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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
<Table>
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED JUNE 30, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
</Table>
COMMISSION FILE NUMBER: 0-19024
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FRONTSTEP, INC.
(Exact name of registrant as specified in its charter)
<Table>
OHIO 31-1083175
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
</Table>
2800 CORPORATE EXCHANGE DRIVE
COLUMBUS, OHIO 43231
(Address of principal executive offices and zip code)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (614) 523-7000
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SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT: COMMON STOCK, NO PAR
VALUE
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
The aggregate market value of voting and non-voting common equity held by
non-affiliates of the registrant, based on the closing price for the
registrant's common stock in the Nasdaq National Market on September 10, 2002,
was approximately $22,704,654. This calculation does not reflect a determination
that certain persons are affiliates of the registrant for any other purpose. As
of September 10, 2002, 7,568,218 shares of the issuer's common stock, without
par value, were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
None.
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FRONTSTEP, INC. AND SUBSIDIARIES
FISCAL YEAR 2002 FORM 10-K AND ANNUAL REPORT
INDEX
<Table>
<Caption>
PAGE
----
PART I
Item 1. Business.................................................... 3
Item 2. Properties.................................................. 11
Item 3. Legal Proceedings........................................... 11
Item 4. Submission of Matters to a Vote of Securities Holders....... 11
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters......................................... 12
Item 6. Selected Financial Data..................................... 14
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 15
Item 7A. Quantitative and Qualitative Disclosures about Market
Risk........................................................ 28
Item 8. Financial Statements and Supplementary Data................. 29
Item 9. Changes in and Disagreements with Accountants on Accounting
and Financial Disclosure.................................... 55
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 55
Item 11. Executive Compensation...................................... 57
Item 12. Security Ownership of Certain Beneficial Owners and
Management and Related Stockholder Matters.................. 63
Item 13. Certain Relationships and Related Transactions.............. 66
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form
8-K......................................................... 67
</Table>
---------------------
FORWARD-LOOKING STATEMENTS
In addition to historical information, this Annual Report on Form 10-K
contains forward-looking statements that have been made pursuant to the
provisions of the Private Securities Litigation Reform Act of 1995. Such
forward-looking statements are based on current beliefs, plans, objectives and
expectations of the Company's management. The words "expect," "anticipate,"
"intend," "plan," "believe," "estimate," "would" and similar expressions
identify forward-looking statements. These statements are not guarantees of
future performance and are subject to certain risks and uncertainties that could
cause actual results to differ materially from those reflected in the
forward-looking statements. Factors that might cause such a difference include
but are not limited to those discussed in the sections entitled "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Factors That May Affect Future Results and Market Price of Stock". Readers are
cautioned not to place undue reliance on these forward-looking statements, which
reflect management's opinions only as of the date hereof. We undertake no
obligation to revise or update or publicly release the results of any revision
or update to these forward-looking statements. Readers should carefully review
the risk factors described in other documents we file from time to time with the
Securities and Exchange Commission, including our Quarterly Reports on Form 10-Q
to be filed in the coming year.
2
PART I
ITEM 1. BUSINESS
OVERVIEW
Frontstep, Inc. is a leading global provider of software and services for
midsize discrete, to-order manufacturers and business units of larger companies.
For more than 23 years, Frontstep has helped manufacturers create and implement
business solutions -- including extended enterprise resource management,
customer relationship management, and supply chain management -- that simplify
and streamline business processes and operations. Through these innovative and
practical solutions, manufacturers can respond better and faster to customers'
demands for quality products and services.
Our innovative and practical solutions are designed specifically for
meeting the unique needs of manufacturers of complex, custom products in
to-order, job shop and mixed-mode environments. Our software solutions span the
business of manufacturing and provide our customers a comprehensive suite of
integrated software and services that (1) support the enterprise resource
planning ("ERP") and traditional back-office management needs of an extended
enterprise; (2) support customer relationship management ("CRM"); and (3)
support an enterprise's supply chain management ("SCM") activities. The software
products associated with each of these solutions provide a customer with a
comprehensive business system that is typically their primary business system.
Over the last three years, we have advanced the architecture of our
products and have chosen Microsoft as our primary technology platform for the
continued delivery of our software applications. Our CustomerSynchronized
Solutions, built on Microsoft enterprise servers, languages and development
tools, represent a fundamental technology shift that takes advantage of the
vision and capabilities of Microsoft.NET. By providing a complete business
solution on a single technology platform, Frontstep is able to offer a practical
combination of industry-standard technologies designed specifically to work well
together. Eliminating the need for disparate technology integration increases
efficiency and value, making our solutions more attractive to cost-conscious
manufacturers in today's lean economy. Frontstep will continue to support the
current Progress-based versions of SyteLine.
Frontstep develops, markets and supports the following products:
Extended ERP. Manufacturers are spending more time improving
operations and processes to compete in this economy. Frontstep's
comprehensive Extended ERP offering, SyteLine, is designed to enable
manufacturing companies to continue improving internal operations while
extending the reach of the enterprise beyond the four walls.
The SyteLine software suite provides the means for forward-thinking
to-order manufacturers to connect sales, marketing, manufacturing,
financials and service. SyteLine also helps companies connect manufacturing
operations and core business processes with suppliers and customers.
The SyteLine suite goes beyond standard ERP functionality by providing
them with the means for competing effectively through enterprise-wide
customer visibility and dynamic personalization. SyteLine is the platform
for establishing and maintaining a strong business and technical foundation
for manufacturing.
Customer Relationship Management. Manufacturers are seeking to
increase customer loyalty and retention, increase productivity and grow
sales revenue. At the same time, with the wealth of information available
to customers, expectations are on the rise.
Frontstep's customer relationship management solutions provide a
single interface point for customers, employees, suppliers and partners to
view and execute activity with orders and customers. Frontstep's
applications tightly integrate order management and back-office execution
capabilities.
Frontstep's customer relationship management solutions provide
seamless integration of every business process that touches the customer.
3
Supply Chain Management. Supply chain management requires
communication among a variety of trading partners. Frontstep's supply chain
management applications provide real-time, Internet-based synchronization
of manufacturing, distribution and external supply to customer demand.
Based on the Microsoft infrastructure for successful business-to-business
commerce, Frontstep's supply chain management integrates a company's
front-office order entry and customer service operations with its back-
office execution systems to assure that promises made are promises kept.
Frontstep's supply chain management applications streamline the
planning process by providing real-time order promising, dynamic
synchronization, real-time intelligent messaging and analysis in both
single-site and multisite, multi-ERP environments.
Services and Support. Frontstep offers a full portfolio of
professional services to help manufacturers achieve a rapid, ongoing return
on their business system investment. With more than 23 years experience
helping manufacturers, the Frontstep services team can help improve
operations over the life of the partnership with Frontstep. Frontstep also
provides a full range of education, support, and application hosting
services to help operate business systems efficiently, at a low cost, and
with high reliability.
Our reputation for successful installations and implementations of these
CustomerSynchronized Solutions is a function of our discipline and product
capabilities and distinguishes the Company from its competition. Our solutions
are rapidly deployable, scalable, flexible and reliable resulting in a
comparatively low total cost of ownership and rapid return on investment. This
is especially true of our newer product offerings, which are based on Microsoft
technology to further enhance the ease of maintenance and long-term value. We
believe that our approach to solving customers' business system issues results
in increased efficiencies, reduced total costs of ownership and enhanced
customer relations. More specifically:
Increased efficiencies. In today's fast-paced, competitive
environment, increased intra-enterprise business process efficiency is more
critical to manufacturers than ever before. Frontstep's customers typically
manufacture customer products order-by-order, often in small quantities.
Increasing the efficiency and transparency of every step, from order entry
to shipment and service, translates into valuable competitive benefit.
Frontstep's software allows manufacturers to automate business processes,
thereby building customer value by enabling and optimizing enterprise and
intra-enterprise collaborative operational and financial processes, gaining
greater efficiency at every stage.
Reduced total cost of ownership. The Company's solutions are designed
to minimize the total cost of implementing, operating and maintaining
enterprise systems and to maximize operating efficiency, thereby providing
tangible return on investments made by the customer. Our software runs on
standard hardware platforms, providing users with the flexibility to
leverage existing technology systems and to optimize system configurations.
The modular design of the Company's software allows manufacturers to
implement systems quickly and easily and provides the flexibility to add
additional functionality or change business process models as customer
needs and business requirements change. Our newer products utilize a
unified architecture that is open, integrated, and leverages Microsoft SQL
Server 2000, Web services, and more.
Enhanced customer relationships. The Company's extended ERP, CRM and
SCM solutions integrate customer requirements with sales, marketing,
engineering, manufacturing and customer service information, in order to
achieve more accurate planning and scheduling decisions, rapid response
times, better on-time deliveries, improved order fulfillment, improved
field service delivery and overall customer satisfaction. This
customer-centric focus satisfies manufacturers' needs by unifying and
synchronizing valued-customer touch points. It promotes knowledge
accessibility so manufacturers can efficiently respond and deliver on
time -- every time, thereby creating customer value by elevating the
quality of knowledge.
As a result of these factors, which we believe set us apart from our
competition, Frontstep has been one of the leading providers of software and
services in the enterprise software industry for more than 23 years,
particularly with midsize discrete, to-order manufacturing companies. We provide
our customers with the software solutions we have developed, professional
consulting services associated with the implementation of our products and
related training for customer personnel. We have more than 4,400 customer sites
and a worldwide network of 26 offices in 16 countries. Our offices are equipped
to provide our services, support our products and,
4
in several countries around the world, translate our products into other
languages. The Company's principal executive offices are located at 2800
Corporate Exchange Drive, Columbus, Ohio 43231, and its telephone number is
(614) 523-7000.
THE ENTERPRISE APPLICATIONS SOFTWARE INDUSTRY
We are in the enterprise applications software industry. This industry is
large and has many companies that provide various types of software to meet
general or specific business needs. Frontstep develops and markets products that
solve business system issues for the manufacturing industry, specifically for
midsize companies or divisions of larger companies. The enterprise application
software industry has experienced tremendous change during 2001 and 2002 as
software providers were impacted by difficult economic conditions. Software
companies focused on generating revenues from their current customers and
serving the market with improved return on investment and lower total cost of
ownership.
The enterprise applications market has been characterized historically as
enterprise resource planning. Enterprise resource planning has generally been
available since the early 1990's when corporate reengineering began and
primarily supports the control and management of operations of a manufacturing
enterprise. It has its roots with material requirements planning software and
inventory control software that were utilized in the 1980's as a means of
managing inventories and production schedules. More recently, our industry has
been described as "Collaborative Commerce" by industry analysts, to more
accurately reflect a changing business systems model for manufacturing companies
to a more Internet-centric model. In recent years, many software providers have
focused in recent years on system integration, security and development of
Web-based solutions to meet the requirements of an Internet-driven marketplace.
Our customers do business in an extremely competitive manufacturing
environment. Changing technologies and the prospects for growth of collaboration
via the Internet have dramatically altered the manner in which these customers
do business or will do business in the future. These changes are also impacting
business systems requirements to support these new ways of doing business. We
believe that maximizing manufacturing efficiency and productivity, managing
customer relationships, managing distribution channels, improving supplier
relationships and improving performance of supply chains are essential
requirements for the economy of the 21st century as companies seek to increase
global reach, innovation, productivity and profitability.
Given the difficult economic climate of the last few years and intense
competitive factors affecting our customers and potential customers, we believe
that mid-market companies are rethinking their business models and changing the
way they do business to remain competitive. As they change, business systems
requirements will include an enterprise management software solution that
integrates front-office capabilities, customer relationship management and
supply chain management, with more traditional ERP applications. We also believe
that, in the mid-market, the solution must be rapidly deployable, scalable and
flexible, resulting in a comparatively low total cost of ownership and rapid
return on investment. Since 1998, the Company has been investing in the
development of such software products and capabilities and the open architecture
required to effectively solve these new challenges for our customers.
According to AMR Research, a software market analysis firm, the worldwide
marketplace for enterprise software will grow from approximately $37 billion in
calendar year 2001 to more than $70 billion in calendar year 2006. For each of
the major product markets, the projected annual growth rates are estimated to be
approximately as follows:
<Table>
<Caption>
WORLDWIDE WORLDWIDE
SOFTWARE MARKET REVENUES 2001 REVENUES 2006 GROWTH RATE
- --------------- ------------- ------------- -----------
(IN BILLIONS)
Supply chain and product life-cycle
management.................................. $5.6 $13.6 20%
Customer relationship management.............. 11.0 26.0 19%
Enterprise resource planning.................. 20.0 31.0 9%
</Table>
5
STRATEGY
Our objective is to become the leading provider of enterprise business
software solutions for discrete, to-order manufacturing companies concentrated
primarily in the mid-market, including subsidiaries and divisions of larger
companies on a single platform: Microsoft. Our customer focus includes both
single-site and multi-site manufacturers, including those with facilities around
the world. Our product focus centers on extended ERP as the enterprise platform,
together with fully integrated CRM and SCM solutions to meet all of an
enterprise's primary business system requirements. The key components of our
strategy include:
Deliver a comprehensive, high value solution. We believe that we have
the most complete software suite available to discrete, to-order
manufacturing companies. The SyteLine brand is a well-known ERP software
solution, and we have invested heavily over the last several years in
delivering a new version of SyteLine on a 100% Microsoft-based platform and
enhancing its base capabilities. Our efforts have also included the
integration of complementary software applications to broaden the scope and
flexibility of our offerings. We believe companies in our target vertical
markets typically have limited economic and staff resources and prefer a
single vendor to provide their end-to-end business system. As a result, we
believe we can compete with larger, better-capitalized competitors on both
the price and functionality of our offerings.
Embrace a single technology platform for growing market share. We are
committed to delivering a simple, but powerful, technology solution to
better manage and leverage our costs of development and maintenance and to
simplify our customers' information technology environment. We have chosen
Microsoft as our primary technology platform for the continued delivery of
all software applications. This standard technology, used by many of the
Company's customers in other areas of their business, allows customers to
leverage their existing technology investments and capabilities. While
currently deployed versions of our ERP software use the Progress Software
Corporation database and tools, the new version of SyteLine will advance,
standardize and simplify our customers' technology platform as the
marketplace increasingly adopts the Microsoft database and architecture. We
intend to continue leveraging our strategic relationship with Microsoft to
provide complementary solutions to its business applications.
Provide outstanding services and support. We are committed to serving
our customers beyond the sale of our products with excellence in
professional services and support. The Company's worldwide services
organization, which employs approximately 175 consultants and managers,
uses a tailored, consultative approach and structured implementation
methodology. Services include account management, consulting, project
management, implementation, education, technical consulting, programming
and system integration services, and ongoing maintenance and support. Our
methodology and capabilities allow customers to rapidly and efficiently
install and maximize the benefits of the Company's software products. The
Company considers its ability to implement its software solution rapidly to
more quickly provide business value a key competitive factor.
Build on our leadership position in key vertical sectors. We believe
that we are a leading provider of enterprise system solutions, which are
broad and deep, to specific business environments. Our solutions fit
single- or multi-site manufacturing companies in specific key verticals
including: industrial equipment, fabricated metals, electrical equipment
and electronics, furniture and fixtures, specialty vehicles and automotive,
and aerospace. These companies employ discrete, to-order manufacturing
styles such as engineer-to-order, make-to-order, and mixed mode/hybrid.
They are demand pull-driven and need to compress lead times to better
manage a complex product ordering and sales process. They need solutions
that easily integrate with and complement parent-company systems like SAP
or Oracle. We intend to leverage our experience and customer base to
enhance our leadership position in the discrete, to-order manufacturing
market.
Leverage our global alliance of partners. We continue to nurture and
grow our alliances with strategic technology partners to expand the breadth
of our product capabilities, to expand our ability to market and sell our
products, and to support our customers after the product sale. Microsoft,
Cognos, Lexign and Crystal Decisions are notable alliances we have
undertaken to date. We also retain an exceptional network of preferred
business partners around the world that provide sales, consulting and
technical services to expand our ability to serve our customers. We believe
these alliances bring the best of many disciplines to our
6
customers while allowing us to maintain control over our costs of doing
business. We intend to continue to pursue additional important alliances
with industry-leading companies that will further enhance the Company's
offerings and capabilities.
Gain international market share and awareness. We have been serving
the mid-market for 23 years and have more than 4,400 customer sites around
the world. We service and support these customers from our worldwide
network of 26 offices in 16 countries. Given this substantial and loyal
customer base, we intend to leverage our comprehensive, integrated suite to
further enhance add-on sales. In addition, we intend to enhance our
leadership position by leveraging our new SyteLine version as a replacement
for less-modern ERP software to grow market share within the 25,000
manufacturing locations using legacy or unsupported ERP software versions.
Advance our innovative and practical solutions. Collaborative
business is absolutely essential to improving manufacturers' productivity
and competitive position. Because of the importance of technology return on
investment, ERP solutions must address the extended enterprise and
collaboration. We are committed to leveraging enabling technologies, like
Web services, to deliver services capabilities as manufacturers are looking
to extend their enterprises to collaborate with customers and partners
outside their four walls.
Advance our products rapidly. We have rapidly advanced our products
and capabilities as technologies and business systems requirements have
dramatically changed over the last few years. Since fiscal 1998, we have
heavily invested in both the acquisition and development of our products
and product capabilities. Approximately $60 million has been invested in
acquired and developed software along with research and development
expenditures. We are committed to ensuring that the Company's products are
technologically advanced and best-of-class in the mid-market.
PRODUCTS
The software solutions we provide to our customers include a comprehensive
suite of integrated software and services that (1) support the traditional
back-office management and resources of an enterprise through Extended ERP, (2)
support customer relationship management and other front-office business
activities and (3) support an enterprise's supply chain management activities.
The software products associated with each of these solutions are comprised of
the following:
Extended ERP. SyteLine is the Company's hallmark Enterprise Resource
Planning product for midsize discrete manufacturing companies that provides
a comprehensive operations and financial business process solution to an
enterprise. SyteLine's functionality includes support for customer service,
order processing, inventory control and purchasing, manufacturing
production management, production planning and scheduling, cost management,
project control, accounting functions and financial administration. With
the release of SyteLine 7 in September 2002, the Company will offer this
product for use on the Microsoft platform. For many years, this product has
been offered for use on the Progress platform.
Additional Extended ERP products include:
- SyteLine Configuration -- product configuration for sales order and
manufacturing
- SyteLine Advanced Planning and Scheduling (APS) -- real-time inventory
and capacity planning
- SyteLine Business Intelligence -- data analysis and charting
- SyteLine Workflow Automation -- business process definition and
execution
- SyteLine Data Collection -- labor and materials data management
- SyteLine EDI -- integrate SyteLine with industry-leading EDI
translators
- SyteLine Advanced Forms -- design and deployment of custom laser
printed forms
- SyteLine Business Process Management -- enterprise business process
modeling
7
SyteLine is designed to operate with all of our other products to
create a collaborative and integrated business management solution to meet
all of the front office and back office needs of an enterprise.
SyteDistribution is the Company's ERP product designed for mid-sized
distributors to meet their unique operational process demands to better
control inventories, shipments and orders among enterprises.
CRM. Frontstep CRM is a single interface point for employees, sales
representatives and channel partners to view and execute marketing and
sales activity pertaining to prospects and customer orders. CRM solutions
improve customer service, lower costs and drive increased revenues.
Frontstep CRM provides a sales force automation solution, contact and
customer management, marketing, customer service and order management tools
integrated with SyteLine and architected for integration with other ERP
systems.
Additional customer relationship management products include:
- Frontstep Customer Center -- Web-based customer self-service
solution
- Frontstep Configuration -- Web-based product and sales order
configuration
- Frontstep Advanced Pricer -- Web-based pricing for complex orders
SCM. Frontstep's SCM solutions provide the fastest way for companies
to align supply with demand, provide real-time order promise dates to
customers and ensure on-time delivery. Our solution provides the capability
to improve customer service by synchronizing inventory and capacity with
customer orders. This solution lowers operational costs and improves
on-time deliveries by automating inventory sourcing and manufacturing
planning activities through real-time synchronization of demand and supply
across multi-site operations and suppliers.
Our Supply Chain products include:
- Frontstep Intelligent Sourcer -- starting point when accessing
sourcing rules and promising engines to balance supply and demand
between multiple sites or suppliers
- Frontstep Point Promiser -- promising engine for
Available-to-Promise (ATP) collaboration that balances inventory
availability with demand requirements
- Frontstep Capacity Promiser -- promising engine for
Capable-to-Promise (CTP) collaboration that balances selected
materials and rate based capacity with demand requirements
- Frontstep Advanced Planning and Scheduling (APS) -- advanced
planning and scheduling for all materials and capacities across
multiple sites or through multiple levels of the supply chain
Frontstep Knowledge Zone. Frontstep Knowledge Zone is our
subscription-based, on-line education service. Users can access education
for Frontstep solutions anytime and anywhere they have Internet access. It
is a convenient, low cost alternative to hardcopy training manuals and
selected classroom education.
SERVICES AND SUPPORT
We maintain a worldwide professional services organization of over 175
employees and a network of more than 40 business partners and strategic
alliances which offer to our customers a full range of services to support
installation and ongoing operations and to maximize the benefits of our software
products. These services include, but are not limited to, project management,
implementation support, product education, technical consulting, programming and
system integration services and ongoing maintenance and product support. We
employ our own structured services methodology to manage and support customer
implementation.
Our services are priced separately and fees for our services are not
included in the price for our software products. These services are billed as
incurred. Although we attempt to minimize customization of our software
products, we do provide professional programming services to modify our software
products to address specific customer requirements. These modifications may
include designing and programming complete applications or integrating our
software products with legacy systems.
8
Maintenance and support services include product enhancements and updates,
upgrades to new versions, telephone support during extended business hours,
full-time emergency support and access to our customer support service center on
our Internet home page. Fees for maintenance and support services generally are
billed annually in advance and revenue is deferred and recognized ratably over
the term of the maintenance and support agreement.
SALES AND DISTRIBUTION
We currently license our software to customers primarily based on a license
fee for each concurrent session or concurrent execution of its software
products. We receive additional license fees whenever a customer increases the
number of concurrent sessions, usually as a result of the growth of the
customer's business or expansion to other sites. Sales opportunities are
generated through a combination of in-house telemarketing, our web site, leads
from consulting partners, advertising, trade shows and direct contacts by sales
representatives. Our product offerings are sold to customers through two primary
channels:
Direct sales. This sales channel is comprised of direct sales
representatives selling to manufacturers and focuses on selling the total
business system under the Frontstep brand name. This channel targets the
Company's traditional midsize manufacturing markets. We presently have
approximately 40 direct sales representatives located around the world.
Business partners. This sales channel is comprised of approximately
40 third-party business partner firms that resell the Company's entire
suite of products. These partners include sales and consulting firms and
application service providers that specialize in the Company's products.
We derive our revenues and service our customers in 16 countries around the
world. We derived approximately 28%, 22% and 20% of our fiscal 2002, 2001 and
2000 revenues, respectively, from sales outside of North America. The
distribution of total revenue, operating income and identifiable assets
attributable to each of our geographic market areas for fiscal years 2002, 2001
and 2000 were as follows (in thousands):
<Table>
<Caption>
NORTH AMERICA EUROPE ASIA/PACIFIC
------------- ------- ------------
FISCAL 2002
Total Revenue...................................... $ 66,425 $16,036 $10,125
Operating Income (loss)............................ (2,535) 928 (389)
Long-lived assets.................................. 4,301 397 332
FISCAL 2001
Total Revenue...................................... $ 91,508 $14,736 $10,832
Operating Income (loss)............................ (25,190) (189) (2,238)
Long-lived assets.................................. 6,822 312 512
FISCAL 2000
Total Revenue...................................... $103,065 $13,941 $11,902
Operating Income (loss)............................ (5,737) (3,904) (1,155)
Long-lived assets.................................. 7,135 383 468
</Table>
PRODUCT DEVELOPMENT
We devote a significant percentage of our resources to identifying the
needs of our customers and prospects in developing new features and enhancements
to existing products and designing and developing new products. We perform the
majority of our development activities with our own professional development and
product organization of more than 160 professionals located at the Company's
headquarters facility in Columbus, Ohio, as well as Indiana, Arizona and
Minnesota. In addition, we subcontract certain of our development efforts to
development partners located in Asia and elsewhere overseas.
9
Our practice is to release updates and major enhancements on a regular
basis since the market for our products is characterized by changes in customer
requirements, rapid technological change, and evolving industry standards in
computer hardware and software technology.
We are committed to product and technological excellence and to meeting the
changing needs of our customers. As a result, we commit a substantial portion of
our revenues to research and development and to building new products, which are
typically capitalized as developed. Total research and product development
costs, including amounts capitalized, were $13.7 million, $18.4 million, and
$22.7 million for the fiscal years ended June 30, 2002, 2001 and 2000,
respectively. Additions to capitalized software were $7.6 million, $5.1 million,
and $7.0 million for the same respective periods and were capitalized in
accordance with applicable accounting standards.
COMPETITION
The market for enterprise solutions is intensely competitive, rapidly
changing and highly fragmented. This market has become even more fragmented
after the rise and fall of many companies during the "dot-com" era and now with
new technology changes and standards. This market is also affected by new
product offerings, mergers and acquisitions and other market activities. We have
a large number of competitors that vary in size, computing environments and
overall product scope. Within our market, our primary competition comes from
independent software vendors in three distinct groups: (1) traditional
enterprise software developers, including J.D. Edwards & Co., QAD, Inc., Lilly
Software Associates, IFS and Epicor Software Corporation; (2) large software
developers, like SAP, PeopleSoft and Oracle, moving into the mid-market; and (3)
specialized software developers focusing on CRM and supply chain management.
A number of companies offer products that are similar to our products that
are directed at the market for enterprise software and compete against us on a
regular basis. Many of the these competitors have more established and larger
marketing and sales organizations, significantly greater financial, technical
and other resources and a larger installed base of customers than the Company.
We believe that we compete favorably against our competition in the following
areas, which we consider to be the most important considerations for potential
customers:
- knowledge of and experience with midsize businesses
- focus on discrete-to-order manufacturing vertical markets
- breadth and depth of our comprehensive enterprise application
solutions (ERP, CRM, SCM) for our target markets
- collaboration and workflow automation across the enterprise and
outside the enterprise with customers and suppliers
- rapid implementation
- single industry-standard technology: Microsoft
- competitive pricing
- corporate reputation based on more than 23 years of experience
- size of installed user base
PROPRIETARY TECHNOLOGY
Our ability to compete is dependent in part upon our internally developed,
proprietary intellectual property. We regard our products as proprietary trade
secrets and confidential information. We rely upon our license agreements with
customers, distribution agreements with distributors and our own security
systems, confidentiality procedures and employee agreements to maintain the
trade secrecy of our products. For all of our significant products, we have
registered with appropriate Federal agencies for protection of our programs,
documentation and other written materials under copyright and trademark laws.
See also "Item 7. Factors That
10
May Affect Future Results and Market Price of Stock -- Our success is dependent
in part upon our proprietary technology and other intellectual property."
EMPLOYEES
As of June 30, 2002, we employed 574 persons of which 197 were employed in
international operations outside of North America. None of our employees are
represented by a labor union. We have never experienced a work stoppage and
believe that our employee relations are good.
ITEM 2. PROPERTIES
Our corporate headquarters and principal administrative, product
development, and sales and marketing operations are located in approximately
70,000 square feet of leased office and storage space in Columbus, Ohio. The
lease agreement commenced July 1, 2002 and will expire on June 30, 2004. The
lease agreement provides for an annual base rent and operating expenses of
approximately $984,000. Additionally, we have 25 leased sales and support
offices throughout the United States and elsewhere.
ITEM 3. LEGAL PROCEEDINGS
We are subject to legal proceedings and claims that arise in the normal
course of business. While the outcome of these matters cannot be predicted with
certainty, management does not believe the outcome of any of these legal matters
will have a material adverse effect on our business, financial condition or
results of operations.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
(a) The Company held a special meeting of the shareholders on June 20, 2002
(the "Meeting").
(b) Not applicable.
(c) The only matters voted on at the Meeting were (i) a proposal to approve
the issuance of the Convertible Notes (as defined below), the issuance
of common shares upon conversion of the Initial Notes (as defined
below) and the issuance of that portion of the Warrants issued to
Lawrence J. Fox and James A. Rutherford pursuant to the Securities
Purchase Agreement dated March 7, 2002 between the Company and the
investors named therein (the "Convertible Note proposal") and (ii) a
proposal to approve the Amended and Restated Frontstep, Inc. Stock
Option Plan for Outside Directors (the "Director Stock Option Plan
proposal").
The manner in which the votes were cast with respect to the Convertible
Note proposal was as follows:
<Table>
<Caption>
SHARES VOTED SHARES VOTED BROKER
"FOR" "AGAINST" ABSTENTIONS NON-VOTES
- ------------ ------------ ----------- ---------
3,989,816 482,766 15,339 None
</Table>
The manner in which the votes were cast with respect to the Director Stock
Option Plan proposal was as follows:
<Table>
<Caption>
SHARES VOTED SHARES VOTED BROKER
"FOR" "AGAINST" ABSTENTIONS NON-VOTES
- ------------ ------------ ----------- ---------
7,341,320 302,621 15,730 None
</Table>
(d) Not applicable.
11
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common shares are traded in the over-the-counter market and are quoted
on the Nasdaq National Market ("NASDAQ") under the symbol "FSTP". As of
September 20, 2002, we had approximately 212 shareholders of record. The
following table sets forth, for the periods indicated, the range of high and low
sale prices for Frontstep's common shares as reported by NASDAQ:
<Table>
<Caption>
PRICE RANGE
--------------
HIGH LOW
------ -----
FISCAL 2002
First Quarter............................................. $ 4.24 $2.84
Second Quarter............................................ 5.25 2.85
Third Quarter............................................. 5.50 2.00
Fourth Quarter............................................ 3.47 2.68
FISCAL 2001
First Quarter............................................. $10.00 $5.31
Second Quarter............................................ 6.88 2.63
Third Quarter............................................. 7.13 3.13
Fourth Quarter............................................ 3.90 1.89
</Table>
We have never paid cash dividends on our shares. We expect that all future
earnings will be retained to finance our operations and for the growth and
development of our business. Accordingly, we do not currently anticipate paying
cash dividends on our shares in the foreseeable future. The payment of any
future dividends will be subject to the discretion of the Board of Directors of
Frontstep and will depend on our results of operations, financial position and
capital requirements, general business conditions, restrictions imposed by
financing arrangements, if any, legal restrictions on the payment of dividends
and other factors the Board of Directors deems relevant. In addition, holders of
Frontstep's outstanding preferred shares may be entitled to receive dividends on
the preferred shares prior to the payment of dividends on the common shares, in
certain cases, under our Amended Articles of Incorporation.
SALE OF UNREGISTERED SECURITIES
On March 7, 2002, we issued 600,000 warrants with an exercise price of
$0.01 per share and 10% subordinated notes in the aggregate principal amount of
$1.5 million (the "Initial Notes") in a private placement to certain of our
preferred shareholders, including Fallen Angel Equity Fund and entities
affiliated with Morgan Stanley, and two other shareholders and directors of the
Company, Lawrence J. Fox and James A. Rutherford (collectively, the
"Investors"), pursuant to a Securities Purchase Agreement dated March 7, 2002
(the "Original Agreement"). The March transaction was part of an agreement by
the Investors, subject to certain conditions, to provide a total of $5 million
of funding to the Company. The warrants were issued in reliance upon an
exemption from registration under Section 4(2) of the Act and Rule 506
promulgated by the Securities and Exchange Commission (the "Commission") under
the Act. Under the Original Agreement, we agreed to issue and sell to the
Investors, subject to certain conditions, including the approval of the
Company's shareholders, in the aggregate an additional $3.5 million principal
amount of 10% subordinated convertible notes due May 10, 2004 (the "Convertible
Notes"). On June 20, 2002, shareholders of the Company approved the issuance of
the Convertible Notes, the issuance of common shares upon conversion of the
Initial Notes and the issuance of that portion of the warrants issued in March
2002 to Mr. Fox and Mr. Rutherford. On July 9, 2002, we entered into Amendment
Number One to the Original Agreement (the "Amendment") with the Investors and
completed the closing of the Convertible Notes transaction. The closing
constituted the "Convertible Closing" as such term is defined in the Original
Agreement and, therefore, as a result of the closing, the Initial Notes became
convertible into common shares of the Company, at the election of the holders,
at a conversion price of $2.4876 per share at any time after July 9, 2002. In
addition, the Amendment permitted us to issue up to $3.5 million in principal
12
amount of additional Convertible Notes to the Investors. By August 28, 2002 the
remaining amount of Convertible Notes had been issued. Under the agreement with
the Investors, we are required to file with the Commission a registration
statement covering the resale by the Investors of the common shares issuable to
them upon conversion of the Convertible Notes and the Initial Notes and upon
exercise of the warrants.
In July 2001, we entered into a new credit facility arrangement with
Foothill Capital Corporation. The credit facility includes a $15 million,
three-year term note and a $10 million revolving credit facility. In connection
with the new credit facility arrangement with Foothill, we issued to Foothill a
warrant to purchase 550,000 common shares at an initial exercise price of $3.36
per share, which was the average of the closing bid price for our common shares
for the 10 trading days immediately preceding the closing date for the new
credit facility. The exercise price of the warrant and the number of common
shares issuable upon exercise of the warrant are subject to adjustments from
time to time under the anti-dilution provision contained in the warrant. The
warrant expires in July 2006 and is exercisable at any time prior to its
expiration. The warrant was amended and restated in November 2001 to clarify
certain provisions relating to adjustments under the terms of the warrant upon
the occurrence of certain events. The warrant (as originally issued and as
amended and restated warrant) was issued in reliance upon an exemption from
registration under Section 4(2) of the Act and Rule 506 promulgated by the
Commission under the Act. As required by our agreement with Foothill, we filed
with the Commission on October 11, 2001 a preliminary registration statement on
Form S-3 covering the resale by Foothill of the shares issuable upon exercise of
the warrant. The registration statement has not been declared effective by the
Commission.
13
ITEM 6. SELECTED FINANCIAL DATA
The following selected consolidated financial data as of and for the years
ended June 30, 1998 through 2002 have been derived from the Consolidated
Financial Statements of Frontstep. The selected consolidated financial data
below should be read in conjunction with the Consolidated Financial Statements
and notes thereto and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" included elsewhere in this Form 10-K (in
thousands, except per share data).
<Table>
<Caption>
YEAR ENDED JUNE 30,
--------------------------------------------------
2002 2001 2000 1999 1998
------- -------- -------- -------- -------
STATEMENT OF OPERATION DATA:
Total revenue..................... $92,586 $117,076 $128,908 $129,072 $97,597
Cost of revenue................... 44,702 58,826 61,856 52,025 35,701
------- -------- -------- -------- -------
Gross margin...................... 47,884 58,250 67,052 77,047 61,896
Operating expenses:
Selling, general and
administrative............... 41,921 62,847 57,504 56,801 43,995
Research and development........ 6,182 13,332 15,684 10,217 7,901
Amortization of acquired
intangibles.................. 1,777 3,285 3,593 2,140 1,479
Restructuring and other
charges...................... -- 6,403 1,067 835 6,503
------- -------- -------- -------- -------
Total operating expenses..... 49,880 85,867 77,848 69,993 59,878
------- -------- -------- -------- -------
Operating income (loss)........... (1,996) (27,617) (10,796) 7,054 2,018
Other (expense) income, net....... (2,142) (510) (966) 151 (178)
------- -------- -------- -------- -------
(Loss) income before income
taxes........................... (4,138) (28,127) (11,762) 7,205 1,840
(Benefit from) provision for
income taxes.................... (693) (2,063) (1,557) 3,206 3,196
------- -------- -------- -------- -------
Net (loss) income................. $(3,445) $(26,064) $(10,205) $ 3,999 $(1,356)
======= ======== ======== ======== =======
Net (loss) income per common
share -- diluted................ $ (0.46) $ (3.46) $ (1.38) $ 0.55 $ (0.21)
======= ======== ======== ======== =======
Weighted average shares
outstanding -- diluted.......... 7,568 7,535 7,411 7,264 6,317
BALANCE SHEET DATA:
Working capital................... $ 2,418 $ 2,649 $ 19,348 $ 21,926 $13,575
Total assets...................... 73,415 72,593 94,368 90,600 66,382
Total long-term debt and lease
obligations..................... 8,928 8,742 3,169 5,759 2,305
Total shareholders' equity........ 19,618 21,004 36,709 42,401 31,301
</Table>
14
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of our financial condition and results of
operations should be read in conjunction with the information set forth under
Item 6 -- Selected Financial Data and the financial statements and the Notes to
those statements included elsewhere in this Report on Form 10-K, as well as the
following section titled "Factors That May Affect Future Results and Market
Price of Stock" herein.
OVERVIEW
Frontstep, Inc. is a leading global provider of software and services for
midsize discrete, to-order manufacturers and business units of larger companies.
For more than 23 years, Frontstep has helped manufacturers create and implement
business solutions -- including extended ERP, customer relationship management,
and supply chain management -- that simplify and streamline business processes
and operations. Through these innovative and practical solutions, manufacturers
can respond better and faster to customers' demands for quality products and
services.
For the last several years, since the second quarter of fiscal 2000, our
industry, and specifically, our Company have experienced (1) dramatic changes in
worldwide economic conditions, (2) dramatic changes in our market conditions
resulting from a recession in many manufacturing industries and (3) a lessening
of information technology spending that is a result of these economic and market
conditions. Prior to fiscal 2000, and well before these economic and market
changes began to affect our results of operations, we began to enhance our
product offerings beyond traditional ERP systems to participate in higher growth
market segments. These enhancements include a comprehensive suite of integrated
software and services that support (1) the management and resources of an
enterprise, (2) customer relationship management and other front office business
activities and (3) an enterprise's supply chain management activities. In
November 2000, the shareholders of the Company approved a change in the
Company's name to Frontstep, Inc. to reflect this transformation in our
corporate identity. In July 2002, we achieved the culmination of these efforts
with the announcement of SyteLine 7, a new version of our flagship ERP product
that fully integrates the Company's efforts in traditional ERP, customer
relationship management and supply chain management. Additionally, the release
of SyteLine 7 offers our customers a product based on Microsoft SQL Server 2000
technology which supports Microsoft's .NET strategy. We believe our strategic
efforts to develop this total business system on an industry-standard technology
platform greatly expand our market opportunities, increase our potential for a
stronger business partner network and will provide better gross margins in the
years ahead.
However, over the last few years, it has been difficult to manage and
predict our revenues due to ever more difficult economic conditions and a lack
of demand from manufacturers who have significantly limited their capital
spending budgets, especially for information technology investments. This
situation has been most severe in North America which has been mired in a
recession for nearly two years. We have reacted to these difficult economic and
market conditions in several ways. We have accomplished significant reductions
in the Company's operating costs and we have completed several financing
transactions; each with the intentions of balancing our costs with expected
revenues and of ensuring adequate cash to meet our operating needs. In the
quarter ended June 30, 2002, we reported operating income in excess of $1.0
million, net income of $487,000 or $0.05 per share and we had positive cash flow
of $0.5 million as measured by earnings before interest, taxes, depreciation and
amortization ("EBITDA").
Our expectations for our operating results in the September 2002 fiscal
quarter and for the full fiscal year ending June 30, 2003 are conservative. We
expect revenues during the September 2002 quarter to be slightly below the
revenues reported for the most recent quarter ended June 30, 2002 and only
modestly increase in our December 2002 quarter as a result of our SyteLine 7
announcement. We will continue to manage our costs very tightly. As a result, we
believe that our operating results and EBITDA will be positive for the fiscal
2003 ending June 30, 2003 despite our expectation for continued difficulty in
the economy and a lack of information technology spending in our target
manufacturing market. While the economy has, at times, over the last several
months, shown signs of improvement; we continue to be concerned about our
ability to predict revenues in the near term, due to current economic and market
conditions. As a result we may not achieve positive operating results in the
current quarter ending September 30, 2002. The Company can provide no assurance
that it will achieve these expected financial results for the September 2002
quarter or for the remainder of fiscal 2003.
15
CRITICAL ACCOUNTING POLICIES
The Company's total revenue is derived primarily from licensing software,
providing related services, including installation, implementation, training,
consulting and systems integration and providing maintenance and support on an
annual basis. Revenue is accounted for in accordance with Statement of Position
97-2, Software Revenue Recognition, as amended and interpreted from time to
time. License fees revenue is generally recognized when the software product is
shipped. Services revenues are recognized as the services are performed and
revenues from maintenance agreements are billed periodically, deferred and
recognized straight-line over the term of the agreements.
Cost of license fees revenue includes royalties, amortization of
capitalized software development costs and software delivery expenses. Cost of
service, maintenance and support revenue includes the personnel and related
overhead costs for implementation, training and customer support services,
together with fees paid to third parties for subcontracted services.
Selling, general and administrative expenses consist of personnel,
facilities and related overhead costs, together with other operating costs of
the Company, including advertising and marketing costs.
Research and development expenses include personnel and related overhead
costs for product development, enhancement, upgrades, quality assurance and
testing. The amount of such expenses is dependent on the nature and status of
the development process for the Company's products. Development costs
capitalized in a given period are dependent upon the nature and status of the
development process. Upon general release of a product, related capitalized
costs are amortized over three to five years and recorded as license fees cost
of revenue.
Frontstep's discussion and analysis of its financial condition 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 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. On an on-going basis, we evaluate our critical accounting policies
and estimates, including those related to revenue recognition, bad debts,
intangible assets, restructuring costs, contingencies and litigation. We base
our estimates on historical experience and on various other assumptions that we
believe 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. Actual results may differ from
these estimates under different assumptions or conditions.
We believe the following critical accounting policies affect the more
significant judgments and estimates used in the preparation of our consolidated
financial statements:
Revenue recognition. The Company's total revenue is derived primarily
from licensing software, providing related services, including
installation, implementation, training, consulting and systems integration
and providing maintenance and support on an annual basis. Revenue is
accounted for in accordance with Statement of Position 97-2, Software
Revenue Recognition, as amended and interpreted from time to time.
Revenue is derived principally from the sale of internally produced
software products and maintenance and support agreements from software
sales. The Company licenses software generally under non-cancelable license
agreements and provides product support services and periodic updates
including training, installation, consulting and maintenance. License fees
revenue is generally recognized when a non-cancelable license agreement has
been signed, the software product has been shipped, there are no
uncertainties surrounding product acceptance, the fees are fixed and
determinable and collection is considered probable. For customer license
agreements, which meet these recognition criteria, the portion of the fees
related to software licenses, which is determined using the residual
method, will generally be recognized in the current period, while the
portion of the fees related to services is recognized as the services are
performed. The amount allocated to services revenues is based on the
Company's standard rate per hour. Revenue from maintenance and support
agreements, which is determined based on renewal rates, is billed
periodically, deferred and recognized ratably over the life of the
agreements. In the event revenue is
16
contingent upon customer acceptance criteria, the Company defers that
revenue until the contingencies are resolved.
Bad Debts. A considerable amount of judgment is required when
determining the allowance for bad debt, including assessing the probability
of collection as well as the credit-worthiness of each customer. The
Company has recorded bad debt reserves in recent periods due to recent
economic conditions especially as they affect the Company's customer base.
The Company may determine in future periods that additional charges must be
recorded.
Capitalized Software. The Company capitalizes the cost of developing
its software products in accordance with SFAS No. 86, Accounting for the
Costs of Computer Software to be Sold, Leased or Otherwise Marketed.
Capitalized software is stated at the lower of cost or net realizable
value. The Company's judgment is required when determining the net
realizable value of its software and any impairment loss could have a
material adverse impact on our financial condition and results of
operations.
Impairment of Intangible Assets. The Company periodically evaluates
acquired intangibles for potential impairment indicators. Our judgments
regarding the existence of impairment indicators are based on legal
factors, market conditions and operational performance of our acquired
businesses. Future events could cause us to conclude that impairment
indicators exist and that goodwill and other intangible assets associated
with our acquired businesses are impaired. Any resulting impairment loss
could have a material adverse impact on our financial condition and results
of operations.
Contingencies and Litigation. The Company is subject to proceedings,
lawsuits and other claims related to ongoing business and other matters. We
are required to assess the likelihood of any adverse judgments or outcomes
to these matters as well as potential ranges of probable losses. If an
adverse judgment or outcome can be predicted, an accrual in the determined
amount is recorded on the Company's ledger. An accrual may change in the
future due to new developments in each matter or changes in approach such
as a change in settlement strategy in dealing with these matters. The
Company is not involved in any actions that currently require an accrual to
be recorded.
ACCOUNTING PRONOUNCEMENTS
In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets. This Statement established a single
accounting model for the impairment or disposal of long-lived assets. SFAS No.
144 is effective for fiscal years beginning after December 15, 2001. The Company
will adopt SFAS No. 144 in the first quarter of fiscal 2003 and does not expect
the adoption of this statement to have a material impact on the Company's
consolidated financial statements.
In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated
with Exit or Disposal Activities. This statement addresses financial accounting
and reporting for costs associated with exit or disposal activities and
nullifies Emerging Issues Task Force Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit an Activity
(including certain costs incurred in a restructuring). SFAS No. 146 is effective
for exit or disposal activities that are initiated after December 15, 2002.
Management does not expect adoption of this Statement to have a material impact
on the Company's consolidated financial statements.
RESULTS OF OPERATIONS
The fiscal year that ended June 30, 2002 is our "current fiscal year" or
"fiscal 2002". The prior year that ended June 30, 2001 is the "prior fiscal
year" or "fiscal 2001". The year ended June 30, 2000 is "fiscal 2000".
17
FISCAL 2002 COMPARED TO FISCAL 2001
Revenue. Total revenue decreased $24.5 million, or 20.9%, to $92.6 million
in fiscal 2002 from $117.1 million in fiscal 2001. The total revenue mix is
shown in the table below (in thousands, except percentage data):
<Table>
<Caption>
FISCAL YEARS ENDED JUNE 30,
------------------------------------
2002 2001
--------------- ----------------
License fees revenue............................ $35,372 38.2% $ 51,309 43.8%
Service revenue................................. 21,787 23.5% 30,921 26.4%
Maintenance and support revenue................. 35,427 38.3% 34,846 29.8%
------- ----- -------- -----
Total revenue......................... $92,586 100.0% $117,076 100.0%
======= ===== ======== =====
</Table>
License fees revenue decreased 31.1% in the current fiscal year from the
prior fiscal year. We believe that the decrease in license fees revenue in
fiscal 2002 is industry-wide due to the current economic climate that is causing
our customers and potential customers to defer their buying decisions related to
large capital investments, particularly information technology investments. The
Company further believes that our customers in North America have been impacted
more dramatically than elsewhere in the world. Our license fees revenues in
Europe improved from fiscal 2001 and were comparable to fiscal 2001 license fees
revenues in Asia Pacific. We expect that license fees revenues will remain
stable or decline slightly in the September 2002 quarter and will not begin to
grow again until the current economic climate improves and demand for our
products improves as a result.
Service revenue decreased 29.5% in the current fiscal year from the prior
fiscal year. The decrease is primarily the result of the significant decline in
license fees revenues in the current fiscal year as compared to such revenues in
the prior fiscal year. Service revenues in particular are directly dependent on
new license purchases by new and existing customers. We expect that service
revenues have stabilized and will remain stable in the September 2002 quarter.
We do not expect any growth to occur until license fees revenue improve.
Maintenance and support revenue increased 1.7% in the current fiscal year
from the prior fiscal year. Maintenance and support revenue increased as a
percentage of total revenue primarily due to the lower license fees and service
revenue. Our maintenance and support revenues have been stable after several
years of growth. Stability in maintenance and support revenues in the coming
year is dependent upon continued renewals of such maintenance and support by our
existing customers. We believe that the release of SyteLine 7 will enhance the
value of such arrangements to our customers and that there will be sufficient
renewals in the coming year to provide for stable maintenance and support
revenues.
Cost of Revenue. Total cost of revenue as a percentage of total revenue
decreased to 48.3% for the current fiscal year from 50.2% for the prior fiscal
year.
Cost of license fees revenue decreased $4.4 million, or 20.2%, to $17.5
million in the current fiscal year from $21.9 million in the prior fiscal year
and as a percentage of license fees revenue, increased to 49.4% in the current
fiscal year from 42.7% in the prior fiscal year. Fiscal year 2001 includes $1.9
million of capitalized software written off as part of restructuring the
business. In the current fiscal year, the increase as a percentage of license
fees revenue is primarily attributable to the effects of product mix relative to
third-party product royalty arrangements, discounting as a result of weakened
demand and lower license fees revenue affecting certain fixed and related costs.
Cost of license fees revenue includes certain fixed components including
amortization of capitalized software. Amortization of capitalized software has
increased in the current fiscal year over the amount of amortization in the
prior fiscal year.
Cost of service, maintenance and support revenue decreased $9.7 million, or
26.3%, to $27.2 million in the current fiscal year from $36.9 million in the
prior fiscal year and as a percentage of service, maintenance and support
revenue, decreased to 47.6% in the current fiscal year from 56.2% in the prior
fiscal year. The decrease in cost is attributable to a decline in service
revenue for the reasons discussed above and significant cost reductions as part
of the Company's overall restructuring efforts. The percentage decrease is
primarily due to greater percentage in the current year of maintenance and
support revenues relative to service revenue which have higher margins than
service revenues.
18
Selling, General and Administrative Expenses. Selling, general and
administrative expenses decreased $20.9 million, or 33.3%, to $41.9 million in
the current fiscal year from $62.8 million in the prior fiscal year. Such
expenses as a percentage of total revenue decreased to 45.3% in the current
fiscal year from 53.7% in the prior fiscal year. The decrease in costs and as a
percentage of total revenue is attributable to the Company's efforts since April
2001 to significantly reduce its operating costs and to a $6.8 million charge to
write-off certain accounts receivable which was recorded in the prior fiscal
year.
Research and Development. Total research and development costs, including
amounts capitalized, were $13.7 million in the current fiscal year, a decrease
of $4.7 million or 25.4% from $18.4 million of such costs in the prior fiscal
year. Total research and development costs decreased as a percentage of total
revenues to 14.8% in the current fiscal year from 15.7% in the prior fiscal
year. Although total research and development spending decreased from the prior
fiscal year, we are continuing to spend a substantial portion of total revenues
on the development of our expanded product offerings and product capabilities,
development of future releases of our ERP software and development of interfaces
with third-party software products. We believe that these investments are
critical to the success and market acceptance of our new product offerings and
total suite of comprehensive business systems.
We capitalized development costs of $7.6 million during the current fiscal
year and $5.1 million during the prior fiscal year. We amortized $6.6 million
during the current fiscal year and $5.1 million during the prior fiscal year.
Restructuring and Other Charges. In April 2001, we announced a broad
restructuring plan in order to reduce the Company's workforce, reduce expenses
associated with non-essential activities and to improve the Company's ability to
be profitable at lower levels of revenue. We reduced our worldwide workforce by
approximately 20%, discontinued certain product development and other
non-essential activities and closed certain office facilities. In relation to
this restructuring plan, we also wrote-off certain accounts receivable and other
non-performing assets. We do not believe that the restructuring has had or will
have a significant negative impact to our business operations because our
personnel and facilities were in excess of needed levels. The significant and
positive impact of this restructuring effort on our operating costs is discussed
above.
As a result of the April 2001 restructuring plan, the Company recorded
pre-tax restructuring and other charges of $4.2 million during the year ended
June 30, 2001. Of these charges, $80,000 was non-cash primarily relating to the
write-off of non-performing assets and $4.1 million represented future cash
requirements. The Company expended $2.1 million of the cash requirements in
fiscal 2001 and $1.2 million in fiscal year 2002, primarily in the first two
fiscal quarters. Certain cash requirements will occur in future fiscal periods.
See "Note 2 -- Restructuring and Other Charges" in Item 8 in this Annual Report.
The Company's restructuring plan consisted of the following significant
items:
- Employee separation costs of $2.2 million -- The Company reduced its
workforce by approximately 20%, or 162 employees. These costs consist
primarily of severance for these employees.
- Contract termination liabilities of $900,000 -- The Company elected to
discontinue its SyteCentre ERP product to focus resources on the
Company's primary ERP product, SyteLine. The Company also discontinued
its ASP hosting solution and its Internet procurement software due to
sluggish demand and unprofitable operations. As a result, the Company
reserved $900,000 to cover anticipated contractual obligations and costs
associated with customers currently using the discontinued products and
services.
- Facility closure costs of $1.2 million -- The Company recorded
approximately $1.2 million of costs associated with closing certain
offices in Arizona, California, Canada and Asia. Cancelable lease term
costs were based on actual determinable amounts. For those leases with
non-cancelable lease terms, the Company assumed that subleases would be
obtained after a one-year period.
In July 2000, the Company announced several structural changes to
discontinue certain business operations, write off non-performing assets and to
restructure the Company to better focus on its core business strategy. These
changes included divesting the Company's FieldPro subsidiary, terminating the
operations of its e-Mongoose, Inc. subsidiary, consolidating the Company's
product development organizations and restructuring
19
the Company's sales channels. In connection with this announcement, the Company
recorded a non-recurring charge of $429,000, pre-tax, in the three months ended
June 30, 2000 and an additional non-recurring charge of $2.2 million, pre-tax,
in the three months ended September 30, 2000. The aggregate pre-tax charge of
$2.6 million included non-cash charges of $429,000 related primarily to the sale
of Visual Applications Software, Inc. The remaining $2.2 million was related to
the reduction of the Company's headcount. The headcount reduction included
approximately 90 employees associated with the operations discussed above and
others terminated as part of the restructuring. The costs were for severance
payments and were paid during the year ended June 30, 2001. No accruals remain
for these costs as of June 30, 2001.
Benefit from Income Taxes. The benefit from income taxes for the current
and prior fiscal years reflects an effective tax rate of 16.7% and 7.3%,
respectively. The effective tax rate in the current fiscal year differs from the
expected corporate tax rate primarily due to valuation allowances recorded
against the deferred tax assets.
FISCAL 2001 COMPARED TO FISCAL 2000
Revenue. Total revenue decreased $11.8 million, or 9.2%, to $117.1 million
in fiscal 2001 from $128.9 million in fiscal 2000. The total revenue mix is
shown in the table below (in thousands, except percentage data):
<Table>
<Caption>
FISCAL YEARS ENDED JUNE 30,
-------------------------------------
2001 2000
---------------- ----------------
License fees revenue........................... $ 51,309 43.8% $ 57,858 44.9%
Service revenue................................ 30,921 26.4% 39,626 30.7%
Maintenance and support revenue................ 34,846 29.8% 31,424 24.4%
-------- ----- -------- -----
Total revenue........................ $117,076 100.0% $128,908 100.0%
======== ===== ======== =====
</Table>
License fees revenue decreased 11.3% in fiscal 2001 from fiscal 2000. We
believe that the decrease in license fees revenue in fiscal 2001 was due to the
economic climate which caused our customers and potential customers to defer
their buying decisions related to large capital investments, particularly
information technology investments.
Service revenue decreased 22.0% in fiscal 2001 from fiscal 2000. The
decrease was primarily the result of sluggish license fees revenue experienced
by the Company in fiscal 2001. Service revenues in particular are directly
dependent on new license purchases by new and existing customers, which
decreased 11.3% in fiscal 2001 from fiscal 2000. Maintenance and support revenue
increased 10.9% due primarily to steadily improving number of active customer
contracts over the last few years as the base of customers under such programs
has continued to grow.
Cost of Revenue. Total cost of revenue as a percentage of total revenue
increased to 50.2% for the 2001 fiscal year from 48.0% for the 2000 fiscal year.
Cost of license fees revenue increased $0.4 million, or 1.8%, to $21.9
million in fiscal 2001 from $21.5 million in fiscal 2000 and as a percentage of
license fees revenue, increased to 42.7% in fiscal 2001 from 37.2% in fiscal
2000. Both years include $1.9 million of capitalized software written off as
part of restructuring the business in each of these years. The percentage
increase was primarily attributable to an increase in the number of third party
product vendors included in our new product offerings, discounting as a result
of weakened demand and lower license fees revenue affecting certain fixed and
related costs.
Cost of service, maintenance and support revenue decreased $3.4 million, or
8.5%, to $36.9 million in fiscal 2001 from $40.4 million in fiscal 2000 and as a
percentage of service, maintenance and support revenue, decreased to 56.2% in
fiscal 2001 from 56.8% in fiscal 2000. The decrease in cost was attributable to
a decline in service revenue resulting from sluggish license fees revenue in
fiscal 2001 and the percentage decrease was primarily due to the continued
growth of maintenance and support revenues which have higher margins than
service revenues. As noted above, service revenues in particular are directly
dependent on new license purchases by new and existing customers.
20
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased $5.3 million, or 9.3%, to $62.8 million in
fiscal 2001 from $57.5 million in fiscal 2000. Such expenses as a percentage of
total revenue increased to 53.7% in fiscal 2001 from 44.6% in fiscal 2000. The
increase in costs and in the percentage of such costs to total revenue in fiscal
2001 was attributable to a $6.8 million charge to write-off accounts receivable,
offset by the initial impact of the Company's restructuring that commenced in
April 2001, the full effect of which substantially reduced such costs in fiscal
2002.
Research and Development. Total research and development costs, including
amounts capitalized, decreased $4.3 million or 18.9%, to $18.4 million for
fiscal 2001 from $22.7 million for fiscal 2000 and decreased as a percentage of
total revenues to 15.7% in fiscal 2001 from 17.6% in fiscal 2000. Although total
research and development spending decreased from the prior fiscal year, we
continued to spend a substantial portion of total revenues on the development of
our expanded product offerings and product capabilities, development of future
releases of our ERP software and development of interfaces with third-party
software products. We believe that these investments were critical to the
success and market acceptance of our new product offerings and total suite of
comprehensive business systems.
Restructuring and Other Charges. In April 2001, we announced a broad
restructuring plan in order to reduce the Company's workforce, reduce expenses
associated with non-essential activities and to improve the Company's ability to
be profitable at lower levels of revenue. This restructuring is discussed above
under the section entitled "Fiscal 2002 Compared to Fiscal 2001".
Benefit from Income Taxes. The benefit from income taxes for the 2001 and
2000 fiscal years reflects an effective tax rate of 7.3% and 13.2%,
respectively. The effective tax rate in the current fiscal year differs from the
expected corporate tax rate primarily due to valuation allowances recorded
against the deferred tax assets related to net operating losses incurred
domestically.
QUARTERLY RESULTS
<Table>
<Caption>
THREE MONTHS ENDED
(IN THOUSANDS)
FISCAL 2002 FISCAL 2001
----------------------------------------------- -----------------------------------------------
JUNE 30 MARCH 31 DECEMBER 31 SEPTEMBER 30 JUNE 30 MARCH 31 DECEMBER 31 SEPTEMBER 30
------- -------- ----------- ------------ ------- -------- ----------- ------------
Total revenue.......... $22,556 $21,732 $23,327 $24,971 $28,821 $26,334 $33,856 $28,065
Gross margin........... 11,647 10,862 11,580 13,795 16,066 9,605 18,801 13,778
Operating income
(loss)............... 1,038 (1,278) (2,507) 751 (4,994) (15,928) (1,492) (5,203)
% of total revenue
Gross margin........... 51.6% 50.0% 49.6% 55.2% 55.7% 36.5% 55.5% 49.1%
Operating income
(loss)............... 4.6% (5.9)% (10.7)% 3.0% (17.3)% (60.5)% (4.4)% (18.5)%
</Table>
Our results of operations have fluctuated on a quarterly basis. Our
expenses, with the principal exception of sales commissions and certain
components of cost of revenue, are generally fixed and do not vary with revenue.
As a result, any shortfall of actual revenue in a given quarter would adversely
affect net earnings for that quarter. Further explanation of significant
variations by quarter is as follows:
FISCAL 2001:
QUARTER ENDED SEPTEMBER 30, 2000. The Company continued to experience
decreasing revenues, for the economic and market reasons discussed under
"Overview" above. Total revenues decreased by approximately $2.9 million, or
9.4%, from the prior quarter ended June 30, 2000. The Company's operating
results were negatively affected by the Company's investments related to new
products as discussed above in the section entitled "Fiscal 2001 Compared to
Fiscal 2002, Research and Development". These operating results include an
additional non-recurring restructuring charge of $2.1 million for reductions in
workforce and related costs, which contributed to a reported operating loss of
$5.2 million.
21
QUARTER ENDED DECEMBER 31, 2000. The Company experienced a $5.8 million,
or 20.6%, growth in total revenues due to strong license sales for the first
time since the year earlier December quarter. The strong demand was partially a
result of new product offerings and the related development expenditures of the
prior several quarters. Gross margin increased $5.0 million, or 36.5%, to 55.5%
of revenues compared to 49.1% for the prior quarter. This was primarily due to
strong revenues offsetting the impact of the fixed expenses. While the Company
continued to make significant investment in research and development relating to
these new products and to maintain the supporting infrastructure, the operating
loss in the quarter was $1.5 million, significantly less than recent quarters as
a result of the stronger revenues.
QUARTER ENDED MARCH 31, 2001. Total revenues decreased $7.5 million, or
22.2%, from the prior quarter ended December 31, 2000. While the Company had
anticipated a continued improvement in revenues from stronger demand as was
evidenced in the prior quarter, customers chose to defer planned purchases in
response to economic turmoil and a rapidly slowing economy. The decrease in
revenues directly impacted both gross margin and operating losses due to the
fixed nature of the Company's expenses. Gross margin declined $9.2 million, or
48.9%, to 36.5% of revenues from 55.5% in the prior quarter. This was primarily
due to decreased revenues and the fixed nature of many of the costs associated
with product sales. The Company reported an operating loss of $15.9 million, of
which $580,000 was a non-recurring non-cash restructuring charge. The Company
also incurred one-time non-cash charges totaling $8.8 million for write-offs of
certain accounts receivable and capitalized software related to discontinued
products and services.
QUARTER ENDED JUNE 30, 2001. The Company experienced a $2.5 million, or
9.4%, improvement in license fees revenue compared to the prior quarter ended
March 31, 2001. This increase was a result of modest improvements in customer
purchasing behavior following the March quarter. Gross margin improved $6.5
million, or 67.3%, to 55.7% of revenues from 36.5% for the prior quarter. This
improvement was a result of the revenue increase and cost reductions associated
with the restructuring of the business in April 2001. The April restructuring
also significantly reduced the Company's selling, general and administrative
expenses and research and development expenses. The Company reported an
operating loss of $5.0 million of which $3.7 million was a non-recurring charge
relating to the April restructuring.
FISCAL 2002:
QUARTER ENDED SEPTEMBER 30, 2001. The Company continued to experience
decreasing revenue for the same reasons as discussed in the prior quarters
above, but heightened by the events of September 11th and the impact of these on
the economy, particularly in North America. Total revenues decreased by
approximately $3.9 million, or 13.4%, from the prior quarter ended June 30,
2001. However, the Company's operating results were positively impacted by the
Company's restructuring efforts. Operating expenses were down $8.0 million, or
38.1%, from the prior quarter ended June 30, 2001. This resulted in an operating
income of $0.8 million for the quarter.
QUARTER ENDED DECEMBER 31, 2001. Despite an expectation for an improvement
in the economy and in market conditions, the Company experienced a further
reduction in revenue of $1.6 million, or 6.4%. License fees revenue was down and
service revenue was down approximately $1.0 million from the September quarter.
The Company believes the lingering effect of the events of September 11th and
further economic weakness impacted our ability to achieve our expected financial
results. We reported an operating loss of $2.5 million for the quarter.
QUARTER ENDED MARCH 31, 2002. Total revenues decreased $1.6 million, or
6.8%, from the prior quarter ended December 31, 2001. The Company expected
revenue to continue to be flat from the prior quarter; however, customers
continued to defer planned purchases in response to economic turmoil and a
recession in the North American economy. However, the Company took action in
January 2002 to further reduce its operating costs in an effort to return to
profitability at lower revenue levels. The Company's cost reductions included
workforce reductions and streamlining of operations by reducing the number and
size of office facilities. As a result of these actions, operating expenses
continued to decline. However, the effect of reduced revenue caused us to report
an operating loss of $1.3 million for the quarter.
QUARTER ENDED JUNE 30, 2002. The Company experienced a $0.8 million, or
3.8%, improvement in revenues compared to the prior quarter ended March 31,
2002. This increase was a result of modest
22
improvements in customer purchasing behavior following the March quarter,
especially in license fees revenue. The Company also realized a greater impact
of the January cost reduction actions. These positive trends in both revenue and
operating costs resulted in reported operating income of $1.0 million for the
quarter.
For additional discussion of quarterly fluctuations refer to previously
filed quarterly reports on Form 10-Q.
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 2002, we had cash and cash equivalents of $3.4 million and
working capital of $2.4 million. During the fiscal year ended June 30, 2002, we
generated $3.7 million of cash from operating activities, including the
restructuring and other charges described above. We purchased $119,000 of
property and equipment and used $7.6 million for capitalized software.
In July 2001, the Company executed a new credit facility (the "Credit
Facility") with Foothill Capital Corporation ("Foothill"). The Credit Facility
includes a $15,000,000 three-year term note and a $10,000,000 revolving credit
facility. Availability under the Credit Facility is based on and secured by
qualifying accounts receivable originating within the United States and Canada.
The revolving credit facility bears interest either at the Federal Funds rate
plus 1.5%, or at the Eurodollar market rate plus 3.0%. The term note bears
interest at the rate of 10.5% plus 1.5% per annum added to principal. The term
note is payable in monthly installments commencing October 1, 2001. The Credit
Facility is subject to customary terms and conditions and includes financial
covenants for maintenance of a minimum tangible net worth, a minimum level of
earnings before interest, taxes, depreciation and amortization and a maximum
ratio of debt to earnings before interest, taxes, depreciation and amortization.
The proceeds from the Credit Facility were used to repay, in full, the Company's
revolving credit facility with PNC Bank, National Association.
On November 9, 2001, the Company and Foothill amended the Credit Facility
to allow for temporary increased borrowing capacity through January 31, 2002 to
support the Company's cash needs. Also as part of the amendment, all financial
covenants were modified to give account to the current economic conditions
affecting the Company. The modification of the financial covenants was effective
starting as of September 29, 2001.
On February 14, 2002, the Company and Foothill amended the Credit Facility,
again due to economic conditions affecting the Company. The amendment provided
the Company with certain additional borrowing availability on a temporary basis
until July 15, 2002 and allowed the Company to defer principal payments due
under the primary term note for a six-month period commencing in January 2002.
Also, the financial covenants were modified to reflect the current economic
environment. The Company and Foothill further amended the credit facility on
July 15, 2002 to extend a portion of the additional availability to August 15,
2002.
On September 15, 2002, effective June 28, 2002, the Company and Foothill
amended the agreement to modify the covenants to reflect the restatement of the
Company's financial statements for the year ended June 30, 2001 and quarter
ended March 31, 2002 and at June 30, 2002. After giving effect to these
modifications, the Company was in compliance with the financial covenants under
the Credit Facility.
As we discussed in "Overview" above, it has been difficult in the last
several quarters to manage and predict our revenues for any quarterly period.
While customer activity has not diminished recently, economic conditions and
industry-wide lack of demand for new investments may cause us to generate less
revenue than we expect. If we do not generate sufficient revenue to meet our
forecast in any quarter in the current fiscal year, including the quarter ending
September 30, 2002, the Company may not be in compliance with one or more of the
financial covenants under the Credit Facility.
In August 2002, we completed the funding of $3.5 million from the issuance
of Convertible Notes (See "Item 1. Business -- Sale of Unregistered Securities"
herein). However, we continue to experience difficulties in meeting all of our
cash operating needs, due to unpredictability in our revenues and the impact of
economic conditions on our customers. If we do not meet our revenue expectations
in any quarters in the current fiscal year, including the quarter ending
September 30, 2002, we may have further difficulty in meeting our operating cash
needs.
23
On September 30, 2002, the Company and Foothill amended the Credit Facility
with respect to the financial covenants for the quarter ending September 30,
2002 and reset the covenants for the balance of fiscal 2003. This amendment was
completed due to the current economic and market conditions. Also, Foothill has
agreed in principle to further amend the Credit Facility to provide temporary
additional borrowing availability under the revolving credit portion of the
Credit Facility. The Company expects that the bank will impose certain
conditions to borrowing the additional credit availability. These conditions are
expected to include milestones for completion of strategic and operating
objectives as agreed to by the parties and for increased participation by
Foothill in evaluating the Company's strategic and business alternatives. We
expect to complete and execute this further amendment in early October 2002.
We have been able to demonstrate positive financial results and positive
cash flows as evidenced by the results for the quarter ended June 30, 2002. We
also believe that our restructuring efforts in the last several months, and our
tight cost management since that time, will support our efforts to achieve
quarterly profitability and positive cash flow from operations in the future. By
doing so, we expect to be able, over time, to improve our cash to meet operating
needs and to meet the financial covenants imposed under the Credit Facility. As
such, we believe we will have sufficient cash and cash flow from operations to
satisfy cash flow needs for the next 12 months.
There can be no assurance that we can achieve levels of quarterly revenue
sufficient to satisfy our cash flow needs or to meet the financial covenants of
the Credit Facility in future periods and that the bank will continue to provide
special financing arrangements to support us in meeting our operating cash
needs, including execution of the proposed amendment. We continue to evaluate
the Company's strategic and business alternatives. Such alternatives include,
but are not limited to, seeking additional sources of capital, further
cost-cutting actions, merger with, acquisition of or sale to another software
company, or other financial restructuring. All of the Company's strategic
efforts are being directed toward 1) reviewing and evaluating our strategic and
business alternatives, 2) continuing to serve our customers needs, 3) advancing
our product strategies, which includes SyteLine 7 and our other product
offerings and 4) improving the Company's competitive position for the future.
FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK
Changes in demand for our products and services could cause potential
significant fluctuations in our quarterly and annual operating results. Our
operating results may vary significantly from quarter to quarter. Our quarterly
operating results are affected by a number of factors that could materially and
adversely affect our revenues and profitability. These factors also make
estimation of operating results prior to the end of a quarter extremely
uncertain. These factors include:
- demand for our products and services
- competitive conditions in the software industry
- the timing of the introduction or market acceptance of new or enhanced
products which we offer or which are offered by our competitors
- the potential for delay or deferral of customer purchases of our products
in anticipation of product enhancements or new product offerings by us or
our competitors
- the timing of any acquisitions by us and related write-offs
- the mix of our product and services net revenues
- the mix of our North American and international net revenues
- dependence on a few very large new license sales in each quarter to meet
our quarterly goals
- general economic conditions and other factors affecting capital
expenditures by our customers
- the size, timing and structure of significant licenses with our customers
- the entry of new competitors and technological advances by competitors
24
- delays in localizing our products for new markets
- product life cycles
The purchase of our products and services may involve a significant
commitment of capital and other resources by our customers. As a result, the
sales cycles for our products and services, from initial evaluation to delivery
or performance, vary from customer to customer. The timing of individual sales
is difficult to predict, and sales can occur in quarters subsequent to those
anticipated by us. In addition, sales through indirect channels, such as through
business partners, are difficult to predict and may have lower profit margins
than direct sales.
Our revenues in any quarter are substantially dependent on orders signed
and shipped in that quarter. Typically, we realize higher revenues in our second
and fourth fiscal quarters. Generally, we record a majority of our quarterly
revenues in the third month of each quarter, mostly in the latter half of the
third month. We believe that the fluctuations in our operating results is caused
primarily by the budgeting cycles of our customers and established buying
patterns by our customers or potential customers in the industry. As a result,
our quarterly operating results are difficult to predict. In addition, delays in
product delivery or in closings of sales near the end of a quarter could cause
our quarterly operating results to fall substantially short of anticipated
levels.
Adverse economic conditions in the general business economy or specifically
in the manufacturing industries we serve could result in reduced purchases of
our products and services. Our customers are primarily discrete to-order
manufacturers. Our business depends substantially upon the capital expenditures
of our customers. Capital expenditures by our customers are somewhat dependent
upon the demand for their manufactured products and the strength of their
financial condition. A recession or other adverse economic event in general or
one that specifically affects manufacturers could cause them to curtail or delay
capital expenditures for computer software products. Any significant changes in
the timing or amount of capital expenditures by manufacturers could have a
material adverse effect on our business, operating results and financial
condition.
Industries in which our customers operate have been affected by weakened
demand for their products for approximately one to two years and we believe that
the demand for our products and services has already been significantly
impacted, which has negatively affected our financial results and financial
condition. However, there can be no assurance that economic conditions relating
to our customers or potential customers will not become more severe.
Any decrease in our licensing activity is likely to result in reduced
services revenue in future periods. Our service, maintenance and support
revenue is derived from our installation, implementation, training, consulting,
systems integration and software product maintenance and support services.
Typically a decrease in our service, maintenance and support revenue follows a
decrease in our licensed software installations. Our ability to maintain or
increase our service, maintenance and support revenue depends in large part on
our ability to increase our software licensing activity.
The market for our products is characterized by rapid technological change,
evolving industry standards in computer hardware and software technology,
changes in customer requirements and frequent new product introductions and
enhancements. The introduction of products embodying new technologies and the
emergence of new industry standards can cause customers to delay their
purchasing decisions and render existing products obsolete and unmarketable. The
life cycles of our software products are difficult to estimate. Consequently,
our future success will depend, in part, upon our ability to continue to enhance
our existing products and to develop and introduce in a timely manner new
products with technological developments that satisfy customer requirements and
achieve market acceptance. There can be no assurance that we will successfully
identify new product opportunities and develop and bring new products to market
in a timely and cost-effective manner or that products, capabilities or
technologies developed by others will not render our products or technologies
obsolete or noncompetitive or shorten the life cycles of our products. If we are
unable to develop on a timely and cost-effective basis new software products or
enhancement to existing products, or if our products or enhancements do not
achieve market acceptance, our business, operating results and financial
condition may be materially adversely affected.
We derive a significant portion of our business from operations that are
subject to foreign economic conditions and currency fluctuations. We derive a
significant portion of our business from international sales.
25
We expect to continue to expand our international operations, which will require
significant management attention and financial resources. Our international
operations are subject to various risks, including the following:
- the impact of a recession in foreign countries, particularly in Europe
and the Asia/Pacific regions
- cultural and language difficulties associated with serving customers and
localizing products
- staffing and management problems related to foreign operations
- exchange controls and reduced protection for intellectual property in
some countries
- political instability
- unexpected changes in foreign regulatory requirements
- difficulties in collecting accounts receivable and longer collection
periods
- restrictions on the repatriation of foreign earnings
- the impact of local economic conditions and practices
- fluctuations in foreign exchange rates
- potential adverse foreign tax consequences
Termination of agreement with Progress would cause a disruption of service
to our customers and may result in lower operating margins or a loss of
business. Our core product, SyteLine, through version 6.0, is written in
Progress, a proprietary programming language which we license from Progress
Software Corporation. We market and distribute Progress in connection with the
sale of our products under a non-exclusive agreement with Progress. The
agreement may be terminated by either party upon written notice to the other
party. In addition, the agreement may be terminated immediately by either party
if a material breach of the agreement by the other party continues after written
notice. Our relationship with Progress involves other risks which could have a
material adverse effect on our business, operating results or financial
condition, including the following:
- the failure of Progress to continue its business relationship with us
- the failure of Progress to develop, support or enhance Progress in a
manner that is competitive with enhancements of other programming
languages
- delays in the release of Progress products or product enhancements that
require a delay in the release of our products or product enhancements
- the loss of market acceptance of Progress and its relational database
management system
- our inability to migrate our software products to other programming
languages on a timely basis if Progress is no longer available
We have begun to mitigate these risks for future periods by developing
SyteLine Version 7.0 which was released in September 2002 and does not require
the use of the Progress database or toolset.
Conversion of our outstanding Series A preferred shares or our Convertible
Notes and exercise of our outstanding warrants could result in substantial
dilution, a detrimental effect on the market liquidity of our common shares and
ability to raise additional capital, and a significant decline in the market
value of our common shares. As of September 20, 2002, we had approximately
7,568,218 common shares outstanding. As of this date we had 2,267,732 additional
common shares reserved for issuance upon conversion of our outstanding Series A
preferred shares, 2,009,969 additional common shares reserved for conversion of
our Convertible Notes and 1,603,546 additional shares reserved for exercise of
our outstanding warrants. Our Series A preferred shares, Convertible Notes and
outstanding warrants also contain or are subject to various anti-dilution and
similar provisions which may require us to issue additional common shares in
certain circumstances. If these securities are converted or exercised, other
holders of our common shares may experience significant dilution in the market
value of our common shares held by them. If the holders were to sell all or a
substantial
26
amount of those common shares into the open market, the sales could have a
negative effect on the market price of our common shares. The sales also might
make it more difficult for us to sell equity or equity-related securities in the
future at a price we deem appropriate.
We have no intention of paying cash dividends. We have never paid any cash
dividends on our common shares. We currently intend to retain all future
earnings, if any, for use in our business and we do not expect to pay any cash
dividends in the foreseeable future. In addition, dividend payments to holders
of our common shares are subject to the rights of holders of our preferred
shares. As long as our Series A preferred shares are outstanding, no dividends
may be declared or paid on our securities that rank junior to our Series A
preferred shares, including our common shares, unless all required cumulative
dividends are paid or a sum sufficient for the payment of the dividends is set
apart for such payment.
Turnover in our senior management or other key employees could have a
material adverse effect on our business, operating results and financial
condition. Our success depends to a significant extent upon senior management
and other key employees. The loss of one or more key employees could have a
material adverse effect on our business. We do not have employment agreements
with our executive officers, except Stephen A. Sasser, our President and Chief
Executive Officer, and we do not maintain key man life insurance on our
executive officers. We believe that our future success will depend in part on
our ability to attract and retain highly skilled technical, managerial, sales,
marketing, service and support personnel. Competition for personnel in the
computer software industry has historically been intense. There can be no
assurance that we will be successful in attracting and retaining key personnel,
and the failure to do so could have a material adverse effect on our business,
operating results and financial condition.
Our success is dependent in part upon our proprietary technology and other
intellectual property. Our ability to compete is dependent in part upon our
internally developed proprietary intellectual property. We regard our products
as proprietary trade secrets and confidential information. We rely largely upon
a combination of copyright, trade secret and trademark laws, license agreements
with our customers, distribution agreements with our distributors, and our own
security systems, confidentiality procedures and employee agreements to maintain
the confidentiality and trade secrecy of our products. In certain cases, we also
seek to protect our programs, documentation and other written materials through
registration of our trademarks and service marks and copyrights of our products
under trademark and copyright laws in the United States and certain other
countries, but we have not secured registration of all our marks and copyrights.
None of our products are patented.
There can be no assurance that our means of protecting our proprietary
rights in the United States or abroad are adequate or that competitors will not
independently develop similar technology. In addition, the laws of some foreign
countries do not protect our proprietary rights as fully as do the laws of the
United States, and effective copyright, trademark and trade secret protection
may not be available in other jurisdictions. Preventing or detecting
unauthorized use of our products is difficult. Despite our efforts, it may be
possible for third parties to copy certain portions or reverse engineer our
products, or to obtain and use our proprietary or confidential information.
We also rely on certain other technology which we license from third
parties, including software that is integrated with internally developed
software and used in our products to perform key functions. No assurance can be
given that the steps taken by us will prevent misappropriation of our technology
or that our license agreements will be enforceable. In addition, litigation may
be necessary in the future to enforce our intellectual property rights, to
protect our trade secrets, to determine the validity and scope of the
proprietary rights of others or to defend against claims of infringement or
invalidity. Any such litigation, even if not meritorious, could result in
substantial costs and diversion of resources and could have a material adverse
effect on our business, operating results and financial condition.
We may be exposed to property rights infringement claims. Although we do
not believe that our products infringe the proprietary rights of third parties,
there can be no assurance that infringement or invalidity claims, including
claims for indemnification resulting from infringement claims, will not be
asserted or prosecuted against us. Regardless of the validity or the successful
assertion of such claims, defending against such claims could result in
significant costs and diversion of resources which could have a material adverse
effect on our business, operating results and financial condition. In addition,
the assertion of such infringement claims could
27
result in injunctions preventing us from distributing certain products, which
would have a material adverse effect on our business, operating results and
financial condition. If any claims or actions are asserted against us, we may
seek to obtain a license to such intellectual property rights. There can be no
assurance, however; that such a license would be available to us on reasonable
terms or at all.
We may be exposed to product liability claims. Our products may contain
undetected operating errors due to the complex nature of our software. Such
operating errors are usually resolved through regular maintenance and updating
processes. However, our products also may contain more serious operating errors
or failures that may not be detected until the products have been delivered to
customers. As a result of serious operating errors or failures, our customers
could suffer major business interruptions or other problems that could lead to
claims for damages against us. Such operating errors or failures could also
delay the scheduled release of new or enhanced products or diminish the market
acceptance of our products. As a result, our financial results of operations and
financial condition may be materially adversely affected.
Our future revenue is substantially dependent upon our installed customer
base. In the past, we have depended on our installed customer base for
additional future revenue from services, support and maintenance and licensing
of additional products. Our maintenance and support agreements generally are
renewable annually at the option of the customer. Fees for maintenance and
support services are billed 12 months in advance, and maintenance and support
revenue is deferred and recognized ratably over the term of the maintenance and
support agreement. There can be no assurance that current installed customers
will renew their maintenance and support in future periods, continue to use the
Company for professional services or purchase additional products; each of which
would have a material negative impact on our financial results and financial
condition.
We may not be able to maintain or expand our relationships with business
partners. We believe that we need to maintain and expand our relationships with
our existing business partners and enter into relationships with additional
business partners in order to expand the distribution of our products. Many of
our business partners also sell products that compete with our products. There
can be no assurance that we will be able to maintain effective, long-term
relationships with our business partners or that selected business partners will
continue to meet our sales needs. Further, there can be no assurance that our
business partners will not market software products in competition with our
products in the future or will not otherwise reduce or discontinue their
relationships with us. If we fail to maintain successfully our existing business
partner relationships or to establish new business partner relationships in the
future, our business, operating results and financial condition could be
materially and adversely affected.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Exchange Risk. Frontstep's revenues originating outside
of North America were 28%, 22% and 20% of our total revenues for fiscal years
2002, 2001 and 2000, respectively. By geographic region, revenues originating in
Europe were 17%, 13% and 11% of total revenues for fiscal years 2002, 2001 and
2000, respectively. Revenues originating in Asia Pacific were 11%, 9% and 9% of
total revenues for fiscal years 2002, 2001 and 2000, respectively. International
sales are made mostly from our foreign sales subsidiaries in the local countries
and are typically denominated in the local currency of each country. These
subsidiaries also incur most of their expenses in the local currency.
Accordingly, all foreign subsidiaries use the local currency as their functional
currency.
Our exposure to foreign exchange rate fluctuations arises in part from
intercompany accounts in which costs of software, including certain development
costs, incurred in the United States are charged to our foreign sales
subsidiaries. These intercompany accounts are typically denominated in the
functional currency of the foreign subsidiary in order to centralize foreign
exchange risk with the parent company in the United States. We are also exposed
to foreign exchange rate fluctuations as the financial results of foreign
subsidiaries are translated into U.S. dollars in consolidation. Foreign currency
gains and losses will continue to result from fluctuations in the value of the
currencies in which we conduct our operations as compared to the U.S. dollar and
future operating results will be affected by gains and losses from foreign
currency exposure. We do not currently hedge against losses arising from our
foreign currency exposure. We have considered the potential impact of a
hypothetical 10%
28
adverse change in foreign exchange rates and we believe that such a change would
not have a material impact on financial results or financial condition in the
coming fiscal year.
Interest Rate Risk. We invest our surplus cash in financial instruments
such as short-term marketable securities and interest-bearing time deposits. We
also incur interest at variable rates, dependent upon the prime rate or LIBOR
rate that may be in effect from time to time. We have considered the potential
impact of a hypothetical one hundred basis point adverse change in interest
rates and we believe that such a change would not have a material impact on
financial results or financial condition in the coming fiscal year.
29
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders
Frontstep, Inc.
We have audited the accompanying consolidated balance sheets of Frontstep, Inc.
and subsidiaries as of June 30, 2002 and 2001, and the related consolidated
statements of operations, shareholders' equity, and cash flows for the years
then ended. These consolidated financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Frontstep, Inc. and
subsidiaries as of June 30, 2002 and 2001, and the results of their operations
and their cash flows for the years then ended, in conformity with accounting
principles generally accepted in the United States of America.
As discussed in Note 1 to consolidated financial statements, effective July 1,
2001, the Company adopted the provisions of Statement of the Financial
Accounting Standards ("SFAS") No. 141, "Business Combinations" and SFAS No. 142,
"Goodwill and Other Intangible Assets".
/s/ KPMG LLP
Columbus, Ohio
September 30, 2002
30
REPORT OF INDEPENDENT AUDITORS
Board of Directors
Frontstep, Inc.
We have audited the accompanying consolidated statements of operations,
shareholders' equity, and cash flows of Frontstep, Inc (formerly Symix Systems,
Inc.) and Subsidiaries for the year ended June 30, 2000. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with auditing standards generally accepted
in the United States. Those standards require that we plan and perform the audit
to obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audit provides a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated results of operations and cash flows of
Frontstep, Inc. and Subsidiaries for the period ended June 30, 2000, in
conformity with accounting principles generally accepted in the United States.
/s/ Ernst & Young LLP
Columbus, Ohio
July 27, 2000
31
FRONTSTEP, INC.
CONSOLIDATED BALANCE SHEETS
<Table>
<Caption>
JUNE 30,
-------------------
2002 2001
-------- --------
(IN THOUSANDS,
EXCEPT SHARE DATA)
ASSETS
Current assets:
Cash and cash equivalents................................. $ 3,389 $ 1,512
Trade accounts receivable, net............................ 29,049 31,446
Prepaid expenses.......................................... 6,224 3,756
Income taxes receivable................................... -- 47
Deferred income taxes..................................... 3,386 2,026
Inventories............................................... 491 738
Other current assets...................................... 362 979
-------- --------
42,901 40,504
Capitalized software, net................................... 16,371 15,094
Intangibles, net............................................ 8,039 7,911
Property and equipment, net................................. 5,030 7,646
Other assets................................................ 1,074 1,438
-------- --------
Total assets................................................ $ 73,415 $ 72,593
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses..................... $ 13,284 $ 15,610
Deferred revenue.......................................... 18,796 20,278
Current portion of long-term obligations.................. 7,998 1,967
Income taxes payable...................................... 405 --
-------- --------
40,483 37,855
Noncurrent liabilities:
Long-term debt............................................ 8,928 8,337
Deferred income taxes..................................... 4,268 2,891
Other..................................................... -- 405
-------- --------
13,196 11,633
Minority interest........................................... 118 2,101
Shareholders' equity:
Series A Convertible Participating Preferred Stock, no par
value; 1,000,000 shares authorized; 566,933 shares
issued and outstanding at June 30, 2002 and 2001;
liquidation preference $13,606,392..................... 10,865 10,865
Common stock, no par value; 20,000,000 shares authorized;
7,872,418 shares issued at June 30, 2002 and 2001, at
stated capital amounts of $0.01 per share.............. 79 79
Additional paid-in capital................................ 39,341 37,470
Treasury stock, at cost; 304,200 shares at June 30, 2002
and 2001............................................... (1,320) (1,320)
Retained earnings (accumulated deficit)................... (26,217) (22,772)
Accumulated other comprehensive loss...................... (3,130) (3,318)
-------- --------
19,618 21,004
-------- --------
Total liabilities and shareholders' equity.................. $ 73,415 $ 72,593
======== ========
</Table>
The accompanying notes are an integral part of these consolidated financial
statements.
32
FRONTSTEP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<Table>
<Caption>
YEAR ENDED JUNE 30,
--------------------------------------
2002 2001 2000
---------- ----------- -----------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
Revenue:
License fees.............................................. $35,372 $ 51,309 $ 57,858
Service................................................... 21,787 30,921 39,626
Maintenance and support................................... 35,427 34,846 31,424
------- -------- --------
Total revenue..................................... 92,586 117,076 128,908
Cost of revenue:
License fees.............................................. 17,464 21,885 21,504
Service, maintenance and support.......................... 27,238 36,941 40,352
------- -------- --------
Total cost of revenue............................. 44,702 58,826 61,856
------- -------- --------
Gross margin................................................ 47,884 58,250 67,052
Operating expenses:
Selling, general and administrative....................... 41,921 62,847 57,504
Research and development.................................. 6,182 13,332 15,684
Amortization of acquired intangibles...................... 1,777 3,285 3,593
Restructuring and other charges........................... -- 6,403 1,067
------- -------- --------
Total operating expenses.......................... 49,880 85,867 77,848
------- -------- --------
Operating income (loss)..................................... (1,996) (27,617) (10,796)
Interest expense............................................ (2,317) (623) (782)
Other income (expense), net................................. 175 113 (184)
------- -------- --------
Income (loss) before income taxes........................... (4,138) (28,127) (11,762)
Provision for (benefit from) income taxes................... (693) (2,063) (1,557)
------- -------- --------
Net income (loss)........................................... $(3,445) $(26,064) $(10,205)
======= ======== ========
Net income (loss) per common share:
Basic..................................................... $ (0.46) $ (3.46) $ (1.38)
======= ======== ========
Diluted................................................... $ (0.46) $ (3.46) $ (1.38)
======= ======== ========
Shares used in computing per share amounts:
Basic..................................................... 7,568 7,535 7,411
Diluted................................................... 7,568 7,535 7,411
</Table>
The accompanying notes are an integral part of these consolidated financial
statements.
33
FRONTSTEP, INC.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
<Table>
<Caption>
ACCUM.
PREFERRED STOCK COMMON STOCK ADDITIONAL RETAINED OTHER
---------------- --------------- PAID-IN TREASURY EARNINGS COMPR.
SHARES AMOUNT SHARES AMOUNT CAPITAL STOCK (DEFICIT) LOSS TOTAL
------ ------- ------ ------ ---------- -------- --------- ------- --------
Balance at June 30, 1999... -- $ -- 7,654 $76 $32,363 $(1,320) $ 13,497 $(2,214) $ 42,402
Issuance of common stock:
Acquisitions............. -- -- -- -- 3 -- -- -- 3
Stock option exercises... -- -- 118 2 1,009 -- -- -- 1,011
Employee stock purchase
plan................... -- -- 35 -- 577 -- -- -- 577
Tax benefit on stock
options exercised........ -- -- -- -- 754 -- -- -- 754
Issuance of common stock
warrants................. -- -- -- -- 2,510 -- -- -- 2,510
Net loss................. -- -- -- -- -- -- (10,205) -- (10,205)
Foreign currency
translation
adjustment............. -- -- -- -- -- -- -- (343) (343)
--------
Comprehensive loss:........ (10,548)
--- ------- ----- --- ------- ------- -------- ------- --------
Balance at June 30, 2000... -- -- 7,807 78 37,216 (1,320) 3,292 (2,557) 36,709
Issuance of common stock:
Stock option exercises... -- -- 2 -- 60 -- -- -- 60
Employee stock purchase
plan................... -- -- 63 1 194 -- -- -- 195
Convertible preferred stock
transferred from
temporary equity......... 567 10,865 -- -- -- -- -- -- 10,865
Net loss................. -- -- -- -- -- -- (26,064) -- (26,064)
Foreign currency
translation
adjustment............. -- -- -- -- -- -- -- (761) (761)
--------
Comprehensive loss:........ (26,825)
--- ------- ----- --- ------- ------- -------- ------- --------
Balance at June 30, 2001... 567 10,865 7,872 79 37,470 (1,320) (22,772) (3,318) 21,004
Issuance of common stock:
Common stock warrants.... -- -- -- -- 1,871 -- -- -- 1,871
Employee stock purchase
plan................... -- -- -- -- -- -- -- -- --
Net loss................. -- -- -- -- -- -- (3,445) -- (3,445)
Foreign currency
translation
adjustment............. -- -- -- -- -- -- -- 188 188
--------
Comprehensive loss:........ (3,257)
--- ------- ----- --- ------- ------- -------- ------- --------
Balance at June 30, 2002... 567 $10,865 7,872 $79 $39,341 $(1,320) $(26,217) $(3,130) $ 19,618
=== ======= ===== === ======= ======= ======== ======= ========
</Table>
The accompanying notes are an integral part of these consolidated financial
statements.
34
FRONTSTEP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<Table>
<Caption>
YEAR ENDED JUNE 30,
------------------------------
2002 2001 2000
-------- -------- --------
(IN THOUSANDS)
CASH FLOW FROM OPERATING ACTIVITIES:
Net loss.................................................. $ (3,445) $(26,064) $(10,205)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation........................................... 2,305 4,149 3,618
Amortization........................................... 6,609 7,333 7,811
Restructuring and other charges........................ -- 6,403 1,067
Deferred income taxes.................................. 16 (2,040) (2,333)
Gain/loss on disposal of assets........................ 269 18 162
Tax benefit on stock options exercised................. -- -- 754
Write-off of capitalized software...................... -- 1,913 1,868
Changes in operating assets and liabilities, net of
restructuring and other charges:
Accounts receivable.................................. 2,900 5,214 7,403
Prepaid expenses and other assets.................... (2,000) (855) (22)
Accounts payable and accrued expenses................ (2,377) (3,680) (3,409)
Deferred revenue..................................... (1,212) 2,274 1,267
Income taxes payable/receivable...................... 639 1,820 (1,331)
-------- -------- --------
Net cash provided by (used in) operating activities......... 3,704 (3,515) 6,650
CASH FLOW FROM INVESTING ACTIVITIES:
Purchases of property and equipment....................... (119) (3,996) (4,496)
Additions to capitalized software......................... (7,554) (5,074) (7,009)
Proceeds from sale of subsidiary.......................... -- -- 2,585
Purchase of subsidiaries, net of acquired cash............ -- -- (2,116)
-------- -------- --------
Net cash used in investing activities....................... (7,673) (9,070) (11,036)
CASH FLOW FROM FINANCING ACTIVITIES:
Proceeds from issuance of convertible preferred stock,
net.................................................... -- -- 10,865
Proceeds from issuance of common stock warrants, net...... 1,871 -- 2,510
Proceeds from issuance of common stock, net............... -- 253 654
Proceeds from long-term obligations....................... 69,138 76,090 40,964
Payments on long-term obligations......................... (64,562) (74,026) (44,076)
-------- -------- --------
Net cash provided by financing activities................... 6,447 2,317 10,917
Effect of exchange rate changes on cash..................... (601) (88) 101
-------- -------- --------
Net increase (decrease) in cash and cash equivalents........ 1,877 (10,356) 6,632
Cash and cash equivalents at beginning of year.............. 1,512 11,868 5,236
-------- -------- --------
Cash and cash equivalents at end of year.................... $ 3,389 $ 1,512 $ 11,868
======== ======== ========
</Table>
The accompanying notes are an integral part of these consolidated financial
statements.
35
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(FOR THE YEARS ENDED JUNE 30, 2002, 2001 AND 2000)
NOTE 1 -- SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation and Description of Business. Frontstep, Inc. and its
subsidiaries ("Frontstep" or the "Company"), is a leading global provider of
business software and services for midsize manufacturing companies, including
business units of larger companies. The Company offers a comprehensive suite of
integrated, collaborative network-centric software and services that (1) support
the traditional back office management and resources of an enterprise ("ERP"),
(2) support customer relationship management ("CRM") and other front office
business activities and (3) support an enterprise's supply chain management
activities. The accompanying financial statements include the accounts of
Frontstep and its subsidiaries after elimination of intercompany accounts and
transactions.
Founded in 1979, Frontstep is headquartered in Columbus, Ohio. The Company
has more than 4,400 customers that it serves from 26 sales and service offices
in North America, Europe and the Pacific Rim, as well as through independent
software and support business partners worldwide. The Company changed its name
from Symix Systems, Inc. to Frontstep, Inc. as of 2000.
Revenue Recognition. The Company's revenue is derived primarily from
licensing software, providing related services, including installation,
implementation, training, consulting and systems integration and providing
maintenance and support on an annual basis. Revenue is accounted for in
accordance with Statement of Position 97-2, Software Revenue Recognition, as
amended and interpreted from time to time.
Revenue is derived principally from the sale of internally produced
software products and maintenance and support agreements from software sales.
The Company licenses software generally under non-cancelable license agreements
and provides product support services and periodic updates including training,
installation, consulting and maintenance. License fees revenue is generally
recognized when a non-cancelable license agreement has been signed, the software
product has been shipped, there are no uncertainties surrounding product
acceptance, the fees are fixed and determinable and collection is considered
probable. For customer license agreements, which meet these recognition
criteria, the portion of the fees related to software licenses, which is
determined using the residual method, will generally be recognized in the
current period, while the portion of the fees related to services is recognized
as the services are performed. The amount allocated to services revenues is
based on the Company's standard rate per hour. Revenue from maintenance and
support agreements, which is determined based on renewal rates, is billed
periodically, deferred and recognized ratably over the life of the agreements.
In the event revenue is contingent upon customer acceptance criteria, the
Company defers recognizing that revenue until the contingencies are resolved.
Inventories. Inventories consist primarily of software-related products
that are held for resale. The Company values inventory at the lower of cost or
market. Cost is determined using the specific identification method.
Capitalized Software. Capitalized software is stated at the lower of cost
or net realizable value. The Company capitalizes the cost of developing its
software products in accordance with Statement of Financial Accounting Standards
("SFAS") No. 86, Accounting for the Costs of Computer Software to be Sold,
Leased or Otherwise Marketed. Capitalized software costs are amortized by the
straight-line method using estimated useful lives of three to five years.
Amortization expense was $6,609,000, $5,071,000 and $6,764,000 for the years
ended June 30, 2002, 2001 and 2000, respectively. In addition, during fiscal
years 2001 and 2000, the Company wrote off $1,913,000 and $1,868,000,
respectively of capitalized software as part of restructuring operations (see
Note 2).
36
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Capitalized software is summarized as follows:
<Table>
<Caption>
JUNE 30,
---------------------------
2002 2001 2000
------- ------- -------
(IN THOUSANDS)
Capitalized cost of:
Internally developed software......................... $33,014 $25,106 $22,196
Acquired software..................................... 11,616 11,608 10,459
------- ------- -------
Total capitalized software at cost...................... 44,630 36,714 32,655
Accumulated amortization.............................. 28,259 21,620 14,326
------- ------- -------
Capitalized software, net............................... $16,371 $15,094 $18,329
======= ======= =======
</Table>
Intangibles. As of June 30, 2002, the Company had unamortized intangibles
in the amount of $8,039,000. Intangibles consist of goodwill resulting from
acquisitions accounted for using the purchase method of accounting according to
SFAS No. 141, Business Combinations, which specifies criteria intangible assets
acquired in a purchase method business combination must meet to be recognized
and reported apart from goodwill. For fiscal year 2002, the Company has adopted
SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other
Intangible Assets, which requires that goodwill and intangible assets with
indefinite lives no longer be amortized and be tested for impairment at least
annually. The Company conducted such an evaluation and determined that the
assets underlying the Company's goodwill are not impaired, resulting in no
revaluation of goodwill at this time. Prior to adopting SFAS No. 142, the
intangible assets were amortized using the straight-line method over a period of
three to ten years. There were no additions to goodwill in 2002. The only change
is from the effect of foreign currency translation. Accumulated amortization of
intangibles as of June 30, 2001 and 2000 was $3,309,000 and $1,047,000,
respectively.
The following table illustrates what reported net income (loss) and net
income (loss) per share would have been in the periods presented exclusive of
amortization expense recognized in those periods related to goodwill (in
thousands, except per share data):
<Table>
<Caption>
YEAR ENDED JUNE 30,
-----------------------------
2002 2001 2000
------- -------- --------
Numerator for basic and diluted loss per share -- net
loss................................................. $(3,445) $(26,064) $(10,205)
Goodwill amortization................................ -- 2,262 1,047
------- -------- --------
Adjusted net income /(loss)............................ $(3,445) $(23,802) $ (9,158)
======= ======== ========
Basic and diluted net income (loss) per share:
Net income (loss)................................. $ (0.46) $ (3.46) $ (1.38)
Goodwill amortization............................. -- $ 0.30 $ 0.14
------- -------- --------
Adjusted net income (loss)........................ $ (0.46) $ (3.16) $ (1.24)
======= ======== ========
</Table>
Property and Equipment. Property and equipment are recorded at cost and
include expenditures which substantially increase the useful lives of the
assets. Property and equipment under capital leases are stated at the present
value of minimum lease payments. Maintenance and repairs that do not improve or
extend the life of the respective assets are expensed as incurred. Depreciation
is provided over the estimated useful lives of the respective assets using the
straight-line method. Amortization of capital leases is provided over the lease
terms using the straight-line method and is included in depreciation expense.
37
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Depreciation and amortization on the Company's property and equipment has
been computed based on the following useful lives:
<Table>
<Caption>
YEARS
-------
Furniture and fixtures...................................... 3 to 7
Computers and other equipment............................... 2 to 7
Leasehold improvements...................................... 5 to 10
</Table>
Income Taxes. Income taxes are accounted for under the asset and liability
method. Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to taxable
income in the years in which those temporary differences are expected to be
recovered or settled. The effect on deferred tax assets and liabilities of a
change in tax rates is recognized in income in the period that includes the
enactment date.
Foreign Currency Translation. The Company has determined that the
functional currency of each foreign operation is the local currency. The effects
of translation rate changes related to assets and liabilities located outside
the United States are included as a component of other comprehensive income
(loss). Foreign currency transaction gains and losses are included in "Other
income (expense), net" on the Consolidated Statements of Operations.
Comprehensive Loss. The Company believes that the only item in addition to
net income (loss) that would be included in comprehensive income is the foreign
currency translation adjustment. Comprehensive income (loss) for the years ended
June 30, 2002, 2001 and 2000 is as follows (in thousands):
<Table>
<Caption>
YEAR ENDED JUNE 30,
-----------------------------
2002 2001 2000
------- -------- --------
Net loss............................................... $(3,445) $(26,064) $(10,205)
Foreign currency translation adjustment................ 188 (761) (343)
------- -------- --------
Comprehensive net income (loss)........................ $(3,257) $(26,825) $(10,548)
======= ======== ========
</Table>
Stock-based Compensation. The Company applies the intrinsic value-based
method of accounting prescribed by Accounting Principles Board Opinion No. 25,
Accounting for Stock Issued to Employees, and related interpretations, in
accounting for its fixed plan stock options. As such, compensation expense would
be recorded on the date of grant and amortized over the period of service, only
if the current market price of the underlying stock exceeded the exercise price.
SFAS No. 123, Accounting for Stock-Based Compensation, established accounting
and disclosure requirements using a fair value-based method of accounting for
stock-based employee compensation plans. As allowed by SFAS No. 123, the Company
has elected to continue to apply the intrinsic value-based method of accounting
described above, and has adopted the disclosure requirements of SFAS No. 123.
Statement of Cash Flows. The Company considers all demand deposits and
highly liquid investments with an original maturity of three months or less as
cash equivalents. Cash paid for (received from) income taxes, net of refunds,
for fiscal 2002, 2001 and 2000 was $1,146,000, $(2,251,000) and $1,756,000,
respectively. Cash paid for interest was $2,282,000, $671,000 and $782,000 for
fiscal 2002, 2001 and 2000, respectively.
Financial Instruments. Financial instruments consist primarily of cash,
accounts receivable, accounts payable and long-term debt. The carrying value of
all financial instruments at June 30, 2002 and 2001 approximated their fair
value.
38
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Long-lived Assets. The Company accounts for long-lived assets in
accordance with the provisions of SFAS No. 121, Accounting for the Impairment of
Long-Lived Assets and for Long-Lived Assets to Be Disposed Of. This Statement
requires that long-lived assets be reviewed for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable. Recoverability of assets to be held and used is measured by a
comparison of the carrying amount of an asset to future undiscounted net cash
flows expected to be generated by the asset. If such assets are considered to be
impaired, the impairment to be recognized is measured by the amount by which the
carrying amount of the assets exceeds the fair value of the assets. Assets to be
disposed of are reported at the lower of the carrying amount or fair value less
costs to sell.
Use of Estimates. The preparation of financial statements in conformity
with generally accepted accounting principles requires management to make
estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
NOTE 2 -- RESTRUCTURING AND OTHER CHARGES
Fiscal 2001 Restructuring Charges. In April 2001, the Company announced a
broad restructuring plan to reduce operating costs by reducing its worldwide
workforce by approximately 20%, or 162 employees, all of which were direct
employees involved in all aspects of the Company's business, both domestic and
international; discontinuing certain product development and other non-essential
activities, including terminating activities related to its SyteCentre product
and exiting certain license agreements; and closing certain office facilities in
Arizona, California, Canada and Asia.
As a result of this restructuring plan, the Company recorded pre-tax
restructuring charges of $580,000 and $3,660,000 in the three months ended March
31, 2001 and June 30, 2001, respectively. These restructuring charges are
recorded as a separate line in the Consolidated Statements of Operations. The
Company's restructuring plan consisted of the following significant items:
- Employee separation costs of $2,182,000 -- The Company reduced its
workforce by approximately 20%, or 162 employees. These costs consist
primarily of severance for these employees.
- Contract termination liabilities of $900,000 -- The Company elected to
discontinue its SyteCentre ERP product to focus resources on the
Company's primary ERP product, SyteLine. The Company also discontinued
its ASP hosting solution and its Internet procurement software due to
sluggish demand and unprofitable operations. As a result, the Company
provided $900,000 to cover anticipated contractual obligations and costs
associated with customers currently using the discontinued products and
services.
- Facility closure costs of $1,158,000 -- The Company recorded $1,158,000
of costs associated with closing certain offices in Arizona, California,
Canada and Asia. Cancelable lease term costs were based on actual
determinable amounts. For those leases with non-cancelable lease terms,
the Company assumed that subleases would be obtained after a one-year
period.
39
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
The following table displays a rollforward of the accruals established for
the restructuring and other charges from the announcement of the plan to June
30, 2002 (in thousands):
<Table>
<Caption>
AMOUNTS AMOUNTS
USED IN ACCRUAL AMOUNTS USED IN
INITIAL FISCAL BALANCE AT RECLASSIFIED FISCAL ACCRUAL AT
CHARGE 2001 JUNE 30, 2001 IN 2002 2002 JUNE 30, 2002
------- ------- ------------- ------------ ------- -------------
Termination costs
related to
employees........... $2,182 $1,770 $ 412 $723 $ 570 $565
Exit costs:
Facility closure
costs............ 1,158 280 878 (248) 396 234
Contract termination
liabilities...... 900 120 780 (475) 215 90
------ ------ ------ ---- ------ ----
Total................. $4,240 $2,170 $2,070 $ 0 $1,181 $889
====== ====== ====== ==== ====== ====
</Table>
The amounts used of $1,181,000 and $2,170,000 in fiscal 2002 and 2001,
respectively, reflect cash payments of $3,271,000 and non-cash charges of
$80,000. During fiscal 2002, the Company reclassified estimated amounts
previously allocated in the restructuring reserve, as noted in the above table,
to reflect the actual amounts needed for each category. The remaining accrual of
$889,000, which is included in accounts payable and accrued expenses, represents
cash payments to be made over the course of remaining contracts through 2004.
In relation to the April 2001 restructuring plan, the Company wrote off
certain accounts receivable amounting to $6,840,000 during 2001, which is
presented in the Statement of Operations in Operating expenses: Selling, general
and administrative. Also, in relation to the restructuring plan, the Company
wrote off other non-performing assets amounting to $1,913,000 in 2001, which is
presented in the Statement of Operations in Cost of revenue: License fees. The
accounts receivable write-offs were recorded to reflect accounts deemed to be
uncollectible due to economic and other situations that occurred subsequent to
the recording of the sales related to those receivables. The non-performing
assets are no longer in use and were completely written off.
Fiscal 2001 Other Charges. In relation to this restructuring plan, the
Company also wrote off certain accounts receivable and other non-performing
assets. These charges have been reported separately from the restructuring
charge in the Statement of Operations. The accounts receivable write offs were
recorded to reflect accounts deemed to be uncollectible due to economic and
other situations that occurred subsequent to the recording of the sales related
to those receivables. The non-performing assets are no longer in use. These
charges are:
- Accounts receivable write-offs -- $6,840,000 -- As part of the
restructuring, the Company elected to discontinue certain product lines
and focus on more profitable endeavors. During the third quarter of the
year, the Company realized this would result in related collection
issues. Thus, the Company wrote off $3,460,000 in receivables related to
discontinued products and services. Additionally, in the third quarter
ended March 31, 2001, the Company recorded other charges of $3,380,000 to
write off customer receivables as a result of customer bankruptcies and
solvency issues. These charges are reported in Operating expenses:
Selling, general and administrative in the Statement of Operations for
the year ended June 30, 2001.
- Capitalized software write-offs -- $1,913,000 -- The Company elected to
discontinue its SyteCentre ERP product to focus resources on the
Company's primary ERP product, SyteLine. The Company also discontinued
its ASP hosting solution and its Internet procurement software due to
sluggish demand and unprofitable operations. As a result, the Company
wrote off $1,463,000 of capitalized internally developed software
relating to SyteCentre and $450,000 of capitalized purchased software
relating to Internet procurement products. These charges are reported in
Cost of revenue: License fees in the Statement of Operations for the year
ended June 30, 2001.
40
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Fiscal 2000 Restructuring Charges. In July 2000, the Company announced
several structural changes to discontinue certain business operations, write off
non-performing assets which are no longer in use and to restructure the Company
to better focus on its core business strategy. These changes included divesting
the Company's FieldPro subsidiary, terminating the operations of its e-Mongoose,
Inc. subsidiary, consolidating the Company's product development organizations
and restructuring the Company's sales channels. In connection with this
announcement, the Company recorded a non-recurring charge of $429,000, pre-tax,
in the three months ended June 30, 2000 and an additional non-recurring charge
of $2,163,000, pre-tax, in the three months ended September 30, 2000. The
aggregate pre-tax charge of $2,592,000 included non-cash charges of $429,000
related primarily to the sale of Visual Applications Software, Inc., all of
which was expended in Fiscal 2000, and $2,163,000 to reduce the Company's
headcount. The headcount reduction included approximately 90 employees
associated with the operations discussed above and others terminated as part of
the restructuring. All severance payments were paid during the year ended June
30, 2001 and no accruals remain for these costs as of June 30, 2001 and 2002.
The following table displays a rollforward of the accruals at June 30, 2000
and June 30, 2001 established for the structural changes:
<Table>
<Caption>
INITIAL CHARGE AMOUNTS USED IN ACCRUAL AT
IN 2000 FISCAL 2000 JUNE 30, 2000
-------------- --------------- -------------
2000 (IN THOUSANDS)
Loss on sale of Visual Applications
Software, Inc. assets..................... $429 $429 --
---- ---- --
$429 $429 --
==== ==== ==
</Table>
<Table>
<Caption>
INITIAL CHARGE AMOUNTS USED IN ACCRUAL AT
IN 2001 FISCAL 2001 JUNE 30, 2001
2001 -------------- --------------- -------------
(IN THOUSANDS)
Termination costs to employees.............. $2,163 $2,163 --
</Table>
Fiscal 2000 Other Charges. In relation to the fiscal 2000 restructuring
plan, the Company also wrote-off certain accounts receivable and other
non-performing assets. These charges have been reported separately from the
restructuring charge in the Statement of Operations. The accounts receivable
write-offs were recorded to reflect accounts deemed to be uncollectible due to
economic and other situations that occurred subsequent to the recording of the
sales related to those receivables. The non-performing assets are no longer in
use. These charges are:
- Accounts receivable write offs -- The Company wrote off $714,000 in
receivables related to the discontinuation of the e-Mongoose products.
These charges are reported in Operating expenses: Selling, general and
administrative in the Statement of Operations for the year ended June 30,
2000.
- Capitalized software write offs -- The Company wrote off $1,868,000 of
capitalized internally developed software relating to e-Mongoose. These
charges are reported in Cost of revenue: License fees in the Statement of
Operations for the year ended June 30, 2000.
41
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
NOTE 3 -- ACCOUNTS RECEIVABLE
Accounts receivable is summarized as follows (in thousands):
<Table>
<Caption>
JUNE 30,
-----------------
2002 2001
------- -------
Accounts receivable......................................... $31,378 $32,877
Less allowance for doubtful accounts........................ 2,329 1,431
------- -------
$29,049 $31,446
======= =======
</Table>
The following is a summary of activity in the allowance for doubtful
accounts (in thousands):
<Table>
<Caption>
YEAR ENDED JUNE 30,
----------------------------
2002 2001 2000
------- -------- -------
Beginning balance....................................... $ 1,431 $ 2,075 $ 1,500
Provision for bad debts................................. 2,143 9,731 3,255
Account write-offs, net................................. (1,245) (10,375) (2,680)
------- -------- -------
Ending balance.......................................... $ 2,329 $ 1,431 $ 2,075
======= ======== =======
</Table>
NOTE 4 -- PROPERTY AND EQUIPMENT
Property and equipment is summarized as follows (in thousands):
<Table>
<Caption>
JUNE 30,
-----------------
2002 2001
------- -------
Furniture and fixtures...................................... $ 3,438 $ 3,655
Computers and other equipment............................... 21,715 21,720
Leasehold improvements...................................... 1,823 1,827
------- -------
26,976 27,202
Less accumulated depreciation and amortization.............. 21,946 19,556
------- -------
$ 5,030 $ 7,646
======= =======
</Table>
NOTE 5 -- ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses are summarized as follows (in
thousands):
<Table>
<Caption>
JUNE 30,
-----------------
2002 2001
------- -------
Accounts payable............................................ $ 5,287 $ 5,579
Accrued payroll and related costs........................... 2,670 2,441
Third party royalties....................................... 1,197 2,408
Restructuring and other charges............................. 889 2,070
Other....................................................... 3,241 3,112
------- -------
$13,284 $15,610
======= =======
</Table>
42
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
NOTE 6 -- OPERATING LEASE COMMITMENTS
The Company has entered into certain operating lease agreements for the
rental of office facilities and computer equipment. The facility leases provide
for annual rentals which are subject to escalation for increased operating
costs.
Amounts expensed under all operating lease agreements were approximately
$4,215,000, $5,401,000 and $4,822,000 for the years ended June 30, 2002, 2001
and 2000, respectively.
The future minimum lease payments required under noncancelable operating
leases for the five years ending June 30 are: 2003, $3,302,000; 2004,
$2,237,000; 2005, $829,000; 2006, $321,000; 2007, $164,000; 2008 and thereafter,
$328,000.
These amounts were adjusted for certain sub-lease agreements in the amount
of $132,000 in fiscal 2003 and $66 in fiscal 2004.
NOTE 7 -- LONG-TERM OBLIGATIONS
Long-term debt is summarized as follows (in thousands):
<Table>
<Caption>
JUNE 30,
-----------------
2002 2001
------- -------
Term notes payable, net of discount......................... $13,799 $ --
Minority interest notes payable............................. 2,000 --
Convertible notes payable, net of discount.................. 1,031 --
Revolving credit facility................................... -- 8,337
Acquisition notes payable................................... -- 1,573
Present value of minimum capital lease payments............. -- 742
Other....................................................... 96 57
------- -------
16,926 10,709
Less current maturities..................................... 7,998 1,967
------- -------
$ 8,928 $ 8,742
======= =======
</Table>
Term notes payable and revolving credit facility. In July 2001, the
Company executed a new credit facility (the "Credit Facility") with Foothill
Capital Corporation ("Foothill"). The Credit Facility includes a $15,000,000,
three-year term note and a $10,000,000 revolving credit facility. Availability
under the Credit Facility is based on and secured by qualifying accounts
receivable originating within the United States and Canada. The revolving credit
facility bears interest either at the Federal Funds rate plus 1.5%, or at the
Eurodollar market rate plus 3.0%. The term note bears interest at the rate of
10.5% plus 1.5% per annum added to principal. The term note is payable in
monthly installments commencing October 1, 2001. The Credit Facility is subject
to customary terms and conditions and includes financial covenants for
maintenance of a minimum tangible net worth, a minimum level of earnings before
interest, taxes, depreciation and amortization and a maximum ratio of debt to
earnings before interest, taxes, depreciation and amortization. The proceeds
from the Credit Facility were used to repay, in full, the Company's revolving
credit facility with PNC Bank, National Association.
In connection with the Credit Facility, Foothill was granted a warrant to
purchase 550,000 of the Company's common shares priced at the current market
price at closing of the transaction ($3.36 per share), which expire in July
2006. The warrant is subject to certain anti-dilution provisions as defined in
the warrant agreement. The relative fair value of the warrant, $1,276,000, was
recorded as a debt discount and is being amortized as interest expense over the
three-year term of the Credit Facility. The Company determined this value, as of
the date of the transaction, using a modified Black-Scholes option pricing model
with the following assumptions: risk-free
43
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
interest rate of 5.5%, no dividend yield, volatility factor of 0.95, and option
life of 5 years. As of June 30, 2002, the unamortized balance of the debt
discount was $957,000.
In connection with the grant of the warrants to Foothill as discussed
above, and pursuant to the contractual terms of the warrant agreement associated
with the private placement of preferred shares by the Company in fiscal 2000,
the original exercise price of $15.00 per share for the existing warrants to
purchase 453,546 common shares of the Company issued in fiscal 2000 was adjusted
to $3.36 per share. Because this change in price was due to contractual
provisions already in place at the inception of the arrangement, there is no
impact on the Company's financial statements.
On November 9, 2001, the Company and Foothill amended the Credit Facility
to allow for temporary increased borrowing capacity through January 31, 2002.
Also as part of the amendment, all financial covenants were modified to give
account to the current economic conditions affecting the Company. The
modification of the financial covenants was effective starting as of September
29, 2001.
On February 14, 2002, the Company and Foothill amended the Credit Facility,
again due to economic conditions affecting the Company. The amendment provided
the Company with certain additional borrowing availability on a temporary basis
until July 15, 2002 and allowed the Company to defer principal payments due
under the primary term note for a six-month period commencing in January 2002.
Also, the financial covenants were modified to reflect the current economic
environment. Fees associated with the amendment to the credit facility of
$900,000 which have been recorded as other assets and are included in current
portion of long-term obligations, are payable in nine installments commencing
July 2002 and are being amortized as interest expense over the remaining life of
the credit facility.
As of June 30, 2002, the Company was not in compliance with certain
financial covenants under the Credit Facility as a result of its financial
results for the three months ended June 30, 2002. The noncompliance does not
relate to any payment due under the Credit Facility. On September 15, 2002,
effective as of June 28, 2002, the Company and Foothill amended the Credit
Facility to waive the conditions of noncompliance and to reset the related
financial covenants as of June 30, 2002 and for the Company's fiscal 2003 year.
Minority interest notes payable. In 2001, certain minority interest
investors, including Mitsui & Co., Asia Investment Ltd. and its affiliates
(collectively, "Mitsui") exercised their put option agreements which gave them
the right to sell their shares in a Company subsidiary to another subsidiary of
the Company at a formula price as provided in the put options, to be not less
than an aggregate of $2,000,000. At that time the Company reclassified
$2,000,000 from minority interest equity to current portion of long-term
obligations. In May 2002 and July 2002, the Company and Mitsui executed
convertible note agreements that provide for the Company to pay Mitsui
approximately $1.1 million principal amount of the notes, plus accrued interest
at approximately 4.4% per annum, on September 1, 2002 and the remainder, plus
accrued interest, on March 1, 2003. The Mitsui convertible note agreements are
subordinated to the Company's senior indebtedness as defined in the agreement.
The Mitsui convertible note agreements also provide that, in certain
circumstances, Mitsui is entitled to convert the notes, plus accrued interest,
into common stock of the Company at a price of $12 per share. The Mitsui
convertible note agreements were modified in principle in September 2002. See
Note 13 -- Minority Interest and Note 19 -- Subsequent Events.
Convertible notes payable. On March 7, 2002, the Company executed an
agreement pursuant to which certain holders of its Series A Convertible
Participating Preferred Shares and certain members of the Company's Board,
including the Company's founder (collectively, the "Investors"), agreed to
provide up to $5.0 million to the Company for working capital needs in exchange
for convertible notes (the "Convertible Notes") with a term expiring in May
2004. Under the terms of the agreement, the Company issued an aggregate
principal amount of $1.5 million of initial notes and warrants to purchase
600,000 common shares of the Company to the Investors on March 7, 2002. The
initial notes bear interest at 10% per annum. The warrants are exercisable at a
price of $0.01 per share. The transaction was approved by the Company's
shareholders in June 2002. Upon the subsequent
44
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
closing of the sale of the remaining portion of the $5.0 million of convertible
notes in July, 2002, the initial notes became convertible into Company common
shares at the conversion price of $2.4876 per share. The remaining portion of
the convertible notes were issued by the Company in August, 2002. See also Note
19 -- Subsequent Events.
The Company recorded the relative fair value of the 600,000 warrants issued
in connection with the initial notes ($595,153) as a debt discount and is
amortizing the debt discount over the three-year expected life of the Notes. The
Company determined the value, as of the date of the transaction using a modified
Black-Scholes option pricing model with the following assumptions: risk-free
interest rate of 5.5%, no dividend yield, volatility factor of 1.00, and option
life of 10 years. Also, due to the debt being convertible into common stock at
80% of an average price per share, there is a beneficial conversion feature. The
beneficial conversion feature is calculated at the commitment date as the
difference between the conversion price and the fair value of the common stock
into which the debt is convertible, multiplied by the number of shares into
which the debt is convertible (intrinsic value). The beneficial conversion
feature totaled $145,000. Because the debt is immediately convertible starting
in the first quarter of 2003, this amount will be charged to interest expense in
the first quarter of 2003.
The aggregate maturities of long-term debt for the five years ending June
30 are: 2003, $7,998,000; 2004, $8,928,000; 2005 and thereafter, $0.
NOTE 8 -- INCOME TAXES
The components of the provision for (benefit from) income taxes are
summarized as follows (in thousands):
<Table>
<Caption>
YEAR ENDED JUNE 30,
---------------------------
2002 2001 2000
------- ------- -------
Current:
Federal................................................ $(1,281) $ -- $ (516)
State and local........................................ -- -- (17)
Foreign................................................ 572 (23) 541
------- ------- -------
(709) (23) 8
Deferred:
Federal................................................ 16 (1,778) (1,399)
State and local........................................ -- (262) (206)
Foreign................................................ -- -- 40
------- ------- -------
16 (2,040) (1,565)
------- ------- -------
$ (693) $(2,063) $(1,557)
======= ======= =======
</Table>
45
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
The significant components of the Company's deferred tax asset and
liability are as follows (in thousands):
<Table>
<Caption>
JUNE 30,
----------------
2002 2001
------- ------
Current deferred tax asset:
Allowance for doubtful accounts........................... $ 1,412 $ 195
Accrued liabilities....................................... 1,974 1,831
------- ------
$ 3,386 $2,026
======= ======
Long-term deferred tax (asset) liability:
Capitalized software...................................... $ 4,654 $5,072
Intangibles............................................... 881 1,038
Capitalized leases........................................ 422 422
Accrued liabilities....................................... -- 239
Book over tax depreciation................................ (932) (602)
Domestic losses........................................... (6,696) (9,776)
Foreign losses............................................ (2,095) (682)
Tax credits............................................... (2,672) (1,935)
------- ------
(6,438) (6,227)
Less valuation allowance.................................. 10,706 9,118
------- ------
$ 4,268 $2,891
======= ======
</Table>
The long-term deferred tax assets pertaining to foreign losses are net
operating loss carryforwards for certain foreign subsidiaries. The Company has
set a valuation allowance for the foreign net operating loss carryforwards,
domestic tax credits and the majority of the domestic net operating loss
carryforwards. Management believes it is more likely than not that the remaining
deferred tax assets will be recovered through taxable income from future
operations.
Deferred taxes are not provided on unremitted earnings of subsidiaries
outside the United States because it is expected that the earnings are
permanently reinvested. Such earnings may become taxable upon the sale or
liquidation of these subsidiaries or upon the remittance of dividends.
46
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Differences arising between the provision for (benefit from) income taxes
and the amount computed by applying the statutory federal income tax rate to
income before income taxes are as follows:
<Table>
<Caption>
YEAR ENDED JUNE 30,
--------------------
2002 2001 2000
---- ---- ----
Federal tax at statutory rate............................... (34)% (34)% (34)%
State and local income taxes net of federal tax benefit..... -- (4) (3)
Foreign operations taxes at rates different from U.S.
federal statutory rate.................................... -- 3 7
Disposition of foreign operation............................ -- -- 5
Nondeductible acquisition research and development write
off....................................................... -- -- 2
General business credits.................................... -- (2) --
Nondeductible permanent differences......................... 2 1 4
Valuation allowance recorded against deferred tax assets,
net of tax benefit recorded due to 2002 tax law change
pertaining to NOL carryback provisions.................... 15 29 6
--- --- ---
(17)% (7)% (13)%
=== === ===
</Table>
The Company has domestic net operating loss carryforwards for tax purposes
of $490,000, $347,000, $37,000, $752,000, $1,344,000, $1,779,000, $8,466,000 and
$3,954,000 which expire in fiscal years 2008, 2010, 2012, 2013, 2018, 2019, 2021
and 2022, respectively.
NOTE 9 -- STOCK OPTION PLANS
The Company has a non-qualified stock option plan (the "Plan") that
provides for the granting of up to 2,653,070 options to officers and other key
employees for common shares at purchase prices of not less than the fair market
value on the date of the grant as determined by the Stock Option Committee of
the Board of Directors. Options under the Plan generally vest over periods of up
to four years and must be exercised within ten years of the date of grant. As of
June 30, 2002, options for 942,811 common shares were outstanding at a weighted
average exercise price of $6.42 per share.
Shareholder approval was obtained on November 17, 1999 for a separate
non-qualified stock option plan (the "1999 Plan"). The 1999 Plan, which was
amended on November 7, 2001 to increase the options available to grant from
600,000 to 900,000, provides for the granting of options to officers and key
employees for common shares at purchase prices of not less than the fair market
value on the date of the grant as determined by the Stock Option Committee of
the Board of Directors. Options under the 1999 Plan generally vest over periods
of up to four years and must be exercised within ten years of the date of the
grant. As of June 30, 2002, options for 683,325 common shares were outstanding
at a weighted average exercise price of $4.94 per share.
The Company also has a non-qualified stock option plan for Key Executives
(the "Key Executives Plan"). A total of 400,000 common shares are designated for
issuance under the Key Executives Plan. The Stock Option Committee of the Board
of Directors is authorized to set the price and terms and conditions of the
options granted under the Key Executives Plan. Options under the Key Executives
Plan must be exercised within ten years of the date of the grant. As of June 30,
2002, options for 400,000 common shares were outstanding at a weighted average
exercise price of $3.81 per share.
The Company also has a stock option plan for Outside Directors (the
"Outside Directors Plan"). The Outside Directors Plan provides for the issuance
of options for 20,000 shares of stock to each Outside Director upon his/her
election to the Board of Directors. A total of 200,000 common shares may be
issued under the Outside Directors Plan. The Outside Directors Plan was amended
June 20, 2002 to allow discretionary grants in addition to those provided upon
election. Options under the Outside Directors Plan vest immediately and must be
47
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
exercised within ten years of the date of grant. As of June 30, 2002, options
for 80,000 common shares were outstanding at a weighted average exercise price
of $6.46.
Pro forma information regarding net income and earnings per share is
required by SFAS No. 123, which also requires that the information be determined
as if the Company has accounted for its employee stock options granted under
that statement. The fair value for these options was estimated at the date of
grant using a Black-Scholes option pricing model with the following
weighted-average assumptions for 2002, 2001 and 2000: risk-free interest rates
of 5.0%, 5.0% and 6.5%, respectively; no dividend yield; volatility factor of
the Company's common shares of 0.69, 1.0 and 0.9, respectively; and expected
life of each option of 7 years, 7 years and 7 years, respectively.
If the Company had elected to recognize compensation cost based on the fair
value of options at the grant date (which includes shares issuable under the
Employee Stock Purchase Plan -- see Note 10) as prescribed by SFAS No. 123, the
following table displays what reported net income (loss) and per share amounts
would have been (in thousands, except per share data):
<Table>
<Caption>
PRO FORMA YEAR ENDED JUNE 30,
-----------------------------
2002 2001 2000
------- -------- --------
Net income (loss)...................................... $(5,285) $(27,895) $(11,402)
Net income (loss) per share, assuming dilution......... (0.70) (3.70) (1.54)
</Table>
The pro forma financial effects of applying SFAS No. 123 may not be
representative of the pro forma effects on reported results of operations for
future years.
The following table summarizes stock option activity:
<Table>
<Caption>
WEIGHTED-
AVERAGE
NUMBER OF EXERCISE PRICE
OPTIONS (#) PER SHARE ($)
----------- --------------
Outstanding at June 30, 1999................................ 1,755,272 8.26
Granted................................................... 377,100 9.69
Cancelled................................................. (79,150) 13.00
Exercised................................................. (117,300) 6.73
---------
Outstanding at June 30, 2000................................ 1,935,922 8.44
Granted................................................... 351,000 5.95
Cancelled................................................. (204,550) 11.39
Exercised................................................. (1,500) 5.66
---------
Outstanding at June 30, 2001................................ 2,080,872 7.73
Granted................................................... 650,264 3.37
Cancelled................................................. (625,000) 10.75
Exercised................................................. -- --
---------
Outstanding at June 30, 2002................................ 2,106,136 5.45
=========
</Table>
The weighted average fair value exercise price per share of options granted
during the years ended June 30, 2002, 2001 and 2000 was $2.35, $5.12 and $5.92,
respectively. At June 30, 2002, 626,620 shares remained available for grant
under the Company's stock option plans.
On October 30, 2001, the Company offered the participants in its employee
stock option plans (excluding the Key Executive Plan) the opportunity to
exchange existing stock options for new stock options under the plans to be
granted at a future date at least six months and one day after the date of
cancellation of the old options by
48
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
the Company. The stock option exchange program expired on December 7, 2001 and
options to purchase 366,111 common shares were returned to the Company and
cancelled. Subject to the terms and conditions of the offer, the Company granted
options to purchase 333,764 common shares on June 10, 2002 with an exercise
price per share equal to the closing market price per share of the Company's
common shares, $3.12 per share. The new options have other terms and conditions
substantially the same as the old options. Executive officers of the Company who
participated in the program returned options for 125,000 common shares for
cancellation and were issued new options for 100,000 common shares in exchange
for the cancelled options which vest over a two year period.
The following tables summarize information regarding stock options
outstanding as of June 30, 2002:
<Table>
<Caption>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
STOCKHOLDER APPROVED PLANS ------------------------------------------ ------------------------
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
RANGE OF EXERCISE REMAINING EXERCISE EXERCISE
PRICE ($) # OF OPTIONS LIFE (YEARS) PRICE ($) # OF OPTIONS PRICE ($)
----------------- ------------ ------------ ------------ ------------ ---------
3.12 412,764 9.9 3.12 0 N/A
3.13- 5.00 348,100 7.0 3.97 128,875 4.27
5.01- 7.00 438,125 5.5 5.86 279,125 5.42
7.01- 10.00 360,175 4.5 7.89 333,725 7.59
10.01- 20.50 146,972 6.2 14.36 119,647 13.99
--------- -------
Total 1,706,136 6.7 5.97 861,372 7.28
========= =======
</Table>
<Table>
<Caption>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
------------------------------------------ ------------------------
NON-STOCKHOLDER APPROVED PLANS
WEIGHTED WEIGHTED WEIGHTED
AVERAGE AVERAGE AVERAGE
RANGE OF EXERCISE REMAINING EXERCISE EXERCISE
PRICE ($) # OF OPTIONS LIFE (YEARS) PRICE ($) # OF OPTIONS PRICE ($)
----------------- ------------ ------------ ------------ ------------ ---------
3.81 400,000 3.0 3.81 400,000 3.81
------- -------
Total 400,000 3.0 3.81 400,000 3.81
======= === ==== ======= ====
</Table>
NOTE 10 -- EMPLOYEE BENEFIT PLANS
The Company has a 401(k) plan that covers substantially all employees over
21 years of age. The Company contributes to the plan based upon employee
contributions and may make additional contributions at the discretion of the
Board of Directors. The Company made contributions to this plan of approximately
$575,000, $837,000 and $683,000, for the years ended June 30, 2002, 2001, and
2000, respectively.
The Company has an employee stock purchase plan that is in accordance with
Section 423 of the Internal Revenue Code whereby participants are eligible to
purchase common shares of the Company during the plan year. The purchase price
for a common share is determined by the Compensation Committee of the Board of
Directors prior to the effective date. The purchase price may not be less than
90% of the per share fair market value of the Company's common shares on either
the effective date or the option date for the offering, whichever is the lesser.
Substantially all non-officer employees are eligible to participate. During the
plan period ended December 31, 2000, the plan did not have any more shares
available for purchase.
At the November 2001 annual shareholder's meeting, the shareholders
approved the Board of Directors' proposal to amend the Company's Employee Stock
Purchase Plan to increase the aggregate number of shares available for issuance
under the plan from 200,000 to 400,000. The plan remained inactive during the
year ended June 30, 2002. The Compensation Committee of the Board of Directors
determines the date on which any future offering under the Employee Stock
Purchase Plan will commence.
49
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
NOTE 11 -- ACQUISITIONS
On February 9, 2000, the Company acquired Profit Solutions, Inc. ("PSI"), a
Minnesota corporation and provider of Web-centric customer relationship
management applications with sales, marketing, service and business intelligence
functionality, for approximately $2,100,000 in cash paid at closing and
$5,000,000 in unsecured, subordinated promissory notes. The transaction was
accounted for as a purchase and resulted in a one-time, non-recurring charge of
$638,000 relating to the write-off of acquired in-process technology of PSI.
The following table sets forth the unaudited consolidated pro forma results
of operations for the period indicated giving effect to the acquisition as if it
had occurred at the beginning of the period indicated. The non-recurring charge
of $638,000 is excluded from pro forma net income (loss). No pro forma
information is required for the years ended June 30, 2002 and 2001 since all
acquisitions occurred in prior years.
<Table>
<Caption>
YEAR ENDED
JUNE 30, 2000
---------------------
(IN THOUSANDS, EXCEPT
PER SHARE DATA)
Revenue..................................................... $129,333
Net income (loss)........................................... (10,888)
Net income (loss) per share, assuming dilution.............. (1.47)
</Table>
NOTE 12 -- EARNINGS PER SHARE
The following table sets forth the computation of basic and diluted
earnings (loss) per share (in thousands, except per share data):
<Table>
<Caption>
YEAR ENDED JUNE 30,
-----------------------------
2002 2001 2000
------- -------- --------
Numerator for basic and diluted income (loss) per
share -- net income (loss)........................... $(3,445) $(26,064) $(10,205)
======= ======== ========
Denominator:
Weighted average common shares outstanding........... 7,568 7,535 7,411
Contingently issuable shares......................... -- -- --
------- -------- --------
Denominator for basic income (loss) per share..... 7,568 7,535 7,411
Effect of dilutive employee stock options............ -- -- --
------- -------- --------
Denominator for diluted income (loss) per share... 7,568 7,535 7,411
======= ======== ========
Basic net income (loss) per share...................... $ (0.46) $ (3.46) $ (1.38)
======= ======== ========
Diluted net income (loss) per share.................... $ (0.46) $ (3.46) $ (1.38)
======= ======== ========
</Table>
During years ended June 30, 2002, 2001 and 2000 common share equivalents in
stock options, warrants and convertible preferred shares were outstanding.
However, such common share equivalents were not included in the computation of
diluted net income per share because the Company reported a net loss for the
period and, therefore, the effect would be anti-dilutive. As of June 30, 2002,
2,106,136 common share equivalents in stock options, 1,603,546 common share
equivalents in warrants and 2,267,732 common share equivalents in convertible
preferred shares were outstanding.
50
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
NOTE 13 -- MINORITY INTEREST
In June 1998, Frontstep Computer Systems (Singapore) Pte. Ltd., a
wholly-owned subsidiary of the Company, sold previously unissued shares of
common stock (representing a 13.3% interest in that subsidiary) to Mitsui for
$2,000,000. No gain or loss was recognized on the sale of the subsidiary stock.
The Company, through another subsidiary, and Mitsui also entered into put
options which provided that during a six month period which commenced on
September 1, 2001, Mitsui would have the right to put the subsidiary shares to
the Company at a formula price as provided in the put options, to be not less
than an aggregate of $2,000,000. Mitsui exercised the put options in September
2001. Subsequently, the parties executed convertible notes relating to the
payment for the subsidiary shares. See Note 7 -- Long-Term Obligations --
Minority interest notes payable. The Mitsui convertible notes were modified in
principle in September 2002. See Note 19 -- Subsequent Events.
In September 1999, the Company formed a new subsidiary, Frontstep Japan
Ltd., of which 15% of the initial capitalization was contributed by a minority
interest investor.
NOTE 14 -- PREFERRED STOCK
The Company's Amended Articles of Incorporation authorize 1,000,000 shares
of preferred stock, no par value. The Board of Directors is authorized to
determine the rights and preferences of these shares. Effective May 10, 2000,
the Company consummated a private placement of 566,933 shares of Series A
convertible participating preferred shares and warrants to purchase 453,546
common shares (the "Transaction"). Net proceeds realized from the Transaction
were $13,375,000.
The preferred shares are convertible to common shares at any time, in whole
or in part, at the holder's option at a defined conversion rate. This conversion
rate was originally two common shares for one preferred share. On March 7, 2002,
in connection with the Transaction (See Note 7 -- Long-Term Obligations), the
Company and the holders of its Series A preferred shares agreed that the
conversion price for the Series A preferred shares would be immediately reset
from $12.00 per share to $6.00 per share and therefore the conversion rate
became four shares for one preferred share. Additionally, concurrent with the
Transaction adjustments relating to share price and anti-dilution rights under
the original preferred share agreement were waived by the holders of the
preferred shares only with respect to the Transaction. The conversion price
applicable to the preferred shares is subject to adjustment on the fourth
anniversary of the Transaction if the average daily price of the Company's
common shares, weighted by trading volume, for the forty consecutive trading
days immediately preceding the fourth anniversary ("Average Weighted Price") is
less than $6 per share. The adjusted conversion rate is determined by dividing
$6 by the Average Weighted Price. This potential adjustment to the conversion
rate represents a contingent beneficial conversion feature. Assuming the Average
Weighted Price on the fourth anniversary is equal to the closing price of the
Company's common shares on June 30, 2002 ($2.99), the adjusted conversion rate
would be 8.02 common shares for one preferred share. Mandatory conversion occurs
if, at any time after the second anniversary of the Transaction, the daily price
of the Company's common shares exceeds $24 for each and every day of any period
of forty consecutive trading days.
The Company may, at its option, redeem all, but not less than all, of the
outstanding preferred shares within thirty days after the fourth anniversary of
the Transaction for $30.72 per preferred share plus accumulated, but unpaid,
dividends, if any.
Holders of the preferred shares have a liquidation preference whereby upon
voluntary or involuntary liquidation/dissolution/winding-up of the Company the
preferred holders have a preference against the assets of the Company available
for distribution. The liquidation preference is equal to the greater of a) $24
per preferred share outstanding plus accumulated, but unpaid, dividends, if any,
or b) the amount that would be received by a holder of the number of common
shares underlying the preferred shares if all the preferred shares were
converted to common shares immediately prior to
liquidation/dissolution/winding-up.
51
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
Concurrent with the execution of the Credit Facility with Foothill (see
Note 7 -- Long-Term Obligations) in July 2001, the exercise price of the
warrants issued in the Transaction was reduced to $3.36 per share from $15 per
share. The warrants expire five years from the date of the Transaction. The
warrants also contain certain adjustment provisions related to share price and
provisions for anti-dilution rights, which were waived in connection with the
execution of the Credit Facility agreement. The exercise price of the warrants
is subject to adjustment on the fourth anniversary of the Transaction if the
Average Weighted Price is less than $15 per share. The adjusted exercise price
is the greater of a) the Average Weighted Price or b) 75% of the exercise price.
Mandatory exercise occurs if, at any time after the second anniversary of the
Transaction, the daily price of the Company's common shares exceeds $12 per
share for each and every day in any period of forty consecutive trading days.
The Company determined that the fair value of the warrants on the date of the
Transaction, net of issuance costs, was $2,510,000. This value was determined
using a Black-Scholes option pricing model with the following assumptions:
risk-free interest rate of 6.5%, no dividend yield, volatility factor of .827,
and option life of 5 years.
Under applicable Nasdaq rules, the Company was required to obtain
shareholder approval of the issuance of common shares upon conversion of the
convertible preferred shares and/or the exercise of the warrants at a price less
than the market price of the Company's common shares on the date of the
Transaction ($9.1875 per share). The Company submitted to its shareholders at
the Company's annual meeting on November 8, 2000 a proposal to approve such
issuance and such approval was obtained at that meeting.
NOTE 15 -- BUSINESS SEGMENT AND GEOGRAPHIC INFORMATION
The Company designs, develops, markets and supports business software and
services for midsize manufacturing companies, including business units of larger
companies. The Company operates exclusively in this market and, therefore, only
reports on one primary segment.
Summarized financial information attributable to each of the Company's
geographic areas is shown in the following table (in thousands):
<Table>
<Caption>
NORTH AMERICA,
UNITED STATES EXCLUDING U.S. EUROPE ASIA/PACIFIC
------------- -------------- ------- ------------
FISCAL 2002
Total Revenue......................... $63,386 $3,039 $16,036 $10,125
Operating income (loss) before
amortization of intangibles and
special charges..................... (2,622) 1,800 992 (389)
Operating Income (loss)............... (4,335) 1,800 928 (389)
Long-lived assets..................... 4,287 14 397 332
FISCAL 2001
Total Revenue......................... $87,405 $4,103 $14,736 $10,832
Operating income (loss) before
amortization of intangibles and
special charges..................... (18,099) 2,115 259 (2,204)
Operating Income (loss)............... (27,305) 2,115 (189) (2,238)
Long-lived assets..................... 6,793 29 312 512
FISCAL 2000
Total Revenue......................... $98,739 $4,326 $13,941 $11,902
Operating income (loss) before
amortization of intangibles and
special charges..................... (3,564) 1,881 (3,376) (1,077)
Operating Income (loss)............... (7,618) 1,881 (3,904) (1,155)
Long-lived assets..................... 7,099 36 383 468
</Table>
52
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
NOTE 16 -- COMMITMENTS AND CONTINGENCIES
The Company is subject to claims and lawsuits in the ordinary course of its
business. It is the Company's policy to vigorously defend any action brought
against it, to the fullest extent, in the normal legal process. In the opinion
of management, the outcome of these actions, which is not clearly determinable
at the present time, are either adequately covered by insurance, or if not
insured, will not, in the aggregate, have a material adverse effect upon the
Company's financial position or its results of future operations.
NOTE 17 -- SALE OF VISUAL APPLICATIONS SOFTWARE
Effective June 21, 2000, the Company sold certain assets of its Visual
Applications Software, Inc. subsidiary for $2,915,000. The Company has
recognized a $429,000 net loss in connection with the sale of which
approximately $1,200,000 includes write-off of purchased goodwill. The costs
related to the disposition of Visual Applications Software, Inc. are included in
"restructuring and other charges" in the Consolidated Statements of Operations
for the year ended June 30, 2000.
NOTE 18 -- SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
<Table>
<Caption>
THREE MONTHS ENDED
-----------------------------------------------
JUNE 30 MARCH 31 DECEMBER 31 SEPTEMBER 30
------- -------- ----------- ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
FISCAL 2002
Total revenue.......................... $22,556 $21,732 $23,327 $24,971
Gross margin........................... 11,647 10,862 11,580 13,795
Operating income (loss)................ 1,038 (1,278) (2,507) 751
Net income (loss)...................... 487 (1,242) (2,887) 197
Basic income (loss) per common share... $ 0.06 $ (0.16) $ (0.38) $ 0.03
Diluted income (loss) per common
share............................... $ 0.05 $ (0.16) $ (0.38) $ 0.03
FISCAL 2001
Total revenue.......................... $28,821 $26,334 $33,856 $28,065
Gross margin........................... 16,066 9,605 18,801 13,778
Operating income (loss)................ (4,994) (15,928) (1,492) (5,203)
Net income (loss)...................... (5,197) (16,186) (1,164) (3,517)
Basic income (loss) per common share... $ (0.69) $ (2.14) $ (0.16) $ (0.47)
Diluted income (loss) per common
share............................... $ (0.69) $ (2.14) $ (0.16) $ (0.47)
</Table>
NOTE 19 -- SUBSEQUENT EVENTS
On August 12, 2002 and August 28, 2002, the Company issued its 10%
convertible subordinated notes (the "Convertible Notes") in the aggregate
principal amount of $2.5 million and $1.0 million, respectively to, and received
$2.5 million and $1.0 million, respectively in cash from, certain of its
preferred shareholders, including Fallen Angel Equity Fund and entities
affiliated with Morgan Stanley, and two other shareholders and directors of the
Company, Lawrence J. Fox and James A. Rutherford (collectively, the
"Investors"), in accordance with the terms of a private placement transaction.
The Convertible Notes are each due on May 10, 2004 and are convertible into
common shares of the Company at a conversion rate of $2.4876 per share. All $5.0
million of the Convertible Notes have now been drawn down by the Company. See
Note 7 -- Long-Term Obligations.
53
FRONTSTEP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- CONTINUED
A summary of all convertible notes issued as part of the private placement
transaction is as follows:
<Table>
<Caption>
PRINCIPAL AMOUNT OF PRINCIPAL AMOUNT OF
INITIAL NOTES CONVERTIBLE NOTES
NAME OF INVESTOR PURCHASED PURCHASED
- ---------------- ------------------- -------------------
Morgan Stanley Dean Witter Venture Partners IV,
L.P............................................. $ 550,131 $1,283,639
Morgan Stanley Dean Witter Venture Investors IV,
L.P............................................. $ 63,824 $ 148,923
Morgan Stanley Dean Witter Venture Offshore
Investors IV, L.P............................... $ 21,463 $ 50,080
Fallen Angel Equity Fund, L.P..................... $ 264,582 $ 617,358
Lawrence J. Fox................................... $ 450,000 $1,050,000
James A. Rutherford............................... $ 150,000 $ 350,000
---------- ----------
Total........................................... $1,500,000 $3,500,000
========== ==========
</Table>
The Company and Mitsui entered into convertible note agreements in May 2002
and July 2002 for the payment of $2,000,000 to Mitsui in connection with the
exercise of put options. See Note 7 - Long-Term Obligations. In September 2002,
the Company and Mitsui agreed in principle to modify the terms of these
convertible note agreements with respect to the notes due originally due
September 1, 2002. Under the modified terms, 50% of the principal amount of the
Mitsui convertible notes that were due September 1, 2002, plus the accrued
interest on such amount, will be payable in common shares of the Company based
upon a conversion price of $2.85 per share. The Company must register the shares
for resale and may issue the common shares to Mitsui at any time prior to
January 1, 2003. However, interest continues to accrue on these notes until the
common shares are issued and the notes are exchanged. The remaining 50% of the
principal amount of the Mitsui convertible notes due September 1, 2002, plus
accrued interest, is due and payable no later than January 1, 2003. The amended
agreement will provide that, in the event of non-payment, Mitsui has the right
to require late payment interest on the unpaid principal and accrue interest at
16% per annum or to convert all of the unpaid principal and accrued interest
into common shares of the Company. The price per share for such conversion is
the lower of (a) $2.85 or (b) the average of the daily closing price for 30
consecutive trading days prior to January 1, 2003. The Company may repay the
Mitsui convertible notes at any time, including the portion exchangeable for
common shares of the Company, prior to the issuance of such shares. The Company
expects to execute an amended agreement with Mitsui in early October 2002.
The Company has outstanding under its employee stock option plans options
granted pursuant to stock option agreements which contain provisions that
provide that the options covered by the agreements will become fully exercisable
as of the date of a "change in control" of the Company, as defined in the
agreements, if the option has been outstanding six months or more at the time of
such change in control. For purposes of the agreements, a "change in control" is
deemed to have occurred on the date that any entity or person (including a
"group" as defined in Section 13(d)(3) of the Securities Exchange Act of 1933,
other than a trustee or other fiduciary of securities held under an employee
benefit plan of the Company or its subsidiaries) becomes the beneficial owner
of, or obtains voting control over, any percentage of the Company's outstanding
common shares greater than or equal to the percentage beneficially owned by
Lawrence J. Fox. On August 12, 2002, as a result of the Convertible Note
offering made by the Company and subsequent draws thereon, Morgan Stanley
beneficially owned a greater number of our common shares and, consequently a
greater percentage of our outstanding common shares than Mr. Fox. As a result,
employee stock options covering 388,575 common shares, with exercise prices
ranging from $3.55 to $20.50 per share, became vested.
54
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None. The Company filed a current report on Form 8-K, dated November 8,
2000, to report under Item 4 (Changes in Registrant's Certifying Accountant)
that effective November 8, 2000, the registrant appointed KPMG LLP as its
Certifying Accountant. Ernst & Young LLP was previously the principal accountant
for Frontstep. The decision to change accountants was approved by the Audit
Committee and the Board of Directors.
In connection with the audits of the two fiscal years ended June 30, 2000
and during the subsequent interim period through September 30, 2000, there were
no disagreements with Ernst & Young LLP on any matter of accounting principles
or practices, financial statement disclosure, or auditing scope or procedures,
which disagreements if not resolved to their satisfaction would have caused them
to make reference in connection with their opinion to the subject matter of the
disagreement.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The Company's Directors are as follows:
<Table>
<Caption>
DIRECTOR OF
FRONTSTEP
DIRECTOR AGE PRINCIPAL OCCUPATIONS SINCE
- -------- --- --------------------- -----------
Lawrence J. Fox..... 45 Chairman of the Board of Frontstep 1984
Stephen A. Sasser... 52 President and Chief Executive Officer of Frontstep 1995
Duke W. Thomas...... 64 Partner, Vorys, Sater, Seymour and Pease LLP 1988
James A.
Rutherford........ 55 President of Wingset Inc. 1995
Roger D.
Blackwell......... 61 Professor of Marketing, Fisher College of Business, The 2000
Ohio State University and President and Chief Executive
Officer Roger Blackwell Associates, Inc.
Guy L. de Chazal.... 54 Managing Director of each of Morgan Stanley & Co. Inc. 2000
and MSDW Venture Partners IV, Inc.
Barry M.
Goldsmith......... 57 General Partner, Updata Venture Associates, L.P. 2000
A. Zuheir Sofia..... 58 Chairman of Sofia & Company, Inc. 2001
</Table>
Mr. Fox founded a predecessor to Frontstep in 1979 as a sole
proprietorship. He has held his present office as Chairman of the Board since a
predecessor to the Company was incorporated in 1984. From 1984 to 1998, Mr. Fox
also served as Chief Executive Officer of the Company. Mr. Fox is also a
director of Alkon Corporation, a provider of enterprise solutions to the
construction industry.
Mr. Sasser has held the positions of President and Chief Executive Officer
of the Company since January 1999. Mr. Sasser previously served the Company,
from the time that he joined the Company in July 1995 until January 1999, as
President and Chief Operating Officer. Mr. Sasser has served as a director of
the Company since July 1995. Mr. Sasser also is a director of Aelita, Inc., a
provider of systems management utility tools.
Mr. Thomas has been a partner of Vorys, Sater, Seymour and Pease LLP, a law
firm based in Columbus, Ohio, since 1970. Mr. Thomas is also a director of The
Ohio Bar Liability Insurance Co., a lawyers professional liability company, and
the Ohio Printing Company, a commercial printing company.
Mr. Rutherford founded Wingset Inc., a private investment management
corporation, and has served as its President since 1992. Mr. Rutherford also
serves as Managing Director of Wingset Investments Ltd., a private investment
management corporation. Mr. Rutherford is also a director of Ciber, Inc., a
provider of information technology consulting services.
Dr. Blackwell has been associated with The Ohio State University since 1965
and is currently a Professor of Marketing in the Fisher College of Business. Dr.
Blackwell also has been President and Chief Executive Officer of Roger Blackwell
Associates, Inc., a consulting firm in Columbus, Ohio, since 1980. Dr. Blackwell
is a board
55
member of Anthony & Sylvan Pools, Inc., a pool builder and designer; Flex-Funds,
a manager and marketer of mutual and money market funds and other investment
vehicles; AirNet Systems, Inc., a provider of specialty air courier services;
Intimate Brands, Inc., the parent company of several former divisions of The
Limited Inc. which includes Victoria's Secret, Victoria's Secret Catalogue and
Bath & Body Works; Max & Erma's Restaurants, a chain of casual family dining
restaurants throughout the Midwest; Applied Industrial Technologies, which is
engaged in business-to-business electronic commerce and distribution; and
Diamond Hill Capital Management, Inc., an investment management company.
Mr. de Chazal has been Managing Director of Morgan Stanley & Co. Inc., an
investment bank, since 1994. Mr. de Chazal also serves as a Managing Director of
MSDW Venture Partners IV, Inc., a venture capital investments fund. Mr. de
Chazal also is a director of Lionbridge Technologies, a provider of
globalization services to software publishers, computer hardware manufacturers
and telecommunications companies. See also footnotes 4 and 5 under "Principal
Holders of Securities."
Mr. Goldsmith has been a General Partner of Updata Venture Partners, a
technology private equity firm, since March of 2000. He also has been the
Managing Director of Updata Capital, Inc., a mergers and acquisitions consulting
organization, since 1987. Mr. Goldsmith also is the general partner of Fallen
Angel Capital, L.L.C. Mr. Goldsmith is currently a board member of Compuware
Corporation, a provider of software and professional services for information
technology departments of business enterprises; and Dendrite International,
Inc., a specialized software services provider. See also footnotes 6 and 7 under
"Principal Holders of Securities."
Mr. Sofia has been Chairman of Sofia & Company, Inc., an Ohio based
investment-banking firm, since 2001. He has also been the President of Stanberry
Group, LLC, a registered investment advisor, since 1999. Previously, Mr. Sofia
was President, COO, Treasurer and Director of Huntington Bancshares Inc., a $26
billion bank holding company which he joined in 1971. Mr. Sofia is also director
of the Lancaster Colony Corporation. Mr. Sofia is Vice Chairman of the Ohio
Banking Commission and serves on the Western Kentucky University Board of
Advisors.
The Company's executive officers (excluding those that are also directors)
are as follows:
<Table>
<Caption>
NAME AGE TITLE
- ---- --- -----
Lawrence W. DeLeon................... 47 Executive Vice President, Worldwide Field Operations
Daryll L. Wartluft................... 61 Executive Vice President, Products Group
Robert D. Williams................... 47 Vice President, Human Resources
Aggie G. Haslup...................... 51 Vice President, Marketing
Daniel P. Buettin.................... 49 Vice President, Finance, Chief Financial Officer and
Secretary
</Table>
Lawrence W. DeLeon has held the position of Executive Vice President
Worldwide Field Operations since August 2000. Mr. DeLeon previously served the
Company as Vice President, Chief Financial Officer and Secretary from the time
that he joined the Company in 1995 to July 2000.
Daryll L. Wartluft has held the position of Executive Vice President
Frontstep Product Group since August 2000. Mr. Wartluft previously served as
Vice President and General Manager, SyteLine Division from the time that he
joined the Company in May 1998 until July 2000. From 1995 to 1998, he was
President and Chief Executive Officer and a director of Pivotpoint Inc., an ERP
software and services provider.
Robert D. Williams joined the Company in September 1995 as Vice President,
Human Resources.
Aggie G. Haslup has held the position of Vice President of Corporate
Marketing since November 2001. Ms. Haslup joined the Company in 1996 and has
previously served as an operating Vice President with various marketing
responsibilities.
Daniel P. Buettin joined the Company in August 2000 as Vice President,
Finance, Chief Financial Officer and Secretary. Mr. Buettin served from 1995 to
August 2000 as Vice President and Chief Financial Officer of MPW Industrial
Services Group, Inc., a publicly-traded services company.
56
The executive officers of the Company are appointed by and serve at the
pleasure of the Company's Board of Directors. There are no arrangements or
understandings between any officer and any other person pursuant to which the
officer was so appointed.
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934, as amended, requires
Frontstep executive officers and directors, and persons who beneficially own
more than 10% of the outstanding common shares, to file initial reports of
ownership and reports of changes in ownership of their equity securities of
Frontstep with the Commission and the National Association of Securities
Dealers, Inc. Frontstep executive officers, directors and greater than 10%
beneficial owners are required by Commission regulations to furnish Frontstep
with copies of all Section 16(a) forms filed by them. Based solely on a review
of the copies of such forms furnished to Frontstep and written representations
from Frontstep's executive officers and directors, Frontstep believes that all
Section 16(a) filing requirements applicable to its executive officers,
directors and greater than 10% beneficial owners were complied with for fiscal
2002.
ITEM 11. EXECUTIVE COMPENSATION
EXECUTIVE COMPENSATION
The following table shows, as to the Chief Executive Officer and the other
four most highly compensated executive officers of Frontstep whose salary plus
bonus exceeded $100,000, information concerning compensation paid for services
to Frontstep in all capacities during the fiscal year ended June 30, 2002, as
well as the total compensation paid to each such individual for Frontstep's two
previous fiscal years (if such person was the Chief Executive Officer or an
executive officer, as the case may be, during any part of such fiscal years).
SUMMARY COMPENSATION TABLE
<Table>
<Caption>
LONG TERM
COMPENSATION
AWARDS
ANNUAL COMPENSATION ------------
----------------------------------------- SECURITIES
NAME AND OTHER ANNUAL UNDERLYING ALL OTHER
PRINCIPAL POSITION(S) YEAR SALARY ($) BONUS ($) COMPENSATION ($) OPTIONS COMPENSATION ($)
- --------------------- ---- ---------- --------- ---------------- ------------ ----------------
Lawrence J. Fox............ 2002 $247,500 None $28,236(1) 22,400(12) $ 5,049(2)
Chairman of the Board 2001 269,271 None 39,771(1) None 33,107(3)
2000 275,000 None 36,690(1) None 33,000(4)
Stephen A. Sasser.......... 2002 $270,000 None None None $ 5,505(5)
President and Chief 2001 293,750 $74,880 None None 7,494(6)
Executive Officer 2000 272,000 None None None 6,262(7)
Stephen A. Yount (8)....... 2002 $165,600 $12,000 None 20,000 $53,807(9)
Executive Vice President 2001 180,167 26,774 None None 1,565(10)
Business Development 2000 170,000 42,778 None 10,000 14,024(11)
and Channel Operations
Lawrence W. DeLeon......... 2002 $171,000 None None 30,000 $ 4,215(2)
Executive Vice President 2001 186,042 48,170 None 10,000 5,855(2)
Frontstep Worldwide 2000 165,000 7,440 None None 5,055(2)
Field Operations
Daryll L. Wartluft......... 2002 $180,000 None None 98,800(13) $ 2,250(2)
Executive Vice President 2001 195,833 35,170 None 25,000 2,694(2)
Frontstep Product Group 2000 189,000 19,828 None None 2,684(2)
</Table>
- ---------------
(l) Includes payment for automobile allowance, other travel costs, club dues,
legal fees and tax preparation costs.
(2) Represents Frontstep's matching contribution to the 401(k) Profit Sharing
Plan for the named officer.
57
(3) Includes $28,000 paid for premiums on split term life insurance on the
named officer and Frontstep's matching contribution to 401(K) Profit
Sharing Plan of $5,107.
(4) Includes $28,000 paid for premiums on split term life insurance on the
named officer and Frontstep's matching contribution to 401(K) Profit
Sharing Plan of $5,000.
(5) Includes $2,130 paid for premiums on split term life insurance on the named
officer and Frontstep's matching contribution to the 401(K) Profit Sharing
Plan of $3,375.
(6) Includes $2,130 paid for premiums on split term life insurance on the named
officer and Frontstep's matching contribution to the 401(K) Profit Sharing
Plan of $5,364.
(7) Includes $2,130 paid for premiums on split term life insurance on the named
officer and Frontstep's matching contribution to the 401(k) Profit Sharing
Plan of $4,132.
(8) Mr. Yount terminated his employment with the Company in August 2002.
(9) Includes a reduction of $37,500 to the principal balance outstanding on a
loan made by Frontstep to the named officer, relocation costs of $14,754
and Frontstep's matching contribution of $1,553 to the 401(k) Profit
Sharing Plan for the named officer.
(10) Represents Frontstep's matching contribution to the 401(K) Profit Sharing
Plan for the named officer.
(11) Includes a reduction of $12,500 to the principal balance outstanding on a
loan made by Frontstep to the named officer, and Frontstep's matching
contribution of $1,413 to the 401(K) Profit Sharing Plan for the named
officer.
(12) Stock options issued in connection with the Company's exchange offer. Mr.
Fox returned 28,000 outstanding options for cancellation.
(13) Includes 68,800 stock options issued in connection with the Company's
exchange offer. Mr. Wartluft returned 86,000 outstanding options for
cancellation.
STOCK OPTION GRANTS AND EXERCISES
The following table sets forth certain information with respect to stock
options awarded during fiscal year 2002 to executive officers named in the
Summary Compensation Table. These option grants are also reflected in the
Summary Compensation Table. In accordance with Securities and Exchange
Commission ("Commission") rules, the hypothetical realizable values for each
option grant are shown based on compound annual rates of stock price
appreciation of 5% and 10% from the grant date to the expiration date. The
assumed rates of appreciation are prescribed by the Commission and are for
illustration purposes only; they are not intended to predict future stock
prices, which will depend upon market conditions and Frontstep's future
performance and prospects.
OPTION GRANTS IN LAST FISCAL YEAR
<Table>
<Caption>
INDIVIDUAL GRANTS POTENTIAL REALIZABLE
------------------------------------------------------ VALUE AT ASSUMED
NUMBER OF % OF TOTAL ANNUAL RATES OF STOCK
SHARES OPTIONS PRICE APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM(2)
OPTIONS EMPLOYEES IN PRICE EXPIRATION -----------------------
NAME GRANTED (#) FISCAL YEAR ($/SHARE)(1) DATE 5% ($) 10% ($)
- ---- ----------- ------------ ------------ ---------- ---------- ----------
Lawrence J. Fox.......... 22,400(3) 3.21% $3.12 6/10/2012 $ 43,952 $111,383
Stephen A. Sasser........ -0- N/A N/A N/A N/A N/A
Stephen A. Yount......... 20,000 2.86% $3.92 11/07/2011 $ 49,305 $124,949
Lawrence W. DeLeon....... 30,000 4.30% $3.92 11/07/2011 $ 73,958 $187,424
Daryll L. Wartluft....... 98,800(4) 14.15% $3.12 6/10/2012 $193,861 $491,281
</Table>
- ---------------
(1) Represents the market price of the Shares on the date of grant.
(2) The dollar amounts reflected in this table are the result of calculations at
the 5% and 10% annual appreciation rates set by the Commission for
illustrative purposes and assume the options are held until their expiration
date. Such dollar amounts are not intended to forecast future financial
performance or possible future appreciation in the price of the Company's
common shares. Shareholders are therefore cautioned against
58
drawing any conclusions from the appreciation data shown, aside from the
fact that the persons indicated will only realize value from the option
grants shown when the price of the Company's common shares appreciates,
which benefits all shareholders commensurately.
(3) Stock options issued in connection with the Company's exchange offer. Mr.
Fox returned 28,000 outstanding options for cancellation.
(4) Includes 68,800 stock options issued in connection with the Company's
exchange program. Mr. Wartluft returned 86,000 outstanding options for
cancellation.
Options granted to Frontstep executive officers generally vest and become
exercisable in increments of 25% on each anniversary of the grant date, provided
the executive officer continues in the employ of Frontstep, and provided further
that, upon the occurrence of certain change in control events (defined in the
Frontstep stock option agreements) all such options outstanding six months or
more prior to the date of such change in control event will become fully vested.
See discussion below regarding the Company voluntary option exchange program.
We have outstanding under our employee stock option plans options granted
pursuant to stock option agreements which contain provisions that provide that
the options covered by the agreements will become fully exercisable as of the
date of a "change in control" of the Company, as defined in the agreements, if
the option has been outstanding six months or more at the time of such change in
control. For purposes of the agreements, a "change in control" is deemed to have
occurred on the date that any entity or person (including a "group" as defined
in Section 13(d)(3) of the Securities Exchange Act of 1933, other than a trustee
or other fiduciary of securities held under an employee benefit plan of the
Company or its subsidiaries) becomes the beneficial owner of, or obtains voting
control over, any percentage of our outstanding common shares greater than or
equal to the percentage beneficially owned by Lawrence J. Fox. On August 12,
2002, as a result of the Convertible Note offering made by the Company and
subsequent draws thereon, Morgan Stanley beneficially owned a greater number of
our common shares and, consequently a greater percentage of our outstanding
common shares than Mr. Fox. As a result, employee stock options covering 388,575
common shares, with exercise prices ranging from $3.55 to $20.50 per share,
became vested. Of these, none were held by Mr. Fox and options for 192,000
common shares with exercise prices ranging from $3.92 to $10.69 per share were
held by other executive officers of the Company.
On October 30, 2001, the Company offered all participants, including
executive officers, of its Non-Qualified Stock Option Plan for Key Employees and
its 1999 Non-Qualified Stock Option Plan for Key Employees (collectively, "the
Plans") the opportunity to participate in a voluntary stock option exchange
program. The program generally allowed a participant to return options held at
that time to the Company in exchange for new options to be granted at a future
date at least six months and one day after the date of cancellation of the old
options by the Company. As of the date of the offer, options to purchase
1,586,054 shares of the Company were outstanding pursuant to the Plans. The
offer expired on December 7, 2001 and options to purchase 366,111 common shares
were returned to the Company and cancelled. On June 10, 2002, the Company issued
333,764 new options with an exercise price of $3.12 per share, which was the
market price per share of the Company's common shares on the date of grant. The
new options have other terms and conditions substantially the same as the old
options. Executive officers of the Company who participated in the exchange
program returned options for 125,000 common shares for cancellation and were
issued for new options on June 10, 2002 for 100,000 common shares in exchange
for the cancelled options which vest over 2 years.
59
The following table shows the number of all vested (exercisable) and
unvested (not yet exercisable) stock options held by each executive officer
named in the Summary Compensation Table at the end of fiscal year 2002, and the
value of all such options that were "in the money" (i.e., the market price of
the common shares covered by the options was greater than the exercise price of
the options) at the end of fiscal year 2002.
AGGREGATED OPTION EXERCISES IN LAST FISCAL YEAR
AND
FISCAL YEAR END OPTION VALUES
<Table>
<Caption>
NUMBER OF SHARES VALUE OF
UNDERLYING UNEXERCISED UNEXERCISED IN-THE-
SHARES OPTIONS AT MONEY OPTIONS HELD AT
ACQUIRED ON VALUE FISCAL YEAR END (#) FISCAL YEAR END ($)
EXERCISE REALIZED ------------------------- -------------------------
NAME (#) ($) EXERCISABLE/UNEXERCISABLE EXERCISABLE/UNEXERCISABLE
- ---- ----------- -------- ------------------------- -------------------------
Lawrence J. Fox -0- -0- 160,000/22,400 $0/$0
Stephen A. Sasser -0- -0- 540,000/0 $0/$0
Stephen A. Yount -0- -0- 122,500/22,500 $0/$0
Lawrence W. DeLeon -0- -0- 167,000/0 $0/$0
Daryll L. Wartluft -0- -0- 25,000/98,800 $0/$0
</Table>
EQUITY COMPENSATION PLAN INFORMATION
The following table sets forth certain information regarding the Company's
employee and outside directors stock option plans at September 15, 2002 and as
of June 30, 2002:
<Table>
<Caption>
SEPTEMBER 15, 2002 JUNE 30, 2002
------------------------------------------- -------------------------------------------
NUMBER OF NUMBER OF
SECURITIES SECURITIES
NUMBER OF REMAINING NUMBER OF REMAINING
SECURITIES TO WEIGHTED- AVAILABLE FOR SECURITIES TO WEIGHTED- AVAILABLE FOR
BE ISSUED AVERAGE FUTURE BE ISSUED AVERAGE FUTURE
UPON EXERCISE ISSUANCE UPON EXERCISE ISSUANCE
EXERCISE OF PRICE OF UNDER EQUITY EXERCISE OF PRICE OF UNDER EQUITY
OUTSTANDING OUTSTANDING COMPENSATION OUTSTANDING OUTSTANDING COMPENSATION
PLAN CATEGORY OPTIONS OPTIONS PLANS OPTIONS OPTIONS PLANS
- ------------- ------------- ----------- ------------- ------------- ----------- -------------
Equity compensation
plans approved by
security holders..... 1,776,136 $5.68 665,140 1,706,136 $5.97 626,620
Equity compensation
plans not approved by
security holders..... 400,000 $3.81 -0- 400,000 $3.81 -0-
Total.................. 2,176,136 $4.63 665,140 2,106,136 $5.45 626,620
</Table>
The Company has a Non-Qualified Stock Option Plan for Key Executives (the
"Key Executives Plan") which has not been approved by shareholders of the
Company. The Key Executive Plan provides for the grant of a total of 400,000
common shares and, as of June 30, 2002, all such options were issued and are
outstanding.
COMPENSATION OF DIRECTORS
The Board of Directors held a total of seventeen meetings during 2002. The
board has an Audit Committee, a Compensation Committee, a Stock Option Committee
and a Corporate Development Committee. Each of these committees is responsible
to the full Board of Directors and its activities are therefore subject to
approval of the board.
For the fiscal year ended June 30, 2002, the compensation arrangement
between Frontstep and all directors who are not employees of Frontstep ("Outside
Directors") was as follows: $500 for each Board meeting attended; and $1,250 per
quarter. During the 2002 fiscal year, each of the Outside Directors agreed to
defer the payment of such compensation. In addition, from time to time, the
Outside Directors receive options to acquire common shares under the Frontstep,
Inc. Stock Option Plan for Outside Directors (the "Directors' Plan").
60
During the 2002 fiscal year, 20,000 options were granted under the Directors'
Plan. In August 2002, each outside Director, excluding Mr. Goldsmith and Mr. de
Chazal, received a grant of 25,000 options in consideration for deferral of
their compensation in Fiscal 2002. Employee directors do not receive any
additional compensation for serving as a director.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
No current member of the compensation committee is an officer or employee
of Frontstep. No member of the compensation committee serves as a member of the
board of directors or compensation committee of any entity that has one or more
executive officers serving as a member of our board of directors or compensation
committee.
Mr. Thomas is a partner of the law firm of Vorys, Sater, Seymour and Pease
LLP. During fiscal 2002, Frontstep used, and anticipates that it will continue
to use, the services of such firm.
Mr. Goldsmith is the general partner of Fallen Angel Capital, L.L.C., which
is the general partner of Fallen Angel Equity Fund. Fallen Angel Equity Fund is
a holder of Series A preferred shares and Convertible Notes and Frontstep has
issued warrants to purchase common shares to Fallen Angel Equity Fund relating
to each of these transactions, as described above under the heading "Certain
Transactions and Relationships" and in footnotes 6 and 7 under "Principal
Holders of Securities."
REPRESENTATION ARRANGEMENT
On May 10, 2000, the Company entered into an Investor Rights Agreement with
affiliates of Morgan Stanley, Fallen Angel Equity Fund ("Fallen Angel") and
Lawrence J. Fox in connection with the sale of its preferred shares and warrants
to the preferred shareholders of the Company. The agreement was amended and
restated in March 2002 in connection with the issuance of convertible notes and
warrants to certain of the preferred shareholders and to Mr. Fox and Mr.
Rutherford. Pursuant to the terms of the Amended and Restated Investor Rights
Agreement, each of the parties to the original agreement, including the Company,
and Mr. Rutherford have agreed to take all reasonably necessary or desirable
legal actions within its or his control so that, among other things, until May
10, 2004 (i) the authorized number of the Company's directors will be 8; (ii)
one director on the Company's board will be designated by each of Morgan Stanley
and Fallen Angel; (iii) one director on the Company's board will be Lawrence J.
Fox; and (iv) management's slate of directors, including the designees of Morgan
Stanley and Fallen Angel, and Mr. Fox, will be elected to the Company's board.
Guy de Chazal currently serves as the representative of Morgan Stanley on
the Frontstep Board of Directors. Mr. de Chazal is a Managing Director of Morgan
Stanley & Co. Inc. and of MSDW Venture Partners IV, Inc., an entity controlled
by Morgan Stanley and the managing member of MSDW Venture Partners IV, L.L.C.,
the general partner of each of the Morgan Stanley affiliate entities that hold
outstanding preferred shares, warrants and/or convertible notes of the Company.
See also footnotes 4 and 5 to the principal shareholders table in Item 12.
Security Ownership of Certain Beneficial Owners and Management.
Barry Goldsmith currently serves as the representative of Fallen Angel on
the Frontstep Board of Directors. Mr. Goldsmith is the general partner of Fallen
Angel Capital, L.L.C., which is the general partner of Fallen Angel. See also
footnotes 6 and 7 to the principal shareholders table in Item 12. Security
Ownership of Certain Beneficial Owners and Management.
EMPLOYMENT AGREEMENT AND CHANGE-IN-CONTROL ARRANGEMENTS
Stephen A. Sasser. Frontstep has an employment agreement dated July 5,
1995, as amended on April 1, 1997 and December 15, 1998, with Stephen A. Sasser,
President and Chief Executive Officer (the "Sasser Agreement"). Mr. Sasser also
is a director of the Company. The term of the Agreement extends to July 5, 2002.
The Sasser Agreement, however, provides for automatic renewal for one additional
year to each July 4 thereafter unless prior notice of non-renewal is given by
Frontstep at least 120 days before the expiration of the term of the Sasser
Agreement. Under the Sasser Agreement, Mr. Sasser agrees to serve as President
and Chief Executive
61
Officer of Frontstep. He further agrees to serve as director of Frontstep and as
an officer and/or director of any of Frontstep's subsidiaries or affiliates if
elected as such.
The Sasser Agreement provides for an annual base salary of not less than
$272,000 and additional compensation pursuant to a bonus plan approved by the
Compensation Committee of the Frontstep Board of Directors with an annual target
bonus opportunity of not less than $188,000. The Company did not meet the
aggregate target bonus opportunity for the fiscal 2001, but Mr. Sasser did
receive a bonus payment of $74,880 with respect to the Company's quarterly
performance through December 2000. Mr. Sasser did not receive bonus payment in
fiscal 2000 and his fiscal 1999 bonus payment was $101,520.
If Mr. Sasser's employment with Frontstep is terminated as the result of
his death or disability (as defined in the Sasser Agreement), or by Frontstep
for cause (as defined in the Sasser Agreement), then he will be entitled to
receive his base salary through the date of termination and bonus compensation
as provided for under the Sasser Agreement on a pro rata basis to the extent
that Frontstep has achieved annual targets and objectives as of the date of
termination. In the event of termination of Mr. Sasser's employment by Frontstep
other than for cause or disability (in each case, as defined in the Agreement)
or by Mr. Sasser within one year after a "change in control" of Frontstep (as
defined in the Sasser Agreement), in addition to the prorated base salary and
bonus compensation previously described, Mr. Sasser will be entitled to receive
an amount equal to his annual base salary, plus an amount equal to the highest
bonus earned by him under the terms of the Sasser Agreement for any fiscal year
prior to the date of termination, and other specified benefits. If any of this
results in additional tax to him under Section 4999 of the Internal Revenue
Code, Frontstep is required to make an additional payment to him so as to
provide Mr. Sasser with the benefits he would have received in the absence of
such tax. Pursuant to other terms of the Sasser Agreement, an option for 400,000
common shares was granted to Mr. Sasser effective in January 1996 and an option
for an additional 140,000 common shares was granted to Mr. Sasser in July 1996.
The Sasser Agreement also requires Frontstep to maintain a policy of
insurance on Mr. Sasser's life in the amount of $1 million, the proceeds of
which policy to be payable upon his death to beneficiaries designated by Mr.
Sasser or to his estate if no such designation is made.
Lawrence J. Fox. Pursuant to a resolution adopted by the Compensation
Committee of the Board of Directors, the Company has agreed to maintain the
salary of Mr. Fox, Chairman of the Board of Directors, at $250,000 a year, so
long as any of the Notes held by him remain unpaid and outstanding.
Severance Arrangements with Executive Officers. Each of the Company's
executive officers, other than Mr. Fox and Mr. Sasser, have entered into
severance agreements with the Company dated September 13, 2002. These agreements
are intended to foster the continued employment of the executive officers with
the Company in the event of a "Change in Control" as such term is defined in the
agreements. Generally, for a period of six months following a Change in Control,
the executive officers are entitled to an amount of severance equal to six
months of their current base salary and benefits in effect at the time of their
termination if, for certain reasons provided in the agreement, their employment
is terminated. These agreements expire on August 31, 2004 or six months
following a Change in Control. The term of the agreements will be automatically
extended for one-year terms after August 31, 2004 unless otherwise terminated
prior to such time by the Company's Board of Directors.
Miscellaneous. Awards of stock options to Frontstep employees under any of
Frontstep's stock option programs, including the named executive officers,
generally will vest upon a change in control of Frontstep (as defined in
Frontstep's employee stock option agreements).
62
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth the names and addresses of, and the number
and percentage of our common shares and Series A preferred shares, respectively,
beneficially owned as of September 15, 2002 (except as otherwise noted) by, the
only persons known to Frontstep to beneficially own more than 5% of each class
of outstanding shares:
<Table>
<Caption>
SERIES A
COMMON SHARES PREFERRED SHARES
------------------------- -------------------------
AMOUNT AND AMOUNT AND
NATURE OF NATURE OF
NAME AND BENEFICIAL PERCENT BENEFICIAL PERCENT
ADDRESS OWNERSHIP(1) OF CLASS OWNERSHIP(1) OF CLASS
-------- ------------ -------- ------------ --------
Lawrence J. Fox.......................... 2,824,754(2) 33.19% None None
2800 Corporate Exchange Drive
Columbus, Ohio 43231
Stephen A. Sasser........................ 567,199(3) 7.00% None None
2800 Corporate Exchange Drive
Columbus, Ohio 43231
Morgan Stanley affiliated entities....... 3,026,886(4) 28.57% 400,266(5) 70.6%
1585 Broadway
New York, New York 10036
Fallen Angel Equity Fund, L.P............ 1,260,368(6) 14.28% 166,667(7) 29.4%
960 Holmdel Road
Holmdel, New Jersey 07733
James A. Rutherford...................... 424,397(8) 5.39% None None
15 South High Street
New Albany, Ohio 43054
</Table>
- ---------------
(1) Unless otherwise indicated, each named person has voting and investment
power over the listed shares and such voting and investment power is
exercised solely by the named person or shared with a spouse. The Series A
preferred shares are convertible on a 4-for-1 basis (subject to adjustment)
into common shares.
(2) Includes (i) 1,878,924 shares held directly by Mr. Fox, (ii) 180,000 shares
issuable upon exercise of outstanding warrants exercisable within the next
60 days, (iii) 160,000 shares subject to options exercisable within the next
60 days, (iv) 602,991 shares issuable upon conversion of outstanding
Convertible Notes within the next 60 days and (v) 2,839.1091 shares held for
the account of Mr. Fox in the Company's 401(k) Plan.
(3) Includes (i) 540,000 shares subject to options exercisable within the next
60 days and (ii) 6,199 shares held for the account of Mr. Sasser in the
Company's 401(k) Plan.
(4) As reported in a Schedule 13D filed on May 19, 2002 as amended with the
Securities and Exchange Commission (the "MS Schedule 13D"). Includes (i)
1,601,064 shares issuable upon conversion of outstanding Series A Preferred
shares which are convertible on a 4-for-1 basis within the next 60 days,
(ii) 574,379 shares issuable upon exercise of outstanding warrants which are
exercisable within the next 60 days and (iii) 851,443 shares issuable upon
conversion of outstanding Convertible Notes within the next 60 days.
According to the MS Schedule 13D, Morgan Stanley has shared voting and
investment power with respect to 3,026,886 of the shares shown; MSDW Venture
Partners IV, Inc. ("MSVP Inc.") and MSDW Venture Partners IV, L.L.C. ("MSVP
LLC") each have shared voting and investment power with respect to 2,611,676
of the shares shown; Morgan Stanley Dean Witter Venture Partners IV, L.P.
("MSVP IV") has shared voting and investment power with respect to 2,261,135
of the shares shown; Morgan Stanley Dean Witter Venture Offshore Investors
IV, L.P. ("MSVOI IV") has shared voting and investment power with respect to
88,214 of the shares shown; Morgan Stanley Dean Witter Venture Investors IV,
L.P. ("MSVI IV") has shared investment and voting power with respect to
262,327 of the shares shown; Morgan Stanley Dean Witter Equity Funding, Inc.
("Equity Funding") has shared voting and investment power with respect to
394,445 of the shares shown; and Originators Investment Plan, L.P. ("OIP")
has shared voting and investment power with respect to 20,765 of the shares
shown. According to the MSDW Schedule 13D, the
63
general partner of each of MSVP IV, MSVI IV and MSVOI IV is MSVP LLC, and
the corporate managing member of MSVP LLC is MSVP Inc. a wholly-owned
subsidiary of Morgan Stanley ("MS"). Equity Funding also is a wholly-owned
subsidiary of MS as reported in the MS Schedule 13D. The managing member of
OIP is MSDW Investors, Inc. ("OIP Investors"), which is a wholly-owned
subsidiary of MS. According to the MS Schedule 13D, the principal business
address of MSVP Inc., MSVP LLC, MSVP IV, MSVOI IV, MSVI IV Equity Funding,
OIP and OIP Investors address is 1585 Broadway, New York, New York 10036.
Guy de Chazal, a director of Frontstep, is Managing Director of MSVP Inc.,
and may be deemed to share beneficial ownership of 2,611,676 of the shares
shown. Mr. de Chazal disclaims beneficial ownership of these shares.
(5) As reported in the MS Schedule 13D. Includes 400,266 shares which are
convertible within the next 60 days on a 4-for-1 basis into 1,601,064 common
shares. According to the MS Schedule 13D, MS has shared voting and
investment power with respect to 400,266 of the shares shown, MSVP Inc. and
MSVP LLC each have shared voting and investment power with respect to
313,764 of the shares shown, MSVP IV has shared voting and investment power
with respect to 271,650 of the shares shown, MSVOI IV has shared voting and
investment power with respect to 10,598 of the shares shown, MSVI IV has
shared voting and investment power with respect to 31,516 of the shares
shown, Equity Funding has shared voting and investment power with respect to
82,176 of the shares shown and OIP has shared voting and investment power
with respect to 4,326 of the shares shown. Guy de Chazal, a director of
Frontstep, is Managing Director of MSVP, Inc., and may be deemed to share
beneficial ownership of 313,764 of the shares shown. Mr. de Chazal disclaims
beneficial ownership of these shares.
(6) As reported in a Schedule 13D filed on May 19, 2000 as amended with the
Securities and Exchange Commission (the "Fallen Angel Schedule 13D").
Includes (i) 666,668 shares issuable upon conversion of outstanding Series A
preferred shares which are convertible on a 4-for-1 basis into common shares
within the next 60 days, (ii) 239,167 shares issuable upon exercise of
outstanding warrants which are exercisable within the next 60 days and (iii)
354,533 shares issuable upon conversion of outstanding convertible notes
within the next 60 days. According to the Fallen Angel Schedule 13D, Fallen
Angel Capital, L.L.C. ("FAC"), the general partner of Fallen Angel Equity
Fund, L.P., has shared voting and investment power with respect to these
shares. The principal business address of FAC is 125 Half Mile Road, Red
Bank, New Jersey 07701. Barry Goldsmith, a director of Frontstep, is the
general partner of FAC and may be deemed to share beneficial ownership of
the shares shown. Mr. Goldsmith disclaims beneficial ownership of these
shares.
(7) As reported in the Fallen Angel Schedule 13D. Includes 166,667 shares which
are convertible on a 4-for-1 basis within the next 60 days into 666,668
shares. According to the Fallen Angel Schedule 13D, FAC, the general partner
of Fallen Angel Equity Fund, L.P., has shared voting and investment power
with respect to the shares shown. Barry Goldsmith, a director of Frontstep,
is the general partner of FAC and may be deemed to share beneficial
ownership of the shares shown. Mr. Goldsmith disclaims beneficial ownership
of these shares.
(8) Includes (i) 118,400 shares held directly by Mr. Rutherford , (ii) 60,000
shares issuable upon exercise of outstanding warrants exercisable within the
next 60 days, (iii) 45,000 shares subject to options exercisable within the
next 60 days and (iv) 200,997 shares issuable upon conversion of outstanding
convertible notes within the next 60 days.
64
The following table sets forth, as of September 15, 2002, certain
information with respect to the Shares beneficially owned by each director of
Frontstep, each executive officer of Frontstep named in the Summary Compensation
Table herein and by all directors and executive officers of Frontstep as a
group.
COMMON SHARES
<Table>
<Caption>
AMOUNT AND NATURE OF
NAME BENEFICIAL OWNERSHIP(1) PERCENT OF CLASS(2)
- ---- ----------------------- -------------------
Lawrence J. Fox.......................................... 2,824,754(3) 33.19%
Duke W. Thomas........................................... 65,819(4) *
James A. Rutherford...................................... 424,397(5) 5.39%
Stephen A. Sasser........................................ 567,199(6) 7.00%
Roger D. Blackwell....................................... 55,000(4) *
Guy de Chazal............................................ None(7) None
Barry Goldsmith.......................................... 20,000(8) *
A. Zuheir Sofia.......................................... 45,000(4) *
Lawrence W. DeLeon....................................... 176,000(9) 2.28%
Stephen A. Yount......................................... 123,500(10) 1.61%
Daryll L. Wartluft....................................... 25,000(11) *
Aggie G. Haslup.......................................... 33,839(12) *
Robert D. Williams....................................... 23,000(13) *
Daniel P. Buettin........................................ 105,000(14) 1.37%
All directors and executive Officers as a group (14
persons)............................................... 4,488,508(15) 45.10%
</Table>
- ---------------
* Represents less than 1% of the outstanding common shares.
(1) Each named beneficial owner has sole voting and investment power with
respect to the shares listed, except as otherwise noted. None of the
persons listed hold any Series A Preferred Shares. See also footnotes 4, 5,
6 and 7 under "Principal Holders of Securities."
(2) Percentage of beneficial ownership is based on 7,568,218 common shares
outstanding as of September 15, 2002 and the other beneficially owned
shares by the persons listed above.
(3) Includes (i) 1,878,924 shares held directly by Mr. Fox, (ii) 180,000 shares
issuable upon exercise of outstanding warrants exercisable within the next
60 days, (iii) 160,000 shares subject to options exercisable within the
next 60 days, (iv) 602,991 shares issuable upon conversion of outstanding
convertible notes within the next 60 days and (v) 2,839.1091 shares held
for the account of Mr. Fox in the Company's 401(k) Plan.
(4) Includes 45,000 shares subject to options exercisable within the next 60
days.
(5) Includes (i) 118,400 shares held directly by Mr. Rutherford , (ii) 60,000
shares issuable upon exercise of outstanding warrants exercisable within
the next 60 days, (iii) 45,000 shares subject to options exercisable within
the next 60 days and (iv) 200,997 shares issuable upon conversion of
outstanding Convertible Notes within the next 60 days.
(6) Includes (i) 540,000 shares subject to options exercisable within the next
60 days and (ii) 6,199 shares held for the account of Mr. Sasser in the
Company's 401(k) Plan.
(7) Does not include shares beneficially owned by Morgan Stanley, as to which
shares Mr. de Chazal disclaims beneficial ownership. See also footnotes 4
and 5 under "Principal Holders of Securities".
(8) Does not include shares beneficially owned by Fallen Angel Equity Fund,
L.P., as to which shares Mr. Goldsmith disclaims beneficial ownership. See
also footnotes 6 and 7 under "Principal Holders of Securities."
(9) Includes 167,000 shares subject to options exercisable within the next 60
days.
65
(10) Includes 122,500 shares subject to options exercisable within the next 60
days. Mr. Yount terminated his employment with the Company in August, 2002.
(11) Includes 25,000 shares subject to options exercisable within the next 60
days.
(12) Includes (i) 22,300 shares subject to options exercisable within the next
60 days and (ii) 1,811 shares held for the account of Mrs. Haslup in the
Company's 401(k) Plan. Mrs. Haslup disclaims beneficial ownership of 5,065
shares.
(13) Includes 22,000 shares subject to options exercisable within the next 60
days.
(14) Includes 105,000 shares subject to options exercisable within the next 60
days.
(15) Includes (i) 240,000 shares issuable upon exercise of outstanding warrants
exercisable within the next 60 days, (ii) 1.339,800 shares subject to
options exercisable within the next 60 days and (iii) $2,000,000 principal
amount of Convertible Notes convertible into 803,988 shares within the next
60 days.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In March and August 2002, the Company issued its convertible notes and
warrants to certain of its preferred shareholders, including entities affiliated
with Morgan Stanley and Fallen Angel Equity Fund, and two of its directors,
Lawrence J. Fox and James A. Rutherford. In connection with the transaction, the
Company's preferred shareholders, including the Morgan Stanley affiliates and
Fallen Angel, agreed to waive pre-emptive and anti-dilution rights which they
may have had under the original Investor Rights Agreement with the Company as a
result of the convertible notes transaction. The Company agreed to reduce the
conversion price on its outstanding preferred shares held by them from $12.00
per share to $6.00 per share. For more detailed information regarding this
transaction, see Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters -- Sale of Unregistered Securities and Note 7 -- Long-Term
Obligations to Financial Statements and Note 19 -- Subsequent Events to
Financial Statements. On May 10, 2000, the Company sold its preferred shares and
warrants to purchase its common shares to entities controlled by Morgan Stanley
and Fallen Angel Equity Fund. The warrants originally were exercisable at an
exercise price of $15.00 per share, subject to adjustment, until May 10, 2005.
In connection with the Foothill transaction, we agreed to reduce the exercise
price of the warrants to $3.36 per share and the warrant holders agreed to waive
adjustments to the exercise price of the warrants and the conversion price for
the preferred shares held by them as a result of the Foothill transaction. See
Note 14 -- Preferred Stock to Financial Statements included herein in Item 8.
Guy de Chazal, a director of Frontstep, is Managing Director of MSDW
Venture Partners IV, Inc., an entity controlled by Morgan Stanley and the
managing member of MSDW Venture Partners IV, LLC. See also footnotes 4 and 5 to
the principal shareholders table under Item 12. Security Ownership of Certain
Beneficial Owners and Management. Barry Goldsmith, a director of the Company, is
the general partner of Fallen Angel Capital, L.L.C., the general partner of
Fallen Angel. See also footnotes 6 and 7 to the principal shareholders table
under Item 12. Security Ownership of Certain Beneficial Owners and Management.
Messrs. Fox and Rutherford are directors and principal shareholders of the
Company. See the principal shareholders table under Item 12. Security Ownership
of Certain Beneficial Owners and Management.
On February 25, 2002, the Company entered into an agreement with Updata
Capital, Inc. ("Updata Capital") under which Updata Capital will provide various
services to assist the Company in its evaluation of strategic and business
alternatives and other financial advisory services as agreed upon by the
parties. Under this agreement, Updata will be paid a fee, the amount and timing
of which is contingent upon successful completion of its responsibilities. Barry
Goldsmith, a director of the Company, is Managing Director of Updata Capital,
Inc. See also footnotes 6 and 7 to the principal shareholders table under Item
12. Security Ownership of Certain Beneficial Owners and Management. In the
current fiscal year, no fees were paid to Updata Capital.
During the Company's last fiscal year, Vorys, Sater, Seymour and Pease LLP
rendered legal services on behalf of Frontstep. Duke W. Thomas, a director of
Frontstep, is a partner in that firm.
66
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a)(1) The following consolidated financial statements of the Company and
its subsidiaries are included in Item 8:
Reports of Independent Auditors
Consolidated Balance Sheets as of June 30, 2002 and 2001
Consolidated Statements of Operations for the Years Ended June 30, 2002,
2001 and 2000
Consolidated Statements of Shareholders' Equity for the Years Ended June
30, 2002, 2001 and 2000
Consolidated Statements of Cash Flows for the Years Ended June 30, 2002,
2001 and 2000
Notes to Consolidated Financial Statements
(a)(2) All schedules for which provision is made in the applicable
accounting regulations of the Securities and Exchange Commission are either not
required under the related instructions, are inapplicable and therefore have
been omitted, or the required information is provided in the Consolidated
Financial Statements of the Company and its subsidiaries or Notes thereto.
(a)(3) Exhibits
The following exhibits are included in this Annual Report on Form 10-K:
<Table>
<Caption>
EXHIBIT NO. DESCRIPTION PAGE
- ----------- --------------------------------------- ---------------------------------------
3(a)(1) Amended Articles of Incorporation of Incorporated herein by reference to
Frontstep, (f/k/a "Symix Systems, Exhibit 3(a)(1) to the Registrant's
Inc.") (the "Registrant") (as filed Annual Report on Form 10-K Inc. for the
with the Ohio Secretary of State on fiscal year ended June 30, 1997 (File
February 8, 1991) No. 0-19024)
3(a)(2) Certificate of Amendment to the Amended Incorporated herein by reference to
Articles of Incorporation of the Exhibit 3(a)(2) to the Registrant's
Registrant (as filed with the Ohio Annual Report on Form 10-K for the
Secretary of State on July 16, 1996) fiscal year ended June 30, 1997 (File
No. 0-19024)
3(a)(3) Certificate of Amendment to the Amended Incorporated herein by reference to
Articles of Incorporation, as amended Exhibit 3(a)(3) to the Registrant's
of the Registrant (as filed with the Quarterly Report on Form 10-Q for the
Ohio Secretary of State on May 10, fiscal quarter ended March 31, 2000
2000) (File No. 0-19024)
3(a)(4) Certificate of Amendment to the Amended Incorporated herein by reference to
Articles of Incorporation, as amended Exhibit 3(a)(4) to the Registrant's
of the Registrant (as filed with the Quarterly Report on Form 10-Q for the
Ohio Secretary of State on November 8, fiscal quarter ended September 30, 2000
2000) (File No. 0-19024)
3(a)(5) Amended Articles of Incorporation, as Incorporated herein by reference to
amended of the Registrant (reflecting Exhibit 3(a)(5) to the Registrant's
amendments through November 8, 2000 for Quarterly Report on Form 10-Q for the
purposes of Securities and Exchange fiscal quarter ended September 30, 2000
Commission reporting compliance only) (File No. 0-19024)
3(b) Amended Regulations of the Registrant Incorporated herein by reference to
Exhibit 3(b) to the Registrant's
Registration Statement on Form S-1, as
filed with the Securities and Exchange
Commission on February 12, 1991
(Registration No. 33-38878)
4(a)(1) Amended Articles of Incorporation of Incorporated herein by reference to
the Registrant (as filed with the Ohio Exhibit 3(a)(1) to the Registrant's
Secretary of State on February 8, 1991) Annual Report on Form 10-K for the
fiscal year ended June 30, 1997 (File
No. 0-19024)
</Table>
67
<Table>
<Caption>
EXHIBIT NO. DESCRIPTION PAGE
- ----------- --------------------------------------- ---------------------------------------
4(a)(2) Certificate of Amendment to the Amended Incorporated herein by reference to
Articles of Incorporation of the Exhibit 3(a)(2) to the Registrant's
Registrant (as filed with the Ohio Annual Report on Form 10-K for the
Secretary of State on July 16, 1996) fiscal year ended June 30, 1997 (File
No. 0-19024)
4(a)(3) Certificate of Amendment to the Amended Incorporated herein by reference to
Articles of Incorporation, as amended Exhibit 3(a)(3) to the Registrant's
of the Registrant (as filed with the Quarterly Report on Form 10-Q for the
Ohio Secretary of State on May 10, fiscal quarter ended March 31, 2000
2000) (File No. 0-19024)
4(a)(4) Certificate of Amendment to the Amended Incorporated herein by reference to
Articles of Incorporation, as amended Exhibit 3(a)(4) to the Registrant's
of the Registrant (as filed with the Quarterly Report on Form 10-Q for the
Ohio Secretary of State on November 8, fiscal quarter ended September 30, 2000
2000) (File No. 0-19024)
4(a)(5) Amended Articles of Incorporation, as Incorporated herein by reference to
amended of the Registrant (reflecting Exhibit 3(a)(5) to the Registrant's
amendments through November 8, 2000 for Quarterly Report on Form 10-Q for the
purposes of Securities and Exchange fiscal quarter ended September 30, 2000
Commission reporting compliance only) (File No. 0-19024)
4(b) Amended Regulations of the Registrant Incorporated herein by reference to
Exhibit 3(b) to the Registrant's
Registration Statement on Form S-1, as
filed with the Securities and Exchange
Commission on February 12, 1991
(Registration No. 33-38878)
4(c) Amended and Restated Investor Rights Incorporated herein by reference to
Agreement, dated as of March 7, 2002, Exhibit 4(a) to the Registrant's
among the Registrant, the Investors Current Report on Form 8-K, as filed
identified therein and Lawrence J. Fox with the Securities and Exchange
Commission on March 11, 2002 (File No.
0-19024)
4(d) Warrant for the Purchase of Shares of Incorporated herein by reference to
Common Stock of the Registrant issued Exhibit 4(e) to the Registrant's Annual
to Morgan Stanley Dean Witter Venture Report on Form 10-K for the fiscal year
Partners IV, L.P. on May 10, 2000, and ended June 30, 2001 (File No. 0-19024)
Exhibit A, identifying other identical
warrants issued to the investors
identified on Exhibit A on the dates
indicated, for the number of common
shares listed on Exhibit A
4(e) Assignment and Assumption Agreement, by Incorporated herein by reference to
and between Morgan Stanley Dean Witter Exhibit 4(g) to the Registrant's
Equity Funding, Inc. and the Quarterly Report on Form 10-Q for the
Originators Investment Plan, L.P., fiscal quarter ended December 31, 2000
dated November 24, 2000 (File No. 0-19024)
4(f) Amended and Restated Common Share Filed herein
Purchase Warrant, dated November 15,
2001, issued to Foothill Capital
Corporation
4(g) Registration Rights Agreement, dated Incorporated herein by reference to
July 17, 2001, by and between the Exhibit 4(h) to the Registrant's Annual
Registrant and Foothill Capital Report on Form 10-K for the fiscal year
Corporation ended June 30, 2001 (File No. 0-19024)
4(h) Share Exchange Agreement, dated January Incorporated herein by reference to
9, 1997 Exhibit 99 to Registrant's Current
Report on Form 8-K, as filed with the
Securities and Exchange Commission on
January 24, 1997 (File No. 0-19024)
</Table>
68
<Table>
<Caption>
EXHIBIT NO. DESCRIPTION PAGE
- ----------- --------------------------------------- ---------------------------------------
4(i) Form of Warrant for the purchase of Incorporated herein by reference to
common shares of the Registrant dated Exhibit 4(b) to the Registrant's
March 7, 2002 Current Report on Form 8-K, as filed
with the Securities and Exchange
Commission on March 11, 2002 (File No.
0-19024)
4(j) Form of Initial Note issued by Incorporated herein by reference to
Registrant dated March 7, 2002 Exhibit 4(c) to the Registrant's
Current Report on Form 8-K, as filed
with the Securities and Exchange
Commission on March 11, 2002 (File No.
0-19024)
4(k) Convertible Subordinated Note issued Incorporated herein by reference to
August 12, 2002 issued to Morgan Exhibit 4 to Registrant's Current
Stanley Dean Witter Venture Partners Report on Form 8-K, as filed with the
IV, L.P. and Exhibit A identifying Securities and Exchange Commission on
other identical Notes issued to the August 15, 2002 (File No. 0-19024)
investors identified, on the dates
indicated, for the number of common
shares listed on Exhibit A
4(l) Convertible Subordinated Note issued Incorporated herein by reference to
August 28, 2002 issued to Morgan Exhibit 4 to Registrant's Current
Stanley Dean Witter Venture Partners Report on Form 8-K, as filed with the
IV, L.P. and Exhibit A identifying Securities and Exchange Commission on
other identical Notes issued to the September 4, 2002 (File No. 0-19024)
investors identified, on the dates
indicated, for the number of common
shares listed on Exhibit A
10(a) Lease Agreement dated June 26, 2002 for Filed herein
corporate office located at 2800
Corporate Exchange Drive, Columbus,
Ohio
10(b) Progress Software Application Partner Filed herein
Agreement dated February 6, 2002
10(c)* Amended and Restated Stock Option Plan Filed herein
for Outside Directors
10(d)* Non-Qualified Stock Option Plan for Key Incorporated herein by reference to
Executives Exhibit 10(a) to Registrant's Quarterly
Report on Form 10-Q for the fiscal
quarter ended March 31, 1996 (File No.
0-19024)
10(e)* Amended and Restated Non-Qualified Filed herein
Stock Option Plan for Key Employees
10(f)* Second Amended and Restated 1999 Non- Filed herein
Qualified Stock Option Plan for Key
Employees
10(g)* Employment Agreement for Stephen A. Incorporated herein by reference to
Sasser Exhibit 10(b) to Registrant's Quarterly
Report Form 10-Q for the fiscal quarter
ended March 31, 1996 (File No. 0-19024)
10(h)* Amendment to Employment Agreement for Incorporated herein by reference to
Stephen A. Sasser Exhibit 10(p) to Registrant's Annual
Report on Form 10-K for the fiscal year
ended June 30, 1999 (File No. 0-19024)
10(i)* Second Amendment to Employment Incorporated herein by reference to
Agreement for Stephen A. Sasser Exhibit 10(q) to Registrant's Annual
Report on Form 10-K for the fiscal year
ended June 30, 1999 (File No. 0-19024)
</Table>
69
<Table>
<Caption>
EXHIBIT NO. DESCRIPTION PAGE
- ----------- --------------------------------------- ---------------------------------------
10(j)* Stock Option Agreement between the Incorporated herein by reference to
Registrant and Stephen A. Sasser dated Exhibit 10(c) to Registrant's Quarterly
January 17, 1996 Report on Form 10-Q for the fiscal
quarter ended March 31, 1996 (File No.
0-19024)
10(k) Employee Stock Purchase Plan, as Incorporated herein by reference to
amended on November 11, 1998 Exhibit 10(a)(a) to Registrant's Annual
Report on Form 10-K for the fiscal year
ended June 30, 2000 (File No. 0-19024)
10(l) Loan and Security Agreement, by and Incorporated by reference to Exhibit
among the Registrant and certain of its 10(u) to Registrant's Annual Report on
affiliates, as Borrowers, and the Form 10-K for the fiscal year ended
Lenders signatory thereto, as Lenders, June 30, 2001 (File No. 0-19024)
and Foothill Capital Corporation, as
Arranger and Administrative Agent
10(m) First Amendment to Loan and Security Incorporated herein by reference to
Agreement Exhibit 10(a) to Registrant's Quarterly
Report on Form 10-Q for the fiscal
quarter ended December 31, 2001 (File
No. 0-19024)
10(o) Second Amendment to Loan and Security Filed herein
Agreement
10(p) Third Amendment to Loan and Security Filed herein
Agreement
10(q) Fourth Amendment to Loan and Security Filed herein
Agreement
10(r) Fifth Amendment to Loan and Security Filed herein
Agreement
10(s) Sixth Amendment to Loan and Security Filed herein
Agreement
10(t) Registration Rights Agreement, dated Incorporated herein by reference to
July 17, 2001, by and between the Exhibit 4(h) to Registrant's Annual
Registrant and Foothill Capital Report on Form 10-K for the fiscal year
Corporation ended June 30, 2001 (File No. 0-19024)
10(u) Pledge and Security Agreement Incorporated herein by reference to
(Foreign), date July 17, 2001, made by Exhibit 10(x) to Registrant's Annual
the Registrant and Frontstep Solutions Report on Form 10-K for the fiscal year
Group, Inc., in favor of Foothill ended June 30, 2001 (File No. 0-19024)
Capital Corporation, as agent for
certain Lenders
10(v) Pledge and Security Agreement Incorporated herein by reference to
(Domestic), dated July 17, 2001, made Exhibit 10(y) to Registrant's Annual
by the Registrant and Frontstep Report on Form 10-K for the fiscal year
Solutions Group, Inc., in favor of ended June 30, 2001 (File No. 0-19024)
Foothill Capital Corporation, as agent
for certain Lenders
10(w) Copyright Security Agreement, dated Incorporated herein by reference to
July 17, 2000, made by the Registrant Exhibit 10(z) to Registrant's Annual
and certain of its affiliates, in favor Report on Form 10-K for the fiscal year
of Foothill Capital Corporation, as ended June 30, 2001 (File No. 0-19024)
agent for certain Lenders
10(x) Trademark Security Agreement, dated Incorporated herein by reference to
July 17, 2001, made by the Registrant Exhibit 10(a)(a) to Registrant's Annual
and certain of its affiliates, in favor Report on Form 10-K for the fiscal year
of Foothill Capital Corporation, as ended June 30, 2001 (File No. 0-19024)
agent for certain Lenders
10(y) Intercompany Subordination Agreement, Incorporated herein by reference to
dated July 17, 2001, made among the Exhibit 10(a)(b) to Registrant's Annual
Registrant, certain of its affiliates Report on Form 10-K for the fiscal year
and Foothill Capital Corporation, as ended June 30, 2001 (File No. 0-19024)
agent for certain Lenders
</Table>
70
<Table>
<Caption>
EXHIBIT NO. DESCRIPTION PAGE
- ----------- --------------------------------------- ---------------------------------------
10(z) Securities Purchase Agreement, dated as Incorporated herein by reference to
of May 10, 2000, between the Registrant Exhibit 10(a) to Registrant's Quarterly
and the Investors identified therein Report on Form 10-Q for the fiscal
quarter ended March 31, 2000 (File No.
0-19024)
10(a)(a) Amended and Restated Investor Rights Incorporated herein by reference to
Agreement, dated March 7, 2002, among Exhibit 4(a) to Registrant's Current
the Registrant, the Investors Report on Form 8-K, as filed with the
identified therein and Lawrence J. Fox Securities and Exchange Commission on
March 11, 2002 (File No. 0-19024)
10(a)(b) Warrant for the Purchase of Shares of Incorporated herein by reference to
Common Stock of the Registrant issued Exhibit 4(e) to the Registrant's Annual
to Morgan Stanley Dean Witter Venture Report on Form 10-K for the fiscal year
Partners IV, L.P. and Exhibit A, ended June 30, 2001 (File No. 0-19024)
identifying other identical warrants
issued to the Investors identified on
Exhibit A, for the number of common
shares identified on Exhibit A, on the
dates indicated
10(a)(c) Assignment and Assumption Agreement, by Incorporated herein by reference to
and between Morgan Stanley Dean Witter Exhibit 4(g) to Registrant's Quarterly
Equity Funding, Inc. and the Report on Form 10-Q for the fiscal
Originators Investment Plan, L.P., quarter ended December 31, 2000 (File
dated November 24, 2000 No. 0-19024)
10(a)(d) Securities Purchase Agreement dated as Incorporated herein by reference to
of March 7, 2002 by and between the Exhibit 10 to Registrant's Current
Registrant and the Investors named Report on Form 8-K, as filed with the
therein Securities and Exchange Commission on
March 11, 2002 (File No. 0-19024)
10(a)(e) Amendment Number One to Securities Incorporated herein by reference to
Purchase Agreement dated as of July 9, Exhibit 10 to Registrant's Current
2002 Report on Form 8-K, as filed with the
Securities and Exchange Commission on
July 15, 2002 (File No. 0-19024)
10(a)(f)* Form of Severance Agreement with Filed herein
Executive Officers
21 Subsidiaries of the Registrant Filed herein
23 Consents of Independent Auditors Filed herein
24 Powers of Attorney Filed herein
99(a) Certificates of Chief Executive Officer Filed herein
and Chief Financial Officer pursuant to
Title 18, United States Code, Section
1350, as adopted pursuant to Section
906 of the Sarbanes-Oxley Act of 2002
</Table>
- ---------------
* Indicates management contracts or compensatory plans or arrangements that are
required to be filed as an exhibit to this Annual Report on Form 10-K for the
fiscal year ended June 30, 2002
(b) There were no reports on Form 8-K filed during the three months ended
June 30, 2002.
71
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, on the 30th day of
September, 2002.
FRONTSTEP, INC.
By: /s/ STEPHEN A. SASSER
------------------------------------
Stephen A. Sasser
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities indicated, on the 30th day of September, 2002.
<Table>
<Caption>
SIGNATURE TITLE
--------- -----
* Chairman of the Board and Director
- ---------------------------------------------------
Lawrence J. Fox
* President, Chief Executive Officer and Director
- ---------------------------------------------------
Stephen A. Sasser
* Vice President, Finance, Chief Financial Officer
- --------------------------------------------------- and Secretary Principal Financial and Accounting
Daniel P. Buettin Officer
* Director
- ---------------------------------------------------
Duke W. Thomas
* Director
- ---------------------------------------------------
James A. Rutherford
* Director
- ---------------------------------------------------
Roger D. Blackwell
* Director
- ---------------------------------------------------
Guy L. de Chazal
* Director
- ---------------------------------------------------
Barry M. Goldsmith
* Director
- ---------------------------------------------------
A. Zuheir Sofia
*By Power of Attorney
/s/ DANIEL P. BUETTIN
- ---------------------------------------------------
Daniel P. Buettin (Attorney-in-Fact)
</Table>
72
CERTIFICATIONS
I, Stephen A. Sasser, certify that:
1. I have reviewed this report on Form 10-K of Frontstep, Inc.;
2. Based on my knowledge, this 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 annual report; and
3. Based on my knowledge, the financial statements, and other
financial information included in this annual 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
annual report.
Date: September 30, 2002
By: /s/ STEPHEN A. SASSER
------------------------------------
Stephen A. Sasser
President and Chief Executive
Officer
I, Daniel P. Buettin, certify that:
1. I have reviewed this report on Form 10-K of Frontstep, Inc.;
2. Based on my knowledge, this 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 annual report; and
3. Based on my knowledge, the financial statements, and other
financial information included in this annual 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
annual report.
Date: September 30, 2002
By: /s/ DANIEL P. BUETTIN
------------------------------------
Daniel P. Buettin
Vice President, Finance, Chief
Financial Officer and Secretary,
Principal Financial and Accounting
Officer
73