1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K (Mark one) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the fiscal year ended December 31, 1997 or [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from __________ to ___________ COMMISSION FILE NUMBER: 0-21541 BITSTREAM INC. -------------- (Exact name of registrant as specified in its charter) DELAWARE 04-2744890 -------- ---------- (State or other jurisdiction of incorporation or organization) (I.R.S. Employer Identification No.) 215 FIRST STREET CAMBRIDGE, MASSACHUSETTS 02142 ------------------------ ----- (Address of principal executive offices) (Zip Code) (617) 497-6222 -------------- (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(g) of the Act: Class A Common Stock, par value $.01 per share Not Applicable --------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) 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 (ss. 229.405 of this chapter) is 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. [ ] The aggregate market value of voting stock held by non-affiliates of the Registrant as of March 23, 1998 was approximately $11.9 million. On March 23, 1998, there were 6,625,440 shares of Class A Common Stock, par value $0.01 per share, and no shares of Class B Common Stock, par value $0.01 per share, outstanding. DOCUMENTS INCORPORATED BY REFERENCE Portions of the Registrant's definitive proxy statement for the 1998 Annual Meeting of Stockholders, to be filed with the Securities and Exchange Commission, are incorporated by reference into Part III of this Annual Report on Form 10-K. 1 2 INDEX PAGE NUMBERS ------- PART I. ITEM 1. BUSINESS............................................................. 3 ITEM 2. PROPERTIES........................................................... 10 ITEM 3. LEGAL PROCEEDINGS.................................................... 10 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.................. 11 PART II. ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS................................................ 12 ITEM 6. SELECTED FINANCIAL DATA.............................................. 13 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.............................................. 14 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.......................... 18 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE........................................... 18 PART III. ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT................... 18 ITEM 11. EXECUTIVE COMPENSATION............................................... 19 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT......................................................... 19 ITEM 13. CERTAIN REALTIONSHIPS AND RELATED TRANSACTIONS....................... 19 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K...... 19 SIGNATURES............................................................... 22 2 3 PART I ITEM 1. BUSINESS GENERAL Bitstream Inc. ("Bitstream" or the "Company") develops, markets and supports software products and technologies to enhance the creation, management and transport of electronic documents. The Company is organized into two operating divisions. The Type and Technology division primarily licenses its products, including text imaging and page layout technologies, to original equipment manufacturers ("OEMs") and independent software vendors ("ISVs") for inclusion in their output devices, embedded systems, applications, Internet authoring tools, World Wide Web browsers and other products. The Archetype Applications division develops server-based publishing applications that are sold to publishers, advertising agencies, and other major corporations. The Company's products and technologies consist of: (i) MediaBank, a digital asset management product that allows for the cataloging, archiving, and management of electronic images, text and documents; (ii) InterSep OPI and InterSep Output Manager, advanced open prepress interface and print management for clients working with raster image processors and servers; (iii) NuDoc, an advanced document composition technology; (iv) type products, such as libraries of type designs (fonts) and custom type products; (v) enabling technologies, which deliver typographic capabilities to hardware output devices and software applications; and (vi) TrueDoc(R), a portable type technology providing for the efficient distribution of text, with fidelity, in a highly compact format. Bitstream was founded in 1981 as a digital type supplier to computer hardware and software developers. The Company's library of type products is used by OEMs, ISVs and end users around the world in the creation of electronic documents. The Company was also an early developer of typographic enabling software for hardware and software developers. Its font processor products are used to provide type scaling functionality to operating systems, network servers and a wide variety of computer printers and other output devices. The Company has focused its product development and marketing efforts on technology solutions that address the font-related issues of document creation and portability in the Internet and corporate intranets. In January 1997, the Company purchased substantially all of the assets of Mainstream Software Solutions Ltd., a corporation organized under the laws of England primarily engaged in the business of marketing, selling, distributing and supporting Bitstream type products in the United Kingdom. As a result, Bitstream directly distributes its own products in the United Kingdom. In April 1997, the Company acquired Archetype, Inc. ("Archetype"), a Delaware corporation primarily engaged in the business of developing and marketing server-based information management computer software for the graphic arts industry. Archetype was founded in 1985 to develop page layout technology to capture the look of a document in a digital "archetype". In 1991, Archetype built up a Value Added Reseller ("VAR") distributed product line for sale primarily to end users. Archetype's first product was InterSep(TM), an advanced open prepress interface and print management products for raster image processors and servers. In late 1995, Archetype introduced its second product, MediaBank(TM), a digital asset management product that allows for the cataloging, archiving, and management of electronic images, text and documents. INDUSTRY BACKGROUND Type Industry The rapid growth in the use of personal computers, advanced software applications and laser printers has dramatically transformed the document creation, production and distribution process, giving rise to the widespread use of word processing and desktop publishing applications. Underlying the growth in word processing and desktop publishing were enabling technologies such as page description languages, printer control languages and outline font technologies. Adobe Systems Corporation's PostScript Type One format ("Type One"), the original outline font technology, gained acceptance among graphic artists and the high-end electronic publishing market due to the technology's close links to high-resolution output devices used in service bureaus and publishing houses. TrueType was developed by Apple Computer, Inc. ("Apple") as an alternative outline font technology to Type One and is integrated into the Windows and Macintosh operating systems. While capable of producing high-quality printed images and documents, these technologies were designed to operate as part of stand-alone systems. As a result, users were required to invest in expensive hardware and software combinations to enable competing technologies to co-exist and work together in the same environment. The problems presented by such competing standards have been further complicated by the adoption of multi-vendor client/server network architectures and the advent of new distribution media, including the Internet, corporate intranets, and new classes of information appliances. 3 4 The increased use of distributed client/server network architectures in the 1990s has resulted in complex computing environments comprised of mixed operating systems and multiple networking protocols. To create, transport, view and print text-based digital information in such an environment, while preserving the appearance intended by the document's author, each individual computer must have resident on it specific font software and hardware drivers to display or print the document as the author intended. If a user's system should lack a particular typeface used by the author or attempt to output a document to a device that differs from the device on which the document was originally created, the user's end-product often lacks the appearance intended by the creator. For example, if an output device prints a document with a font used in substitution of the author's original font, a complete loss of original pagination or formatting within the document can often result. Such a result would make it difficult, if not impossible, for multiple users to review and comment collaboratively on the same document. Difficulties in retaining text integrity can be further complicated when users try to incorporate non-Latin fonts such as Kanji, Greek or Hebrew, because font substitution for non-Latin fonts is typically not available in most operating systems and output devices. Currently, techniques used to present text and graphics are based on existing desktop publishing technologies and, when used in new distribution media, often result in a loss of visual integrity, degraded system performance, or both. To efficiently deliver digital information that retains the author's intended visual impression, computer systems must utilize enabling technologies that reduce file size, minimize bandwidth consumption and operate reliably across heterogeneous computing environments. Publishing Industry The worldwide publishing industry is undergoing significant change in response to competitive pressures. Publishers of newspapers and magazines are consolidating into larger organizations with multiple titles, formats and geographic locations. Publishing enterprises are also facing competition from alternative publishing on new media such as the Internet. Increased competition for subscribers has resulted in a trend toward more demographically targeted editorial, feature and advertising content. As a result, publishers are beginning to view their content assets, such as photos, graphics, illustrations, text and captions, as key competitive differentiators. Publishers are seeking ways to improve the management and utilization of that content both within their organizations and with their customers, while continuing to meet demanding time schedules and reduce costs. Traditionally, publishers used highly labor-intensive systems for production of printed materials, such as manual typesetting. As computer technology evolved during the 1960's and 1970's, publishers invested in mainframe-based computer equipment which automated and emulated these traditional production processes. Mainframe systems shortened the production process but were expensive, difficult to access, inflexible to use and required significant training, support and service. These limitations were addressed by the widespread adoption during the late 1980's of PC-based solutions for desktop publishing that were cost-effective, easy to use and highly flexible. For the first time, personnel across the editorial and production process could use software to perform typesetting and page-making functions at the desktop, bringing reporters, writers and editors closer to the final, printed product. This software also enabled users outside the traditional publishing industry to publish and distribute high-quality printed materials in-house. THE BITSTREAM SOLUTION Bitstream products and technologies enhance the creation, management and transport of electronic documents. These products and technologies create, view, transport and print documents without regard to the specific computing platforms, operating systems or resident applications used to create or view the original document. The Company's enabling technologies including TrueDoc allow text-based digital information to maintain its intended appearance in any computing environment. Bitstream's enabling technologies and its TrueDoc portable type technology allow OEMs and ISVs to embed compact, portable type information into output devices, embedded systems, applications, Internet authoring tools, World Wide Web browsers and other products. The Company's application products provide innovative solutions for accelerating prepress and Internet publishing through advanced information object management. The Company's products decrease production costs by organizing files on the network and tracking jobs and page elements. STRATEGY Bitstream's goal is to become the leading supplier of enabling technologies and portable document products for the creation, transport, viewing and printing of electronic documents. Key elements of the Company's strategy include the following: 4 5 Maintain Technology Leadership. Since its founding over 15 years ago, Bitstream has played a leading role in the development of industry-standard type products and enabling technologies (e.g. font processing software). Bitstream has been actively developing font portability and compaction technology. The Company has built substantial expertise in digital type design and production, technical font formats, and font portability and compression software. Bitstream intends to continue to develop or acquire technology to support its leadership position in these areas. Expand OEM, ISV and VAR Distribution Channels. During 1997, the Company concentrated its efforts on the development and sale of technology and products to OEM and ISV customers and through Value Added Resellers (VARs). The Company believes that marketing to OEMs and ISVs and distributing its application products through VARs provides it with the opportunity to build a base of revenue and to minimize production, marketing and inventory costs. The Company plans to continue to place significant emphasis on building its OEM and ISV customer base and expanding its VAR channel. Extend Technology to New Markets. The Company believes that certain features of its products such as their small file and application size, high typographic quality, performance, system scalability and cross-platform portability will facilitate their adaptation to new and emerging markets. These markets include the Internet, corporate intranets, embedded systems, multi-function devices (e.g. combined printer/fax/copiers) and information appliances. Bitstream is currently developing, adapting and marketing its enabling technologies and type products to third parties whose products address these new and developing markets. Support Industry Standards. Bitstream's products and technologies have been designed to support existing technological and typographic standards, such as Hypertext Markup Language ("HTML"), Standard Generalized Markup Language ("SGML"), UNICODE, TrueType and Type One, and to be embedded within full-featured products produced by OEMs and ISVs. The Company's products have also been designed to function in multi-platform computing environments, including Windows, UNIX and Macintosh, OS/9 and Java. The Company plans to continue to promote the use of its products in multivendor configurations and is a member of the World Wide Web Consortium (W3C) and the Unicode Consortium. PRODUCTS The Company's products and technologies consist of (i) MediaBank, a digital asset management product that allows for the cataloging, archiving, and management of electronic images, text and documents; (ii) InterSep OPI and InterSep Output Manager, advanced open prepress interface and print management products for raster image processors and servers; (iii) NuDoc(TM), an advanced document composition technology; (iv) type products, such as libraries of type designs (fonts) and custom type products; (v) enabling technologies, which deliver typographic capabilities to hardware output devices and software applications; and (vi) TrueDoc, a portable type technology providing for the efficient distribution of text, with fidelity, in a highly compact format. Each of the Company's major products and technologies is described in greater detail below. MediaBank and MediaBank Enterprise MediaBank is a server-based information and media asset management package that archives and tracks images, pages, text, and multi-media files on a network. It provides all members of a publishing or print production workgroup permissioned access to any job or job elements regardless of whether they have been archived or are still in process. The software package consists of the server application which can be configured for five or more users and client software which allows users to browse the database from Macintosh or Windows platforms. It also offers a wide range of compatibility with server platforms such as Windows NT, Sun, RS/6000, Silicon Graphics, and Apple Network Servers. MediaBank Enterprise, expected to be released in 1998, is an enhanced version of MediaBank that will run as an application server on a choice of high-end, enterprise-level databases such as Microsoft SQL server or Oracle. InterSep OPI and InterSep Output Manager InterSep OPI Server is an advanced Open Prepress Interface and print manager. It offers the acceleration of OPI processing, freeing up MacOS and Windows workstations. InterSep Output Manager is a desktop print queue manager focused on the effective coordination of PostScript output. It displays queues, output devices and print status information on Mac or Windows client workstations in an easy to learn graphical display. 5 6 NuDoc NuDoc is an advanced document composition engine. Leveraging object-oriented technology, NuDoc is a reusable building block for document processing applications. NuDoc SDK object classes provide an Application Programming Interface (API) that supports the import, editing, display, or printing of electronic documents. One of the strengths of NuDoc is its ability to dynamically create layout intensive pages from separate content and style file imports. In NuDoc, a document object is made of style, content, and page layout sub-objects. A style object contains rules that govern the form (or appearance) of the document. Content elements such as words, images, movies, etc. are organized into a tagged tree structure that represents the logical organization of the information (sections, sub-sections, etc.). The W3C's extensible markup language (XML) is the default content data representation. Styles are represented by a set of model objects. NuDoc uses a new style file format called Template Style Language (TSL) to represent the model objects. The TSL styles describe the colors, fonts, and geometric rules that govern how structured content is formatted into its visual appearance. The TSL uses a flexible container metaphor to describe how to adjust the sizes and positions of text, images, and other containers to result in a well designed page. Type Products Bitstream has developed a library of over 1,400 digital typefaces deliverable in industry-standard font formats (such as TrueType or Type One). Approximately 1,200 of these typefaces are for use with English or other western European language-based computer systems. This large number of typefaces is necessary to support OEMs and ISVs focused on the graphic arts market, who are accustomed to having a wide variety of type designs to choose from. The remainder of the Company's type designs are non-western language typefaces such as Kanji, Greek, Chinese, Korean, Russian, Hebrew and Arabic that are marketed only to OEM and ISV customers. In addition to typefaces, the Company also offers custom type services to its customers. Depending on the needs of the client, the Company can digitize corporate logos, modify existing typeface designs, add special characters to typefaces and create new typefaces. The Company's custom type services are marketed to its OEM, ISV and large corporate customers. Bitstream has developed its own proprietary type product design software tools. These tools enable the Company's type product engineers to develop and expand the Company's library of type products and to generate custom type products in an efficient and cost-effective manner. By using its own tools, Bitstream can largely avoid licensing or paying royalties for the use of third party development tools. In addition, the Company believes that its design tools improve its competitive position in the marketplace by assisting the Company in adapting its products rapidly to the specific requirements of its customers. Enabling Technologies The Company's enabling technologies consist of font processors (also known as type scalers or rasterizers) in a modular architecture that provide OEM and ISV customers with a complete type processing subsystem for integration into their hardware or software products. Font processors are a necessary component in laser printers and operating systems because they interpret type information stored within a document and generate the indicated characters in the required size and resolution as determined by the application, the output device or user-defined specifications. The modular architecture of the Company's "4-in-1" enabling technology provides software hooks to allow OEMs and ISVs to incorporate font scaling technologies into their products. The four font scaling technologies provided for are the two industry standard font formats (TrueType and Type One), the resident fonts used in Hewlett-Packard Company LaserJet laser printers, and a Bitstream TrueDoc-based type rasterizer that processes Bitstream-supplied resident font sets. In addition, this 4-in-1 architecture includes software that routes incoming typeface data to the appropriate processor, and prepares the final rasterized characters for imaging by an output device or computer screen. The Company markets this technology under the name "Bitstream 4-in-1 TrueDoc Imaging System." Font Navigator(TM) is a powerful font management tool that allows users a quick and easy way to find, install, and organize fonts into manageable groups. This tool also features a way to view and print font samples. TrueDoc TrueDoc is a portable type compaction technology designed for the distribution of electronic text based information. OEMs and ISVs license and incorporate TrueDoc into their document creation and viewing products to achieve the reliable, compact and efficient recording, transport, viewing and printing of typographic information regardless of whether the fonts used for the original 6 7 creation of the document are resident on the recipient's system. TrueDoc has been engineered to be small in file and application size, to comply with all industry font standards, and to be cross-platform compatible. TrueDoc is composed of two main software components. The TrueDoc Character Shape Recorder, approximately 75 kilobytes in size, captures character shapes from a font processor, such as TrueType or Type One, and creates a portable font resource ("PFR") that is transportable across networks or the Internet. TrueDoc's Character Shape Player, approximately 65 kilobytes in size, recreates the type shapes stored in the PFR and displays the text in a manner that maintains the integrity of the original type shapes. The Company believes that TrueDoc's small file size and efficient playback capabilities present advantages in applications where limitations on bandwidth and memory are significant factors. Bitstream JET Java-based Extendible Typography (Bitstream JET(TM)) is a complete outline font scaling and rasterization solution for Java applets, applications, and information. Using Bitstream JET Java programs will have access to a rich diversity of fonts without having to rely on native methods or extension APIs. In developing Bitstream JET, Bitstream completely redesigned the scaling and rasterizing of outline fonts. The resulting object-oriented architecture modularizes these two processes so that new capabilities can be plugged in. Bitstream JET works with TrueType(R) and Postscript(TM) Type 1 fonts via Bitstream's TrueDoc technology. Direct font format rendering (including OpenType) is planned for future releases. Future Products The Company has identified other emerging and complementary areas for which it believes its products will be well suited. Bitstream is currently developing products to enhance the performance of text-based document creation, transport, viewing and printing within such markets. Products under development and future markets being addressed include: - - TrueDoc-based utilities for the graphic arts market that address font portability issues in the electronic delivery of desktop publishing documents. - - Type products, enabling technologies and versions of TrueDoc for integration into new products and applications such as set-top boxes, personal digital assistants and other information applications based on new programming languages or operating systems. - - PageFlex(TM), which is expected to be released in late 1998, is a variable data front-end solution for driving digital presses built from modular components and open standards. It is the first solution to use XML as the intermediate data format between databases and the page composition process. The output formatter is based on Bitstream's NuDoc page composition engine. NuDoc offers control over the graphic design of page templates while maintaining a strict separation of form from the input XML content. MARKETING AND SALES The principal objective of the Company's marketing strategy is to continue to expand the sale of (a) the Company's type products and software to OEMs and ISVs who integrate the Company's software into their own products and (b) the Company's application software to end users through its VAR channel. OEM and ISV relationships range from the license of a small group of typefaces to agreements whereby an entire range of type products and/or technologies are incorporated into the customer's hardware or software products. As new opportunities arise, particularly in the newly emerging areas of corporate intranets and portable document software, the Company intends to evaluate other marketing approaches. The Company's Type and Technology sales organization, as of March 23, 1998, consisted of 13 people focused on OEM and ISV sales and four people focused on corporate direct sales. The Company's Archetype Applications sales organization, consisted of seven people focused on sales through the Company's VAR channel. The Company's sales efforts are managed from its corporate headquarters in Cambridge, Massachusetts. In addition, the Company maintains a European sales headquarters in Amsterdam, The Netherlands and sales offices in San Mateo, California, Reading, England and Cheltenham, England. Finally, the Company has a sales agent based in Tokyo to facilitate OEM sales to Japanese hardware manufacturers. The Company's sales personnel receive a base salary plus commissions based on meeting annual sales targets, with additional commissions for sales in excess of annual targets. 7 8 The Company seeks to enhance its relationships with existing customers through its 11 person training and technical support team that works with customers or prospects to support sales and to facilitate the implementation and use of the Company's software products and technologies. Marketing activities are carried out by a team of nine people located at the Company's headquarters in Cambridge, Massachusetts. In addition, the Company promotes its products through attendance and exhibition at major industry trade shows. CUSTOMERS The Company licenses type products, enabling technologies and TrueDoc to a wide variety of OEM and ISV customers. The Company sells custom and other type products directly to corporate customers. The Company licenses its application products to publishers, advertising agencies, retailers, printers, service bureaus and other major corporations. No single Bitstream customer accounted for 10% or more of the Company's revenues for the year ended December 31, 1997. From time to time, product sales to large customers during a single fiscal quarter may constitute more than 10% of Company revenues for such quarter. In the future, the Company intends to broaden its customer base through expanded product offerings and increased marketing efforts within the OEM/ISV, corporate and VAR channels. The Company's major customers, which are representative of the various industry groups served by the Company, include those listed below. OEMS AND ISVS --------------------------------------------------------------------------------------------------------------- Apple Computer, Inc. Corel Systems Corporation DaiNippon Screen Mfg. Co. Ltd. Digital Equipment Corporation Hewlett-Packard Company Kyocera Corp. Ricoh Company, Ltd. Seiko Epson Corporation Sharp Electronics Corporation Silicon Graphics, Inc. Sony Electronics Inc. Sun Microsystems, Inc. CORPORATE END USERS --------------------------------------------------------------------------------------------------------------- CNA Insurance Company Kemper Financial Services Price Waterhouse L.L.P. PUBLISHERS AND ADVERTISING AGENCIES --------------------------------------------------------------------------------------------------------------- MacMillan Publishing Reader's Digest Bronner, Slosberg and Humphrey CATALOGERS AND RETAILERS --------------------------------------------------------------------------------------------------------------- Ames Department Store Coupon Clipper The May Co. Cabela's J. Crew PRINTERS AND SERVICE BUREAUS --------------------------------------------------------------------------------------------------------------- Graphics Express Quebecor RR Donnelly RESEARCH AND PRODUCT DEVELOPMENT Bitstream is committed to developing innovative software to enhance electronic document creation, transport, viewing and printing. To accomplish this goal, the Company has invested, and expects to continue to invest, significant resources in research and development. The Company's research and development activities are centered around advancing the Company's software products for its OEM, ISV and corporate customers and advancing products and technologies developed by the Archetype Applications division for sale through its VAR channel. The Company maintains specific expertise in the areas of font formats, multi-lingual fonts, font portability, font compression and font processing technology, digital asset management, OPI server, composition and media technology. The Company emphasizes cross-platform portability, small file and application size and extensibility to new technologies in its software development. To support these design objectives, the Company employs advanced software development techniques. For example, the Company is developing software using the Java programming language to adapt its products to devices and software applications written to take advantage of Java's advanced structure and cross-platform portability. Java versions of TrueDoc in platform specific format are currently available for Windows and UNIX. While the Company had anticipated releasing a Java version of TrueDoc in late 1997, the Company decided it was in its best interest to redirect some of its research and development resources 8 9 toward the development of other products during 1997. The Company currently expects to have a Java version of TrueDoc that will work on all computing platforms available in late 1998. There can, however, be no assurance that such a version of TrueDoc will be completed in the late 1998, if at all. COMPETITION The markets in which the Company participates are intensely competitive, evolving and subject to rapid technological change. The Company expects competition to persist and increase in the future. The Company believes that while it competes with no single organization across its entire product line, a variety of companies offer products which compete some of its products. Certain of the Company's competitors, including Adobe Systems Corporation and Agfa Division, Miles Inc. ("Agfa"), have greater name recognition, a larger customer base and significantly greater financial, technical and marketing resources than the Company. The Company's products compete with the solutions offered by a variety of companies, including other suppliers of enabling technologies, software application developers, and vendors of computer operating systems. Moreover, the market for the Company's enabling technologies and products may be adversely impacted to the extent that computer hardware, operating system and application software vendors incorporate similar functionality or bundle competitive offerings with their products and thereby reduce the market for the Company's technology or products. The Company's markets are the subject of intense industry activity, and it is likely that a number of software developers are devoting significant resources to developing and marketing technology and products that may compete with the Company's technology and products. The competition for the Company's sales of type products to OEM and ISV customers generally comes from a number of comparably sized or smaller companies offering their own type libraries and custom type services. Competition to the Company's enabling technologies principally comes from Agfa with its Universal Font Scaling Technology ("UFST"). UFST has a similar architecture to the Company's 4-in-1 enabling technology product. The competition for TrueDoc consists primarily of software from Agfa, which includes a font compression technology known as MicroType Express. The competition for the Company's sales of its digital asset management software principally comes from Cascade Systems, Inc., the Publishing Group at Imation Enterprises Corp. and MediaManager Inc. The competition for the Company's OPI Server principally comes from the Publishing Group at Imation Enterprises Corp., Helios Design Laboratories and Xinet, Inc. The Company believes that the principal competitive factors affecting its market include product features and functionalities, such as scalability, ease of integration, ease of implementation, ease of use, quality, performance, price, customer service and support, and effectiveness of sales and marketing efforts. Although the Company believes that it currently competes effectively with respect to such factors, there can be no assurance that the Company will be able to maintain its competitive position against current and potential competitors. Future sales of the Company's products will depend upon the Company's ability to develop or acquire, on a timely basis, new products or enhanced versions of its existing products that compete successfully with products offered by developers of competing technologies. There can be no assurance that the Company will be able to compete successfully against current or future competitors or that competitive pressures faced by the Company will not materially adversely affect its business, financial condition and results of operations. INTELLECTUAL PROPERTY The Company relies on a combination of trade secret, copyright, patent, and trademark laws and contractual restrictions to establish and protect proprietary rights in its technology. The Company has entered into confidentiality and invention assignment agreements with its employees, and when obtainable, enters into non-disclosure agreements with its suppliers, distributors and others so as to limit access to and disclosure of its proprietary information. There can be no assurance that these statutory and contractual arrangements will prove sufficient to deter misappropriation of the Company's technologies or that the Company's competitors will not independently develop non-infringing technologies that are substantially similar to or superior to the Company's technology. The laws of certain foreign countries in which the Company's products are or may be developed, manufactured or licensed may not protect the Company's products or intellectual property rights to the same extent as do the laws of the United States and thus make the possibility of piracy of the Company's technology and products more likely. The Company believes that, because of the rapid pace of technological change in the software and electronic commerce markets, legal protection for its products will be a less significant factor in the Company's future success than the knowledge, ability and experience of the Company's employees, the frequency of product enhancements and the ability of the Company to satisfy its customers. 9 10 The Company's policy is to apply for U.S. patents with respect to its technology and seek copyright registration of its technology or trademark registration of its marks from time to time when management determines that it is competitively advantageous and cost effective to do so. The Company has been granted two patents and a third is pending before the United States Patent and Trademark Office and each is directed to certain aspects or applications of the Company's TrueDoc technology. Additionally, the Company has sought foreign patent rights to certain aspects of its TrueDoc technology by filing an International Application under the Patent Cooperation Treaty. EMPLOYEES As of March 23, 1998, the Company employed 102 persons, including 33 in sales and marketing, 48 in research and development and 21 in general administrative functions. Of the Company's 102 employees, 98 are full time and 4 are part time. The Company also retains consultants from time to time to assist it with particular projects for limited periods of time. The Company believes that its future success will depend in part on its ability to attract, motivate and retain highly qualified personnel. None of the Company's employees is represented by a labor union and the Company has not experienced any work stoppages. The Company considers its employee relations to be good. Bitstream(R) and TrueDoc(R) are federally registered trademarks of the Company. All other trademarks, service marks or tradenames referred to in this Annual Report are the property of their respective owners. ITEM 2. PROPERTIES The Company's corporate headquarters is located in Cambridge, Massachusetts where it currently leases approximately 27,500 square feet, of which approximately 17,200 square feet is under a lease expiring in October 1998, with the right to renew for an additional five years, and approximately 10,300 square feet is under a lease amendment expiring in October 2003. Management believes that these facilities are adequate for the Company's current needs and that suitable additional space, should it be needed, will be available to accommodate expansion of the Company's operations on commercially reasonable terms. ITEM 3. LEGAL PROCEEDINGS On May 26, 1995, The Friends of the Museum of Printing, Inc. (the "Museum") filed a lawsuit in the Middlesex County Superior Court of Massachusetts against the Company in connection with a letter agreement (the "Letter") dated July 23, 1992 from the Company to the Museum concerning storage of certain font materials for the Museum. The Letter provided that the Company would have no liability to the Museum, over and above the proceeds of insurance, for damage or loss of any of the font materials, and that neither the Company nor the Museum would incur any liability to the other for any loss or damage arising out of their respective rights and obligations set forth in the Letter. The Museum alleges that after the two-year storage period had expired, the Company disposed of the font materials and that such conduct by the Company breached the terms of the Letter and violated Chapter 93A of the Massachusetts General Laws, which provides, among other things, that persons found to have engaged in an unfair or deceptive act in the conduct of a trade or business may be liable for double or treble damages and attorney fees. The Museum further demanded an accounting of royalties the Museum claims are due from the Company for use of the font materials. On December 10, 1997, in consideration of a payment of $560,000 by the Company's insurance carrier, of which the Company contributed $56,000, the Museum formally released all claims it had against Bitstream in such lawsuit. The case was dismissed with prejudice by Bitstream and the Museum on December 30, 1997. On November 22, 1996, Mr. Robert S. Friedman, a former director and officer of the Company, and Mr. Gordon Greer, and Ms. Faith G. Friedman, as trustees of the Robert S. Friedman Family Trust, filed a lawsuit in the Middlesex County Superior Court of Massachusetts against the Company, asserting that the Company has breached certain obligations the plaintiffs allege are due to them under a separation agreement dated May 22, 1991 (the "Separation Agreement") between Mr. Friedman and the Company. The plaintiffs are seeking monetary damages from the Company based on their claim that, in connection with the 1994 recapitalization of the Company, the Company allegedly made adjustments to the stock and options of the officers of the Company and that a provision in the Separation Agreement entitled the plaintiffs to equivalent adjustments with respect to the stock and options of the Company held by them. The plaintiffs further allege that the breach by the Company resulted in a loss to them of stock and options valued at $2.2 million. The Company believes that these claims are without merit and intends to vigorously contest their validity. 10 11 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. EXECUTIVE OFFICERS OF THE COMPANY The Company's executive officers and their ages as of March 23, 1998 are as follows: NAME AGE POSITION - ----------------- --- ------------------------------------------------- Charles Ying 51 Chairman of the Board and Chief Executive Officer John S. Collins 58 Vice President, Engineering Wendy Darland 41 Vice President, Finance and Administration, and Chief Financial Officer Geoffrey W. Greve 40 Vice President, Product Development Susan Robertson 36 Vice President and General Manager, Archetype Applications Division John L. Seguin 43 Vice President and General Manager, Type and Technology Division Paul Trevithick 38 Vice President, Marketing - ---------- Charles Ying has been Chief Executive Officer of the Company since May 1997 and Chairman of the Board of Directors since April 1997. From January 1992 to January 1996, Mr. Ying served as Chief Executive Officer of Information International Inc., a corporation engaged in the business of designing, manufacturing and marketing computer-based systems that automate document production and publishing. Mr. Ying also serves as a member of the Board of Directors of NodeWarrior Networks Inc., an Internet Service Provider located in Los Angeles, California. Mr. Ying holds a B.S. and M.S. in Electrical Engineering from Massachusetts Institute of Technology. John S. Collins has been Vice President of Engineering since 1988. Mr. Collins has been employed by the Company since 1986. Mr. Collins was the inventor or a co-inventor in respect of a number of the patents held by the Company relating to font imaging technology. He is the principal inventor of the Company's TrueDoc technology. Mr. Collins holds a B.Sc. and a PhD in Electrical Engineering from the University of London. Wendy Darland has been Vice President, Finance and Administration, and Chief Financial Officer since September 1997. From September 1993 to August 1997, Ms. Darland served as President of Xitron Inc. ("Xitron"), a wholly-owned subsidiary of Autologic Information International Inc., a provider of high performance Rastor Image Processing Systems ("RIPs"), print servers and custom interfaces for the publishing industry. Prior to joining Xitron in September 1993, Ms. Darland was a consultant assisting entrepreneurs in business plan development and raising investment capital from October 1992 to August 1993. From September 1988 to October 1992, Ms. Darland served as Vice President, Finance and Administration, and Chief Financial Officer of Rastor Image Processing Systems Inc., a manufacturer of high performance RIPs for OEM manufacturers and end users. Ms. Darland holds a B.S. in Accounting from Arizona State University and a M.S. in Accounting from the University of Colorado at Denver. Ms. Darland is also a Certified Public Accountant in the State of Colorado. Geoffrey W. Greve has been Vice President, Product Development of the Company since February 1998. Mr. Greve has been employed by the Company since 1987 and previously served as Director of Production Control from 1990 through May 1995 and Vice President, Type Operations from May 1995 to February 1998. Susan Robertson has been Vice President and General Manager of the Archetype Applications Division since the Company's acquisition of Archetype, Inc. ("Archetype") in April 1997. Ms. Robertson was employed by Archetype since September 1987 and previously served as Executive Vice President from September 1994 to April 1997 and Chief Operating Officer from September 1995 to April 1997. She holds a Sc.B. in Computer Science from Brown University. John L. Seguin has been Vice President and General Manager of the Type and Technology Division since July 1997. From August 1994 to July 1997, Mr. Seguin served as Bitstream's Vice President, Sales and Marketing. From July 1993 through July 1994, Mr. Seguin served as Vice President and General Manager of XLI Corp., a corporation engaged in manufacturing printer 11 12 enhancements. From November 1987 through July 1993, he was employed by Howtek, Inc., a corporation engaged in manufacturing color imaging products, and most recently served as its Vice President, Sales and Marketing. Mr. Seguin holds a B.S. in Marketing from the University of Massachusetts at Dartmouth. Paul Trevithick has been Vice President, Marketing since the Company's acquisition of Archetype in April 1997. Mr. Trevithick founded and was President of Archetype since 1985. Mr. Trevithick holds a B.S.E.E. from the Massachusetts Institute of Technology. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS MARKET INFORMATION The Company's Class A Common Stock, $.01 par value per share ("Class A Common Stock"), began trading publicly on the Nasdaq National Market tier of The Nasdaq Stock Market on October 30, 1996 under the symbol "BITS." Prior to October 30, 1996, there was no public market for Bitstream's Class A Common Stock. The following table sets forth the high and low closing sale prices of the Company's Class A Common Stock as reported on the Nasdaq National Market for the period from January 1, 1997 through December 31, 1997. Such information reflects interdealer prices, without retail markup, markdown, or commission, and may not represent actual transactions. HIGH LOW ---- --- First Quarter 6 3/16 3 7/8 Second Quarter 4 3/8 2 1/2 Third Quarter 3 1 1/2 Fourth Quarter 2 3/4 1 5/8 As of March 23, 1998, the Company's Class A Common Stock was held by approximately 82 holders of record and the Company believes that the Company's Class A Common Stock was beneficially held by more than 500 holders. As of March 23, 1998, the Company's Class B Common Stock was not held by any holders of record. DIVIDENDS The Company has never declared or paid cash dividends on its capital stock. The Company currently intends to retain earnings, if any, to support its growth strategy and does not anticipate paying cash dividends on its capital stock in the foreseeable future. RECENT SALES OF UNREGISTERED SECURITIES During the fiscal year ended December 31, 1996, the Company issued an aggregate of 6,833 shares of Class A Common Stock in connection with the exercise of 6,833 vested options and warrants issued under the Company's 1994 Stock Plan. During the fiscal year ended December 31, 1997, the Company issued an aggregate of 648,217 shares of Class A Common Stock in connection with the exercise of 648,217 vested options and warrants issued under the Company's 1994 Stock Plan and 1996 Stock Plan. The sales and issuances of securities in the transactions described above were deemed to be exempt from registration under the Securities Act of 1933, as amended, by virtue of Rule 701 promulgated thereunder, in that they were issued either pursuant to written compensatory benefits plans or pursuant to a written contract relating to compensation, as provided by Rule 701. In addition, on September 30, 1997, the Company filed a Registration Statement on Form S-8 under the Securities Act of 1933, as amended, registering up to an aggregate of 3,500,000 shares of the Company's Class A Common Stock which may be issued upon exercise of stock options and warrants granted or which may be granted under the Company's 1997 Stock Plan, 1996 Stock Plan and 1994 Stock Plan. USE OF PROCEEDS As of December 31, 1997, the net proceeds of the Company's initial public offering (IPO) of its Class A Common Stock pursuant to its Registration Statement on Form S-1, Commission File No. 333-11519, declared effective October 30, 1996, have been used as follows: (i) approximately $200,000 for the buildout of Bitstream's leased facilities in Cambridge, Massachusetts to accommodate the additional personnel that joined the Company as result of the acquisition of Archetype; (ii) approximately $4,141,000 for the acquisition of Mainstream Software Solutions Ltd. and Archetype, Inc.; (iii) approximately $1,500,000 for the repayment of indebtedness, of which 12 13 approximately $548,000 was paid to officers, directors and 10% stockholders of the Company and approximately $762,000 of which was paid to third parties; (iv) approximately $404,000 for royalty payments to others; and (v) approximately $286,000 for the purchase and installation of equipment. The remaining net proceeds of the IPO remain invested in short-term, interest-bearing, investment-grade securities. ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA The selected consolidated financial data presented below as of and for the years ended December 31, 1997, 1996, and 1995, as of and for the three months ended December 31, 1995 and as of and for the year ended September 30, 1995 have been derived from, and are qualified by reference to the Company's audited consolidated financial statements included elsewhere herein. The selected consolidated financial data presented below as of and for the years ended September 30, 1994 and 1993 have been derived from, and are qualified by reference to, the Company's audited financial statements, which are not included herein. The selected consolidated statement of operations data for the three months ended December 31, 1994 have been derived from the unaudited consolidated financial statements of the Company, which are not included herein. In the opinion of management, the unaudited financial statements of the Company have been prepared on the same basis as the audited consolidated financial statements and include all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of financial position and results of operations for this period. The selected consolidated financial data set forth below should be read in conjunction with, and are qualified by reference to, the Consolidated Financial Statements of the Company and Notes thereto, and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Report, and other financial data appearing elsewhere herein. SELECTED CONSOLIDATED FINANCIAL DATA YEAR ENDED THREE MONTHS ENDED YEAR ENDED (In thousands except per share data) DECEMBER 31, DECEMBER 31, SEPTEMBER 30, ----------------------- --------------------- ------------------------------ 1997 1996 1995(1) 1994(1) 1995 1994 1993 ---------- ---------- ---------- ------- ----------- ------ ------- (UNAUDITED) Consolidated Statements of Operations Data: Revenues .................................... $ 13,102 $ 10,551 $ 2,355 $2,276 $ 8,970 $9,832 $17,430 Cost of revenues ............................ 1,518 1,858 411 273 1,579 2,299 6,276 ---------- ---------- ---------- ------ ----------- ------ ------- Gross profit .............................. 11,584 8,693 1,944 2,003 7,391 7,533 11,154 ---------- ---------- ---------- ------ ----------- ------ ------- Operating expenses: Marketing and selling ..................... 6,621 4,386 978 740 3,264 3,334 9,080 Research and development .................. 2,826 1,512 331 255 1,071 1,534 3,536 General and administrative ................ 2,104 1,533 385 266 1,261 1,281 3,006 Acquired in-process research and development 4,930 -- -- -- -- -- -- Severance and other nonrecurring compensation ............................ 1,371 -- -- -- -- -- -- Restructuring charge ...................... -- -- -- -- -- 365 ---------- ---------- ---------- ------ ----------- ------ ------- Total operating expenses ............... 17,852 7,431 1,694 1,261 5,596 6,514 15,622 Operating income (loss) ..................... (6,268) 1,262 250 742 1,795 1,019 (4,468) Other income (expense), net ................. 510 (19) 17 (2) 11 (40) (18) Provision for (benefit from) income taxes ... 232 (94) (471) 17 118 133 319 ---------- ---------- ---------- ------ ----------- ------ ------- Net income (loss) ........................... $ (5,990) $ 1,337 $ 738 $ 723 $ 1,688 $ 846 $(4,805) ========== ========== ========== ====== =========== ====== ======= Basic net income (loss) per share (2) ........ $ (0.95) $ 1.07 $ 2.36 $ 1.11 ========== ========== ========== ========== Basic weighted average shares outstanding (2) ........................... 6,303,216 1,248,118 312,677 1,518,138 ========== ========== ========== ========== Diluted net income (loss) per share (2) ..... $ (0.95) $ 0.25 $ 0.16 $ 0.31 ========== ========== ========== ========== Weighted average common shares outstanding and dilutive potential common shares (2) .. 6,303,216 5,404,351 4,729,976 5,008,850 ========== ========== ========== ========== (IN THOUSANDS) AS OF DECEMBER 31, AS OF SEPTEMBER 30, -------------------------------- ---------------------------------- 1997 1996 1995(1) 1995 1994 1993 ------------------------------------------------------------------------ Consolidated Balance Sheet Data: Cash and cash equivalents................... $ 6,364 $11,718 $ 390 $ 523 $ 654 $ 1,068 Working capital (deficit)................... 9,212 14,220 1,245 881 (920) (2,266) Total assets................................ 17,009 17,477 4,328 3,194 2,640 5,029 Long-term obligations....................... 73 99 210 124 125 17 Mandatorily redeemable convertible preferred stock ........................... -- -- -- -- 2,311 1,204 Stockholders' equity (deficit) ............. $12,683 $15,359 $1,806 $1,066 $ (3,041) $(2,803) - --------------------- (1) Effective December 31, 1995, the Company changed its fiscal year end from a fiscal year end of September 30 to a calendar year end. The fiscal year ended December 31, 1996 commenced January 1, 1996. Because of this change in fiscal year, the Company is presenting certain consolidated statement of operations data for the three months ended December 31, 1994 and December 31, 1995, as well as consolidated balance sheet data as of December 31, 1995. (2) Calculated on the basis described in Note 4 of Notes to the Consolidated Financial Statements. 13 14 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW The Company develops, markets and supports software products and technologies to enhance the creation, management and transport of electronic documents. The Company is organized into two operating divisions. The Type and Technology division primarily licenses its products, including text imaging and page layout technologies, to original equipment manufacturers ("OEMs") and independent software vendors ("ISVs") for inclusion in their output devices, embedded systems, applications, Internet authoring tools, World Wide Web browsers and other products. The Archetype Applications division develops server-based publishing applications that are sold to publishers, advertising agencies, and other major corporations. In January 1997, the Company purchased substantially all of the assets of Mainstream Software Solutions Ltd.("Mainstream"), a corporation organized under the laws of England primarily engaged in the business of marketing, selling, distributing and supporting the Company's type products in the United Kingdom, for approximately $505,000. As a result, the Company directly distributes its own products in the United Kingdom. The acquisition has been accounted for as a purchase and approximately $450,000 of goodwill was recorded. In April 1997, the Company acquired Archetype, Inc. ("Archetype" and together with Mainstream, the "Acquired Subsidiaries"), a Delaware corporation primarily engaged in the business of developing and marketing server-based information management computer software for the graphic arts industry. Archetype's products include: MediaBank, a digital asset management product that allows for the cataloging, archiving, and management of electronic images, text and documents; InterSep OPI and InterSep Output Manager, advanced open prepress interface and print management products for raster image processors and servers; and NuDoc, an advanced document composition technology. The merger was accounted for as a purchase, and accordingly, the purchase price has been allocated to the assets acquired. The operating results of Archetype have been included in the accompanying consolidated financial statements since the date of the acquisition. The Company derives revenues principally from the following sources: (i) licensing fees and royalty payments paid by OEM and ISV customers for text imaging and page layout technologies; (ii) direct and indirect sales of software publishing applications for the creation, enhancement, management, transport, viewing and printing of electronic information; (iii) direct sales of custom and other type products to end users such as graphic artists, desktop publishers and corporations; and (iv) sales of type products to foreign customers primarily through distributors. Royalty payments due from OEM and ISV customers, who generally pay specified minimums or fixed fees for the right to include the Company's products as a component of a larger product for a specified time period or volume limit, are generally recognized as revenue at the time the software is delivered to the OEM or ISV customer. If the royalty payments are to be received over a period of time greater than one year, the amount recognized is discounted to the present value of the future minimum payments. Certain OEM and ISV customers pay royalties only upon the sublicensing of the Company's products to end users. Royalties due from these OEM and ISV customers are recognized when such sublicenses are reported to the Company by the OEM or ISV customer. Revenues from sales to end users and foreign distributors are generally recognized at the time the software products are delivered to the customer. Cost of revenues is comprised of direct costs of licenses and royalties, as well as direct costs of product sales to end users. Included in cost of licenses and royalties are fees paid to third parties for the development or license of rights to technology and/or unique typeface designs and the costs incurred in the fulfillment of custom orders from OEM and ISV customers. Included in cost of product sales to end users and distributors are the direct costs associated with the duplication, packaging and shipping of products, and any royalty fees paid to third parties for rights to license typefaces. Operating expenses consist primarily of sales and marketing expenses (principally compensation and marketing programs), research and development expenses and general and administrative expenses. 14 15 Except for the historical information contained herein, this Annual Report on Form 10-K may contain forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Investors are cautioned that forward-looking statements are inherently uncertain. Actual performance and results of operations may differ materially from those projected or suggested in the forward-looking statements due to certain risks and uncertainties, including, without limitation, market acceptance of the Company's products, competition and the timely introduction of new products. Additional information concerning certain risks and uncertainties that would cause actual results to differ materially from those projected or suggested in the forward-looking statements is contained in the Company's filings with the Securities and Exchange Commission, including those risks and uncertainties discussed in the Company's final Prospectus, dated October 30, 1996, included as part of the Company's Registration Statement on Form S-1 (Commission File No. 333-11519), in the section entitled "Risk Factors." The forward-looking statements contained herein represent the Company's judgment as of the date of this report, and the Company cautions readers not to place undue reliance on such statements. RESULTS OF OPERATIONS The following table sets forth the percentage of revenues represented by certain items reflected in the Company's Statements of Operations Data for the periods presented. THREE MONTHS YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, SEPTEMBER 30, ------------------------ -------------- ------------- 1997 1996 1995 1995 ----- ----- ----- ----- Revenues........................ 100.0% 100.0% 100.0% 100.0% Cost of revenues................ 11.6 17.6 17.5 17.6 ----- ----- ----- ----- Gross profit.................. 88.4 82.4 82.5 82.4 ----- ----- ----- ----- Operating expenses: Marketing and selling......... 50.5 41.6 41.5 36.4 Research and development...... 21.6 14.3 14.1 11.9 General and administrative.... 16.1 14.5 16.4 14.0 Acquired in-process research and development 37.6 -- -- -- Severance and other nonrecurring compensation 10.5 -- -- -- ----- ----- ----- ----- Total operating expenses... 136.3 70.4 72.0 62.3 Operating income (loss)......... (47.9) 12.0 10.5 20.1 Other income (expense), net..... 3.9 (0.2) 0.8 -- ----- ----- ----- ----- Provision for (benefit from) income taxes 1.8 (0.9) (20.0) 1.3 ----- ----- ----- ----- Net income (loss)............... (45.7)% 12.7% 31.3% 18.8% ===== ===== ===== ===== YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996 Revenues. Revenues for the fiscal year ended December 31, 1997 increased by approximately $2.6 million, or 24.5%, to approximately $13.2 million compared to approximately $10.6 million for the fiscal year ended December 31, 1996. Revenues from product sales to OEM and ISV customers for the fiscal year ended December 31, 1997 increased by approximately $300,000, or 3.4%, to approximately $9.0 million, from approximately $8.7 million for the fiscal year ended December 31, 1996, as a result of an increase in the licensing of the Company's application products to OEM and ISV customers of the Company's Acquired Subsidiaries. Revenues from product sales to end users and distributors for the fiscal year ended December 31, 1997 increased by $2.2 million, or 122.2%, to $4.0 million, from $1.8 million for the fiscal year ended December 31, 1996, as a direct result of the revenues produced by the Company's Acquired Subsidiaries. Gross Profit. Gross profit for the fiscal year ended December 31, 1997 increased by approximately $2.9 million, or 33.3%, to approximately $11.6 million, compared to approximately $8.7 million for the fiscal year ended December 31, 1996. The increase in gross profit was primarily a result of the addition of the revenues of the Company's Acquired Subsidiaries as well as a decrease in third party royalties paid on type technologies. Marketing and Selling. Marketing and selling expenses for the fiscal year ended December 31, 1997 increased by approximately $2.2 million, or 50.0%, to approximately $6.6 million, compared to approximately $4.4 million for the fiscal year ended December 31, 1996 due to the addition of the sales, marketing and support programs of the Acquired Subsidiaries. 15 16 Research and Development. Research and development expenses for the fiscal year ended December 31, 1997 increased by approximately $1.3 million, or 86.7%, to approximately $2.8 million, compared to approximately $1.5 million for the fiscal year ended December 31, 1996. This increase reflects the costs associated with the addition of engineering personnel from Archetype to support the application products and the expanded development of the Company's enabling technologies. Research and development expenses consist primarily of personnel costs, consulting fees and fees paid for outside software development. The Company expects to increase research and development expenditures in absolute dollars in future periods to support development of current and future products and technologies. General and Administrative. General and administrative expenses for the fiscal year ended December 31, 1997 increased by approximately $600,000, or 40%, to approximately $2.1 million, compared to $1.5 million for the fiscal year ended December 31, 1996. This increase mainly reflects $334,000 of goodwill amortization related to the purchase of the Acquired Subsidiaries and an increase in professional fees of $249,000 for public filing requirements and litigation. General and administrative expenses principally consist of payroll costs to executives, office, MIS and accounting personnel, as well as outside professional fees and the amortization of goodwill of the Acquired Subsidiaries. Acquired In-Process Research and Development. In connection with the acquisition of Archetype, the Company allocated approximately $4.9 million of the purchase price to in-process research and development. The in-process research and development is related to Archetype projects that had not yet reached technological feasibility and that, until completion of the development, have no alternative future use. These projects were deemed to require substantial high risk development and testing by the Company prior to reaching technological feasibility which resulted in the determination to write-off the acquisition costs of these projects. Severance and Other Non-Recurring Expenses. Operating expenses for the twelve months ended December 31, 1997 reflect $1.4 million for severance and other non-recurring compensation expenses incurred in connection with the acquisition of Archetype and certain severance arrangements between the Company and certain executives. Accounts Receivable, Net of Allowance for Doubtful Accounts. Accounts receivable at December 31, 1997 was approximately $3.7 million as compared to approximately $1.6 million at December 31, 1996. This $2.1 million increase primarily includes the addition of the accounts receivable of the Acquired Subsidiaries in 1997 and the effect of a 1996 single significant multiyear sale which was paid earlier than standard terms within the same year. Other Income and Expense. In the year ended December 31, 1997, the Company recorded $510,000 of net interest income for investing cash balances acquired from the IPO. In the year ended December 31, 1996, the Company recorded net interest expense of $19,000. The Company recorded a tax provision for the year ended December 31, 1997 of $232,000. This provision consists mainly of foreign tax liabilities of $190,000 relating to sales to customers in Japan and minimum income tax provisions of $42,000. For the fiscal year ended December 31, 1996, the Company recorded a tax benefit of $94,000. YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED SEPTEMBER 30, 1995 Revenues. Revenues for the fiscal year ended December 31, 1996 increased by approximately $1.6 million, or 17.6%, to approximately $10.6 million, compared to approximately $9.0 million for the fiscal year ended September 30, 1995. Revenues from product sales to OEM and ISV customers for the fiscal year ended December 31, 1996 increased by approximately $2.4 million, or 38%, to approximately $8.7 million, from approximately $6.3 million for the fiscal year ended September 30, 1995, as a result of the continuing acceptance of the Company's type products and enabling technologies by OEM and ISV customers, as well as the license by additional OEM and ISV customers of the Company's TrueDoc technology. Revenues from product sales to end users and distributors for the fiscal year ended December 31, 1996 declined by $700,000, or 27%, to $1.9 million, from $2.6 million for the fiscal year ended September 30, 1995, as a result of the Company's withdrawal from the computer software reseller channel beginning in fiscal year 1993. Gross Profit. Gross profit for the fiscal year ended December 31, 1996 increased by approximately $1.3 million, or 17.6%, to approximately $8.7 million, compared to approximately $7.4 million for the fiscal year ended September 30, 1995. The increase in gross profit was due primarily to the increase in revenues. Gross profit as a percentage of revenues remained approximately the same for both fiscal years. 16 17 Marketing and Selling. Marketing and selling expenses for the fiscal year ended December 31, 1996 increased by approximately $1.1 million, or 33.3%, to approximately $4.4 million, compared to approximately $3.3 million for the fiscal year ended September 30, 1995, due to higher levels of sales commissions and higher levels of promotional activities in support of new product introductions. Research and Development. Research and development expenses for the fiscal year ended December 31, 1996 increased $441,000, or 41.2%, to approximately $1.5 million, compared to approximately $1.1 million for the fiscal year ended September 30, 1995. This increase reflects the costs associated with the addition of engineering personnel to support expanded development of the Company's enabling technologies. Research and development expenses consist primarily of personnel costs and fees paid for outside software development and consulting fees. The Company expects to increase research and development expenditures in absolute dollars in future periods to support development of current and future products and technologies. General and Administrative. General and administrative expenses for the fiscal year ended December 31, 1996 increased by $272,000, or 22%, to $1.5 million, compared to $1.3 million for the fiscal year ended September 30, 1995. General and administrative expenses principally consist of payroll costs to executives, office, MIS and accounting personnel, as well as outside professional fees. The Company expects to increase general and administrative expenses in absolute dollars in the future to support the Company's growth and infrastructure. The Company recorded a tax benefit for the year ended December 31, 1996 of $94,000. This benefit consisted of a reduction of the valuation allowance for deferred tax assets of $268,000, partially offset by a current tax provision of $174,000. The reduction to the valuation allowance is primarily based upon estimated future utilization of net operating loss carryforwards and federal tax credits. For the fiscal year ended September 30, 1995, the Company recorded a tax provision of $118,000, reflecting an effective tax rate of 6.5%. LIQUIDITY AND CAPITAL RESOURCES The Company has funded its operations primarily through the public and private sale of equity securities, cash flow from operations, and certain bank indebtedness. In November 1996, the Company completed an initial public offering ("IPO") of 2,415,000 shares of its Class A Common Stock. Net proceeds from the IPO were approximately $12.2 million, of which approximately $1.5 million was used to repay outstanding indebtedness. The Company's operating activities used cash of $477,000 for the year ended December 31, 1997 and provided cash of $487,000 for the year ended December 31, 1996. The Company's investing activities used cash of approximately $4.9 million for year ended December 31, 1997 and used cash of $866,000 for the year ended December 31, 1996. Investing activities for the year ended December 31, 1997 consisted of approximately $4.1 million used in the acquisition of businesses and $752,000 for the purchase of property and equipment to support the growing employee base and corporate infrastructure. For the year ended December 31, 1997, cash from financing activities was approximately $16,000. For the year ended December 31, 1996, cash from financing activities was approximately $11.7 million, including approximately $12.2 million from the net proceeds of the IPO. As of December 31, 1997, the Company had cash and cash equivalents of approximately $6.4 million, a decrease of approximately $5.3 million from $11.7 million at December 31, 1996 primarily attributable to cash paid in connection with the purchase of the Acquired Subsidiaries and increased accounts receivable. Working capital was approximately $9.2 million at December 31, 1997, as compared to approximately $14.2 million at December 31, 1996. On August 27, 1997, the Company amended its July 14, 1995 working capital line-of-credit agreement maturing on July 15, 1998 with a bank to provide for borrowings up to $2 million based on a percentage of qualified accounts receivable, as defined. This line bears interest at various per annum rates between the prime rate (8.5% as of December 31, 1997) plus 1% to 2%, as defined. As a component of this agreement, the Company can obtain up to $250,000 in letters of credit. Substantially all of the Company's assets are collateralized under this agreement. No balance was outstanding under this line as of December 31, 1997. The Company believes that the cash anticipated to be generated from operations and current cash balances will be sufficient to meet the Company's operating and capital requirements for at least the next 12 months. There can be no assurance, however, that the Company will not require 17 18 additional financing in the future. If the Company were required to obtain additional financing in the future, there can be no assurance that sources of capital will be available on terms favorable to the Company, if at all. The Company does not project significant capital expenditures for the year ending December 31, 1998. IMPACT OF YEAR 2000 ISSUE The Year 2000 issue results from computer programs that do not differentiate between the year 1900 and the year 2000 because they are written using two digits rather than four to define the applicable year. If not corrected, many computer applications could fail or create erroneous results by or at the year 2000. The Company is in the process of updating its accounting and information systems, where applicable, to ensure that its computer systems are Year 2000 compliant. In addition, the Company maintains a Year 2000 expert on its staff. The financial impact to the Company of its Year 2000 compliance programs has not been and is not anticipated to be material to its financial position or results of operations in any given year. While the Company does not believe it will suffer any major effects from the Year 2000 issue, it is possible that such effects could materially impact future financial results, or cause reported financial information not to be necessarily indicative of future operating results or future financial condition. RECENT DEVELOPMENTS On March 13, 1998, the Company made a $500,000 equity investment in DiamondSoft, Inc., a California corporation primarily engaged in the business of developing, marketing and distributing software tools to a variety of professional markets. This equity investment involved the purchase of 250,000 shares of DiamondSoft's Series A Convertible Preferred Stock, which represented twenty-five (25%) of the outstanding capital stock of Diamondsoft on an as converted basis, at a price of $2.00 per share. In addition, pursuant to a letter agreement with DiamondSoft dated March 17, 1998, the Company will market DiamondSoft's FontReserve software to hardware and software developers and DiamondSoft will license the Company's Font Navigator software to retailers and corporate users. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The index to Financial Statements appears on page F-1, the Independent Auditors' Report appears on page F-2, and the Financial Statements and Notes to Financial Statements appear on pages F-3 to F-21. ITEM 9. CHANGES AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Pursuant to General Instruction G(3) of Form 10-K and instruction 3 to Item 401(b), the information required by this item concerning executive officers, including certain information incorporated herein by reference to the information appearing in the Company's definitive Proxy Statement concerning Directors, is incorporated by reference to the sections entitled "Proposal No. 1 - - Election of Directors" and "Board of Directors" in the Registrant's definitive Proxy Statement for its Annual Meeting of Stockholders to be held June 9, 1998. Certain information with regard to the executive officers of the Company is contained in Item 4 hereof and is incorporated by reference in this Part III. There is incorporated herein by reference to the discussion under "Principal and Management Stockholders - Compliance with Section 16(a) of the Securities Exchange Act of 1934" in the Company's definitive Proxy Statement for its Annual Meeting of Stockholders to be held June 9, 1998, the information with respect to any delinquent filings of reports pursuant to Section 16(a) of the Securities Exchange Act of 1934. 18 19 ITEM 11. EXECUTIVE COMPENSATION Information required by this Item is incorporated herein by reference to the information appearing in the Company's definitive Proxy Statement for its Annual Meeting of Stockholders to be held on June 9, 1998 under the heading "Executive Compensation." ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT Information required by this item is incorporated herein by reference to the information appearing in the Company's definitive Proxy Statement for its Annual Meeting of Stockholders to be held on June 9, 1998 under the heading "Principal and Management Stockholders." ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Information required by this item is incorporated herein by reference to the information appearing in the Company's definitive Proxy Statement for its Annual Meeting of Stockholders to be held on June 9, 1998 under the heading "Certain Relationships and Related Transactions." PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K 1. Financial Statements. (a) The following documents are included as part of this report: (1) Financial Statements Report of Independent Public Accountants Consolidated Balance Sheets Consolidated Statements of Operations Consolidated Statements of Stockholders' Equity Consolidated Statements of Cash Flows Notes to Consolidated Financial Statements (2) Financial Statement Schedules None. (3) Exhibits. Certain of the exhibits listed hereunder have been previously filed with the Commission as exhibits to certain registration statements and periodic reports and are incorporated herein by reference pursuant to Rule 411 promulgated under the Securities Act and Rule 24 of the Commission's Rules of Practice. The location of each document so incorporated by reference is indicated in parenthesis. 3 CERTIFICATE OF INCORPORATION AND BYLAWS 3.1.1 Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 3.1.2 Certificate of Amendment to Restated Certificate of Incorporation of the Company (incorporated by reference to Exhibit 3.1.2 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996). 19 20 3.2 Bylaws of the Company (incorporated by reference to Exhibit 3.2 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 4 INSTRUMENTS DEFINING THE RIGHTS OF SECURITY HOLDERS 4.1 Specimen Common Stock Certificate (incorporated by reference to Exhibit 4.1 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10 MATERIAL CONTRACTS 10.1 1996 Stock Plan Certificate (incorporated by reference to Exhibit 10.1 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.2 1994 Stock Plan Certificate (incorporated by reference to Exhibit 10.2 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.3 Agreement and Plan of Recapitalization dated October 28, 1994 (incorporated by reference to Exhibit 10.3 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.4 Lease between Athenaeum Group and the Company dated March 17, 1992 (incorporated by reference to Exhibit 10.4 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.4.1 First Lease Amendment between Athenaeum Group and the Company dated September 7, 1993 (incorporated by reference to Exhibit 10.4.1 to the Company's Registration Statement filed on Form S-1, Registration No. 333-11519, on September 6, 1996). 10.4.2 Second Lease Amendment between Athenaeum Group and the Company dated July 13, 1994 (incorporated by reference to Exhibit 10.4.2 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.4.3 Third Lease Amendment between Athenaeum Group and the Company dated July 15, 1996 (incorporated by reference to Exhibit 10.4.3 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.4.4 Fourth Lease Amendment between Athenaeum Property LLC and the Company dated March 3, 1997 (incorporated by reference to Exhibit 10.4.4 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996). 10.4.5 Fifth Amendment to Lease between Athenaeum Property LLC and the Company dated April 15, 1997 (incorporated by reference to Exhibit 10.4.5 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997). 10.4.6 Sixth Amendment to Lease between Athenaeum Property LLC and the Company dated June 6, 1997 (incorporated by reference to Exhibit 10.4.6 to the Company's Quarterly Report on Form 10-Q for the quarter ended June 30, 1997). 10.5 First Amendment to Credit Agreement dated August 29, 1997 between BankBoston, N.A. and Company (incorporated by reference to Exhibit 10.4.6 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997). 10.5.1 Amended and Restated Revolving Credit Note dated August 29, 1997 between BankBoston, N.A. and the Company (incorporated by reference to Exhibit 10.4.6 to the Company's Quarterly Report on Form 10-Q for the quarter ended September 30, 1997). 10.6 Bridge Loan Agreement, dated February 22, 1996 among the Company and certain bridge lenders named therein (incorporated by reference to Exhibit 10.5 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.6.1 Amendment to Loan Agreement and to Waiver and Subordination Agreements dated August 22, 1996 among the Company and certain bridge lenders named therein. Agreements dated August 22, 1996 among the Registrant and certain bridge lenders named therein (incorporated by reference to Exhibit 10.5.1 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.6.2 Amendment No. 2 to Loan Agreement and to Waiver and Subordination Agreements dated October 9, 1996 among the Company and certain bridge lenders named therein (incorporated by reference to Exhibit 10.5.2 to Pre-effective Amendment No. 1 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on October 15, 1996). #10.7 Software License Agreement between Novell, Inc. and the Company, dated as of September 6, 1996 (incorporated by reference to Exhibit 10.6 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 20 21 #10.8 Agreement between Tumbleweed Software Corporation and the Company dated as of June 10, 1996 (incorporated by reference to Exhibit 10.6 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.9 Agreement dated as of May 1, 1996 among the Company and James D. Hart (incorporated by reference to Exhibit 10.8 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on September 6, 1996). 10.10 Form of Indemnification Agreement between the Company, its directors and certain of its officers (incorporated by reference to Exhibit 10.9 to Pre-effective Amendment No. 1 to the Company's Registration Statement on Form S-1, Registration No. 333-11519, filed on October 15, 1996). 10.11 Agreement and Plan of Merger dated as of March 27, 1997 among the Company, Archetype Acquisition Corporation and Archetype, Inc. (incorporated by reference to Exhibit 10.10 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996). 10.12 1997 Stock Plan (incorporated by reference to Exhibit 10.11 to the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 1996). 11 COMPUTATION OF EARNINGS PER SHARE *11.1 Computation of Earnings Per Share 21 SUBSIDIARIES OF REGISTRANT *21.1 Subsidiaries of the Company 27 FINANCIAL DATA SCHEDULE *27.1 Financial Data Schedule # Pursuant to Rule 406 under the Securities Act, the Company requested confidential treatment as to certain provisions. * Filed herewith. (b) REPORTS ON FORM 8-K None. 21 22 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, in the City of Cambridge, Commonwealth of Massachusetts on this 31st day of March, 1998. BITSTREAM INC. By: /s/ Charles Ying --------------------------- Charles Ying Chief Executive Officer Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed by the following persons on behalf of the Registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ Charles Ying Chairman of the Board, Director and March 31, 1998 - ------------------------------- Chief Executive Officer (Principal Charles Ying Executive Officer) /s/ Wendy Darland Vice President, Finance and March 31, 1998 - ------------------------------- Administration, Chief Financial Wendy Darland Officer, Treasurer and Assistant Secretary (Principal Financial Officer and Principal Accounting Officer) /s/ Amos Kaminski Director March 31, 1998 - ------------------------------- Amos Kaminski /s/ David G. Lubrano Director March 31, 1998 - ------------------------------- David G. Lubrano /s/ George B. Beitzel Director March 31, 1998 - ------------------------------- George B. Beitzel 22 23 INDEX TO FINANCIAL STATEMENTS PAGE CONSOLIDATED FINANCIAL STATEMENTS OF BITSTREAM INC. AND SUBSIDIARIES Report of Independent Public Accountants................................ F-2 Consolidated Balance Sheets as of December 31,1997 and December 31, 1996................................................. F-3 Consolidated Statements of Operations for the Years Ended December 31, 1997 and 1996, Three Months Ended December 31, 1995 and for the Year Ended September 30, 1995............................. F-4 Consolidated Statements of Stockholders' Equity (Deficit) .............. F-5 Consolidated Statements of Cash Flows for the Years Ended December 31, 1997 and 1996, Three Months Ended December 31, 1995 and for the Year Ended September 30, 1995............................ F-6 Notes to Consolidated Financial Statements.............................. F-7 F-1 24 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To Bitstream Inc.: We have audited the accompanying consolidated balance sheets of Bitstream Inc. (a Delaware corporation) and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity and cash flows for the years ended December 31, 1997 and December 31, 1996, for the three-month period ended December 31, 1995 and for the year ended September 30, 1995. These 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 generally accepted auditing standards. 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 Bitstream Inc. and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for the years ended December 31, 1997 and December 31, 1996, for the three-month period ended December 31, 1995 and for the year ended September 30, 1995, in conformity with generally accepted accounting principles. /s/ Arthur Andersen LLP ------------------------- Arthur Andersen LLP Boston, Massachusetts March 2, 1998 (Except for the matters discussed in Note 17 for which the date is March 13, 1998). F-2 25 BITSTREAM INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS DECEMBER 31, ------------------------------ 1997 1996 ---- ---- ASSETS Current assets: Cash and cash equivalents ........................................ $ 6,364,000 $11,718,000 Accounts receivable, net of allowance for doubtful accounts ...... 3,694,000 1,552,000 Current portion of long-term accounts receivable and extended plan accounts receivable, net of allowance for doubtful accounts 1,855,000 1,667,000 Deferred income taxes ............................................ 868,000 868,000 Other current assets ............................................. 684,000 434,000 ----------- ----------- Total current assets ........................................ 13,465,000 16,239,000 ----------- ----------- Property and equipment, net ........................................ 1,399,000 924,000 ----------- ----------- Other assets Long-term accounts receivable, net of current portion ............ 39,000 123,000 Goodwill, net of amortization .................................... 1,948,000 -- Other assets ..................................................... 158,000 191,000 2,145,000 314,000 ----------- ----------- Total assets ................................................ $17,009,000 $17,477,000 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Current maturities of capital lease obligations................ 28,000 36,000 Accounts payable............................................... 753,000 513,000 Accrued expenses............................................... 3,472,000 1,470,000 ----------- ----------- Total current liabilities................................. 4,253,000 2,019,000 ----------- ----------- Capital lease obligations, less current maturities............... 54,000 79,000 ----------- ----------- Other long-term liabilities...................................... 19,000 20,000 ----------- ----------- Stockholders' equity Common stock................................................... 65,000 59,000 Additional paid-in capital..................................... 29,940,000 26,637,000 Accumulated deficit............................................ (17,283,000) (11,293,000) Cumulative translation adjustment.............................. (39,000) (44,000) ----------- ----------- Total stockholders' equity.................................. 12,683,000 15,359,000 ----------- ----------- Total liabilities and stockholders' equity................ $17,009,000 $17,477,000 =========== =========== The accompanying notes are an integral part of these consolidated financial statements. F-3 26 BITSTREAM INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS THREE MONTHS YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ----------- ----------- ---------- ----------- Revenues .......................................... $13,102,000 $10,551,000 $2,355,000 $ 8,970,000 Cost of revenues.................................. 1,518,000 1,858,000 411,000 1,579,000 ----------- ----------- ---------- ----------- Gross profit................................... 11,584,000 8,693,000 1,944,000 7,391,000 Operating expenses: Marketing and selling.......................... 6,621,000 4,386,000 978,000 3,264,000 Research and development....................... 2,826,000 1,512,000 331,000 1,071,000 General and administrative..................... 2,104,000 1,533,000 385,000 1,261,000 Acquired in-process research and development... 4,930,000 -- -- Severance and other nonrecurring compensation.. 1,371,000 -- -- -- ----------- ----------- ---------- ----------- Total operating expenses................... 17,852,000 7,431,000 1,694,000 5,596,000 Operating income (loss)........................... (6,268,000) 1,262,000 250,000 1,795,000 Other income (expense), net....................... 510,000 (19,000) 17,000 11,000 ----------- ----------- ---------- ----------- Income (Loss) before provision for (benefit from) income taxes................... (5,758,000) 1,243,000 267,000 1,806,000 Provision for (benefit from) income taxes........ 232,000 (94,000) (471,000) 118,000 ----------- ----------- ----------- ----------- Net income (loss)......................... $(5,990,000) $ 1,337,000 $ 738,000 $ 1,688,000 =========== =========== ========== =========== Basic net income (loss) per share................ $ (0.95) $ 1.07 $ 2.36 $ 1.11 =========== =========== ========== =========== Weighted average shares outstanding.............. 6,303,216 1,248,118 312,677 1,518,138 =========== =========== ========== =========== Diluted net income (loss) per share.............. $ (0.95) $ 0.25 $ 0.16 $ 0.31 =========== =========== ========== =========== Weighted average common shares outstanding and dilutive common share equivalents............. 6,303,216 5,404,351 4,729,976 5,008,850 =========== =========== ========== =========== The accompanying notes are an integral part of these consolidated financial statements. F-4 27 BITSTREAM INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT) CONVERTIBLE PREFERRED STOCK COMMON STOCK ----------------- -------------------- ADDITIONAL CUMULATIVE NUMBER $.01 NUMBER $.01 PAID-IN ACCUMULATED TRANSLATION OF SHARES PAR VALUE OF SHARES PAR VALUE CAPITAL DEFICIT ADJUSTMENT --------- --------- --------- --------- ------- ------- ---------- BALANCE, SEPTEMBER 30, 1994 ....... 3,052,647 $31,000 1,759,230 $18,000 $12,277,000 $(15,056,000) $(50,000) Accretion of Series H and Series I mandatorily redeemable convertible preferred stock to redemption value ....... -- -- -- -- (133,000) -- -- Net adjustment to reflect the recapitalization of the Company ............ 121,090 1,000 (1,446,553) (15,000) 2,305,000 -- -- Net income ............... -- -- -- -- -- 1,688,000 -- ---------- ------- ---------- ------- ----------- ----------- ------- BALANCE, SEPTEMBER 30, 1995 ........ 3,173,737 32,000 312,677 3,000 14,449,000 (13,368,000) (50,000) Cumulative translation adjustment ............. -- -- -- -- -- -- 2,000 Net income ............... -- -- -- -- -- 738,000 -- ---------- ------- ---------- ------- ----------- ----------- ------- BALANCE, DECEMBER 31, 1995 ......... 3,173,737 32,000 312,677 3,000 14,449,000 (12,630,000) (48,000) Exercise of stock options and warrants ........... -- -- 6,833 -- 5,000 -- -- Cumulative translation adjustment ............. -- -- -- -- -- -- 4,000 Conversion of convertible preferred stock into common stock ................... (3,173,737) (32,000) 3,173,737 32,000 -- -- -- Sale of 2,415,000 shares of common stock in initial public offering, net of issuance costs of $1,269,000 .............. -- -- 2,415,000 24,000 12,183,000 -- -- Net income ................ -- -- -- -- -- 1,337,000 -- ---------- ------- ---------- ------- ----------- ----------- ------- BALANCE, DECEMBER 31, 1996 .......... -- -- 5,908,247 59,000 26,637,000 (11,293,000) (44,000) ---------- ------- ---------- -------- ------------ ------------ --------- Exercise of stock options and warrants ............ -- -- 137,895 1,000 124,000 -- -- Issuance of Class A common stock upon merger ........ -- -- 510,322 5,000 1,602,000 -- -- IPO related expenses ...... -- -- -- -- (68,000) -- -- Issuance of options upon merger ............. -- -- -- -- 1,400,000 -- -- Options issued for severance .............. -- -- -- -- 245,000 -- -- Cumulative translation adjustment ............ -- -- -- -- -- -- 5,000 Net loss .................. -- -- -- -- -- (5,990,000) -- ---------- ------- ---------- -------- ------------ ------------ --------- BALANCE, DECEMBER 31, 1997 .......... -- $ -- 6,556,464 $ 65,000 $ 29,940,00 $(17,283,000) $(39,000) ========== ======= ========== ======== ============ ============ ======== Total Shareholders' Treasury Notes Equity Stock Receivable (Defict) -------- ---------- ------------ BALANCE, SEPTEMBER 30, 1994 ........ $(247,000) $(14,000) $(3,041,000) Accretion of Series H and Series I mandatorily redeemable convertible preferred stock to redemption value ........ -- -- (133,000) Net adjustment to reflect the recapitalization of the Company ............. 247,000 14,000 2,552,000 Net income ................ -- -- 1,688,000 --------- ------- ----------- BALANCE, SEPTEMBER 30, 1995 ......... -- -- 1,066,000 Cumulative translation adjustment .............. -- -- 2,000 Net income ................ -- -- 738,000 --------- ------- ----------- BALANCE, DECEMBER 31, 1995 .......... -- -- 1,806,000 Exercise of stock options and warrants ............ -- -- 5,000 Cumulative translation adjustment .............. -- -- 4,000 Conversion of convertible preferred stock into common stock ................... -- -- -- Sale of 2,415,000 shares of common stock in initial public offering, net of issuance costs of $1,269,000 .............. -- -- 12,207,000 Net income ................ 1,337,000 --------- -------- ----------- BALANCE, DECEMBER 31, 1996 ......... -- -- 15,359,000 --------- -------- ----------- Exercise of stock options and warrants ........... -- -- 125,000 Issuance of Class A common stock upon merger ....... -- -- 1,607,000 IPO related expenses ..... -- -- (68,000) Issuance of options upon merger ............ -- -- 1,400,000 Options issued for severance .............. -- -- 245,000 Cumulative translation adjustment ............. -- -- 5,000 Net loss ................. -- -- (5,990,000) --------- -------- ----------- BALANCE, DECEMBER 31, 1997 .......... $ -- $ -- $12,683,000 ========== ====== =========== The accompanying notes are an integral part of these consolidated financial statements. F-5 3 28 BITSTREAM INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS THREE MONTHS ENDED YEAR ENDED YEARS ENDED DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ------------- ------------ ------------ ------------ Cash Flows from Operating Activities: Net income (loss) ............................. $ (5,990,000) $ 1,337,000 $ 738,000 $ 1,688,000 Adjustments to reconcile net income to net cash provided by (used in) operating activities-- Depreciation and amortization ................. 831,000 292,000 36,000 214,000 Acquired in-process research and development .. 4,930,000 -- -- -- Deferred income tax benefit ................... -- (268,000) (600,000) -- Net loss (gain) on disposal of property and equipment, net ............................... 1,000 (7,000) (22,000) (14,000) Issuance of common stock for services rendered -- -- -- 108,000 Options issued for severance .................. 245,000 -- -- -- Changes in assets and liabilities -- Accounts receivable ......................... (1,676,000) 294,000 (613,000) (754,000) Long-term and extended plan accounts receivable .............................. (253,000) (1,026,000) 205,000 96,000 Other current assets ........................ (37,000) (240,000) (34,000) 24,000 Accounts payable ............................ -- 47,000 (333,000) (453,000) Accrued expenses ............................ 1,472,000 58,000 319,000 (661,000) ------------ ------------ ------------ ------------ Net cash provided by (used in) operating activities................................. (477,000) 487,000 (304,000) 248,000 ------------ ------------ ------------ ------------ Cash Flows from Investing Activities: Purchase of property and equipment ............ (747,000) (679,000) (140,000) (197,000) Acquisition of businesses, net of cash acquired .................................... (4,141,000) -- -- -- Proceeds from sale of property and equipment .. -- -- 24,000 60,000 Decrease in other assets ...................... (5,000) (187,000) 1,000 -- ------------ ------------ ------------ ------------ Net cash used in investing activities ......... (4,893,000) (866,000) (115,000) (137,000) ------------ ------------ ------------ ------------ Cash Flows from Financing Activities: Proceeds from long-term debt and capital lease obligations ................................ -- 324,000 300,000 -- Proceeds from line of credit .................. -- 100,000 -- -- Payments on line of credit .................... -- (400,000) -- -- Proceeds from debt to stockholders ............ -- 600,000 -- -- Payments on debt to stockholders .............. -- (600,000) -- -- Payments on long-term debt and capital lease obligations ................................. (39,000) (527,000) (26,000) (244,000) Change in other long-term liabilities ......... (1,000) (2,000) 12,000 2,000 Payments on IPO offering expenses ............. (68,000) -- -- -- Proceeds from sale of common stock ............ -- 12,207,000 -- -- Proceeds from the exercise of stock options and warrants .................................... 124,000 5,000 -- -- ------------ ------------ ------------ ------------ Net cash provided by (used in) financing activities ................................. 16,000 11,707,000 286,000 (242,000) ------------ ------------ ------------ ------------ Net Increase (Decrease) in Cash and Cash Equivalents ...................................... (5,354,000) 11,328,000 (133,000) (131,000) Cash and Cash Equivalents, beginning of period ... 11,718,000 390,000 523,000 654,000 ------------ ------------ ------------ ------------ Cash and Cash Equivalents, end of period ......... $ 6,364,000 $ 11,718,000 $ 390,000 $ 523,000 ============ ============ ============ ============ Supplemental Disclosure of Cash Flow Information: Cash paid for interest ........................ $ 8,000 $ 29,000 $ 6,000 $ 16,000 ============ ============ ============ ============ Cash paid for income taxes .................... $ -- $ 41,000 $ 93,000 $ 5,000 ============ ============ ============ ============ Supplemental Schedule for Non-Cash Investing and Financing Activities: Assumed liabilities from Archetype acquisition ................................. $ 1,094,000 $ -- $ -- $ -- ============ ============ ============ ============ Shares and options issued in Archetype acquisition ................................. 510,000 -- -- -- ============ ============ ============ ============ Warrants and options issued in Archetype acquisition ................................. 605,000 -- -- -- ============ ============ ============ ============ The accompanying notes are an integral part of these consolidated financial statements. F-6 29 BITSTREAM INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (1) OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES Bitstream Inc. and subsidiaries (the "Company") develop and market software products and technologies to enhance the creation, transport, viewing and printing of electronic documents. The Company primarily licenses its products and technologies to original equipment manufacturers ("OEMs"), and independent software vendors ("ISVs") for inclusion in their output devices, embedded systems, applications, Internet authoring tools, World Wide Web browsers and other products. The Company generally enters into a license with such customers and charges a combination of licensing fees and royalty payments. In addition, the Company sells custom and other type products and application products directly and indirectly to end users such as graphic artists, publishers, advertising agencies and corporations. In fiscal year 1993, the Company decided to curtail product distribution through the computer software reseller channel and to concentrate the efforts of the Company on the development and sale of technology and products to OEM and ISV customers. In conjunction with this shift in strategic focus, the Company reorganized its operations, changed its senior management and restructured the Company's type design group. During November 1994, the Company consummated a plan of recapitalization (see Note 12(a)). The Company is subject to risks common to technology-based companies, including dependence on key personnel, rapid technological change, competition from alternative product offerings and larger companies, and challenges to the development and marketing of commercial products and services. The accompanying consolidated financial statements reflect the application of certain accounting policies as described in this note and elsewhere in the accompanying consolidated financial statements and notes. The preparation of the accompanying consolidated financial statements required the use of certain estimates by management in determining the Company's assets, liabilities, revenues and expenses. Actual results may differ from these estimates. (a) Principles of Consolidation The accompanying consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, Bitstream World Trade, Inc. (a Delaware corporation), a holding company for Bitstream, B.V. (a Dutch corporation); Bitstream S.A.R.L. (a French corporation); Bitstream B.V. France (a French corporation); Mainstream Software Solutions Ltd. (an English corporation) and Archetype, Inc. (a Delaware corporation). All material intercompany transactions and balances have been eliminated in consolidation. (b) Revenue Recognition Through September 30, 1997, the Company recognized revenue in accordance with the provisions of Statement of Position 91-1 (SOP 91-1), Software Revenue Recognition. The Company adopted Statement of Position 97-2 (SOP 97-2), Software Revenue Recognition, effective October 1, 1997. The adoption of SOP 97-2 did not have a material effect on the results of the Company's operations or financial position. The Company generates revenue from licensing the rights to include its software products in the products and software of OEMs and ISVs as well as the licensing of its software products to end users through direct and indirect sales channels. Certain OEM and ISV customers irrevocably contract to pay a minimum royalty amount over a defined period in exchange for the right to sublicense a certain number of the Company's software products over a specified period. Other OEMs and ISVs elect to pay royalties on a pay-as-you-go basis based on the sublicensing of the Company's software products to end users. Revenue from guaranteed minimum royalty licenses is recognized upon delivery of the software, while revenue on pay-as-you-go licenses is recognized in the period when sublicenses to end users are reported to the Company by the OEM or ISV customer. In certain guaranteed minimum royalty licenses, the Company will enter into extended payment programs with creditworthy customers. If the payments from the customer are to be received over a period greater than one year, revenue is discounted to the present value of future minimum payments. To date, the Company has not experienced any material collection difficulties with the extended payment program receivables. F-7 30 Revenue from end user product sales is recognized upon delivery of the software, net of estimated returns and allowances, if there are no significant post delivery obligations and if collection is probable. Revenue from maintenance contracts is recognized pro rata over the term of the contract. Cost of revenues consists of costs to distribute the product, including the cost of the media on which it is delivered and internal production costs incurred in the fulfillment of custom orders. Additional costs include fees paid to third parties for the development of unique typeface designs and costs associated with fulfilling maintenance contracts. (c) Research and Development Expenses The Company has evaluated the establishment of technological feasibility of its 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. The Company sells products in a market that is subject to rapid technological change, new product development and changing customer needs. The time period during which costs could be capitalized from the point of reaching technological feasibility until the time of general product release is very short, and consequently, the amounts that could be capitalized are not material to the Company's financial position or results of operation. Therefore, the Company has charged all such costs to research and development in the period incurred. (d) Cash and Cash Equivalents As of December 31, 1997, cash and cash equivalents consisted of approximately $1.14 million of bank deposits, approximately $302,000 of money market instruments and approximately $4.9 million of commercial paper. The Company considers all highly liquid investments with original maturities of three months or less at the time of acquisition to be cash equivalents and records such investments at cost. (e) Property and Equipment, Net Property and equipment are stated at cost, less accumulated depreciation and amortization. Property and equipment, net, consists of the following: December 31, ------------------------------ 1997 1996 ---------- ---------- Equipment and computer software............ $ 2,738,000 $2,283,000 Equipment and computer software under capital lease........................... 423,000 433,000 Furniture and fixtures..................... 255,000 235,000 Leasehold improvements..................... 755,000 505,000 ----------- ---------- 4,171,000 3,456,000 Less -- Accumulated depreciation and amortization ..................... 2,772,000 2,532,000 ----------- ---------- $ 1,399,000 $ 924,000 =========== ========== Depreciation is provided on a straight-line basis over the estimated useful lives of the related assets principally as follows: Asset Classification Estimated Useful Life ------------------------------------------ --------------------- Equipment and computer software........... 3 Years Equipment and computer software under capital lease........................... Life of lease Furniture and fixtures.................... 5 Years Leasehold improvements.................... Life of lease F-8 31 (f) Financial Instruments The estimated fair value of the Company's financial instruments, which include cash equivalents, accounts receivable and long-term debt, approximates their carrying value. The accounts receivable balances in the accompanying consolidated financial statements are presented net of the following allowances for doubtful accounts and sales returns: December 31, --------------------------- 1997 1996 ---------- ---------- Accounts receivable ................... ($245,000) ($217,000) Current portion of long-term accounts receivable and extended plan accounts receivable .......................... (207,000) (60,000) --------- --------- ($452,000) ($277,000) ========= ========= (g) Foreign Currency Translation The financial statements of the Company's foreign operations are translated in accordance with SFAS No. 52, Foreign Currency Translation. (h) Postretirement Benefits The Company had no obligations under SFAS No. 106, Employers' Accounting for Postretirement Benefits Other Than Pensions, as it does not currently offer such benefits. (i) Concentration of Credit Risk The Company has no significant off-balance-sheet concentration of credit risk such as foreign exchange contracts, option contracts or other foreign hedging arrangements. For the years ended December 31, 1996 and 1997, no single customer accounted for 10% or greater of the Company's revenues, respectively. (j) Delaware Reincorporation, Amendment to Certificate of Incorporation On May 21, 1996, the Company was reincorporated in the State of Delaware. Every three shares of common and convertible preferred stock of the Massachusetts company were exchanged for two shares of common and convertible preferred stock, respectively, of the Delaware company. On November 4, 1996, the Company filed an amendment to its Certificate of Incorporation changing its authorized capital to be as follows: 30,500,000 shares of Common Stock, $0.01 par value, (30,000,000 of which are authorized shares of Class A Common Stock and 500,000 of which are authorized shares of Class B Common Stock), and 6,000,000 shares of preferred stock, $0.01 par value. All share and per share information has been restated to reflect these transactions. (k) Goodwill, Net Goodwill is stated at cost, less accumulated amortization, and consists of the following: December 31, -------------------------- 1997 1996 ---------- ---------- Goodwill - Acquisition of Mainstream Software Solutions Ltd. ............................. $ 450,000 $ -- Goodwill - Acquisition of Archetype, Inc. .... 1,832,000 -- ---------- --------- 2,282,000 -- Less-- Accumulated amortization .............. 334,000 -- --------- --------- $1,948,000 $ -- ========== ========= Goodwill is amortized on a straight-line basis over the estimated useful life of 5 years. F-9 32 (l) Impairment of Long-Lived Assets The Company periodically assesses the realizability of its long-lived assets in accordance with SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of. Based on this review, the Company does not believe any material impairment of its long-lived assets has occurred. (2) FISCAL YEAR CHANGE Effective December 31, 1995, the Company changed its financial reporting year-end from September 30 to December 31. The condensed consolidated statements of operations for the three months ended December 31, 1994 and 1995 are presented in the following table for comparative purposes: Three Months Ended December 31, -------------------------- 1995 1994 ---------- ----------- (UNAUDITED) Revenues................................... $2,355,000 $2,276,000 Gross profit............................... 1,944,000 2,003,000 Operating expenses......................... 1,694,000 1,261,000 ---------- --------- Income before provision for (benefit from) income taxes............................ 267,000 740,000 ---------- --------- Income tax provision (benefit)............. (471,000) 17,000 ---------- --------- Net income....................... $ 738,000 $ 723,000 ========== ========= (3) RECENTLY ISSUED ACCOUNTING STANDARDS In July 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general purpose financial statements, in order to measure all changes in equity of an enterprise that result from transactions and other economic events of the period other than transactions with owners. Comprehensive income, as defined by SFAS No. 130, is the total of net income and all other non-owner changes in equity. Under SFAS No. 130, companies would include the cumulative total of comprehensive income as a separate component of its stockholders' equity statement. This statement is effective for fiscal years beginning after December 15, 1997, and is applicable on both an interim and annual basis. In July 1997, the FASB issued SFAS No. 131, Disclosures About Segments of an Enterprise and Related Information. SFAS No. 131 requires certain financial and supplementary information to be disclosed on an annual and interim basis for each reportable segment of an enterprise. Reportable segments, as defined by this statement, correspond to the way management organizes units and evaluates performance internally, and may be based upon products, geography, legal entity, management structure or a combination of these methods. SFAS No. 131 is effective for years beginning after December 15, 1997. The Company believes that the adoption of the recently issued accounting standards will not have a material impact on its financial results or financial position. (4) NET INCOME (LOSS) PER SHARE In 1997, the Company adopted SFAS No. 128, Earnings Per Share, effective December 15, 1997. SFAS No. 128 established standards for computing and presenting earnings per share and applies to entities with publicly held common stock or potential common stock. The Company has applied the provisions of SFAS No. 128 and S.E.C. Staff Accounting Bulletin (SAB) No. 98 retroactively to all periods presented. Diluted net loss per share for the year ended December 31, 1997 is the same as basic net loss per share as the inclusion of the potential common stock equivalents would be antidilutive. F-10 33 The following is a reconciliation of shares outstanding for basic and diluted earnings per share: THREE YEAR YEAR MONTHS YEAR ENDED ENDED ENDED ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ----------- ----------- ----------- ---------- Shares outstanding for basic earnings (loss) per share: Weighted average shares outstanding.................. 6,303,216 1,248,118 312,677 1,518,138 --------- --------- --------- --------- Shares outstanding for diluted earnings per share: Weighted average shares outstanding.................. 6,303,216 1,248,118 312,677 1,518,138 Dilutive effect of options issued to employees....... -- 1,197,039 987,253 987,253 Dilutive effect of warrants issued to employees...... -- 327,822 256,309 256,309 Shares issuable upon conversion of preferred stock....... -- 2,631,372 3,173,737 2,247,150 --------- --------- --------- --------- 6,303,216 5,404,351 4,729,976 5,008,850 --------- --------- --------- --------- Options and warrants excluded as they are antidilutive... 2,847,227 95,998 174,156 153,158 --------- --------- --------- --------- Calculations of basic and diluted net income (loss) per common share are as follows: THREE YEAR YEAR MONTHS YEAR ENDED ENDED ENDED ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ----------- ----------- ----------- ------------ Net income (loss).................................... ($5,990,000) $1,337,000 $738,000 $1,688,000 Accretion of preferred stock discount................ -- -- -- (133,000) ----------- ---------- -------- ---------- Net income (loss) applicable to common shareholders...................................... ($5,990,000) $1,337,000 $738,000 $1,555,000 ----------- ---------- -------- ---------- Basic net income (loss) per common share............. (0.95) 1.07 2.36 1.11 ----------- ---------- -------- ---------- Diluted net income (loss) per common share........... (0.95) 0.25 0.16 0.31 ----------- ---------- -------- ---------- (5) ACQUISITIONS MAINSTREAM ACQUISITION In January 1997, the Company purchased substantially all of the assets of Mainstream Software Solutions Ltd., a corporation organized under the laws of England primarily engaged in the business of marketing, selling, distributing and supporting the Company's type products in the United Kingdom, for approximately $505,000. As a result, the Company directly distributes its own products in the United Kingdom. The acquisition was accounted for as a purchase and resulted in approximately $450,000 of goodwill. ARCHETYPE ACQUISITION In April 1997, the Company acquired Archetype, Inc. ("Archetype"), a Delaware corporation primarily engaged in the business of developing and marketing server-based information management computer software for the graphic arts industry, pursuant to an Agreement and Plan of Merger, dated March 27, 1997 among the Company, Archetype, and Archetype Acquisition Corporation, a newly organized wholly owned subsidiary of the Company. Archetype's products include: MediaBank, a digital asset management product that allows for the cataloging, archiving, and management of electronic images, text and documents; InterSep OPI and InterSep Output Manager, advanced open prepress interface and print management products for raster image processors and servers; and NuDoc, an advanced document composition technology. F-11 34 In connection with the Merger, Archetype stockholders received an aggregate of approximately $1.3 million in cash and 510,000 shares of the Company's Class A Common Stock in exchange for their shares of Archetype capital stock. In addition, the Company satisfied approximately $1.8 million of obligations and indebtedness owed by Archetype, and issued options and warrants (the "Options") to purchase approximately 605,000 shares of the Company's Class A Common Stock, in order to induce the former Archetype employees and other persons receiving such Options to become employees of, or perform certain services for, the Company and/or to replace certain outstanding options and warrants issued by Archetype. Of these options, 405,000 have an exercise price of $.90 per share and were issued under the Company's 1996 Stock Plan and the remaining 200,000 have an exercise price of $3.94 per share and were issued under the Company's 1997 Stock Plan. The Merger was accounted for as a purchase, and accordingly, the initial purchase price and acquisition costs aggregating approximately $7.5 million has been allocated to the assets acquired as described below. The aggregate purchase price of $7,454,000 consisted of the following: DESCRIPTION AMOUNT ----------- ------ Common stock and stock options......... $ 2,904,000 Cash paid to shareholders and for the retirement of certain obligations.. 3,056,000 Assumed liabilities.................... 1,094,000 Acquisition costs...................... 400,000 ----------- Total purchase price................... $ 7,454,000 =========== The purchase price allocations represent the fair values of assets acquired determined by an independent appraisal. The appraisal incorporated established valuation procedures and techniques in determining the fair value of each asset. The purchase price has been allocated as follows: DESCRIPTION AMOUNT ----------- ------ Current assets....................... $ 431,000 Property, plant and equipment........ 207,000 Other assets......................... 54,000 In-process research and development.. 4,930,000 Other acquired intangible assets..... 1,832,000 ----------- Total assets acquired................ $ 7,454,000 =========== The amount allocated to in-process research and development related to projects that had not yet reached technological feasibility and that, until completion of the development, had no alternative future use. These projects will require substantial high risk development and testing by the Company prior to reaching technological feasibility. Accordingly, the Company charged the purchase price to operations in the year ended December 31, 1997. Based on the unaudited data, the following table presents selected financial information for Bitstream and Archetype on a pro forma basis, assuming the companies had been combined since the beginning of 1996. YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, 1997 1996 -------------- ------------- REVENUES................................ $ 14,164,000 $ 13,552,000 Net Income (loss)..................... (1,703,000) 915,000 Basic Net Income (loss) per share..... $ (0.26) $ 0.52 The pro forma results are not necessarily indicative of future operations or the actual results that would have occurred had the acquisition been made on January 1, 1996. The pro forma amounts exclude the $4,930,000 write-off of in-process research and development. F-12 35 (6) SEVERANCE AND OTHER NON-RECURRING EXPENSES Operating expenses for the twelve months ended December 31, 1997 reflect $1.4 million for severance and other non-recurring compensation expenses incurred in connection with the acquisition of Archetype and certain severance arrangements between the Company and certain executives. (7) INCOME TAXES The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. A reconciliation between the provision for income taxes computed at statutory rates and the amount reflected in the accompanying consolidated statements of operations is as follows: THREE MONTHS ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ----------- --------- --------- ---------- Computed expected federal tax provision (benefit) ........................... $(1,958,000) $ 422,000 $ 91,000 $ 614,000 State income taxes, net of federal benefit ....... (345,000) 75,000 29,000 112,000 State and foreign net operating loss carryforwards -- (13,000) (23,000) (102,000) Foreign losses not benefited ..................... 195,000 4,000 71,000 19,000 Foreign withholding taxes ........................ 190,000 109,000 92,000 108,000 Nondeductible write off of in-process R & D and other ............................................ 2,052,000 -- -- -- Nondeductible goodwill amoritization.............. 98,000 -- -- -- Domestic net operating loss carryforwards ........ -- (423,000) (131,000) (633,000) Change in valuation allowance .................... -- (268,000) (600,000) -- ----------- --------- --------- ----------- $ 232,000 $ (94,000) $(471,000) $ 118,000 =========== ========= ========= ========== The following is a summary of the provision for (benefit from) income taxes. THREE MONTHS ENDED YEAR ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ---------- ---------- ----------- ---------- Federal -- Current........... $ 36,000 $ 40,000 $ 31,000 $ 8,000 Deferred.......... -- (228,000) (510,000) -- ---------- ---------- ----------- ---------- 36,000 (188,000) (479,000) 8,000 ---------- ---------- ----------- ---------- State -- Current........... 6,000 25,000 6,000 2,000 Deferred.......... -- (40,000) (90,000) -- ---------- ---------- ----------- ---------- 6,000 (15,000) (84,000) 2,000 ---------- ---------- ----------- ---------- Foreign -- Current........... 190,000 109,000 92,000 108,000 Deferred.......... -- -- -- -- ---------- ---------- ----------- ---------- 190,000 109,000 92,000 108,000 ---------- ---------- ----------- ---------- $ 232,000 $ (94,000) $ (471,000) $ 118,000 ========== ========== =========== ========== F-13 36 The significant items comprising the deferred tax asset are as follows: DECEMBER 31, 1997 1996 ----------- ----------- Assets -- Net operating loss carryforwards...... $ 3,869,000 $ 3,374,000 Tax credit carryforwards................ 2,340,000 2,244,000 Other temporary differences.............. 1,065,000 471,000 ----------- ----------- Gross deferred tax asset........ 7,274,000 6,089,000 Valuation allowance................... (6,406,000) (5,221,000) ----------- ----------- Net deferred tax asset........ $ 868,000 $ 868,000 =========== =========== At December 31, 1997, the Company has available federal and state net operating loss carryforwards for income tax purposes and federal and state tax credit carryforwards to reduce future federal income taxes, if any. The table below includes $2,540,000 of NOLs established by Archetype prior to its acquisition by the Company. Utilization of the Archetype NOLs is subject to certain annual limitations in accordance with certain tax laws and regulations. These net operating loss and tax credit carryforwards are subject to review and possible adjustment by the Internal Revenue Service and expire as follows: DECEMBER 31, CREDIT NOLs ---------- ----------- 1998 2,000 -- 1999 4,000 -- 2000 40,000 -- 2001 96,000 20,000 2002 192,000 256,000 2003 250,000 174,000 2004 265,000 183,000 2005 101,000 -- 2006 366,000 599,000 2007 113,000 488,000 2008 311,000 6,783,000 2009 187,000 1,129,000 2010 151,000 -- 2011 153,000 -- 2012 109,000 -- ---------- ----------- $2,340,000 $ 9,632,000 ========== =========== The Tax Reform Act of 1986 (the Reform Act) limits the amount of net operating loss and credit carryforwards which companies may utilize in any one year in the event of cumulative changes in ownership over a three-year period in excess of 50%. The Company has assessed its status with respect to these ownership changes which have occurred over the last three years, as well as the change of ownership interests with the initial public offering and the acquisition of Archetype, Inc., and believes that its ability to utilize its existing net operating loss and credit carryforwards will not be materially affected as a result of these changes in ownership interests. The Company has established a valuation allowance against its deferred tax asset to the extent that it believes it is more likely than not these assets will not be realized. In determining the amount of valuation allowance required, the Company considers numerous factors, including historical profitability, estimated future taxable income and the volatility of the industry in which it operates. F-14 37 (8) ACCRUED EXPENSES Accrued expenses consist of the following: DECEMBER 31, 1997 1996 ---------- ---------- Accrued royalties.................... $ 737,000 $ 535,000 Payroll and other compensation....... 790,000 326,000 Deferred Revenue..................... 216,000 83,000 Other................................ 1,729,000 526,000 ---------- ---------- $3,472,000 $1,470,000 ========== ========== Reclassifications have been made in prior year amounts to conform with the current year's presentation. (9) DEBT (a) Line of Credit On August 29, 1997, the Company amended its July 14, 1995 working capital line-of-credit agreement maturing on July 15, 1998 with a bank to provide for borrowings up to $2,000,000 based on a percentage of qualified accounts receivable, as defined. This line bears interest at various per annum rates between the prime rate (8.5% as of December 31, 1997) plus 1% to 2%, as defined. As a component of this agreement, the Company can obtain up to $250,000 in letters of credit. Substantially all of the Company's assets are collateralized under this agreement. No balance was outstanding under this line as of December 31, 1997. Prior to the August 29, 1997 amendment, the working capital line-of-credit agreement, which was previously amended on March 18, 1996, provided for borrowings up to $1,000,000 based on a percentage of qualified accounts receivable. (b) Capital Leases The Company leases certain equipment under capital leases expiring through fiscal 2000. These capital lease payments are due in equal monthly installments and bear interest at rates ranging from 9% to 14.25%. Future minimum lease payments under the capital lease obligations as of December 31, 1997 are as follows: Year Amount --------------------------------------- ------- 1998 .................................. $31,000 1999 .................................. 31,000 2000 .................................. 31,000 ------- Total minimum lease payments .... 93,000 Less -- Amount representing interest .. 11,000 ------- Capital lease obligations ..... 82,000 Less -- Current portion ............... 28,000 ------- $54,000 ======= (c) Subordinated Notes Payable to Stockholders On February 22, 1996, the Company entered into agreements with certain parties including certain directors and principal stockholders, pursuant to which the Company borrowed an aggregate amount of $600,000. In connection with these note payable agreements, the Company agreed to pay the principal amount borrowed plus simple interest at 12% per annum on August 22, 1996. On August 22, 1996, the Company entered into an amendment to the notes pursuant to which the maturity date was extended to October 22, 1996. On October 9, 1996, the Company entered into a further amendment to the notes pursuant to which the maturity date was extended to December 22, 1996. These notes were subordinate to all other debt facilities. On November 4, 1996, the Company repaid all amounts due under these notes and the notes were canceled. (10) OPERATING LEASES The Company conducts its operations in leased facilities and is obligated to pay monthly rent plus real estate taxes and certain operating expenses through October, 2003. Rent expense charged to operations for the year ended September 30, 1995, the three months ended December 31, 1995 and the years ended December 31, 1996 and 1997 was approximately $244,000, $54,000, F-15 38 $270,000, and $545,000. On July 1, 1997, in accordance with the terms and conditions of a Sixth Amendment to Lease dated June 6, 1996, the Company extended its option on 17,174 square feet to October 1, 1998, and obtained additional space of 10,324 square feet of space through October 1, 2003 in its Cambridge, Massachusetts facility to permit for the relocation of the Archetype application group from Archetype's previous location in Burlington, Massachusetts. The future minimum annual rent commitment as of December 31, 1997 under the Company's leased facilities is as follows: Year Amount ---- --------- 1998 $ 417,000 1999 216,000 2000 217,000 2001 217,000 2002 217,000 2003 162,000 ---------- $1,446,000 ========== (11) CONTINGENT LIABILITIES On May 26, 1995, The Friends of the Museum of Printing, Inc. (the "Museum") filed a lawsuit in the Middlesex County Superior Court of Massachusetts against the Company in connection with a letter agreement (the "Letter") dated July 23, 1992 from the Company to the Museum concerning storage of certain font materials for the Museum. The Letter provided that the Company would have no liability to the Museum, over and above the proceeds of insurance, for damage or loss of any of the font materials, and that neither the Company nor the Museum would incur any liability to the other for any loss or damage arising out of their respective rights and obligations set forth in the Letter. The Museum alleges that after the two-year storage period had expired, the Company disposed of the font materials and that such conduct by the Company breached the terms of the Letter and violated Chapter 93A of the Massachusetts General Laws, which provides, among other things, that persons found to have engaged in an unfair or deceptive act in the conduct of a trade or business may be liable for double or treble damages and attorney fees. The Museum further demanded an accounting of royalties the Museum claims are due from the Company for use of the font materials. On December 10, 1997, in consideration of a payment of $560,000 by the Company's insurance carrier, of which the Company contributed $56,000, the Museum formally released all claims it had against the Company in such lawsuit. The case was dismissed with prejudice by the Company and the Museum on December 30, 1997. On November 22, 1996, Mr. Robert S. Friedman, a former director and officer of the Company, and Mr. Gordon Greer, and Ms. Faith G. Friedman, as trustees of the Robert S. Friedman Family Trust, filed a lawsuit in the Middlesex County Superior Court of Massachusetts against the Company, asserting that the Company has breached certain obligations the plaintiffs allege are due to them under a separation agreement dated May 22, 1991 (the "Separation Agreement") between Mr. Friedman and the Company. The plaintiffs are seeking monetary damages from the Company based on their claim that, in connection with the 1994 recapitalization of the Company, the Company allegedly made adjustments to the stock and options of the officers of the Company and that a provision in the Separation Agreement entitled the plaintiffs to equivalent adjustments with respect to the stock and options of the Company held by them. The plaintiffs further allege that the breach by the Company resulted in a loss to them of stock and options valued at $2.2 million. The Company believes that these claims are without merit and intends to vigorously contest their validity. The Company is self-insured for health costs to its employees up to an annual aggregate amount of approximately $240,000, of which the Company has fully reserved for as of December 31, 1997, after which the Company's insurance carrier pays for all additional claims. F-16 39 (12) STOCKHOLDERS' EQUITY (a) Recapitalization As a result of the reorganization of the Company's operations (see Note 1), on November 21, 1994, the Company filed an amendment to its articles of incorporation pursuant to a recapitalization plan approved by the Company's Board of Directors and stockholders. Pursuant to the recapitalization, the Company authorized 20,000,000 shares of Class A convertible common stock (Class A Common Stock), 1,333,333 shares of Class B convertible common stock (Class B Common Stock), 2,792,580 shares of Class A convertible preferred stock (Class A Preferred Stock) and 391,162 shares of Class B convertible preferred stock (Class B Preferred Stock) all having a par value of $.01 per share. In connection with this recapitalization, (i) all outstanding shares of existing Class A Common Stock, Class B Common Stock and Class A, B, C and D Convertible Preferred Stock were converted into 281,813 shares of Class A Common Stock; (ii) all outstanding shares of Class C Convertible Common Stock and Class E Convertible Preferred Stock were converted into 30,864 shares of Class B Common Stock; (iii) all outstanding shares of Class F Convertible Preferred Stock and Class H and I Mandatorily Redeemable Convertible Preferred Stock were converted into 2,782,575 shares of Class A Preferred Stock; and (iv) all outstanding shares of Class G Convertible Preferred Stock were converted into 391,162 shares of Class B Preferred Stock. In addition, the Board of Directors received 120,000 shares of Class A Common Stock valued at $108,000. On October 30, 1996, upon the effective date of an underwritten public offering of common stock all shares of Class A and B Preferred Stock were automatically converted into an equal number of shares of Class A Common Stock and Class B Common Stock, respectively. The number of common shares issued upon conversion was as follows: OUTSTANDING AS CONVERTED ----------- ------------ Class A Common ............... 288,646 3,071,221 Class B Common ............... 30,864 422,026 Class A Preferred ............ 2,782,575 -- Class B Preferred ............ 391,162 -- (b) Convertible Preferred Stock All of the outstanding shares of Class A Preferred Stock and Class B Preferred Stock were converted into the same number of shares of Class A Common Stock and Class B Common Stock, respectively, on October 30, 1996, the effective date of the IPO (see Note 12(d)). Convertible preferred stock consisted of the following: THREE MONTHS YEAR ENDED ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ------ ------ ------------- ------------ Convertible preferred stock, Class A, $.01 par value -- Authorized -- 2,792,580 shares at September 30, 1995, and December 31, 1995 and no shares at December 31, 1996 and December 31, 1997 .............................................. $ -- $ -- $ -- $ -- Issued and outstanding -- 2,782,575 shares in 1995 and no shares in 1996 and 1997............................... -- -- 28,000 28,000 Convertible preferred stock, Class B, $.01 par value -- Authorized -- 391,162 shares at September 30, 1995 and December 31, 1995 and no shares at December 31, 1996 and December 31, 1997 ............................................. -- -- -- -- Issued and outstanding -- 391,162 shares in 1995 and no shares in 1996 and 1997............................... -- -- 4,000 4,000 ------ ------ ------- ------- $ -- $ -- $32,000 $32,000 ====== ====== ======= ======= (c) Common Stock Class A Common stockholders have full voting rights. Class A Common Stockholders have the option, at any time, to convert any or all shares of Class A Common Stock held into an equal number of shares of Class B Common Stock. The Class B Common Stock has rights similar to Class A Common Stock, except it is nonvoting. The Class B Common stockholders have the option to convert any or all shares of Class B Common Stock held into an equal number of shares of Class A Common Stock, to the extent such stockholder and its affiliates shall be permitted to own, control or have the power to vote such Class A Common Stock under any law, rule or regulation at the time applicable to such stockholder or its affiliates. F-17 40 COMMON STOCK ----------------------------------------------- CLASS A CLASS B ----------------------------------------------- NUMBER $.01 NUMBER $.01 OF SHARES PAR VALUE OF SHARES PAR VALUE --------- --------- --------- --------- September 30, 1995 and December 31, 1995........... 281,813 $ 3,000 30,864 $ -- Initial public offering......................... 2,415,000 24,000 -- -- Conversion of convertible preferred stock....... 2,782,575 28,000 391,162 4,000 Exercise of stock options and warrants.......... 6,833 -- -- -- --------- ------- ------- ------- December 31, 1996.................................. 5,486,221 $55,000 422,026 $ 4,000 --------- ------- ------- ------- Exercise of stock options and warrants.......... 137,895 1,000 -- -- Issuance for acquisition of Archetype........... 510,322 5,000 Conversion of Class B to Class A Common Stock... 422,026 4,000 (422,026) (4,000) --------- ------- -------- ------- December 31, 1997 ................................ 6,556,464 $65,000 -- $ -- --------- ------- -------- ------- (d) Initial Public Offering In November 1996, the Company completed an initial public offering ("IPO") of 2,415,000 shares of its Class A Common Stock at $6.00 per share. Net proceeds from the IPO were approximately $12.2 million, of which approximately $1.5 million was used to repay outstanding indebtedness. (e) Stock Option Plans On September 30, 1997, the Company filed a Registration Statement on Form S-8 under the Securities Act of 1933, as amended, relating to the issuance of up to an aggregate of 3,500,000 shares of the Company's Class A Common Stock, par value $.01 per share, pursuant to stock options and warrants granted or which may be granted under the Company's 1997 Stock Plan, 1996 Stock Plan and 1994 Stock Plan. On March 10, 1997, the Board of Directors adopted the 1997 Stock Plan under which the Company is authorized to grant warrants, incentive stock options and nonqualified stock options to purchase shares of Class A Common Stock. Options granted under this plan are exercisable at such price as shall be determined by the Board of Directors at the time of grant which, in the case of incentive stock options, shall be no less than 100% of the fair market value of the shares on the date of grant and expire no later than 10 years from the date of grant. In addition, the 1997 Stock Plan provides that options granted thereunder, subject to future vesting, shall immediately vest upon the occurrence of certain events, such as the sale of all or substantially all of the assets of the Company or a change in control of the Company. As of December 31, 1997, 704,500 options had been granted under the 1997 Stock Plan. A total of 1,000,000 shares of Class A Common Stock has been reserved for issuance under the 1997 Stock Plan. On May 1, 1996, the Board of Directors adopted the 1996 Stock Plan under which the Company is authorized to grant incentive stock options and nonqualified stock options to purchase shares of Class A Common Stock. Options granted under this plan are exercisable at such price as shall be determined by the Board of Directors at the time of grant which, in the case of incentive stock options, shall be no less than 100% of the fair market value of the shares on the date of grant and expire no later than 10 years from the date of grant. In addition, the 1996 Stock Plan provides that options granted thereunder, subject to future vesting, shall immediately vest upon the occurrence of certain events, such as the sale of all or substantially all of the assets of the Company or a change in control of the Company. As of December 31, 1997, 458,264 options had been granted under the 1996 Stock Plan. A total of 666,667 shares of Class A Common Stock has been reserved for issuance under the 1996 Stock Plan. In connection with the recapitalization, the Board of Directors approved the 1994 Stock Plan (the 1994 Plan) under which the Company is authorized to grant incentive stock options and nonqualified stock options (including warrants) to purchase up to 1,833,333 shares of Class A Common Stock. Incentive stock options granted under the 1994 Plan must be granted at no less than fair market value of the shares at the date of grant, expire no later than 10 years from the date of grant and vest over periods of up to three years. As a result of the recapitalization, certain former employees holding stock options for the purchase of an aggregate of 300,645 shares of Class A Common Stock, at a price range of $.75 to $5.63 per share, had their existing options F-18 41 adjusted to purchase an aggregate of 20,043 shares of Class A Common Stock, at a price range of $11.25 to $84.38 per share. In addition, certain then current employees who held stock options agreed to cancel their options to purchase 221,188 shares of Class A Common Stock at $.75 per share, in exchange for the issuance of new options to purchase 1,371,811 shares of Class A Common Stock at $.90 per share. As of December 31, 1997, the Company had available for issuance, stock options to purchase 377,515 shares of Class A Common Stock pursuant to the 1994 Stock Plan. On December 7, 1992, the Company adopted the 1993 Nonqualified Stock Option Plan (the 1993 Plan). Options outstanding under the 1993 Plan as of December 31, 1997 are exercisable immediately, expire no later than 10 years from the date of grant and were granted at no less than the fair market value on the date of grant, as determined by the Board of Directors. Since the date of the recapitalization, the Company has not granted, and does not intend to grant, any additional options under the 1993 Plan. Information concerning activity under these plans is as follows: NUMBER OF SHARES OPTION PRICE ------------ ------------ Outstanding September 30, 1994 ....................... 522,033 .75 Decrease for adjusted options ....................... (300,845) .75 - 5.63 Increase for adjusted options ....................... 20,043 11.25 - 84.38 Canceled ............................................ (221,188) .75 Granted ............................................. 1,425,811 .90 - 1.50 --------- ------------- Outstanding, September 30, 1995 ...................... 1,445,854 .90 - 84.38 Canceled ........................................... (7,627) 1.50 Granted ............................................ 21,000 3.00 --------- ------------- Outstanding, December 31, 1995 ....................... 1,459,227 .90 - 84.38 Exercised .......................................... (1,333) .90 Canceled ........................................... (5,341) 1.50 - 84.38 Granted ............................................ 21,266 3.00 --------- ------------- Outstanding, December 31, 1996 ....................... 1,473,819 .90 -84.38 Exercised .......................................... (137,895) .90 - 1.50 Canceled ........................................... (248,070) .90 - 4.94 Granted ............................................ 1,162,764 .90 - 4.94 --------- ------------- Outstanding, December 31, 1997 ....................... 2,250,618 .90 -84.38 Exercisable, December 31, 1997 ....................... 1,261,037 .90 -84.38 Weighted average exercise price of all options ....... 2.23 Weighted average exercise price of options exercisable ......................................... 2.08 (f) Warrants All unexercised warrants issued prior to the recapitalization remained outstanding, subject to their initial vesting and expiration terms. Shares purchasable upon the exercise of these warrants have been adjusted to reflect the effect of the recapitalization. No warrants were exercised during the year ended December 31, 1997. Additionally in 1997, the Company issued new warrants under the 1994 Plan for the purchase of 150,000 shares of Class A Common Stock at $ .90 - $4.94 per share, which vest in annual increments over a three year period, to several members of the Company's management team and Board of Directors and an affiliate to the Board of Directors. The Company will recognize compensation expense associated with the warrants over the three year period. As of December 31, 1997, warrants to purchase the following classes of stock remained outstanding. F-19 42 NUMBER OF NUMBER OF SHARES WARRANTS STOCK CLASS PURCHASABLE EXERCISABLE EXERCISE PRICE -------------------- ----------- ----------- --------------- Class A Common Stock 583,571 433,571 $.90 - 111.15 Class B Common Stock 13,038 13,038 $ 22.50 (g) Stock-Based Compensation -- Pro Forma Disclosure The Company accounts for its stock-based compensation plans for employees under APB Opinion No. 25, Accounting for Stock Issued to Employees. In October 1995, The Financial Accounting Standards Board issued SFAS No. 123, Accounting for Stock-Based Compensation, which is effective for fiscal years beginning after December 15, 1995. SFAS No. 123 establishes a fair-value based method of accounting for stock-based compensation plans. The Company has adopted the disclosure-only alternative for grants to employees, which requires disclosure of the pro forma effects on earnings and earnings per share as if SFAS No. 123 had been adopted for employee grants, as well as certain other information. The Company has computed the pro forma disclosures required under SFAS No. 123 for all 1995, 1996, and 1997 stock options granted to employees as of December 31, 1997 using the Black Scholes option pricing model prescribed by SFAS No. 123. Assumptions used and the weighted average information are as follows: YEAR ENDED YEAR ENDED THREE MONTHS ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ------------ ------------ ------------------- -------------- Risk-free interest rates........ 6.21%-6.71% 5.72%-5.82% 5.70%-6.18% 6.71%-7.91% Expected dividend yield......... -- -- -- -- Expected lives.................. 10 years 10 years 3 - 10 years 5 - 10 years Expected volatility............. 95% 61% 61% 61% The total value of the options granted to employees during the year ended September 30, 1995, three months ended December 31, 1995, and years ended December 31, 1996 and 1997 was computed as $1,284,000, $59,000, $48,000 and $1,826,000, respectively. Of these amounts, $1,133,000, $68,000, $84,000 and $587,000 would be charged to operations for the years ended September 30, 1995, three months ended December 31,1995, and years ended December 31, 1996 and 1997, respectively. The remaining amount of $1,344,000 would be amortized over the remaining vesting periods. The effect of applying SFAS No 123 would be as follows: YEAR ENDED YEAR ENDED THREE MONTHS ENDED YEAR ENDED DECEMBER 31, 1997 DECEMBER 31, 1996 DECEMBER 31, 1995 SEPTEMBER 30, 1995 ----------------- ----------------- ----------------- ------------------ Pro Forma Net Income (Loss) .......... ($6,576,000) $1,251,000 $670,000 $555,000 Pro Forma Diluted Net Income (Loss) per Share........................... ($1.04) $0.25 $0.17 $0.16 Pro Forma Basic Net Income (Loss) per Share................................. ($1.04) $1.74 $2.14 $0.47 F-20 43 (13) EMPLOYEE BENEFIT PLAN The Company has an employee benefit plan under Section 401(k) of the Internal Revenue Code. The plan allows employees to make contributions up to a specified percentage of their compensation. Under the plan, the Company may, but is not obligated to, match a portion of the employee's contribution up to a defined maximum. The Company contributed $121,000, $32,000, $6,000 and $26,000 for the years ended December 31, 1997 and 1996, the three-month period ended December 31, 1995 and the year ended September 30, 1995, respectively. (14) RELATED PARTY TRANSACTIONS An employee of a company which is an affiliate of a member of the Company's Board of Directors (the "Affiliate") rendered financial advisory services to the Company on an as-needed basis. As compensation for the services rendered, the Company paid the Affiliate a monthly fee and reimbursed the Affiliate for reasonable expenses incurred by the Affiliate and/or the employee in connection with the performance of services to the Company. From January 1, 1996 through April 30, 1996, the Company paid the affiliate $10,000 per month for such services. From May 1, 1996 to August 30, 1997, the affiliate was an employee of the Company. Effective August 30, 1997, the employee terminated his employment with the Company. (15) OTHER INCOME (EXPENSE), NET Other income (expense), net, consists of the following: THREE YEAR ENDED YEAR ENDED MONTHS ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER 31, SEPTEMBER 30, 1997 1996 1995 1995 ------------ ----------- ------------ ------------ Interest income $ 522,000 $ 97,000 $ 2,000 $ 11,000 Interest expense (9,000) (113,000) (7,000) (16,000) Other.......... (3,000) (3,000) 22,000 16,000 ------------ ---------- --------- --------- $ 510,000 ($ 19,000) $ 17,000 $ 11,000 ============ ========== ========= ========== (16) GEOGRAPHICAL INFORMATION The Company's export sales from the United States to customers in foreign countries are as follows: THREE YEAR ENDED YEAR ENDED MONTHS ENDED YEAR ENDED DECEMBER 31, DECEMBER 31, DECEMBER,31, SEPTEMBER 30, 1997 1996 1995 1995 ---------- ---------- ---------- ----------- Europe $1,942,000 $2,599,000 $ 775,000 $2,407,000 Japan 2,336,000 911,000 548,000 1,177,000 Canada 1,184,000 1,188,000 28,000 894,000 Other 317,000 192,000 7,000 73,000 ---------- ---------- ---------- ---------- $5,779,000 $4,890,000 $1,358,000 $4,551,000 ========== ========== ========== =========== (17) SUBSEQUENT EVENTS On March 13, 1998, the Company made a $500,000 equity investment in DiamondSoft, Inc., a California corporation primarily engaged in the business of developing, marketing and distributing software tools to a variety of professional markets. This equity investment involved the purchase of 250,000 shares of DiamondSoft's Series A Convertible Preferred Stock at a price of $2.00 per share. In addition, pursuant to a letter agreement with DiamondSoft dated March 17, 1998, the Company will market DiamondSoft's FontReserve software to hardware and software developers and DiamondSoft will license the Company's Font Navigator software to retailers and corporate users. F-21