software Revenue Recognition", as amended by Statement of
Position No. 98-4, "Deferral of the Effective Date of SOP 97-2, "Software
Revenue Recognition"" ("SOP 98-4"), and Statement of Position No. 98-9,
"Modification of SOP No. 97-2 with Respect to Certain Transactions" ("SOP 98-9")
and is also consistent with the Securities and Exchange Commission's Staff
Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements." For
each arrangement, we determine whether evidence of an arrangement exists,
delivery has occurred, the fee is fixed or determinable, and collection is
probable. If any of these criteria are not met, revenue recognition is deferred
until such time as all criteria are met. We consider all arrangements with
payment terms extending beyond twelve months and other arrangements with payment
terms longer than normal not to be fixed or determinable. If collectibility is
not considered probable, revenue is recognized when the fee is collected.
Generally, no customer has the right of return.
Arrangements consisting of license and maintenance. For those contracts
that consist solely of license and maintenance, we recognize license revenues
based upon the residual method after all elements other than maintenance have
been delivered as prescribed by SOP 98-9. We recognize maintenance revenues over
the term of the maintenance contract as vendor specific objective evidence of
fair value for maintenance exists. In accordance with paragraph ten of SOP 97-2,
vendor specific objective evidence of fair value of maintenance is determined by
reference to the price the customer will be required to pay when it is sold
separately (that is, the renewal rate). Customers that enter into maintenance
contracts have the ability to renew such contracts at the renewal rate.
Maintenance contracts are typically one year in duration. Revenue is recognized
on a per copy basis for licensed software when each copy of the license
requested by the customer is delivered.
20
Revenue is recognized on licensed software on a per user or per server
basis for a fixed fee when the product master is delivered to the customer.
There is no right of return or price protection for sales to domestic and
international distributors, system integrators, or value added resellers
(collectively, "resellers"). In situations where the reseller has a purchase
order or other contractual agreement from the end user that is immediately
deliverable upon, we recognize revenue on the shipment to the reseller, if other
criteria in SOP 97-2 are met, since we have no risk of concessions. We defer
revenue on shipments to resellers if the reseller does not have a purchase order
or other contractual agreement from an end user that is immediately deliverable
upon or other criteria in SOP 97-2 are not met. We recognize royalty revenues
upon receipt of the quarterly reports from the vendors.
When licenses and maintenance are sold together with professional
services such as consulting and implementation, license fees are recognized upon
shipment, provided that (1) the criteria in the previous paragraph have been
met, (2) payment of the license fee is not dependent upon the performance of the
professional services, and (3) the services do not include significant
alterations to the features and functionality of the software.
Should professional services be essential to the functionality of the
licenses in a license arrangement which contains professional services or should
an arrangement not meet the criteria mentioned above, both the license revenues
and professional service revenues are recognized in accordance with the
provisions of the AICPA's Statement of Position No. 81-1, "Accounting for
Performance of Construction Type and Certain Production Type Contracts" ("SOP
81-1"). When reliable estimates are available for the costs and efforts
necessary to complete the implementation services and the implementation
services do not include contractual milestones or other acceptance criteria, we
account for the arrangements under the percentage of completion contract method
pursuant to SOP 81-1 based upon input measures such as hours or days. When such
estimates are not available, the completed contract method is utilized. When an
arrangement includes contractual milestones, we recognize revenues as such
milestones are achieved provided the milestones are not subject to any
additional acceptance criteria.
Application services. Application services revenues consist primarily
of account set-up, web design and integration fees, video processing fees and
application hosting fees. Account set-up, web design and integration fees are
recognized ratably over the contract term, which is generally six to twelve
months. We generate video processing fees for each hour of video that a customer
deploys. Processing fees are recognized as encoding, indexing and editorial
services are performed and are based upon hourly rates per hour of video
content. Application hosting fees are generated based on the number of video
queries processed, subject to monthly minimums. We recognize revenues on
transaction fees that are subject to monthly minimums on a monthly basis since
we have no further obligations, the payment terms are normal and each month is a
separate measurement period.
Professional services. We provide professional services such as
consulting, implementation and training services to our customers. Revenues from
such services, when not sold in conjunction with product licenses, are generally
recognized as the services are performed provided all other revenue recognition
criteria are met.
Other revenues. Other revenues consist primarily of U.S. government
agency research grants that are best effort arrangements. The
software-development arrangements are within the scope of the Financial
Accounting Standards Board's Statement of Financial Accounting Standards No. 68,
"Research and Development Arrangements." As the financial risks associated with
the software-development arrangement rest solely with the U.S. government
agency, we recognize revenues as the services are performed. The cost of these
services is included in cost of other revenues. The Company's contractual
obligation is to provide the required level of effort (hours), technical
reports, and funds and man-hour expenditure reports.
21
We follow very specific and detailed guidelines, discussed above, in
determining revenues; however, certain judgments and estimates are made and used
to determine revenue recognized in any accounting period. Material differences
may result in the amount and timing of revenue recognized for any period if
different conditions were to prevail. For example, in determining whether
collection is probable, we assess each customer's ability and intent to pay. Our
actual experience with respect to collections could differ from our initial
assessment if, for instance, unforeseen declines in the overall economy occur
and negatively impact our customers' financial condition. To date, we believe
that our revenue recognition has been proper and our related reserves have been
sufficient.
Commitments and Contingencies
In the normal course of business, we are subject to commitments and
contingencies, including operating leases, restructuring liabilities, and legal
proceedings and claims that cover a wide range of matters, including
securities-related litigation and other claims in the ordinary course of
business. We record accruals for such contingencies based upon our assessment of
the probability of occurrence and, where determinable, an estimate of the
liability. We consider many factors in making these assessments including past
history and the specifics of each matter. We believe that there are no claims or
actions pending or threatened against us that would have a material adverse
effect on our operating results. Further, we review our assessment of the
likelihood of loss on any outstanding contingencies as part of our management's
on-going financial processes. However, actual results may differ from these
estimates under different assumptions and conditions.
In July 2002, the FASB issued Statement of Financial Accounting
Standards No. 146, "Accounting for Costs Associated with Exit and Disposal
Activities ("FAS 146")." This statement revises the accounting for exit and
disposal activities under EITF 94-3 by spreading out the reporting of expenses
related to restructuring activities. Commitment to a plan to exit an activity or
dispose of long-lived assets will no longer be sufficient to record a one-time
charge for most anticipated costs. Instead, companies will record exit or
disposal costs when they are "incurred" and can be measured at fair value, and
they will subsequently adjust the recorded liability for changes in estimated
cash flows. Companies may not restate previously issued financial statements for
the effect of the provisions of FAS 146 and liabilities that a company
previously recorded under EITF 94-3 are grandfathered. Based upon the facts and
circumstances around charges that we historically have been required to record,
we currently believe that the adoption of FAS 146 may affect the timing of, but
ultimately will not have a materially different impact on, our operations,
financial position or cash flows as the accounting treatment under the
provisions of FAS 146 are not dissimilar to those prescribed under EITF 94-3.
During the three months ended December 31, 2002, we early adopted FAS
146 and we also adopted a plan that calls for us to consolidate certain
headquarters facilities in March 2003. As a result of this early adoption of FAS
146, approximately $1,858,000 of charges related to the our planned facility
consolidation will be recorded as of the date we cease use of the space we
intend to abandon (March 2003) instead of the plan adoption date (December 2002)
as prescribed under EITF 94-3.
At December 31, 2002, we have contractual and commercial commitments
not included on our balance sheet primarily for our San Mateo, California
facility that we have an obligation to lease through September 2006. For the
remainder of the fiscal year ended March 31, 2003, our total commitments amount
to $2,290,000. Future full fiscal year commitments are as follows: $3,166,000 in
2004, $1,972,000 in 2005, $1,715,000 in 2006 and $1,057,000 in 2007 ($10,200,000
in total commitments as of December 31, 2002). The aforementioned amounts
include our best estimate of expected fair market rental rates in fiscal years
ending March 31, 2004 to March 31, 2007 and if we underestimate these fair
market rental rates, the amount of our contractual commitments will increase.
The aforementioned amounts also include payments of cash and forfeiture of other
collateral of $1,489,000 and $1,076,000 for the years ending March 31, 2003 and
2004, respectively, pursuant to the Lease Amendment described above.
From time to time, we may become involved in litigation claims arising
from our ordinary course of business. We provide further detail about one of
these claims in the notes to our condensed consolidated financial statements
included elsewhere in this quarterly report. We believe that there are no claims
or actions pending or threatened against us, the ultimate disposition of which
would have a material adverse effect on the our consolidated financial position,
results of operations or cash flows.
22
Results of Operations
The following table sets forth consolidated financial data for the
periods indicated, expressed as a percentage of total revenues:
Three Months Ended Nine Months Ended
December 31, December 31,
------------------------------- ------------------------------
2002 2001 2002 2001
------------ ------------- ------------- -------------
Revenues:
License revenues.................... 40 % 31 % 47 % 46 %
Service revenues.................... 60 69 53 52
Other revenues...................... -- -- -- 2
------------ ------------- ------------- -------------
Total revenues.................... 100 100 100 100
Cost of revenues:
License revenues.................... 6 4 5 4
Service revenues.................... 33 45 34 52
Other revenues...................... -- -- -- 1
------------ ------------- ------------- -------------
Total cost of revenues............ 39 49 39 57
------------ ------------- ------------- -------------
Gross profit.......................... 61 51 61 43
Operating expenses:
Research and development............ 54 44 67 51
Sales and marketing................. 71 80 93 94
General and administrative.......... 29 27 32 29
Stock-based compensation............ 8 15 11 17
------------ ------------- ------------- -------------
Total operating expenses.......... 162 166 203 191
------------ ------------- ------------- -------------
Loss from operations.................. (101) (115) (142) (148)
Interest and other income, net........ 3 6 5 9
------------ ------------- ------------- -------------
Net loss.............................. (98)% (109)% (137)% (139)%
============= ============= ============= =============
We incurred net losses of $3,262,000 and $13,506,000 during the three
and nine months ended December 31, 2002, respectively. As of December 31, 2002,
we had an accumulated deficit of $102,430,000. We expect to continue to incur
operating losses for the foreseeable future. In view of the rapidly changing
nature of our market and our limited operating history, we believe that
period-to-period comparisons of our revenues and other operating results are not
necessarily meaningful and should not be relied upon as indications of future
performance. Our historic revenue growth rates have not been sustainable and are
not necessarily indicative of future growth.
Revenues. Total revenues decreased to $3,314,000 for the three months
ended December 31, 2002 from $4,788,000 for the three months ended December 31,
2001, a decrease of $1,474,000 or 31%. Total revenues decreased by $3,698,000 or
27% to $9,826,000 for the nine months ended December 31, 2002 from $13,524,000
for the nine months ended December 31, 2001. These decreases were due to
decreases in license, service, and other revenues. International revenues
increased to $1,025,000, or 31% of total revenues, for the three months ended
December 31, 2002 from $799,000, or 17% of total revenues, for the three months
ended December 31, 2001. International revenues decreased in absolute dollars to
$2,569,000, or 26% of total revenues, for the nine months ended December 31,
2002 from $3,413,000, or 25% of total revenues, for the nine months ended
December 31, 2001. No customer constituted more than 10% of total revenues for
the three or nine months ended December 31, 2002. Sales to one customer
accounted for 30% of total revenues for the three months ended December 31, 2001
and sales to two customers (one of whom was a reseller of our products)
accounted for 15% and 11%, respectively, of total revenues for the nine months
ended December 31, 2001.
23
License revenues decreased to $1,339,000 during the three months ended
December 31, 2002 from $1,478,000 during the three months ended December 31,
2001, a decrease of $139,000 or 9%. License revenues decreased by $1,669,000 or
27% to $4,623,000 during the nine months ended December 31, 2002 from $6,292,000
during the nine months ended December 31, 2001. These decreases are primarily
due to lower unit sales of our platform products, particularly sales of our
SmartEncode product suite to the media and entertainment marketplace. The media
and entertainment marketplace was our weakest market for software licenses
during the three months ended December 31, 2002. Historically, the media and
entertainment marketplace has been our strongest market for software licenses.
We believe the reduction in revenues for our platform products during the three
and nine months ended December 31, 2002 is primarily a function of unfavorable
global macroeconomic conditions affecting a number of our potential customers in
markets such as media and entertainment and resulting in weak demand for
information technology products.
Service revenues decreased to $1,975,000 for the three months ended
December 31, 2002 from $3,290,000 for the three months ended December 31, 2001,
a decrease of $1,315,000. Service revenues decreased by $1,797,000 to $5,203,000
for the nine months ended December 31, 2002 from $7,000,000 for the nine months
ended December 31, 2001. These decreases are primarily the result of lower
revenues in our application services business, primarily due to the non-renewal
of our application services contract with Major League Baseball Advanced Media
("MLBAM"). Service revenues during the three and nine months ended December 31,
2001 include $216,000 and $648,000, respectively, of warrant amortization
recorded as contra-service revenues resulting from a warrant issued to MLBAM.
Other revenues were $20,000 and $232,000 during the three and nine
months ended December 31, 2001 (none during the three and nine months ended
December 31, 2002). These decreases were primarily attributable to the level of
engineering research services performed pursuant to a federal government
research grant.
Cost of Revenues. Cost of license revenues consists primarily of
royalty fees for third-party software products integrated into our products. Our
cost of service revenues includes personnel expenses and other direct costs,
related overhead, communication expenses and capital depreciation costs for
maintenance and support activities and application and professional services.
Our cost of other revenues primarily includes engineering personnel expenses and
related overhead for engineering research for government projects. Total cost of
revenues decreased to $1,285,000, or 39% of total revenues, for the three months
ended December 31, 2002 from $2,329,000, or 49% of total revenues, for the three
months ended December 31, 2001. Total cost of revenues decreased to $3,850,000,
or 39% of total revenues, for the nine months ended December 31, 2002 from
$7,746,000, or 57% of total revenues, for the nine months ended December 31,
2001. These decreases in total cost of revenues were due primarily to decreases
in our cost of service revenues during the three and the nine months ended
December 31, 2002. We expect our total cost of revenues to increase during our
fourth fiscal quarter in comparison to our third fiscal quarter ended December
31, 2002 due to the allocation of the one-time charge to be recorded in
connection with our restructured San Mateo office lease (as discussed under
"Facility Lease Amendment" above). Excluding the one-time effects of this
facility charge, we generally expect that increases or decreases in the dollar
amount of our total cost of revenues will correlate with increases or decreases
in the dollar amount of our total revenues. However, our total cost of revenues
is highly variable and has, in the past, been inconsistent with our
expectations.
Cost of license revenues decreased to $195,000, or 15% of license
revenues, during the three months ended December 31, 2002 from $202,000, or 14%
of license revenues, during the three months ended December 31, 2001. This
decrease (in absolute dollars) was due to lower unit sales of our products that
are subject to unit-based (rather than fixed-fee) license royalty payments for
the three months ended December 31, 2002 in comparison to the three months ended
December 31, 2001. For the nine months ended December 31, 2002, cost of license
revenues increased to $542,000, or 12% of license revenues, from $534,000, or 8%
of license revenues, during the same period in the prior year. This increase
during the nine months ended December 31, 2002 was primarily due to the
introduction of our new application products and other recently introduced
products during our fiscal year 2003 for which we incur a unit-based royalty to
certain technology providers. These additional unit-based royalties paid in
fiscal 2003 were incremental to fixed royalties paid to our historical
technology providers in fiscal 2002 and fiscal 2003.
24
Cost of service revenues decreased to $1,090,000, or 55% of service
revenues, for the three months ended December 31, 2002 from $2,122,000, or 65%
of service revenues for the three months ended December 31, 2001. For the nine
months ended December 31, 2002, cost of service revenues decreased to
$3,308,000, or 64% of service revenues, from $7,059,000, or 101% of service
revenues for the nine months ended December 31, 2001. These decreases were due
to lower expenditures for our application services business, primarily due to
the non-renewal of our contract with MLBAM, which allowed us to reduce our
headcount and infrastructure costs and better aligned our cost structure with
our current revenue levels.
Cost of other revenues was $5,000 and $153,000, or 25% and 66% of other
revenues, during the three and nine months ended December 31, 2001, respectively
(none for the three and nine months ended December 31, 2002). These decreases
were attributable to the level of engineering research services performed
pursuant to federal government research contracts.
Research and Development Expenses. Research and development expenses
consist primarily of personnel and related costs for our product development
efforts. Research and development expenses decreased to $1,781,000, or 54% of
total revenues, for the three months ended December 31, 2002 from $2,117,000, or
44% of total revenues, for the three months ended December 31, 2001. For the
nine months ended December 31, 2002, research and development expenses decreased
to $6,607,000, or 67% of total revenues, from $6,934,000, or 51% of total
revenues, for the nine months ended December 31, 2001. The decreases in absolute
dollars were primarily due to reduced payroll and related expenses resulting
from lower headcount due primarily to our restructuring initiatives in fiscal
2003. We expect research and development expenses to increase during our fourth
fiscal quarter due to the allocation of the one-time charge to be recorded in
connection with the restructured San Mateo office lease (as discussed under
"Facility Lease Amendment" above). Excluding the one-time effects of this
facility charge, we expect that our quarterly research and development expenses
will remain relatively consistent with our third fiscal quarter ended December
31, 2002. To date, we have not capitalized any software development costs as
they have been insignificant after establishing technological feasibility.
Sales and Marketing Expenses. Sales and marketing expenses consist of
personnel and related costs for our direct sales force, pre-sales support and
marketing staff, and marketing programs including trade shows and seminars.
Sales and marketing expenses decreased to $2,357,000, or 71% of total revenues,
during the three months ended December 31, 2002 from $3,858,000, or 80% of total
revenues, during the three months ended December 31, 2001. Sales and marketing
expenses decreased to $9,104,000, or 93% of total revenues, during the nine
months ended December 31, 2002 from $12,720,000, or 94% of total revenues,
during the nine months ended December 31, 2001. These decreases were primarily
due to lower headcount costs due to prior period restructuring efforts and
reduced discretionary marketing program spending. We expect our quarterly sales
and marketing expenses to increase during our fourth fiscal quarter in
comparison to our third fiscal quarter due to the allocation of the one-time
charge to be recorded in connection with the restructured San Mateo office lease
(as discussed under "Facility Lease Amendment" above). Excluding the one-time
effects of this facility charge, we expect our quarterly sales and marketing
expenses to remain in a range of relatively flat to a modest increase in
comparison to our third fiscal quarter ended December 31, 2002, primarily as a
result of variability in our sales personnel's variable compensation programs
and timing of marketing initiatives.
General and Administrative Expenses. General and administrative
expenses consist primarily of personnel and related costs for general corporate
functions, including finance, accounting, legal, human resources, costs of our
external audit firm and costs of our outside legal counsel. General and
administrative expenses decreased to $963,000, or 29% of total revenues, for the
three months ended December 31, 2002 from $1,284,000 or 27% of total revenues,
for the three months ended December 31, 2001. For the nine months ended December
31, 2002, general and administrative expenses decreased to $3,174,000, or 32% of
total revenues, from $3,946,000 or 29% of total revenues, for the nine months
ended December 31, 2001. These decreases in absolute dollars were primarily due
to lower headcount costs as a result of prior period restructuring efforts. We
expect general and administrative expenses to increase during our fourth fiscal
quarter due to the allocation of the one-time charge to be recorded in
connection with the restructured San Mateo office lease (as discussed under
"Facility Lease Amendment" above). Excluding the one-time effects of this
facility charge, we expect our quarterly general and administrative expenses to
increase for the foreseeable future as we incur higher audit, legal and
insurance costs due to a number of external factors including recently passed
legislation such as the Sarbanes-Oxley Act.
25
Stock-Based Compensation Expense. Stock based compensation expense
represents the amortization of deferred compensation (calculated primarily for
stock options granted to our employees prior to the time of our initial public
offering as the difference between the exercise price of the stock options
granted and the then deemed fair value of our common stock). We recognized
stock-based compensation expense of $291,000 and $719,000 for the three months
ended December 31, 2002 and 2001, respectively, and $1,026,000 and $2,257,000
for the nine months ended December 31, 2002 and 2001, respectively, in
connection with the granting of stock options to our employees. Our stock-based
compensation expense decreased during the three and nine months ended December
31, 2002 due to the cancellation of stock options resulting from participation
in our voluntary stock option cancellation and re-grant program for our
employees during the year ended March 31, 2002. The implementation of this
cancellation and re-grant program resulted in the immediate expensing of the
majority of our employee-related deferred compensation in our fourth fiscal
quarter of 2002. As a result, our fiscal 2003 and future stock-based
compensation expenses are, and are expected to continue to be, lower than fiscal
2002 levels. We will continue to amortize the remaining deferred compensation
balance as expense for employees who did not participate in our voluntary stock
option cancellation and re-grant program.
Interest and Other Income. Interest and other income include interest
income from cash, cash equivalents and short-term investments. Interest and
other income decreased to $101,000 and $429,000 for the three and nine months
ended December 31, 2002, respectively, from $315,000 and $1,295,000 for the
three and nine months ended December 31, 2001. These decreases were a result of
lower interest rates and lower average cash balances during the three and nine
months ended December 31, 2002.
Provision for Income Taxes. We have not recorded a provision for any
significant federal and state or foreign income taxes in either the three or
nine months ended December 31, 2002 or 2001 because we have experienced net
losses since inception, which have resulted in deferred tax assets. We have
recorded a valuation allowance for the entire deferred tax asset as a result of
uncertainties regarding the realization of the asset balance through future
taxable profits.
Liquidity and Capital Resources
As of December 31, 2002, we had cash, cash equivalents and short-term
investments of $18,872,000, a decrease of $11,822,000 from March 31, 2002 and
our working capital, defined as current assets less current liabilities, was
$13,628,000, a decrease of $10,449,000 in working capital from March 31, 2002.
The decrease in our cash, cash equivalents, and short-term investments and our
working capital is primarily attributable to cash used in our operating
activities.
Our operating activities resulted in net cash outflows of $11,887,000,
and $13,429,000 for the nine months ended December 31, 2002 and 2001,
respectively. The cash used in these periods was primarily attributable to net
losses of $13,506,000 and $18,784,000 in the nine months ended December 31, 2002
and 2001, respectively, offset by depreciation expense, losses on disposals of
assets, and non-cash, stock-based charges. Investing activities resulted in cash
inflows of $9,953,000 and cash outflows of $32,000 for the nine months ended
December 31, 2002 and 2001, respectively. Our investing activity cash inflows
were due to the sale and maturity of short-term investments. Our investing
activity cash outflows were primarily for the purchase of short-term investments
and capital equipment during both periods. We expect that we will continue to
invest in short-term investments and purchase capital equipment as we replace
older equipment with newer models. Financing activities provided net cash
inflows of $271,000 and $769,000 during the nine months ended December 31, 2002
and 2001, respectively. These net cash inflows were primarily from the proceeds
of our employee stock plans.
We anticipate that our current cash, cash equivalents and short-term
investments will be sufficient to meet our anticipated cash needs for working
capital and capital expenditures for the next 12 months. However, we may need to
raise additional funds in future periods through public or private financings,
or other sources, to fund our operations and potential acquisitions, if any,
until we achieve profitability, if ever. We may not be able to obtain adequate
or favorable financing when necessary to fund our business. Failure to raise
capital when needed could harm our business. If we raise additional funds
through the issuance of equity securities, the percentage of ownership of our
existing stockholders would be reduced. Furthermore, these equity securities
might have rights, preferences or privileges senior to our common stock.
26
Risk Factors
The occurrence of any of the following risks could materially and
adversely affect our business, financial condition and operating results. In
this case, the trading price of our common stock could decline and you might
lose all or part of your investment.
Risks Related to Our Business
Our revenues, cost of revenues, expense and cash balance/cash usage forecasts
are based upon the best information we have available, but our operating results
have historically been volatile and there are a number of risks that make it
difficult for us to foresee or accurately evaluate factors that may impact our
forecasts.
Our quarterly operating results have varied significantly in the past
and are likely to vary significantly in the future. We believe that
period-to-period comparisons of our results of operations are not meaningful and
should not be relied upon as indicators of future performance. Our operating
results have in past quarters fallen below securities analyst expectations and
will likely fall below their expectations in some future quarter or quarters.
We have limited visibility into future demand, and our limited
operating history makes it difficult for us to foresee or accurately evaluate
factors that may impact such future demand. Our visibility over our potential
sales is typically limited to the current quarter and our visibility for even
the current quarter is rather limited. In order to provide a revenue forecast
for the current quarter, we must make assumptions about conversion of sales
prospects into current quarter revenues. Such assumptions may be materially
incorrect due to competition for the customer order, pricing pressures, sales
execution issues, customer selection criteria or length of the customer
selection cycle, the failure of sales contracts to meet our revenue recognition
criteria, our inability to timely perform professional services, our inability
to hire and retain qualified personnel, our inability to develop new markets in
Europe or Asia, the strength of information technology spending, and other
factors that may be beyond our control. In addition, our application products
are early in their product life cycles and we cannot predict how the market for
these products will develop. Our assumptions about conversion of potential
application product sales into current quarter revenues could be materially
incorrect. We are reliant on third party resellers for a significant portion of
our license revenues and we have limited visibility into the status of orders
from these third parties.
For quarters beyond the current quarter, we have very limited
visibility into potential sales opportunities, and thus we have a lower
confidence level in any revenue forecast or forward-looking guidance. In
developing a revenue forecast for such quarters, we assess any customer
indications about future demand, general industry trends, marketing lead
development activities, productivity goals for the sales force and expected
growth in sales personnel, and any demand for products that we may have. Because
visibility into outlying quarters is so limited, we have not provided guidance
beyond the current quarter for the past several quarters.
Our cost of sales and expense forecasts are based upon our budgets and
spending forecasts for each area of the Company. Circumstances we may not
foresee could increase cost and expense levels beyond the levels forecasted.
Such circumstances may include competitive threats in our markets which we may
need to address with additional sales and marketing expenses, severance for
involuntary reductions in headcount should we determine cost cutting measures
are necessary, write-downs of equipment and/or facilities in the event of
unforeseen excess capacity, legal claims, employee turnover, additional royalty
expenses should we lose a source of current technology, losses of key management
personnel, unknown defects in our products, and other factors we cannot foresee.
In addition, many expenditures are planned or committed in advance in
anticipation of future revenues, and if our revenues in a particular quarter are
lower than we anticipate, we may be unable to reduce spending in that quarter.
As a result, any shortfall in revenues or a failure to improve gross profit
margin would likely hurt our quarterly operating results.
27
Our cash balance and cash usage forecasts are typically limited to the
current quarter and are based upon a number of factors including our revenue and
expense forecasts, which are also subject to a number of risks described above.
In addition, in deriving our cash forecasts, we make a number of assumptions
that are subject to other uncertainties including our expected cash payments to
employees, vendors and other parties, expected cash receipts from customers and
interest earned on our cash and investment balances. Such assumptions may be
materially incorrect due to unexpected payments that are required to be made to
employees or vendors, delayed payments from our customers, unfavorable
fluctuations in interest rates and other factors that may be beyond our control.
The failure of any significant contracts to meet our policies for recognizing
revenue may prevent us from achieving our revenue objectives for a quarter or a
fiscal year, which would hurt our operating results.
Our sales contracts are typically based upon standard agreements that
meet our revenue recognition policies. However, our future sales may include
site licenses, professional services or other transactions with customers who
may negotiate special terms and conditions that are not part of our standard
sales contracts. In addition, customers may insist on an extended payment
schedule or may delay payments to us, which may require us to account for those
customers' revenues on a cash basis, rather than accrual basis, of accounting.
If these special terms and conditions cause sales under these contracts to not
qualify under our revenue recognition policies, we would defer revenues to
future periods when all revenue recognition criteria are met, which may hurt our
reported revenues and operating results.
In addition, customers that license our products may require
consulting, implementation, maintenance and training services and obtain them
from our internal professional services, customer support and training
organizations. When we provide significant services in connection with a
software license arrangement, our revenue recognition policy may require us to
recognize the software license fee as the implementation services are performed
or we may be required to defer the fee until the completion of the services,
which may hurt our current quarter's revenues and operating results.
We have allocated significant product development, sales and marketing resources
toward the deployment of our application products, we face a number of risks
that may impede market acceptance of these products and such risks may
ultimately prove our business model invalid, thereby hurting our financial
results.
We have invested significant resources into developing and marketing
our application products and do not know whether our business model and strategy
will be successful. The market for these products is in a relatively early stage
and one of our key assumptions about the market is that digital video will
continue to develop as a more relevant communication medium. We cannot predict
how the market for our applications will develop, and part of our strategic
challenge will be to convince enterprise customers of the productivity, improved
communications, cost savings and other benefits of our application products. Our
future revenues and revenue growth rates will depend in large part on our
success in delivering these new products effectively and creating market
acceptance for these products. If we fail to do so, our products and services
will not achieve widespread market acceptance, and we may not generate
significant revenues to offset our development and sales and marketing costs,
which will hurt our business. Additionally, our future success will continue to
depend upon our ability to develop new products or product enhancements that
address future needs of our target markets and to respond to these changing
standards and practices.
In addition, resources may be required to fund development of our
application products' feature-sets beyond what we have planned due to
unanticipated marketplace demands. We may determine that we are unable to fund
these additional feature-sets due to financial constraints and may halt the
development of a product at a stage that the marketplace perceives as immature.
We may also encounter that the marketplace for an application product is not as
robust as we had expected and we may react to this by leaving the development of
a product at an early stage or combining key features of one or more of our
application products into a single product. Either of these product development
scenarios may impede market acceptance of any of our application products and
therefore hurt our financial results.
28
The length of our sales and deployment cycle is uncertain, which may cause our
revenues and operating results to vary significantly from quarter to quarter.
During our sales cycle, we spend considerable time and expense
providing information to prospective customers about the use and benefits of our
products and services without generating corresponding revenues. Our expense
levels are relatively fixed in the short-term and based in part on our
expectations of future revenues. Therefore, any delay in our sales cycle could
cause significant variations in our operating results, particularly because a
relatively small number of customer orders represent a large portion of our
revenues.
Some of our largest sources of revenues are government entities and
large corporations that often require long testing and approval processes before
making a decision to license our products. In general, the process of entering
into a licensing arrangement with a potential customer may involve lengthy
negotiations. As a result, our sales cycle has been and may continue to be
unpredictable. In the past, our sales cycle has ranged from one to 12 months.
Our sales cycle is also subject to delays as a result of customer-specific
factors over which we have little or no control, including budgetary constraints
and internal approval procedures. In addition, because our technology must often
be integrated with the products and services of other vendors, there may be a
significant delay between the use of our software and services in a pilot system
and our customers' volume deployment of our products and services.
Our application products are aimed toward a broadened business user
base within our key markets. These products are early in their product life
cycles and we are relatively inexperienced with their sales cycle. We cannot
predict how the market for our application products will develop and part of our
strategic challenge will be to convince targeted users of the productivity,
improved communications, cost savings and other benefits. Accordingly, it is
likely that delays in our sales cycles with these application products will
occur and this could cause significant variations in our operating results.
We have not been profitable and if we do not achieve profitability, our business
may fail. If we need additional financing we may not obtain the required
financing on favorable terms and conditions.
We have experienced operating losses in each quarterly and annual
period since we were formed and we expect to incur significant losses in the
future. As of December 31, 2002, we had an accumulated deficit of $102,430,000.
We have made efforts to reduce our expenses over the past several quarters, but
it is possible that we could incur increasing research and development, sales
and marketing and general and administrative expenses at some point in the
future. Our revenues have been relatively flat for the past four quarters and
any inability to increase our revenues significantly in the future will result
in continuing losses and a deteriorating cash position, which will harm our
business. In addition, our cash, cash equivalent and short-term investment
resources (collectively, "cash resources") totaled $18,872,000 as of December
31, 2002 and we used $11,887,000 in our operating activities during the nine
months ended December 31, 2002. We anticipate that our operating activities will
use a substantial portion of our remaining cash resources over the next 12
months. Absent a significant interim improvement in our operating results or a
successful effort to raise additional capital, this will leave us with a
deteriorated cash position in comparison to our cash position as of December 31,
2002 and this may affect our ability to transact future strategic operating and
investing activities, which may harm our business and cause our stock price to
fall. In addition, we may experience reluctance on the part of prospects to
purchase from us if they believe our financial viability is in question. The
current business environment is not conducive to raising additional financing.
If we require additional financing, the terms of such financing may heavily
dilute the ownership interests of current investors, and cause our stock price
to fall significantly or we may not be able to secure financing upon acceptable
terms at all. Accordingly, our stock price and business' viability is heavily
dependent upon our ability to grow our revenues and manage our costs in order to
preserve cash resources.
29
Failure to comply with NASDAQ's listing standards could result in our delisting
by NASDAQ from the NASDAQ National Market and severely limit the ability to sell
any of our common stock.
Our stock is currently traded on the NASDAQ National Market and the bid
price for our common stock has, in the past, been under $1.00 per share for over
30 consecutive trading days. Under NASDAQ's listing maintenance standards, if
the closing bid price of our common stock is under $1.00 per share for 30
consecutive trading days, NASDAQ may choose to notify us that it may delist our
common stock from the NASDAQ National Market.
On January 30, 2003, NASDAQ submitted a proposal to the U.S. Securities
and Exchange Commission ("SEC") to extend its pilot program governing bid price
rules for all companies listed on the NASDAQ National Market and also proposed
additional bid price rules for all companies listed on the NASDAQ SmallCap
Market. Under the National Market proposal, NASDAQ will extend the bid price
grace period of its pilot program for all National Market issuers from 90
calendar days to 180 calendar days. In addition, the NASDAQ Small Cap Market has
proposed to increase its pilot program by an additional 180 day grace period to
gain compliance with the minimum bid price listing requirement (provided that
certain other non-bid price related criteria are met by the registrant). The SEC
must approve all of the NASDAQ's proposals prior to the proposals becoming
effective.
We received a NASDAQ letter on October 31, 2002 that we were not in
compliance with the NASDAQ's minimum bid price listing requirement. Based upon
NASDAQ's proposed changes, which still require SEC approval, we believe that we
may have until approximately April 29, 2003 to regain compliance with the
minimum bid price listing requirement. If we are unable to meet this minimum bid
price listing requirement by April 29, 2003, we expect that we may have the
option of transferring to the NASDAQ SmallCap Market. Based upon a separate
NASDAQ proposal that also requires SEC approval, the NASDAQ SmallCap market
would make available up to two additional 180 calendar day extended grace
periods (ie. until approximately April 23, 2004) to meet the minimum $1.00 bid
price requirement provided we are able to meet certain non-bid price related
criteria. If we transfer to the NASDAQ SmallCap Market, we expect that we may be
eligible to transfer back to the NASDAQ National Market if our bid price
maintains the $1.00 per share requirement for 30 consecutive trading days and we
have maintained compliance with all other continued listing requirements for the
NASDAQ National Market.
Should the SEC not approve the NASDAQ's proposals and/or should we
receive a letter from NASDAQ informing us that we will be delisted due to
noncompliance with the National Market's minimum bid price requirement, we
believe we will have the opportunity to transfer to the NASDAQ Small Cap Market.
From the date of receipt of such a NASDAQ delisting letter, we believe we would
have 90 days to attempt to regain compliance while trading on the NASDAQ
SmallCap Market. In addition, we expect that we may also be eligible for an
additional 180 calendar day grace period on the NASDAQ SmallCap Market provided
that we meet the other non-bid price related listing criteria.
There can be no assurance that the SEC will approve NASDAQ's proposals,
that we will comply with other non-bid price related listing criteria or that
our common stock will remain eligible for trading on the NASDAQ National Market
or the NASDAQ SmallCap Market. If our stock were delisted, the ability of our
stockholders to sell any of our common stock at all would be severely, if not
completely, limited.
30
We expect the market price of our common stock to be volatile.
The market price of our common stock has experienced significant swings
in price over short periods of time. We believe that factors such as
announcements of developments related to our business, fluctuations in our
operating results, failure to meet securities analysts' expectations, our
ability to remain an active listing on the NASDAQ National Market or NASDAQ
Small Cap Market, general conditions in the software and high technology
industries and the worldwide economy, announcements of technological
innovations, new systems or product enhancements by us or our competitors,
acquisitions, changes in governmental regulations, developments in patents or
other intellectual property rights and changes in our relationships with
customers and suppliers could cause the price of our common stock to continue to
fluctuate substantially. Historically, there has been a relatively small number
of buyers and sellers of our common stock and trading volume of our common stock
is relatively low in comparison to many companies listed on the NASDAQ National
Market and other well-known stock exchanges. This low trading volume contributes
to the volatility of our stock. In addition, in recent years the stock market in
general, and the market for small capitalization and high technology stocks in
particular, has experienced extreme price fluctuations. Any of these factors
could adversely affect the market price of our common stock.
Our revenues may be harmed if general economic conditions do not improve.
Our revenues are dependent on the health of the economy (in particular,
the robustness of information technology spending) and the growth of our
customers and potential future customers. The economic environment has not been
conducive to companies involved in information technology infrastructure for
several quarters. In addition, looming conflicts with countries such as Iraq and
North Korea create a great deal of uncertainty for businesses and this
uncertainty generally results in businesses delaying investments in such areas
as information technology. If the economic trend continues, our customers and
potential customers may continue to delay or reduce their spending on our
software and service solutions. When economic conditions for information
technology products weaken, sales cycles for sales of software products and
related services tend to lengthen and companies' information technology and
business unit budgets tend to be reduced. We believe that global economic
conditions have become progressively weaker over the past 24 months and believe
that this has contributed to our decline in revenues for our current year
periods in comparison to our prior year periods. If global economic conditions
continue to weaken or if looming conflicts continue or worsen, our revenues
could continue to suffer and our stock price could decline further.
Our restructuring efforts may not result in the intended benefits. We may be
required to record additional restructuring charges and this may adversely
affect the morale and performance of our personnel we wish to retain and may
also adversely affect our ability to hire new personnel.
During the past several quarters, including the quarter ended December
31, 2002, we took steps to better align the resources required to operate
efficiently in the prevailing market. Through these steps, we reduced our
headcount and incurred charges for employee severance, excess facility capacity
and excess equipment. While we believe that these steps help us achieve greater
operating efficiency, we have limited history with such measures and the results
of these measures are less than predictable. The Company monitors its expenses
closely and benchmarks its expenses against expected revenues. Should the
Company's revenues not meet internal or external expectations or other
circumstances arise that require the Company to better align resources required
to operate efficiently in the prevailing market, additional restructuring
efforts may be required. We believe workforce reductions, management changes and
facility consolidation create anxiety and uncertainty and may adversely affect
employee morale. These measures could adversely affect our employees that we
wish to retain and may also adversely affect our ability to hire new personnel.
They may also affect customers and/or vendors, which could harm our ability to
operate as intended and which would harm our business.
31
As we have better aligned our resources over the past several quarters,
we have consolidated our company's operations into facility space that is less
than our current facility commitment, resulting in excess operating lease
capacity. During the quarter ended December 31, 2002, we adopted the Financial
Accounting Standards Board's Statement No. 146, "Accounting for Costs Associated
with Exit and Disposal Activities" ("FAS 146"). We expect to further consolidate
our space in March 2003 and to record a charge of approximately $1,882,000 as
FAS 146 requires us to record a charge for excess space as of the date we cease
to use the space. Subsequent to this expected consolidation, should we continue
to have excess operating lease capacity and we are unable to find a sub lessee
at a rate equivalent to our operating lease rate, we would be required to record
additional charges for the rental payments that we owe to our landlord relating
to any excess facility capacity, which would harm our operating results. Our
management reviews our facility requirements and assesses whether any excess
capacity exists as part of our on-going financial processes.
The prices we charge for our products and services may decrease or our pricing
assumptions may be incorrect, either of which may impact our ability to develop
a sustainable business.
The prices we charge for our products and services may decrease as a
result of competitive pricing pressures, promotional programs and customers who
negotiate price reductions. For example, we recently reduce the list price of
our VideoLogger product, one of our key platform products, in order to better
compete in the marketplace. In addition, some of our competitors have provided
their services without charge in order to gain market share or new customers and
key accounts. The prices at which we sell and license our products and services
to our customers depend on many factors, including:
o purchase volumes;
o competitive pricing;
o the specific requirements of the order;
o the duration of the licensing arrangement; and
o the level of sales and service support.
Our applications products are intended to increase both our revenues
and the average size of our customers' orders. These products have pricing
models based upon a number of assumptions about the market for our products. If
our assumptions are incorrect or our pricing does not work as intended, we may
not be able to increase the average size of our customer orders or reduce the
costs of selling and marketing for our products and, therefore, we may not be
able to develop a profitable and sustainable business.
Our sales and marketing costs are a high percentage of the revenues
from our orders, due partly to the expense of developing leads and relatively
long sales cycles involved in selling products that are not yet considered
"mainstream" technology investments. For the three and nine months ended
December 31, 2002, our sales and marketing expenses totaled 71% and 93% of our
total revenues, respectively.
32
Our service revenues have substantially lower gross profit margins than our
license revenues, and an increase in service revenues relative to license
revenues could harm our gross margins.
Our service revenues, which include fees for our application services
as well as professional services such as consulting, implementation, maintenance
and training, were 60% and 53% of our total revenues for the three and nine
months ended December 31, 2002, respectively, and were 69% and 52% of our total
revenues for the three and nine months ended December 31, 2001, respectively.
Our service revenues have substantially lower gross profit margins than our
license revenues. Our cost of service revenues for the three and nine months
ended December 31, 2002 were 55% and 64%, respectively, of service revenues and
for the three and nine months ended December 31, 2001 were 64% and 100%,
respectively, of service revenues. An increase in the percentage of total
revenues represented by service revenues could adversely affect our overall
gross profit margins.
Service revenues as a percentage of total revenues and cost of service
revenues as a percentage of total revenues have varied significantly from
quarter to quarter due to our relatively early stage of development.
Historically, the relative amount of service revenues as compared to license
revenues has varied based on customer demand for our application services
revenues. Our application services require a relatively fixed level of
investment in staff, facilities and equipment. In the past, we have operated our
application service business at a loss due to fixed investments that exceeded
actual levels of revenues realized. We have reduced the application service
fixed investments over the past year. However, there is no assurance that the
current level of application service revenues will continue to allow us to
recover our fixed costs and make a positive gross profit margin.
More recently, we have experienced an increase in the percentage of
license customers requesting professional services, which will also impact the
relative amount of service revenues as compared to license revenues. We expect
that the amount and profitability of our professional services will depend in
large part on:
o the software solution that has been licensed;
o the complexity of the customers' information technology
environments;
o the resources directed by customers to their implementation
projects;
o the size and complexity of customer implementations; and
o the extent to which outside consulting organizations provide
services directly to customers.
Because competition for qualified personnel is intense, we may not be able to
recruit or retain personnel, which could impact the development and acceptance
of our products and services.
Our future success depends to a significant extent on the continued
services of our senior management and other key personnel such as senior
development staff, product marketing staff and sales personnel. The loss of key
employees would likely have an adverse effect on our business. We do not have
employment agreements with most of our senior management team. If one or more of
our senior management team were to resign, the loss could result in loss of
sales, delays in new product development and diversion of management resources.
We may also be required to create additional performance and retention
incentives in order to retain our employees including the granting of additional
stock options to employees at or below current prices or issuing incentive cash
bonuses. Such incentives may either dilute our existing stockholder base or
result in unforeseen operating expenses, which may cause our stock price to
fall. For example, in February 2002, we introduced a Voluntary Stock Option
Cancellation and Re-grant Program in which a number of our employees cancelled
stock options that had significantly higher exercise prices in comparison to
where our common stock price currently trades. These employees received
2,538,250 shares at $0.59 per share in August 2002. This may cause dilution to
our existing stockholder base, which may cause our stock price to fall.
We may need to hire sales, development, marketing and administrative
personnel in the foreseeable future. We may be unable to attract or assimilate
other highly qualified employees in the future particularly given our continued
operating losses and weakening cash position. We have in the past experienced,
and we expect to continue to experience, difficulty in hiring highly skilled
employees with appropriate qualifications. In addition, new hires frequently
require extensive training before they achieve desired levels of productivity.
We may fail to attract and retain qualified personnel, which could have a
negative impact on our business.
33
Recently enacted and proposed changes in securities laws and regulations will
increase our costs.
The Sarbanes-Oxley Act ("the Act") of 2002 that became law in July 2002
requires changes in some of our corporate governance and securities disclosure
and/or compliance practices. The Act also requires the SEC to promulgate new
rules on a variety of subjects, in addition to rule proposals already made, and
the NASDAQ National Market has proposed revisions to its requirements for
companies like Virage that are listed on NASDAQ. We believe these developments
will increase our legal and accounting compliance costs. We also expect these
developments to make it more difficult and more expensive for us to obtain
director and officer liability insurance, and we may be required to accept
reduced coverage or incur substantially higher costs to obtain coverage. These
developments could make it more difficult for us to attract and retain qualified
members of our board of directors, or qualified executive officers. We are
presently evaluating and monitoring regulatory developments and cannot reliably
estimate the timing or magnitude of additional costs we will incur as a result
of the Act or other, related legislation.
If the protection of our intellectual property is inadequate or third party
intellectual property is unavailable or if others bring infringement or other
claims against us, we may incur significant costs or lose customers.
We depend on our ability to develop and maintain the proprietary
aspects of our technology. Policing unauthorized use of our products is
difficult and software piracy may become a problem. We license our proprietary
rights to third parties, who may not abide by our compliance guidelines. To
date, we have not sought patent protection of our proprietary rights in any
foreign jurisdiction, and the laws of some foreign countries do not protect our
proprietary rights to as great an extent as do the laws of the United States.
Our efforts to protect our intellectual property rights may not be effective to
prevent misappropriation of our technology or may not prevent the development by
others of products competitive with those developed by us.
In addition, other companies may obtain patents or other proprietary
rights that would limit our ability to conduct our business and could assert
that our technologies infringe their proprietary rights. We could incur
substantial costs to defend any litigation, and intellectual property litigation
could force us to cease using key technology, obtain a license, or redesign our
products. From time to time, we have received notices claiming that our
technology infringes patents held by third parties and in addition may become
involved in litigation claims arising from our ordinary course of business. We
believe that there are no claims or actions pending or threatened against us,
the ultimate disposition of which would have a material adverse effect on us.
However, in the event any claim against us is successful, our operating results
would be significantly harmed.
Furthermore, we license technology from third parties, which may not
continue to be available on commercially reasonable terms, if at all. The loss
of any of these licenses could result in delays in the licensing of our products
until equivalent technology, if available, is developed or licensed for
potentially higher fees and integrated. In the event of any such loss, costs
could be increased and delays could be incurred, thereby harming our business.
Interruptions to our business or internal infrastructure from unforeseen,
adverse events or circumstances will disrupt our business and our operating
results will suffer.
The worldwide socio-political environment has changed dramatically
since September 11, 2001 and potential looming conflicts with countries such as
Iraq and North Korea create a great deal of global uncertainty. Our customers,
potential customers and vendors are located worldwide and generally within major
international metropolitan areas. In addition, the significant majority of our
operations are conducted at offices within a 60-mile radius of the major
metropolitan cities of San Francisco, New York City, Boston and London. Our
business also requires that certain personnel, including our officers, travel in
order to perform their jobs appropriately. A terrorist attack or military
conflict could reduce our ability to travel or could limit our ability to enter
foreign countries, either of which would diminish our effectiveness in closing
international customer opportunities. Should a major catastrophe occur within
the vicinity of any of our operations, our customers' and/or potential
customers' operations and/or vendors' operations, our operations may be
adversely impacted and our business may be harmed.
34
Our communications and network infrastructure are a critical part of
our business operations. Our application services business is dependent upon
providing our customers with fast, efficient and reliable services. To meet our
customers' requirements, we must protect our network against damage from any and
all sources, including among other things:
o human error;
o physical or electronic security breaches;
o computer viruses;
o fire, earthquake, flood and other natural disasters;
o power loss;
o telecommunications failure; and
o sabotage and vandalism.
We have communications hardware and computer hardware operations
located at Exodus Communications' facility in Santa Clara, California and at
Palo Alto Internet Exchange in Palo Alto, CA. We do not have complete backup
systems for these operations. A problem with, or failure of, our communications
hardware or operations could result in interruptions or increases in response
times on the Internet sites of our customers. Furthermore, if these third party
partners fail to adequately maintain or operate our communications hardware or
do not perform our computer hardware operations adequately, our services to our
customers may not be available. We have experienced system failures in the past.
Any disruptions could damage our reputation, reduce our revenues or otherwise
harm our business. Our insurance policies may not adequately compensate us for
any losses that may occur due to any failures or interruptions in our systems.
Defects in our software products or services could diminish demand for our
products or could subject us to liability claims and negative publicity if our
customers' systems, information or video content is damaged through the use of
our products or our application services.
Our software products and related services are complex and may contain
errors that may be detected at any point in the life of the product or service.
Our software products must operate within our customers' hardware and network
environment in order to function as intended. We cannot assure you that, despite
testing by us and our current and potential customers, errors will not be found
in new products or releases after shipment or in the related services that we
perform for our customers. If our customers' systems, information or video
content is damaged by software errors or services that we perform for them, our
business may be harmed. In addition, these errors or defects or the
incompatibility of our products to work within a customers' hardware and network
environment may cause severe customer service and public relations problems.
Errors, bugs, viruses, incompatibility or misimplementation of our products or
services may cause liability claims and negative publicity ultimately resulting
in the loss of market acceptance of our products and services. Our agreements
with customers that attempt to limit our exposure to liability claims may not be
enforceable in jurisdictions where we operate.
35
We may need to make acquisitions or form strategic alliances or partnerships in
order to remain competitive in our market, and potential future acquisitions,
strategic alliances or partnerships could be difficult to integrate, disrupt our
business and dilute stockholder value.
We may acquire or form strategic alliances or partnerships with other
businesses in the future in order to remain competitive or to acquire new
technologies. As a result of these acquisitions, strategic alliances or
partnerships, we may need to integrate products, technologies, widely dispersed
operations and distinct corporate cultures. The products, services or
technologies of the acquired companies may need to be altered or redesigned in
order to be made compatible with our software products and services, or the
software architecture of our customers. These integration efforts may not
succeed or may distract our management from operating our existing business. Our
failure to successfully manage future acquisitions, strategic alliances or
partnerships could seriously harm our operating results. In addition, our
stockholders would be diluted if we finance the acquisitions, strategic
alliances or partnerships by incurring convertible debt or issuing equity
securities.
In addition to the above-stated risks, under the Financial Accounting
Standards Board's Statement of Financial Accounting Standards No. 142, "Goodwill
and Other Intangible Assets" ("FAS 142"), any future goodwill resulting from any
future acquisitions we may undertake will not be amortized but instead reviewed
at least annually for impairment. We will be required to test goodwill for
impairment using the two-step process prescribed in FAS 142. The first step is a
screen for potential impairment, while the second step measures the amount of
impairment, if any. Should we enter into any future acquisition transactions and
general macroeconomic conditions deteriorate subsequent to the acquisition,
which affects our business and operating results over the long-term, and/or
should the future acquisition target not provide the results that are
anticipated when the merger is consummated, we could be required to record
accelerated impairment charges related to goodwill, which could adversely affect
our financial results.
As we operate internationally, we face significant risks in doing business in
foreign countries.
We are subject to a number of risks associated with international
business activities, including:
o costs of customizing our products and services for foreign
countries, including localization, translation and conversion
to international and other foreign technology standards;
o compliance with multiple, conflicting and changing
governmental laws and regulations, including changes in
regulatory requirements that may limit our ability to enter or
sell our products and services in particular countries;
o import and export restrictions, tariffs and greater difficulty
in collecting accounts receivable; and
o foreign currency-related risks if a significant portion of our
revenues become denominated in foreign currencies.
36
Item 3. Quantitative and Qualitative Disclosures About Market Risk
At December 31, 2002, the Company's cash and cash equivalents consisted
primarily of bank deposits and money market funds. The Company's short-term
investments consisted of commercial paper, municipal bonds, and federal agency
and related securities. The Company did not hold any derivative financial
instruments. The Company's interest income is sensitive to changes in the
general level of interest rates. In this regard, changes in interest rates can
affect the interest earned on cash and cash equivalents and short-term
investments.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Within 90 days prior to the filing date of this Quarterly Report on
Form 10-Q (the "Evaluation Date"), we evaluated, under the supervision of our
chief executive officer and our acting chief financial officer, the
effectiveness of our disclosure controls and procedures. Based on this
evaluation, our chief executive officer and acting chief financial officer
concluded that our disclosure controls and procedures are effective to ensure
that information we are required to disclose in reports that we file or submit
under the Securities Exchange Act of 1934 is recorded, processed, summarized and
reported within the time periods specified in Securities and Exchange Commission
rules and forms.
Changes in Internal Controls
Our review of our internal controls was made within the context of the
relevant professional auditing standards defining "internal controls,"
"significant deficiencies," and "material weaknesses." "Internal controls" are
processes designed to provide reasonable assurance that our transactions are
properly authorized, our assets are safeguarded against unauthorized or improper
use, and our transactions are properly recorded and reported, all to permit the
preparation of our financial statements in conformity with generally accepted
accounting principles. "Significant deficiencies" are referred to as "reportable
conditions," or control issues that could have a significant adverse effect on
the ability to record, process, summarize and report financial data in the
financial statements. A "material weakness" is a particularly serious reportable
condition where the internal control does not reduce to a relatively low level
the risk that misstatements caused by error or fraud may occur in amounts that
would be material in relation to the financial statements and not be detected
within a timely period by employees in the normal course of performing their
assigned functions. As part of our internal controls procedures, we also address
other, less significant control matters that we or our auditors identify, and we
determine what revision or improvement to make, if any, in accordance with our
on-going procedures.
Subsequent to the Evaluation Date, there were no significant changes in
our internal controls or in other factors that could significantly affect our
internal controls, including any corrective actions with regard to significant
deficiencies and material weaknesses.
37
PART II: OTHER INFORMATION
Item 1. Legal Proceedings.
Beginning on August 22, 2001, purported securities fraud class action
complaints were filed in the United States District Court for the
Southern District of New York. The cases were consolidated and the
litigation is now captioned as In re Virage, Inc. Initial Public
Offering Securities Litigation, Civ. No. 01-7866 (SAS) (S.D.N.Y.),
related to In re Initial Public Offering Securities Litigation, 21 MC
92 (SAS) (S.D.N.Y.). On or about April 19, 2002, the plaintiffs
electronically served an amended complaint. The amended complaint is
brought purportedly on behalf of all persons who purchased the
Company's common stock from June 28, 2000 through December 6, 2000. It
names as defendants the Company, one current and one former officer of
the Company, and several investment banking firms that served as
underwriters of our initial public offering. The complaint alleges
liability under Sections 11 and 15 of the Securities Act of 1933 and
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, on the
grounds that the registration statement for the offering did not
disclose that: (1) the underwriters had agreed to allow certain
customers to purchase shares in the offerings in exchange for excess
commissions paid to the underwriters; and (2) the underwriters had
arranged for certain customers to purchase additional shares in the
aftermarket at predetermined prices. The amended complaint also alleges
that false analyst reports were issued. No specific damages are
claimed.
We are aware that similar allegations have been made in other lawsuits
filed in the Southern District of New York challenging over 300 other
initial public offerings and secondary offerings conducted in 1999 and
2000. Those cases have been consolidated for pretrial purposes before
the Honorable Judge Shira A. Scheindlin. On July 15, 2002, we (and the
other issuer defendants) filed a motion to dismiss. This motion was
heard on November 1, 2002. We believe that the allegations against our
officers and us are without merit, and we intend to contest them
vigorously.
From time to time, we may become involved in litigation claims arising
from its ordinary course of business. We believe that there are no
claims or actions pending or threatened against us, the ultimate
disposition of which would have a material adverse effect on us.
Item 2. Changes in Securities and Use of Proceeds
(d) Use of Proceeds.
On July 5, 2000, we completed a firm commitment underwritten initial
public offering of 3,500,000 shares of our common stock, at a price of
$11.00 per share. Concurrently with our initial public offering, we
also sold 1,696,391 shares of common stock in a private placement at a
price of $11.00 per share. On July 17, 2000, our underwriters exercised
their over-allotment option for 525,000 shares of our common stock at a
price of $11.00 per share. The shares of the common stock sold in the
offering and exercised via our underwriters' over-allotment option were
registered under the Securities Act of 1933, as amended, on a
Registration Statement on Form S-1 (File No. 333-96315). The Securities
and Exchange Commission declared the Registration Statement effective
on June 28, 2000. The public offering was underwritten by a syndicate
of underwriters led by Credit Suisse First Boston, FleetBoston
Robertson Stephens Inc. and Wit SoundView Corporation, as their
representatives.
The initial public offering and private placement resulted in net
proceeds of $57,476,000, after deducting $3,099,000 in underwriting
discounts and commissions and $1,800,000 in costs and expenses related
to the offering. None of the costs and expenses related to the offering
or the private placement were paid directly or indirectly to any
director, officer, general partner of Virage or their associates,
persons owning 10 percent or more of any class of equity securities of
Virage or an affiliate of Virage. Proceeds from the offering and
private placement have been used for general corporate purposes,
including working capital and capital expenditures. The remaining net
proceeds have been invested in cash, cash equivalents and short-term
investments. The use of the proceeds from the offering and private
placement does not represent a material change in the use of proceeds
described in our prospectus.
38
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
NASDAQ National Market Trading Requirements
Our stock is currently traded on the NASDAQ National Market and the bid
price for our common stock has, in the past, been under $1.00 per share
for over 30 consecutive trading days. Under NASDAQ's listing
maintenance standards, if the closing bid price of our common stock is
under $1.00 per share for 30 consecutive trading days, NASDAQ may
choose to notify us that it may delist our common stock from the NASDAQ
National Market.
On January 30, 2003, NASDAQ submitted a proposal to the U.S. Securities
and Exchange Commission ("SEC") to extend its pilot program governing
bid price rules for all companies listed on the NASDAQ National Market
and also proposed additional bid price rules for all companies listed
on the NASDAQ SmallCap Market. Under the National Market proposal,
NASDAQ will extend the bid price grace period of its pilot program for
all National Market issuers from 90 calendar days to 180 calendar days.
In addition, the NASDAQ Small Cap Market has proposed to increase its
pilot program by an additional 180 day grace period to gain compliance
with the minimum bid price listing requirement (provided that certain
other non-bid price related criteria are met by the registrant). The
SEC must approve all of the NASDAQ's proposals prior to the proposals
becoming effective.
We received a NASDAQ letter on October 31, 2002 that we were not in
compliance with the NASDAQ's minimum bid price listing requirement.
Based upon NASDAQ's proposed changes, which still require SEC approval,
we believe that we may have until approximately April 29, 2003 to
regain compliance with the minimum bid price listing requirement. If we
are unable to meet this minimum bid price listing requirement by April
29, 2003, we expect that we may have the option of transferring to the
NASDAQ SmallCap Market. Based upon a separate NASDAQ proposal that also
requires SEC approval, the NASDAQ SmallCap market would make available
up to two additional 180 calendar day extended grace periods (ie. until
approximately April 23, 2004) to meet the minimum $1.00 bid price
requirement provided we are able to meet certain non-bid price related
criteria. If we transfer to the NASDAQ SmallCap Market, we expect that
we may be eligible to transfer back to the NASDAQ National Market if
our bid price maintains the $1.00 per share requirement for 30
consecutive trading days and we have maintained compliance with all
other continued listing requirements for the NASDAQ National Market.
Should the SEC not approve the NASDAQ's proposals and/or should we
receive a letter from NASDAQ informing us that we will be delisted due
to noncompliance with the National Market's minimum bid price
requirement, we believe we will have the opportunity to transfer to the
NASDAQ Small Cap Market. From the date of receipt of such a NASDAQ
delisting letter, we believe we would have 90 days to attempt to regain
compliance while trading on the NASDAQ SmallCap Market. In addition, we
expect that we may also be eligible for an additional 180 calendar day
grace period on the NASDAQ SmallCap Market provided that we meet the
other non-bid price related listing criteria.
There can be no assurance that the SEC will approve NASDAQ's proposals,
that we will comply with other non-bid price related listing criteria
or that our common stock will remain eligible for trading on the NASDAQ
National Market or the NASDAQ SmallCap Market. If our stock were
delisted, the ability of our stockholders to sell any of our common
stock at all would be severely, if not completely, limited.
39
Item 6. Exhibits and Report on Form 8-K.
(a) Exhibits
Exhibit 4.6 Warrant to Purchase Common Stock Between Registrant
and JRT Investment Company, a limited partnership
wholly owned by the Jim Joseph Revocable Trust, dated
December 23, 2002.
Exhibit 10.14 Amendment to Office Lease, Dated December 23, 2002,
between 411 Borel LLC and Registrant.
Exhibit 99.1 Certification Pursuant to 18 U.S.C. Section 1350
(b) Reports on Form 8-K
None.
40
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
VIRAGE, INC.
Date: February 14, 2003 By: /s/ Scott Gawel
----------------------------------
Scott Gawel
Vice President, Finance &
Acting Chief Financial Officer
(Duly Authorized Officer and
Principal Financial Officer)
41
I, Paul G. Lego, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Virage,
Incorporated;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
Audit Committee of registrant's Board of Directors (or persons
performing the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: February 14, 2003
/s/ Paul G. Lego
-----------------------------------
Paul G. Lego
President & Chief Executive Officer
42
I, Scott Gawel, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Virage,
Incorporated;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect to
the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented in
this quarterly report;
4. The registrant's other certifying officer and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and
we have:
a) designed such disclosure controls and procedures to ensure
that material information relating to the registrant,
including its consolidated subsidiaries, is made known to us
by others within those entities, particularly during the
period in which this quarterly report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure
controls and procedures as of a date within 90 days prior to
the filing date of this quarterly report (the "Evaluation
Date"); and
c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based
on our evaluation as of the Evaluation Date;
5. The registrant's other certifying officer and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the
Audit Committee of registrant's Board of Directors (or persons
performing the equivalent functions):
a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the
registrant's ability to record, process, summarize and report
financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the
registrant's internal controls; and
6. The registrant's other certifying officer and I have indicated in this
quarterly report whether or not there were significant changes in
internal controls or in other factors that could significantly affect
internal controls subsequent to the date of our most recent evaluation,
including any corrective actions with regard to significant
deficiencies and material weaknesses.
Date: February 14, 2003
/s/ Scott Gawel
-------------------------------
Scott Gawel
Vice President, Finance &
Acting Chief Financial Officer
43