1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON DC 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 or 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE YEAR ENDED DECEMBER 31, 1998 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 0-23067 CONCORD COMMUNICATIONS, INC. (Exact name of registrant as specified in its charter) Massachusetts 04-2710876 (State of incorporation) (IRS Employer Identification Number) 33 Boston Post Road, West Marlboro, Massachusetts 01752 (508) 460-4646 (Address and telephone of principal executive offices) ----------- Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, par value $0.01 per share ( Title of class) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. YES X NO --- --- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] The aggregate market value of the voting stock held by non-affiliates of the Registrant, based on the closing sale price of the Company's common stock on March 8, 1999, as reported on the Nasdaq National Market was approximately $847,999,192. The number of shares outstanding of Common Stock as of March 8, 1999 was 13,198,431. DOCUMENTS INCORPORATED BY REFERENCE Document Form 10-K Reference Portions of the Annual Report to Stockholders for the fiscal year ended December 31, 1998. Part II, Item 7 Portions of the Registrant's Proxy Statement Part III for its Annual Meeting of Stockholders to be held on April 27, 1999. THIS DOCUMENT CONTAINS 40 PAGES. THE EXHIBIT INDEX IS ON PAGE 37 . ------ 2 PART I ITEM 1. BUSINESS INTRODUCTION Concord develops, markets and supports a family of turnkey, automated, scalable, Web-based performance analysis and reporting solutions for the management of computer networks. By providing a global view of network performance, the Company's products enable the effective and efficient management of large and medium-size multi-vendor networks, both by end users and network service providers, including telecommunications carriers, Internet Service Providers (ISPs), systems integrators and outsourcers. The Company's Network Health product family retrieves and compiles vital network statistics, performs extensive analyses of those statistics and provides intuitive, informative, user-friendly graphical reports. The Company's software-only solutions provide Information Technology (IT) executives, managers and technicians with the information necessary to assess and correct costly network inefficiencies, make cost-effective network purchasing decisions, predict network failures and set and monitor service levels. The Company's initial target market has been organizations with large and medium-size networks of 150 or more network elements. The Company markets to these potential customers through its own sales force, sales agents, value added resellers, network service providers, including telecommunication carriers, and OEMs. As of December 31, 1998, the Company had over 950 customers operating in and serving a variety of industries. Representative customers include America Online, Inc., Ameritech Corporation, AT&T Corporation, The Bear Stearns Companies, Inc., British Telecommunications plc, Compaq Computer Corporation, Cornell University, Dell Computer Corporation, Delta AirLines, Ernst & Young LLP, MCI Communications Corporation, Motorola Inc., Nike International Ltd., Novartis Pharmaceuticals Corporation, Peoplesoft USA, Pepsi-Cola Company, The Procter & Gamble Company, Sprint Corporation, Toys "R" Us, Twentieth Century Fox, U S WEST, Inc. and Volkswagen. INDUSTRY BACKGROUND The pervasiveness and sophistication of business process applications, such as email, electronic commerce and enterprise resource planning systems, have significantly increased the amount of data traffic across networks. As these applications have become an integral part of managing information within an enterprise, businesses have developed and expanded their computer networks to connect remote operations, branch offices, telecommuters, customers and suppliers, among others. These increases in data traffic, coupled with the emergence of widely distributed computing across heterogeneous platforms, have increased the demands placed on both LANs and WANs. The sophisticated and complex technologies that have been developed to meet these demands, such as LAN switching, frame relay and ATM, must not only enhance bandwidth and connectivity, but must also interface with existing legacy environments in order to build an effective integrated business infrastructure. Increased network complexities, combined with inadequate centralized network analysis and planning functions, have led to network congestion and the inefficient use of both LAN and WAN resources and unnecessary purchases of additional networking hardware, leased lines and digital carrier WAN bandwidth. Because the consequences of network congestion and failure can range from a temporary reduction in productivity to significant financial loss, the reliability and performance of networks has assumed critical importance. To ensure the reliability and performance of these networks, organizations are increasingly relying on network management software. The technical complexity of providing for high levels of automation, aggregation and scalability over thousands of network elements has made comprehensive network management applications difficult to develop. Solutions originally developed for network management were centralized, mainframe-based systems that offered a platform from which the network manager could monitor the network. These 1 3 systems were expensive, provided limited functionality and were generally closed and proprietary. With the emergence of distributed computing environments, independent tool vendors began developing solutions that solved specific technical network problems. The emergence of MIBs along with a standardized protocol (SNMP) provided not only a mechanism to measure all networking elements but also the required enabling technology for technical network management. SNMP facilitated the development of technical tools, such as network element management solutions and RMON and RMON2 probe-based solutions. Network element management solutions allow technical personnel to diagnose problems, but are usually limited to a particular vendor's equipment. Probe-based solutions provide technical information on a specific network segment only and may provide monitoring and reporting capabilities that are usually dependent on data accumulated from the particular probes. Although these tools have enhanced the technical management of networks and are particularly useful in isolating and correcting problems in networks after such problems have already occurred, the dependency of organizations on their networks has necessitated new, broad-based network management solutions. These solutions enable organizations to optimize the performance and minimize the costs of their existing network infrastructure, identify developing network problems and support decisions relating to future network infrastructure growth. IT executives and managers of both large and small networks are coming to recognize that in order to optimize network resources and effectively plan for future demand, performance analysis and reporting solutions must reside at the core of the network as a means of aggregating relevant network data into a comprehensive picture of network health. THE CONCORD SOLUTION Concord develops, markets and supports a family of turnkey, automated, scaleable, Web-based performance analysis and reporting solutions for the management of computer networks. The Company's Network Health product family retrieves and compiles vital network statistics, performs extensive analyses of those statistics and provides intuitive, informative, user-friendly graphical reports. The Company's products are capable of simultaneously polling, analyzing and reporting on between 10,000 and 20,000 elements per workstation. The Company's Network Health product family provides organizations with the following benefits: (i) capacity planning -- providing information to support business decisions relating to network utilization and future capacity requirements; (ii) reduction in data communications expenses --identifying excess capacity on each WAN, leased line or frame relay circuit; (iii) effective allocation of resources -- allowing management to effectively deploy networking resources and personnel; and (iv) service level monitoring -- assisting managers in making network resource allocation decisions within an organization and assisting both network service providers and end users in monitoring the availability of negotiated service level agreements. In providing these benefits, the Company's Network Health product family incorporates the following features: FULLY AUTOMATED, TURNKEY IMPLEMENTATION. The Company's products provide turnkey solutions for fully automated network performance analysis and reporting. Installation can be accomplished in a few hours without the use of additional network hardware. Once installed, the Company's software immediately generates standardized reports on a variety of topics, such as: (i) situations to watch for potential trouble spots; (ii) exceptions analysis for identifying deviations from specified performance levels; and (iii) bandwidth utilization for managing and allocating limited network resources. These standardized reports can be accessed via the Web, directly at the network monitoring console, or through printed reports. SCALEABLE, SOFTWARE-ONLY SOLUTION. The Network Health product family is designed to collect data from heterogeneous networking environments without the use of additional probes and network monitoring tools. The Company's products are easily scaled to meet the demands for network performance analysis 2 4 and reporting as an organization's network infrastructure expands. Network Health provides managers with the ability to purchase add-on software licenses as needed. MULTI-LEVEL REPORTING. The Company's Network Health product family generates a comprehensive package of graphical reports that provide information and analyses on a wide variety of pre-programmed parameters. Information is provided for use at multiple levels of management, from a general overview of network performance for chief information officers to a port-by-port analysis of specific network hardware for managers or technicians. TECHNOLOGY AND VENDOR INDEPENDENCE. The Company's Network Health product family provides performance analysis and reporting of elements within an organization's heterogeneous LAN and WAN infrastructure, independent of network technology and hardware vendor. The Company's products are easily extendible to new technologies and network architectures. PRODUCTS AND TECHNOLOGY The Company's Network Health product family automatically provides enterprise-wide performance analysis and reporting for the large number of elements typically found within networks. The technical complexity of providing for high levels of automation, aggregation and scalability over thousands of network elements has made comprehensive network management applications difficult to develop. The Network Health platform automatically locates devices on the network, identifies MIB variables, polls devices, and stores data in a relational database. After the data has been analyzed, Network Health automatically generates multiple reports which can be retrieved from the network console or via the Web. Network Health software operates continuously to provide full-time data gathering and on demand reporting. Network Health reports show the effects of usage and serve as a basis for agreeing to and understanding service levels, proactively addressing potential network failures, managing bandwidth and capacity, identifying security violations and understanding the usage patterns of the network and the network's various elements. The critical technology components in the Network Health architecture are the polling engine, the MIB translation file, the database and group filter, and the reporting engine. Each of these components is device independent, and thus can function on any type of network device or segment irrespective of the network equipment vendor or technology. These components automate the functions of locating the appropriate devices for polling, gathering only the appropriate variables and data from those devices, and converting the data into canonical format which facilitates analysis. The distributed nature of the product allows for the product components and the user to be located at any location within the organization. Through the use of sophisticated algorithms and heuristics, the gathered data can be analyzed to make predictions of upcoming problems throughout the network. The report viewing components within the reporting engine allow the rendering and display of multiple views and reports in a graphical fashion for Web output, print output or integration level output to other products. By focusing on the issues of capacity, errors, service levels and utilization, Network Health's manner of reporting provides a common model which covers a broad spectrum of network elements and technologies. Pricing for Network Health applications includes a fixed license fee per application and a variable fee based on the number of network elements managed by that application. During 1996, 1997 and 1998, initial orders with new customers for the Company's Network Health products ranged from approximately $10,000 to $525,000. The following are the Company's products: Network Health 4.1, which was released in August 1998, provides enterprise and service provider customers with the first multi-vendor ATM reporting and analysis solution, along with the first device-independent reporting tool for Remote Access equipment. 3 5 NETWORK HEALTH -- LAN/WAN pioneered scaleable performance analysis and reporting for LANs as well as WANs by providing reports that allow users to solve business problems. This application provides information on capacity, errors, trends, over-utilization, under-utilization, and service levels through intuitive charts and graphs. These charts and graphs minimize technology differences to allow a single report format to cover a broad set of technologies, including Ethernet, Token Ring, and fiber distributed data interface (FDDI) to 56Kbps, T1, T3 and switched multimegabit data service (SMDS). NETWORK HEALTH -- FRAME RELAY is used to manage the unique aspects of frame relay Permanent Virtual Circuits (PVCs). This application indicates poor carrier service by: (i) identifying carrier network congestion; (ii) end user over-usage of the Committed Information Rate (CIR); and (iii) timing for upgrades to higher capacities or downgrades to less expensive lower capacities. Network Health -- Frame Relay is often used by network service providers for quality of service discussion. NETWORK HEALTH -- ROUTER/SWITCH expands Network Health reports to cover the increased complexity of managing the behavior of the network's routers and switches. This application gathers information on and analyzes CPUs, memory usage, buffer utilization, buffer misses and other such detail to provide the first level of insight into the operation and capacities of the routers and switches themselves. For example, with the Situations to Watch panel in the Network Health -- Router/Switch report, needed memory upgrades can be forecasted to allow for an orderly upgrade of the router's memory. When a router has been identified as needing attention, the At-A-Glance Reports provide an historical snapshot of a router's recent performance, enabling network managers to determine a course of action. NETWORK HEALTH -- TRAFFIC ACCOUNTANT is a software application that provides information on nodes, access patterns and applications used. This application scales to enterprise networks, providing an array of reports covering cost allocation, security audit trails, security exception reports, reconfiguration reports, application usage, Internet usage and department utilization. The percentage of the entire network used by particular departments or divisions in an organization can be reported in a single chart. NETWORK HEALTH -- SERVER analyzes and reports on servers in a scaleable manner allowing a network manager to understand the trends, capacities and service levels of the server's CPUs, memory, disks, partitions, virtual memory, swapping, paging and performance and operational characteristics. The diversity of server vendors coupled with the increased complexity of servers necessitates a unique application. The product's analysis and prediction capability, for example, can be used to identify the disks in need of upgrade before they become capacity constrained. NETWORK HEALTH -- SERVICE LEVEL REPORTING provides a one to two page report on an entire corporate enterprise's network that summarizes network and server availability, response time and capacity. These reports give IT executives including the CIO a picture of the critical parameters being used by end users of the IT infrastructure. Service Level Reporting is useful in providing a report against pre-determined goals for levels of capacity, availability and response time that can be used by Service Providers with their end user customers. NETWORK HEALTH -- REMOTE ACCESS, the first device-independent reporting tool for remote access equipment, provides three types of reports in one: for individual modems/ISDN interfaces, modem pools, and remote access servers. Remote Access gives ISP's and large organizations the information required to optimize remote access service usage and configuration, while planning for future capacity requirements. This product was introduced during August of 1998. NETWORK HEALTH -- ATM, helps network managers optimize the performance of complex ATM networks by providing executive-level information and easy-to-read utilization details. This software-only solution combines out-of-the-box automation with the ability to create custom reports from a Web interface to meet diverse reporting requirements. This product was introduced during August of 1998. 4 6 CUSTOMER SERVICE The post-sales support organization is responsible for providing ongoing technical support and training for the Company's customers. For an annual fee, a customer will receive telephone and email support, as well as new releases of the Company's products. The Company offers a toll-free customer support line to customers. Support personnel answer the technical support calls and generally provide same-day responses to questions that cannot be resolved during the initial call. All calls are logged, opened, tracked, and closed with daily updates to the customer, Concord's sales teams and Concord's executive management team. Concord will deploy any one of its 25 field pre-sales technical support representatives in the event that an on-site visit is necessary. At December 31, 1998, the Company employed 17 technical post-sales support personnel as well as two product trainers and one registrar. SALES AND MARKETING The Company markets its products in the United States to organizations with large and medium-size networks, as well as network service providers which include telecommunications carriers, ISPs, systems integrators and outsourcers primarily through a direct sales force, sales agents and through value added resellers (VARs). Internationally, the Company markets exclusively through distributors. Additionally, the Company has entered into joint marketing and joint development arrangements with a number of companies. At December 31, 1998, the Company had 23 domestic sales teams each comprised of one direct sales person and one or two technical support people targeting the following 11 different geographic regions: Atlanta and the Southeast; Dallas; Detroit; Denver; New England and East Canada; New York; the Carolinas; Northern California and West Canada; Philadelphia; Southern California; and Virginia and Washington, D.C. In addition, the Company employs five sales personnel to support the 23 domestic sales teams. Internationally, the Company has sales offices in England, Germany, Singapore and France. At December 31, 1998 the Company utilized 17 international distributors in nine geographic regions, including: the United Kingdom, Germany, France, Sweden, Korea, the Benelux region, Australia, South America and South Africa. It is the responsibility of each sales team to manage all sales within its geographic territory by signing up, training, and managing a small number of sales agents, VARs, network service providers and outsourcers, as well as selling directly to customers. The Company generates sales through seminars, trade shows, Internet postings, press articles, referrals, mass mailings and cold calling as well as through relationships with sales agents, VARs, network service providers and outsourcers. The Company distributes its products through a network of more than 22 VARs, and at December 31, 1998, the Company had relationships with over 20 network service providers. The network service providers offer the Company's products as part of their service offerings. At December 31, 1998, the Company also had several joint marketing and development partners, including Ascend Communications, Inc., Cabletron Systems, Inc., Cisco Systems, Inc., NetScout Systems, Inc., Newbridge Networks Corporation and Visual Networks, Inc. that work with the Company's direct sales force. The Company recently introduced a professional services referral program aimed at its key network consulting partners. Under this program, the Company will provide professional services through these partners directly to its customers. At December 31, 1998, the Company employed 12 marketing personnel who position, promote and market the Company's products. These individuals are engaged in a variety of activities, including direct marketing, public relations, tradeshows, advertising, Internet postings, and seminars. At December 31, 1998, the Company employed 63 sales personnel, consisting of five management personnel, 24 sales persons, 25 technical support persons and nine inside sales persons. PRODUCT DEVELOPMENT Management believes that the Company's future success depends in large part on its ability to continue to enhance existing products and develop new products that maintain technological competitiveness and 5 7 deliver value to existing and new customers. The Company has made and intends to continue to make substantial investments in product development. Extensive product development input is obtained through customers and the Company's monitoring of end user needs and changes in the marketplace. The Company introduced the initial version of Network Health focused at the LAN and WAN environments in the first quarter of 1995. During 1996, the Company introduced three additional versions of Network Health -- Frame Relay, Router/Switch and Traffic Accountant. During 1997, the Company introduced two additional versions of Network Health -- Server and Service Level Reporting. During 1998, the Company introduced two additional versions of Network Health -- ATM and Remote Access. The Company is currently developing an enhanced version of Network Health aimed at performance analysis and reporting for other networking and computing environments. The Company's total expenses for research and development for the years 1998, 1997 and 1996 were $7.2 million, $4.6 million and $3.9 million, respectively. The Company anticipates that it will continue to commit substantial resources to research and development in the future and that product development expenses may increase in absolute dollars in future periods. To date, the Company's development efforts have not resulted in any capitalized software development costs. As of December 31, 1998, the Company's product development organization consisted of 55 people. COMPETITION The market for the Company's products is highly competitive and subject to rapid technological change. Although the Company has experienced limited competition to date from products with comparable capabilities, the Company expects competition to increase in the future. The Company currently competes principally on the basis of: (i) the breadth of its products' features; (ii) the automated, scaleable, and cost effective nature of its products; and (iii) the Company's knowledge, expertise and service ability gained from years of close interaction with customers. While the Company believes that it currently competes favorably overall with respect to these factors, there can be no assurance that the Company will be able to continue to do so. The Company competes or may compete directly or indirectly with the following categories of companies: (i) report toolset vendors, such as Desktalk Systems, Inc.; (ii) large, well established networking OEMs such as International Business Machines Corporation, Lucent Technologies, Hewlett-Packard Company, and Cabletron Systems, Inc. that have developed network management platforms; (iii) developers of network element management solutions such as Cisco Systems, Inc., 3Com Corporation and Nortel Networks, Inc.; (iv) companies offering network performance reporting services such as International Network Services (INS); and (v) to a lesser degree, probe vendors such as NetScout Systems, Inc. and Visual Networks, Inc. Additional competitors, including large networking or telecommunications equipment manufacturers, telecommunications service providers, and computer hardware and software companies, may enter this market, thereby further intensifying competition. Additionally, there can be no assurance that one or more of the Company's customers may not attempt to develop competing products internally or that one or more of the companies Concord has developed relationships with, such as the network management platform developers and probe vendors, will not try to develop a product that competes more directly with Network Health. Many of the Company's current and prospective competitors have significantly greater financial, selling and marketing, technical and other resources than the Company. As a result, these competitors may be able to devote greater resources to the development, promotion, sale and support of their products than the Company. Moreover, these companies may introduce additional products that are competitive with or better than those of the Company or may enter into strategic relationships to offer better products than those currently offered by the Company. There can be no assurance that the Company's products would effectively compete with such new products. 6 8 To remain competitive, the Company must continue to invest in research and development, selling and marketing, and customer service and support. In addition, as the Company enters new markets and utilizes different distribution channels, the technical requirements and levels and bases of competition may be different than those experienced in the Company's current market. There can be no assurance that the Company will be able to successfully compete against either current or potential competitors in the future. PROPRIETARY RIGHTS The Company relies on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to establish, maintain and protect its proprietary rights in its products. The Company has four issued U.S. patents, three pending U.S. patent applications and various foreign counterparts. There can be no assurance that patents which have been or may be issued will not be challenged, invalidated or circumvented, or any rights thereunder will provide protection of the Company's intellectual property rights. The Company believes that, because of the rapid pace of technological change in the software and data communications industries, the legal intellectual property protection for its products is a less significant factor in the Company's success than the knowledge, abilities and experience of the Company's employees, the frequency of its product enhancements, the effectiveness of its marketing activities and the timeliness and quality of its support services. See "Risk Factors -- Uncertain Protection of Intellectual Property Rights." Certain technologies used in the Company's products are licensed from third parties, including the database technology employed in the Company's Network Health product family. Such third-party licenses are generally non-exclusive, royalty based licenses. With respect to the database technology, the Company is obligated to make minimum fixed price payments to the extent that the royalty under such license does not exceed a certain minimum threshold. The termination of any such licenses, or the failure of the third-party licensors to adequately maintain or update their products, could result in delay in the Company's ability to ship certain of its products while it seeks to implement technology offered by alternative sources, and any required replacement licenses could prove costly. While it may be necessary or desirable in the future to obtain other licenses relating to one or more of the Company's products or relating to current or future technologies, there can be no assurance that the Company will be able to do so on commercially reasonable terms or at all. EMPLOYEES As of December 31, 1998, the Company had a total of 173 employees, all but seven of whom were based in the United States. Of the total, 55 were in research and development, 22 were in customer service, 63 were in sales, 12 were in marketing, and 21 were in finance, administration and operations. The Company's future performance depends in significant part upon the continued service of its key engineering, technical support and sales personnel. Competition for such personnel is intense and there can be no assurance that the Company will be successful in attracting or retaining such personnel in the future. None of the Company's employees are represented by a labor union or are subject to a collective bargaining agreement. The Company has not experienced any work stoppages and considers its relations with its employees to be good. 7 9 ITEM 1A. EXECUTIVE OFFICERS OF THE REGISTRANT The executive officers of the Company and their ages as of December 31, 1998 are as follows: NAME AGE POSITION ---- --- -------- John A. Blaeser............................................... 57 Chief Executive Officer, President and Director Kevin J. Conklin.............................................. 45 Vice President, Marketing Ferdinand Engel............................................... 50 Vice President, Engineering Gary E. Haroian............................................... 47 Vice President, Finance and Administration, Chief Financial Officer, Clerk and Treasurer Daniel D. Phillips, Jr........................................ 44 Vice President, Worldwide Sales Set forth below is certain information relating to each executive officer's business experience: John A. Blaeser has been Chief Executive Officer and President of the Company since January 1, 1996 and a Director of the Company since 1985. Prior to joining the Company, from 1991 until 1996, Mr. Blaeser was Managing General Partner of EG&G Venture Management, a venture capital firm. Kevin J. Conklin has been Vice President, Marketing of the Company since March 1994. Prior to joining Concord, Mr. Conklin was Vice President of Product Marketing and Development at Artel Communications from June 1993 until joining Concord in March 1994, and from July 1991 to June 1993 Mr. Conklin served as Director of Marketing at Artel Communications. Ferdinand Engel has been the Vice President, Engineering of the Company since 1989. Prior to joining Concord, Mr. Engel was Vice President, Engineering for Technology Concepts at Bell Atlantic. Gary E. Haroian has been the Vice President, Finance and Administration and Chief Financial Officer of the Company since February 1997, and also serves as Clerk and Treasurer of the Company. Prior to joining the Company, Mr. Haroian was President and Chief Executive Officer of Stratus Computer. At Stratus, Mr. Haroian held the positions of Controller from 1983 until 1985, Vice President and Chief Financial Officer from 1985 until 1991, Vice President, Corporate Operations, from 1991 until 1993, Executive Vice President from 1993 until 1994, and President and Chief Operating Officer from 1994 until 1996. Daniel D. Phillips, Jr. has been Vice President, Worldwide Sales of the Company since May 1994. Prior to joining Concord, Mr. Phillips was Vice President, Worldwide Sales of Epoch Systems. While at Epoch Systems from September 1989 until May 1994, Mr. Phillips also held the positions of Vice President, International and OEM Operations, and Director of International Operations. 8 10 RISK FACTORS The Company does not provide forecasts of the future financial performance of the Company. From time to time, however, the information provided by the Company or statements made by its employees may contain forward looking statements. This document contains forward looking statements. Any statements contained herein that do not describe historical facts are forward looking statements. The Company makes such forward looking statements under the provisions of the "safe harbor" section of the Private Securities Litigation Reform Act of 1995. The forward looking statements contained herein are based on current expectations, but are subject to a number of risks and uncertainties. In particular, statements contained in Management's Discussion and Analysis of Financial Condition and Results of Operations which are not historical facts (including, but not limited to, statements concerning the plans and objectives of management; increases in sales and marketing, research and development and general and administrative expenses; expenses associated with Year 2000 and the Company's expected liquidity and capital resources) constitute forward-looking statements. The Company's actual future results may differ significantly from those stated in any forward-looking statements. Factors that may cause such differences include, but are not limited to, the factors discussed below. LIMITED OPERATING HISTORY; UNCERTAINTY OF FUTURE OPERATING RESULTS The Company changed its focus to network management software in 1991 and commercially introduced its first Network Health product in 1995. Accordingly, the Company has only a limited operating history in the network performance analysis and reporting market upon which an evaluation of its business and prospects can be based. The Company has incurred significant net losses in each of the five fiscal years prior to earning a small profit in 1997. As of December 31, 1998, the Company had accumulated net losses of $22.0 million. The limited operating history of the Company and its dependence on a single product family in an emerging market makes the prediction of future results of operations difficult or impossible, and the Company and its prospects must be considered in light of the risks, costs and difficulties frequently encountered by emerging companies, particularly companies in the competitive software industry. Although the Company has achieved recent revenue growth, and profitability for the fiscal years ended 1998 and 1997, there can be no assurance that the Company can generate substantial additional revenue growth on a quarterly or annual basis, or that any revenue growth that is achieved can be sustained. Revenue growth that the Company has achieved or may achieve may not be indicative of future operating results. In addition, the Company has increased, and plans to increase further, its operating expenses in order to fund higher levels of research and development, increase its sales and marketing efforts, develop new distribution channels, broaden its customer support capabilities and expand its administrative resources in anticipation of future growth. To the extent that increases in such expenses precede or are not subsequently followed by increased revenues, the Company's business, results of operations and financial condition would be materially adversely affected. There can be no assurance that the Company will sustain profitability on a quarterly or annual basis. The Company must achieve substantial revenue growth in order to sustain profitability. In addition, in view of recent revenue growth, the rapidly evolving nature of its business and markets and its limited operating history in its current market, the Company believes that period-to-period comparisons of financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. In light of the Company's strong performance in 1998, the Company expects to use all its remaining unrestricted NOL and credit carryforwards in 1998. Accordingly, the Company recorded a tax provision of $532,600 during 1998. However, the continuing restrictions on the future use of its NOL carryforwards will severely limit the benefit, if any, the Company will attribute to this asset. POTENTIAL FLUCTUATIONS IN QUARTERLY OPERATING RESULTS The Company is likely to experience significant fluctuations in quarterly operating results caused by many factors, including, but not limited to: (i) changes in the demand for the Company's products; (ii) the 9 11 timing, composition and size of orders from the Company's customers, including the tendency for significant bookings to occur in the last month of each fiscal quarter; (iii) spending patterns and budgetary resources of its customers on network management software solutions; (iv) the success of the Company's new customer generation activities; (v) introductions or enhancements of products, or delays in the introductions or enhancements of products, by the Company or its competitors; (vi) changes in the Company's pricing policies or those of its competitors; (vii) changes in the distribution channels through which products are sold; (viii) the Company's ability to anticipate and effectively adapt to developing markets and rapidly changing technologies; (ix) changes in networking or communications technologies; (x) the Company's ability to attract, retain and motivate qualified personnel; (xi) changes in the mix of products sold; (xii) the publication of opinions about the Company and its products, or its competitors and their products, by industry analysts or others; and (xiii) changes in general economic conditions. Unlike other software companies with a longer history of operations, the Company does not derive a significant portion of its revenues from maintenance contracts, and therefore does not have a significant ongoing revenue stream that may tend to mitigate quarterly fluctuations in operating results. Furthermore, the Company is attempting to expand its channels of distribution, and increases in the Company's revenues will be dependent on its ability to implement successfully its distribution strategy. Due to the buying patterns of certain of the Company's customers and also to the Company's own sales incentive programs focused on annual sales goals, revenues in the Company's fourth quarter could be higher than revenues in the first quarter of the succeeding year. There also may be other factors that significantly affect the Company's quarterly results which are difficult to predict given the Company's limited operating history, such as seasonality and the timing of receipt and delivery of orders within a fiscal quarter. Consistent with software industry practice, the Company expects to operate with a limited amount of backlog. As a result, quarterly sales and operating results depend generally on the volume and timing of orders within the quarter, the tendency of sales to occur late in fiscal quarters and the ability of the Company to fill orders received within the quarter, all of which are difficult to forecast and manage. The Company's expense levels are based in part on its expectations of future orders and sales, which, given the Company's limited operating history, are extremely difficult to predict. A substantial portion of the Company's operating expenses are related to personnel, facilities, and sales and marketing programs. This level of spending for such expenses cannot be adjusted quickly and is, therefore, relatively fixed in the short term. Accordingly, any significant shortfall in demand for the Company's products in relation to the Company's expectations would have an immediate and material adverse effect on the Company's business, results of operations and financial condition. Due to all of the foregoing factors, the Company believes that its quarterly operating results are likely to vary significantly in the future. Therefore, in some future quarter the Company's results of operations may fall below the expectations of securities analysts and investors. In such event, the trading price of the Company's Common Stock would likely be materially adversely affected. EMERGING NETWORK MANAGEMENT SOFTWARE MARKET The market for the Company's products is in an early stage of development. Although the rapid expansion and increasing complexity of computer networks in recent years has increased the demand for network management software products, the awareness of and the need for such products is a recent development. Because the market for these products is only beginning to develop, it is difficult to assess the size of this market, the appropriate features and prices for products to address this market, the optimal distribution strategy and the competitive environment that will develop. The development of this market and the Company's growth will be significantly dependent on the willingness of network service providers, including telecommunications carriers, ISPs, systems integrators and outsourcers, to integrate network performance analysis and reporting software into their product and service offerings. Failure of the network performance analysis and reporting market to grow or failure of the Company to properly assess and address such market would have a material adverse effect on the Company's business, results of operations and financial condition. 10 12 DEPENDENCE ON TELECOMMUNICATIONS CARRIERS A significant portion of the Company's revenues are, and are expected to continue to be, attributable to sales of products to telecommunications carriers. The Company's future performance is significantly dependent upon telecommunications carriers' increased incorporation of the Company's solutions as part of their package of product and service offerings to end users. The failure of the Company's products to perform favorably in and become an accepted component of the telecommunications carriers' product and service offerings, or a slower than expected increase or a decrease in the volume of sales of the Company's products and services to telecommunications carriers, could have a material adverse effect on the Company's business, results of operations and financial condition. CONCENTRATED PRODUCT FAMILY The Company currently derives substantially all of its revenues from its Network Health product family, and the Company expects that revenues from these products will continue to account for substantially all of the Company's revenues for the foreseeable future. Broad market acceptance of these products is, therefore, critical to the Company's future success, and any factor adversely affecting sales or pricing levels of these products could have a material adverse effect on the Company's business, results of operations and financial condition. There can be no assurance that market acceptance of Network Health will increase or even remain at current levels. Factors that may affect the market acceptance of the Company's products include the availability and price of competing products and technologies and the success of the sales efforts of the Company and its marketing partners. Moreover, the Company anticipates that its competitors will introduce additional competitive products, particularly if demand for network management software products increases, which may reduce future market acceptance of the Company's products. In addition, new competitors could enter the Company's market and offer alternative products which may impact the market acceptance of the Company's products. The Company's future performance will also depend in part on the successful development, introduction and market acceptance of new and enhanced products. There can be no assurance that any such new or enhanced products will be successfully developed, introduced and marketed, and failure to do so would have a material adverse effect on the Company's business, results of operations and financial condition. RAPID TECHNOLOGICAL CHANGE; DEPENDENCE ON STANDARD PROTOCOLS The software industry is characterized by rapid technological change, frequent introductions of new products, changes in customer demands and evolving industry standards. The introduction of products embodying new technologies and the emergence of new industry standards can render existing products obsolete and unmarketable. Network Health's ability to analyze and generate reports, as well as the quality of the reports, is dependent on Network Health's utilization of the industry-standard SNMP protocol and the data resident in conventional MIBs. Any change in these industry standards, the development of vendor-specific proprietary MIB technology, or the emergence of new network technologies could affect the compatibility of Network Health with these devices which, in turn, could affect Network Health's ability to analyze and generate comprehensive reports or the quality of the reports. Furthermore, although the Company's products currently run on industry-standard UNIX operating systems and Windows NT, any significant change in industry-standard operating systems could affect the demand for, or the pricing of, the Company's products. Any of the foregoing developments could have a material adverse effect on the Company's business, results of operations and financial condition. PRODUCT ENHANCEMENTS AND NEW PRODUCTS Because of rapid technological change in the software industry and potential changes in the network management software market and industry standards, the life cycle of versions of Network Health is difficult to estimate. The Company's future success will depend upon its ability to address the increasingly sophisticated needs of its customers by developing and introducing enhancements to Network Health on a timely basis that keep pace with technological developments, emerging industry standards and customer 11 13 requirements. There can be no assurance that the Company will be successful in developing and marketing enhancements to Network Health or in developing new products that respond to technological changes, evolving industry standards or customer requirements, that the Company will not experience difficulties that could delay or prevent the successful development, introduction and sale of such enhancements or new products, or that such enhancements or new products will adequately address the requirements of the marketplace and achieve any significant degree of market acceptance. COMPETITION; NEW ENTRANTS The market for the Company's products is new, intensely competitive, rapidly evolving and subject to technological change. Competitive and alternative offerings are available from the major product categories of remote monitoring (RMON) probe vendors, element management software, and other performance analysis and reporting offerings. Another area of competition comes from a number of companies offering network performance reporting services; including International Network Services (INS). In addition, the Company expects the large network management platform vendors to begin to offer products directly competitive with the Company's products. These companies may bundle their products with other hardware and software in a manner that may discourage users from purchasing products offered by the Company. This strategy may be particularly effective for companies with leading market shares in the network hardware and software market, including Hewlett-Packard Company, Lucent Technologies, International Business Machines Corporation and Cabletron Systems, Inc. Developers of network element management solutions such as Cisco Systems, Inc., 3Com Corporation and Nortel Networks, Inc. may also compete with the Company in the future. The Company expects competition to persist, increase and intensify in the future with possible price competition developing in the Company's markets. Many of the Company's current and potential competitors have longer operating histories and significantly greater financial, technical and marketing resources and name recognition than the Company. The Company does not believe its market will support a large number of competitors and their products. In the past, a number of software markets have become dominated by one or a small number of suppliers, and a small number of suppliers or even a single supplier may dominate the Company's market. If the Company does not provide products that achieve success in its market in the short term, the Company could suffer an insurmountable loss in market share and brand name acceptance, which would result in a material adverse effect on the Company's business, results of operations and financial condition. There can be no assurance that the Company will be able to compete effectively with current and future competitors. UNCERTAIN PROTECTION OF INTELLECTUAL PROPERTY RIGHTS The Company's success depends significantly upon its proprietary technology. The Company relies on a combination of patent, copyright, trademark and trade secret laws, non-disclosure agreements and other contractual provisions to establish, maintain and protect its proprietary rights, all of which afford only limited protection. The Company has four issued U.S. patents, three pending U.S. patent applications, and various foreign counterparts. There can be no assurance that patents will issue from these pending applications or from any future applications or that, if issued, any claims allowed will be sufficiently broad to protect the Company's technology. In addition, there can be no assurance that any patents that have been or may be issued will not be challenged, invalidated or circumvented, or that any rights granted thereunder would provide protection of the Company's proprietary rights. Failure of any patents to protect the Company's technology may make it easier for the Company's competitors to offer equivalent or superior technology. The Company has registered or applied for registration for certain trademarks, and will continue to evaluate the registration of additional trademarks as appropriate. Despite the Company's efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of the Company's products or services or to obtain and use information that the Company regards as proprietary. Third parties may also independently develop similar technology without breach of the Company's proprietary rights. In addition, the laws of some foreign countries do not protect proprietary rights to as great an extent as do the laws of the United States. In addition, the Company's products are licensed under shrink wrap license agreements that are not signed by licensees and therefore may not be binding under the laws of certain jurisdictions. 12 14 Certain technologies used by the Company's products are licensed from third parties, generally on a non-exclusive basis. The termination of any such licenses, or the failure of the third-party licensors to adequately maintain or update their products, could result in delay in the Company's ability to ship certain of its products while it seeks to implement technology offered by alternative sources, and any required replacement licenses could prove costly. While it may be necessary or desirable in the future to obtain other licenses relating to one or more of the Company's products or relating to current or future technologies, there can be no assurance that the Company will be able to do so on commercially reasonable terms or at all. Although the Company does not believe that it is infringing the intellectual property rights of others, claims of infringement are becoming increasingly common as the software industry develops and legal protections, including patents, are applied to software products. Litigation may be necessary to protect the Company's proprietary technology, and third parties may assert infringement claims against the Company with respect to their proprietary rights. Any claims or litigation can be time-consuming and expensive regardless of their merit. Infringement claims against the Company can cause product release delays, require the Company to redesign its products or require the Company to enter into royalty or license agreements, which agreements may not be available on terms acceptable to the Company or at all. RISK OF PRODUCT DEFECTS; PRODUCT LIABILITY As a result of their complexity, software products may contain undetected errors or failures when first introduced or as new versions are released. There can be no assurance that, despite testing by the Company and testing and use by current and potential customers, errors will not be found in new products after commencement of commercial shipments or, if discovered, that the Company will be able to successfully correct such errors in a timely manner or at all. The occurrence of errors and failures in the Company's products could result in loss of or delay in market acceptance of the Company's products, and alleviating such errors and failures could require significant expenditure of capital and other resources by the Company. The consequences of such errors and failures could have a material adverse effect on the Company's business, results of operations and financial condition. Since the Company's products are used by its customers to predict future network problems and avoid failures of the network to support critical business functions, design defects, software errors, misuse of the Company's products, incorrect data from network elements or other potential problems within or out of the Company's control that may arise from the use of the Company's products could result in financial or other damages to the Company's customers. The Company does not maintain product liability insurance. Although the Company's license agreements with its customers typically contain provisions designed to limit the Company's exposure to potential claims as well as any liabilities arising from such claims, such provisions may not effectively protect the Company against such claims and the liability and costs associated therewith. Accordingly, any such claim could have a material adverse effect upon the Company's business, results of operations and financial condition. The Company provides warranties for its products for a period of time (currently three months) after the software is purchased. The Company's license agreements generally do not permit product returns by the customer, and product returns for fiscal 1998, 1997 and 1996 represented less than 1.0% of total revenues during each of such periods. However, no assurance can be given that product returns will not increase as a percentage of total revenues in future periods. RELIANCE ON STRATEGIC PARTNERS AND OTHER EVOLVING DISTRIBUTION CHANNELS The Company's distribution strategy is to develop multiple distribution channels, including sales through strategic marketing partners and value added resellers, such as Newbridge Networks Corporation; telecommunications carriers, such as MCI Communications Corporation; OEMs, such as Cabletron 13 15 Systems, Inc.; and independent software vendors, as well as international distributors (collectively "channel partners"). The Company has developed a number of these relationships and intends to continue to develop new channel partner relationships. Accordingly, the success of the Company will be dependent in large part on its ability to develop these additional distribution relationships and on the performance and success of these third parties, particularly telecommunications carriers and other network service providers. The Company's channel partner relationships have been established recently, and the Company cannot predict the extent to which its channel partners will be successful in marketing the Company's products. The Company generally expects that its agreements with its channel partners will be terminable by either party without cause. None of the Company's channel partners are required to purchase minimum quantities of the Company's products and none of these agreements contain exclusive distribution arrangements. The Company's inability to attract important and effective channel partners, or their inability to penetrate their respective market segments, or the loss of any of the Company's channel partners, as a result of competitive products offered by other companies or products developed internally by these channel partners or otherwise, could materially adversely affect the Company's business, results of operations and financial condition. MANAGEMENT OF POTENTIAL GROWTH The Company recently has experienced significant growth in its sales and operations and in the complexity of its products and product distribution channels. The Company has recently increased and is continuing to increase the size of its sales force and coverage territories. Furthermore, the Company has recently established and is continuing to establish additional distribution channels through third party relationships. The Company's growth, coupled with the rapid evolution of the Company's markets, has placed, and is likely to continue to place, significant strains on its administrative, operational and financial resources and increase demands on its internal systems, procedures and controls. If the Company is unable to manage future growth effectively, the Company's business, results of operations and financial condition could be materially adversely affected. DEPENDENCE ON KEY PERSONNEL The Company's performance is substantially dependent on the performance of its key technical and senior management personnel, none of whom is bound by an employment agreement. The loss of the services of any of such personnel could have a material adverse effect on the business, results of operations and financial condition of the Company. The Company does not maintain key person life insurance policies on any of its employees. The Company's success is highly dependent on its continuing ability to identify, hire, train, motivate and retain highly qualified management, technical, and sales and marketing personnel, including recently hired officers and other employees. Competition for such personnel is intense, and there can be no assurance that the Company will be able to attract, assimilate or retain highly qualified technical and managerial personnel in the future. The inability to attract and retain the necessary management, technical, and sales and marketing personnel could have a material adverse effect on the Company's business, results of operations and financial condition. EXPANSION INTO INTERNATIONAL MARKETS The Company intends to expand its operations outside of the United States and enter additional international markets, primarily through the establishment of additional reseller arrangements. The Company expects to commit additional time and development resources to customizing its products and services for selected international markets and to developing international sales and support channels. There can be no assurance that such efforts will be successful. In addition to the uncertainty as to the Company's ability to establish an international presence, there are certain difficulties and risks inherent in doing business internationally, including, but not limited to: (i) costs of customizing products and services for international markets; (ii) dependence on independent resellers; (iii) multiple and conflicting regulations; (iv) exchange controls; (v) longer payment cycles; (vi) 14 16 unexpected changes in regulatory requirements; (vii) import and export restrictions and tariffs; (viii) difficulties in staffing and managing international operations; (ix) greater difficulty or delay in accounts receivable collection; (x) potentially adverse tax consequences; (xi) the burden of complying with a variety of laws outside the United States; (xii) the impact of possible recessionary environments in economies outside the United States; and (xiii) political and economic instability. In addition, the Company's ability to expand its business in certain countries will require modification of its products, particularly national language support. The Company's current export sales are denominated in United States dollars and the Company currently expects to continue this practice as it expands its international operations. To the extent that international sales continue to be denominated in U.S. dollars, an increase in the value of the United States dollar relative to other currencies could make the Company's products and services more expensive and, therefore, potentially less competitive in international markets. To the extent that future international sales are denominated in foreign currency, the Company's operating results will be subject to risks associated with foreign currency fluctuation and the Company would consider entering into forward exchange contracts or otherwise engaging in hedging activities. To date, as all export sales are denominated in U.S. dollars, the Company has not entered into any such contracts or engaged in any such activities. As the Company increases its international sales, its total revenue may also be affected to a greater extent by seasonal fluctuations resulting from lower sales that typically occur during the summer months in Europe and other parts of the world. YEAR 2000 COMPLIANCE / YEAR 2000 READINESS DISCLOSURE STATEMENT The company is aware of the issues associated with the programming code in existing computer systems and software products as the millennium (Year 2000) approaches. The Company has set up a task force which consists of the Director of IT and Operations, the Manager of System Applications and representative personnel from each functional area. This task force is addressing the Year 2000 issue in the following categories: the Network Health product; internal business computer systems and software applications; internal systems other than computer hardware and software; and systems of the Company's external suppliers and service providers. The Company is also assessing its Year 2000 associated costs, risks and potential contingency plans. Despite the Company's efforts with respect to the Year 2000 issue, there can be no assurance that the Company's business, results of operations or financial condition would not be materially adversely affected by the failure of the Company's products, its internal systems and applications or the systems of its third party suppliers and service providers to properly operate or manage data beyond 1999. NETWORK HEALTH PRODUCT. In 1997, the Company initiated the necessary development to ensure Year 2000 compliance in the Network Health family of applications and believes it has achieved Year 2000 compliance in Network Health 4.1 which was released in August 1998. The Company's existing customers can receive this release, at no charge, through their annual software maintenance contract. The Company requires its customers to purchase software maintenance in order to receive product support. Specifically, the Company defines Year 2000 Compliance as the following: no value for current date will cause any interruption in operation; date-based functionality must behave consistently for dates prior to, during, and after Year 2000; in all interfaces and data storage, the century in any date must be specified either explicitly or by unambiguous algorithms or inferencing rules; Year 2000 must be recognized as a leap year. The Company's definition of Year 2000 Compliance is adopted from the British Standard Institute's Definition of Year 2000 Conformity Requirements (PD2000-1). A copy of the standard is available for review on the Company's website. The Company makes no guarantee of, claims no responsibility for, and disclaims any liability to its customers, with respect to Year 2000 compliance of operating platforms, hardware, software, or other products not developed by the Company, including equipment monitored by the Network Health product. INTERNAL BUSINESS COMPUTER SYSTEMS AND SOFTWARE APPLICATIONS. In 1998, the Company commenced a Year 2000 date conversion project to address all internal existing computer 15 17 systems, software applications, and related computer equipment (e.g. printers) used in conjunction with its internal operations. The Company plans to identify, modify, upgrade, and/or replace any systems that have been identified as non-Year 2000 compliant to minimize the possibility of a material disruption to it business. The Company has finished assessing all existing internal systems and expects to complete the compliance process on these systems before the end of 1999. INTERNAL SYSTEMS OTHER THAN COMPUTER HARDWARE AND SOFTWARE. The operation of office and facilities equipment such as fax machines, photocopiers, telephone switches, security systems, elevators, and other common devices may also be affected by the Year 2000 issue. The Company has identified, and is currently assessing its options to remediate, the Year 2000 issue on its office and facilities equipment. SYSTEMS OF EXTERNAL SUPPLIERS AND SERVICE PROVIDERS. The Company has initiated communications with third party suppliers of the computers, software, and other equipment used, operated, or maintained by the Company to identify and, to the extent possible, to resolve any issues regarding the Year 2000 issue. The Company has also initiated communications with facilities service providers upon which the Company relies for daily operations. All external suppliers and service providers have been asked to provide a written assurance that they are also preparing to be Year 2000 compliant in a timely manner, and that their products/services will be available to the Company up to and beyond the Year 2000, without interruption. A response has been received from approximately 50% of these suppliers and service providers. However, there can be no assurance that the systems operated by other companies upon which the Company relies will be Year 2000 compliant on a timely basis. ASSOCIATED COSTS. To date, the Company has not incurred any material costs related to the assessment of, and preliminary efforts to upgrade or replace existing systems identified as non-Year 2000 compliant. Management is continuing to assess the total Year 2000 compliance expense, but based on a preliminary review to date, does not expect the amounts required to be expensed over the balance of 1999 to have an adverse material effect on its business, results of operations or financial condition. There can be no assurance, however, that further assessment of the Company's internal systems and applications will not indicate that additional Company efforts to assure Year 2000 compliance are necessary, and that such efforts may be costly. ASSOCIATED RISKS. The Company expects to identify and resolve all Year 2000 issues that could materially adversely affect its business, financial condition or results of operations. However, management realizes it may not be possible to determine with complete certainty that all Year 2000 problems affecting the Company will be identified or corrected in a timely manner. As a result, the Company could be at risk of experiencing a significant number of operational inconveniences and inefficiencies that may divert management's time and attention from its ordinary business activities and at risk of experiencing a lesser number of serious system or product failures that may require significant efforts by the Company to prevent or alleviate material business disruptions. CONTINGENCY PLANS. The Company recognizes the importance of readiness for potential worst case scenarios. As a result, the Company is working to identify scenarios with significant risks, which would require contingency plans. The Company expects to develop and complete any needed contingency plans no later than the summer of 1999. POSSIBLE VOLATILITY OF STOCK PRICE The Company completed an initial public offering of its common stock during October of 1997. The market price of the shares of Common Stock may be highly volatile and could be subject to wide fluctuations in response to variations in results of operations, announcements of technological innovations or new products by the Company or its competitors, changes in financial estimates by securities analysts or other events or factors. In addition, the financial markets have experienced significant price and volume fluctuations that have particularly affected the market prices of equity securities of many high technology 16 18 companies and that often have been unrelated to the operating performance of such companies or have resulted from the failure of the operating results of such companies to meet market expectations in a particular quarter. Broad market fluctuations or any failure of the Company's operating results in a particular quarter to meet market expectations may adversely affect the market price of the shares of Common Stock. In the past, following periods of volatility in the market price of a company's securities, securities class action litigation has often been instituted against such a company. Such litigation could result in substantial costs and a diversion of management's attention and resources, which would have a material adverse effect on the Company's business, results of operations and financial condition. FUTURE CAPITAL FUNDING The Company plans to continue to expend substantial funds on the continued development, sales and marketing of the Network Health product family. There can be no assurance that the Company's existing capital resources, the proceeds from the Company's initial public offering during October of 1997 and any funds that may be generated from future operations together will be sufficient to finance the Company's future operations or that other sources of funding will be available on terms acceptable to the Company, if at all. In addition, future sales of substantial amounts of the Company's securities in the public market could adversely affect prevailing market prices and could impair the Company's future ability to raise capital through the sale of its securities. The failure to obtain such funding, if required, could have a material adverse effect on the Company's business, results of operations and financial condition. ITEM 2. PROPERTIES The Company's corporate office and principal facility is located in Marlboro, Massachusetts. Under amendments signed in March of 1997, April of 1998 and July of 1998, the Company increased space under the lease in this facility from 20,000 to 36,000 square feet. The amended lease expires in September of 2003. This facility accommodates finance, administration and operations, research and development, customer support and marketing. The Company also leases, on a short-term basis, sales office space in Tustin, California, Dallas, Texas, London, England, Hamburg, Germany, Paris, France and Singapore. The Company does not believe that its current corporate facilities will meet its needs through the next 12 months and is actively pursuing other facility options. ITEM 3. LEGAL PROCEEDINGS The Company is not a party to any litigation that it believes could have a material adverse effect on the business, results of operations and financial condition of the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 1998. 17 19 PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED STOCKHOLDER MATTERS PRICE RANGE OF COMMON STOCK The Company effected its initial public offering on October 24, 1997 at a price of $14.00 per share. Since that date, the Company's Common Stock has traded on the Nasdaq National Market under the symbol CCRD. The following table sets forth, for the period indicated, the high and low closing sales prices for the Common Stock, all as reported by the Nasdaq National Market. PERIOD HIGH LOW ------ ---- --- October 16, 1997 - December 31, 1997 $ 23.25 $ 15.75 Fiscal 1998: First Quarter.................... $ 28.75 $ 15.13 Second Quarter................... 29.38 21.25 Third Quarter.................... 45.13 26.00 Fourth Quarter................... 56.75 31.25 Fiscal Year........................... 56.75 15.13 As of March 8, 1999, there were approximately 233 stockholders of record of the Company's Common Stock. DIVIDEND POLICY The Company currently anticipates that it will retain all future earnings for use in its business and does not anticipate that it will pay any cash dividends in the foreseeable future. The payment of any future dividends will be at the discretion of the Company's Board of Directors and will depend upon, among other things, future earnings, operations, capital requirements and the general financial condition of the Company, general business conditions and contractual restrictions on payment of dividends, if any. USE OF PROCEEDS On October 16, 1997, the Company commenced an initial public offering ("IPO") of 2,900,000 shares of common stock, par value $.01 per share (the "Common Stock"), of the Company pursuant to the Company's final prospectus dated October 15, 1997 (the "Prospectus"). The Prospectus was contained in the Company's Registration Statement on Form S-1, which was declared effective by the Securities and Exchange Commission (SEC File No. 333-33227) on October 15, 1997. Of the 2,900,000 shares of Common Stock offered, 2,300,000 shares were offered and sold by the Company and 600,000 shares were offered and sold by certain stockholders of the Company. As part of the IPO, the Company granted the several underwriters an overallotment option to purchase up to an additional 435,000 shares of Common Stock (the "Underwriters' Option"). The IPO closed on October 21, 1997 upon the sale of 2,900,000 shares of Common Stock to the underwriters. On October 24, 1997, the Representatives, on behalf of the several underwriters, exercised the Underwriters' Option, purchasing 435,000 additional shares of Common Stock from the Company. The aggregate offering price of the IPO to the public was $40,600,000 (exclusive of the Underwriters' Option), with proceeds to the Company and selling shareholders, after deduction of the underwriting discount,of $29,946,000 (before deducting offering expenses payable by the Company) and $7,812,000 respectively. The aggregate offering price of the Underwriters' Option exercised was $6,090,000, with proceeds to the Company, after deduction of the underwriting discount, of 18 20 $5,663,700 (before deducting offering expenses payable by the Company). The aggregate amount of expenses incurred by the Company in connection with the issuance and distribution of the shares of Common Stock offered and sold in the IPO were approximately $3.6 million, including $2.7 million in underwriting discounts and commissions and $950,000 in other offering expenses. None of the expenses paid by the Company in connection with the IPO or the exercise of the Underwriters' Option were paid, directly or indirectly, to directors, officers, persons owning ten percent or more of the Company's equity securities, or affiliates of the Company. The net proceeds to the Company from the IPO, after deducting underwriting discounts and commissions and other offering expenses were approximately $34.7 million. To date, the Company has not utilized any of the net proceeds from the IPO. The Company has invested all such net proceeds primarily in US treasury obligations and other interest bearing investment grade securities. None of the net proceeds from the IPO were used to pay, directly or indirectly, directors, officers, persons owning ten percent or more of the Company's equity securities, or affiliates of the Company. ITEM 6. SELECTED FINANCIAL DATA FISCAL YEAR ENDED ------------------------------------------------------------ DEC. 31, DEC. 31, DEC. 28, DEC. 30, DEC. 31, 1998 1997 1996 1995 1994 -------- -------- -------- -------- -------- (IN THOUSANDS, EXCEPT PER SHARE DATA) STATEMENT OF OPERATIONS DATA: Revenues: License revenues ........................................... $ 33,030 $ 17,345 $ 7,845 $ 3,443 $ 3,416 Service revenues ........................................... 6,451 2,225 1,162 912 649 -------- -------- -------- -------- --------- Total revenues ......................................... 39,481 19,570 9,007 4,355 4,065 Cost of revenues ............................................... 4,596 2,874 1,957 1,164 1,941 -------- -------- -------- -------- --------- Gross profit ................................................... 34,885 16,696 7,050 3,191 2,124 -------- -------- -------- -------- --------- Operating expenses: Research and development ................................... 7,206 4,631 3,933 2,361 2,374 Sales and marketing ........................................ 17,523 10,173 7,040 3,694 3,391 General and administrative ................................. 2,800 2,058 1,177 1,000 751 -------- -------- -------- -------- --------- Total operating expenses ............................... 27,529 16,862 12,150 7,055 6,516 -------- -------- -------- -------- --------- Operating income (loss) ........................................ 7,356 (166) (5,100) (3,864) (4,392) Other income (expense), net .................................... 2,255 297 45 80 (2) -------- -------- -------- -------- --------- Income (loss) from continuing operations ................... 9,611 131 (5,055) (3,784) (4,394) Income (loss) from discontinued operations ................................................... -- -- -- -- 117 -------- -------- -------- -------- --------- Income (loss) before income taxes ...................... $ 9,611 $ 131 $ (5,055) $ (3,784) $ (4,277) -------- -------- -------- -------- --------- Provision for income taxes ..................................... 532 -- -- -- -- -------- -------- -------- -------- --------- Net income (loss) .............................................. $ 9,079 $ 131 $ (5,055) $ (3,784) $ (4,277) ======== ======== ======== ======== ========= Net income (loss) per common and potential common share: Basic ...................................................... $ 0.72 $ 0.04 $ (6.64) $ (5.07) $ (6.34) Diluted .................................................... 0.64 0.01 (6.64) (5.07) (6.34) Pro forma diluted .......................................... 0.64 0.01 (0.57) (0.84) (1.42) Weighted average common and potential common shares outstanding: Basic ...................................................... 12,642 3,070 761 746 675 Diluted .................................................... 14,077 11,319 761 746 675 Pro forma diluted .......................................... 14,077 11,319 8,869 4,507 3,007 FISCAL YEAR ENDED ------------------------------------------------------------ DEC. 31, DEC. 31, DEC. 28, DEC. 30, DEC. 31, 1998 1997 1996 1995 1994 -------- -------- -------- -------- -------- (IN THOUSANDS) BALANCE SHEET DATA: Cash and cash equivalents................... $ 50,402 $ 36,539 $ 1,664 $ 4,397 $ 1,619 Working capital (deficit)................... 43,024 32,431 (1,387) 3,316 1,907 Total assets................................ 55,961 41,914 5,584 6,729 3,989 Long-term debt, net of current portion...... -- -- 668 -- -- Redeemable convertible preferred stock...... -- -- 14,478 13,616 7,527 Total stockholders' equity (deficit)........ 45,745 34,483 (15,035) (9,126) (4,716) 19 21 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The information appearing under the caption, "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's 1998 Annual Report to Stockholders is incorporated herein by reference. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Derivative Financial Instruments, Other Financial Instruments and Derivative Commodity Instruments. The Company does not invest in derivative financial instruments, other financial instruments or derivative commodity instruments for which fair value disclosure would be required under SFAS No. 107. All of the Company's investments are in investment grade securities with high credit ratings of relatively short duration that trade in highly liquid markets and are carried at fair value on the Company's books. Accordingly, the Company has no quantitative information concerning the market risk of participating in such investments. Primary Market Risk Exposures. The Company's primary market risk exposure is in the area of interest rate risk. The Company's investment portfolio of cash equivalents is subject to interest rate fluctuations, but the Company believes this risk is immaterial due to the short-term nature of these investments. Substantially all of the Company's business outside the United States is conducted in U.S. dollar-denominated transactions, whereas the Company's operating expenses in its international branches are denominated in local currency. The Company has no foreign exchange contracts, option contracts or other foreign hedging arrangements. The Company believes that the operating expenses of its foreign operations are immaterial, and therefore any associated market risk is unlikely to have a material adverse effect on the Company's business, results of operations or financial condition. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The Company's financial statements together with the related notes and the report of Arthur Andersen LLP, independent accountants, are set forth beginning on page F-1 of Item 14. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT The information under the captions "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" as set forth in the Company's proxy statement for its annual stockholders' meeting to be held April 27, 1999 is incorporated herein by reference. The information concerning officers is included in Part I, Item 1A under the caption "Executive Officers". ITEM 11. EXECUTIVE COMPENSATION The information under the caption "Executive Compensation" as set forth in the Company's proxy statement for its annual stockholders' meeting to be held April 27, 1999 is incorporated herein by reference. 20 22 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information under the caption "Securities Ownership of Certain Beneficial Owners and Management" as set forth in the Company's proxy statement for its annual stockholders' meeting to be held April 27, 1999 is incorporated herein by reference. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS Not applicable. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) The following documents are filed as part of this Form: 1. Financial Statements: Page Number Report of Independent Public Accountants F-1 Balance Sheets: December 31, 1998 and December 31, 1997 F-2 Statements of Operations: Years ended December 31, 1998, December 31, 1997 and December 28, 1996 F-3 Statements of Redeemable Convertible Preferred Stock and Stockholders' Equity (Deficit): Years ended December 31, 1998, December 31, 1997 and December 28, 1996 F-4 Statements of Cash Flows: Years ended December 31, 1998, December 31, 1997 and December 28, 1996 F-5 Notes to the Financial Statements F-6 2. Financial Statement Schedules Schedule II - Valuation and Qualifying Accounts Included in Item 12 of Notes to the Financial Statements 3. Exhibits: See Index to Exhibits. The Exhibits listed in the accompanying Index to Exhibits are filed or incorporated by reference as part of this report. (b) Reports on Form 8-K: None 21 23 REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS To the Board of Directors of Concord Communications, Inc.: We have audited the accompanying balance sheets of Concord Communications, Inc. (a Massachusetts corporation) as of December 31, 1998 and December 31, 1997, and the related statements of operations, redeemable convertible preferred stock and stockholders' equity (deficit) and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with 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 financial statements referred to above present fairly, in all material respects, the financial position of Concord Communications, Inc. as of December 31, 1998 and December 31, 1997, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1998, in conformity with generally accepted accounting principles. Arthur Andersen LLP Boston, Massachusetts January 15, 1999 F-1 24 CONCORD COMMUNICATIONS, INC. BALANCE SHEETS DECEMBER 31, DECEMBER 31, 1998 1997 ---------------------------------- ASSETS Current Assets: Cash, cash equivalents and marketable securities................ $ 50,402,029 $ 36,539,303 Accounts receivable, net of allowance of approximately $450,000 and $280,000 in 1998 and 1997, respectively.......... 5,048,879 3,040,850 Prepaid expenses and other current assets....................... 509,805 282,311 ------------ ------------ Total current assets........................................ 55,960,713 39,862,464 ------------ ------------ Equipment and Improvements, at cost: Equipment....................................................... 3,701,266 6,473,305 Leasehold improvements.......................................... 385,128 85,957 ------------ ------------ 4,086,394 6,559,262 Less-- Accumulated depreciation and amortization................ 1,365,222 4,507,737 ------------ ------------ 2,721,172 2,051,525 ------------ ------------ $ 58,681,885 $ 41,913,989 ============ ============ LIABILITIES, REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (DEFICIT) Current Liabilities: Accounts payable................................................ $ 3,553,673 $ 1,764,580 Accrued expenses................................................ 4,086,983 3,368,585 Deferred revenue................................................ 5,296,469 2,298,092 ------------ ------------ Total current liabilities................................... 12,937,125 7,431,257 ------------ ------------ Commitments and Contingencies (Note 8) Stockholders' Equity Preferred Stock, $.01 par value -- Authorized -- 1,000,000 shares Issued and outstanding-- None - - Common stock, $.01 par value-- Authorized -- 50,000,000 shares Issued and outstanding -- 13,040,374 and 12,019,188 shares, in 1998 and 1997 respectively................................. 130,405 120,193 Additional paid-in capital...................................... 69,938,129 67,942,708 Deferred compensation........................................... (101,189) (149,157) Unrealized gains on marketable securities....................... 149,606 19,750 Accumulated deficit............................................. (24,372,191) $(33,450,762) ------------ ------------ Total stockholders' equity ................................. 45,744,760 34,482,732 ------------ ------------ $ 58,681,885 $ 41,913,989 ============ ============ The accompanying notes are an integral part of these financial statements. F-2 25 CONCORD COMMUNICATIONS, INC. STATEMENTS OF OPERATIONS YEAR ENDED -------------------------------------------------- DECEMBER 31, DECEMBER 31, DECEMBER 28, 1998 1997 1996 ------------- ------------ ------------ Revenues: License revenues................... $ 33,030,296 $ 17,344,307 $ 7,844,523 Service revenues................... 6,451,033 2,225,287 1,162,242 ------------- ------------- ------------- Total revenues................ 39,481,329 19,569,594 9,006,765 Cost of Revenues........................ 4,596,314 2,873,840 1,956,889 ------------- ------------- ------------- Gross profit.................. 34,885,015 16,695,754 7,049,876 ------------- ------------- ------------- Operating Expenses: Research and development........... 7,206,399 4,630,560 3,933,483 Sales and marketing................ 17,522,653 10,173,182 7,039,662 General and administrative......... 2,799,924 2,058,402 1,176,938 ------------- ------------- ------------- Total operating expenses........... 27,528,976 16,862,144 12,150,083 ------------- ------------- ------------- Operating income (loss)....... 7,356,039 (166,390) (5,100,207) ------------- ------------- ------------- Other Income (Expense): Interest income.................... 2,320,897 419,733 79,832 Interest expense................... (514) (126,836) (48,564) Other.............................. (65,251) 4,248 14,076 ------------- ------------- ------------- Total other income, net....... 2,255,132 297,145 45,344 ------------- ------------- ------------- Income (loss) before income taxes 9,611,171 130,755 (5,054,863) ------------- ------------- ------------- Provision for income taxes.............. 532,600 - - ------------- ------------- ------------- Net income (loss)............. $ 9,078,571 $ 130,755 $ (5,054,863) ============= ============= ============= Net income (loss) per common and potential common share: Basic $ 0.72 $ 0.04 $ (6.64) ============= ============= ============= Diluted $ 0.64 $ 0.01 $ (6.64) ============= ============= ============= Pro forma diluted $ 0.64 $ 0.01 $ (0.57) ============= ============= ============= Weighted average common and potential common shares outstanding: Basic 12,642,247 3,069,667 760,971 ============= ============= ============= Diluted 14,076,990 11,319,479 760,971 ============= ============= ============= Pro forma diluted 14,076,990 11,319,479 8,869,229 ============= ============= ============= The accompanying notes are an integral part of these financial statements. F-3 26 CONCORD COMMUNICATIONS, INC. STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (DEFICIT) REDEEMABLE CONVERTIBLE PREFERRED STOCK ------------------------------------------------------------ SERIES A SERIES A-1 ------------------------------------------------------------ NUMBER REDEMPTION NUMBER REDEMPTION OF SHARES VALUE OF SHARES VALUE --------- ---------- --------- ---------- BALANCE, DECEMBER 30, 1995.............. 1,940,863 $ 8,893,639 36,070 $ 169,399 Accretion of dividends on preferred stock ..................... -- 533,867 -- 9,707 Exercise of stock options ............. -- -- -- -- Net loss .............................. -- -- -- -- -------------------------------------------------------------- BALANCE, DECEMBER 28, 1996 ............. 1,940,863 9,427,506 36,070 179,106 Issuance of common stock, net of issuance costs of $ 955,359 ......... -- -- -- -- Accretion of dividends on preferred stock ..................... -- 277,156 -- 5,151 Conversion of redeemable convertible preferred stock to common stock ...................... (1,940,863) (9,704,662) (36,070) (184,257) Exercise of stock options ............. -- -- -- -- Deferred compensation related to grants of stock options ............. -- -- -- -- Amortization of deferred compensation related to grants of stock options ................... -- -- -- -- Unrealized gains on available-for- sale securities ..................... -- -- -- -- Net income ............................ -- -- -- -- -------------------------------------------------------------- Comprehensive Income ................. BALANCE, DECEMBER 31, 1997 ............. -- -- -- -- Shares issued in connection with employee stock plans ............... -- -- -- -- Tax Benefit associated with employee stock options ...................... -- -- -- -- Amortization of deferred compensation related to grants of stock options ................... -- -- -- -- Unrealized gains on available-for- sale securities ..................... -- -- -- -- Net income ............................ -- -- -- -- -------------------------------------------------------------- Comprehensive Income BALANCE, DECEMBER 31, 1998 ............. -- $ -- -- $ -- ========== ============ ======= ========= REDEEMABLE CONVERTIBLE PREFERRED STOCK STOCKHOLDERS' EQUITY (DEFICIT) ------------------------------------------------------------------------------ SERIES B COMMON STOCK ------------------------------------------------------------------------------ NUMBER REDEMPTION NUMBER $.01 OF SHARES VALUE TOTAL OF SHARES PAR VALUE ------------ ----------- ------------ --------- --------- BALANCE, DECEMBER 30, 1995 ............. 4,460,789 $ 4,552,617 $ 13,615,655 760,345 $ 7,603 Accretion of dividends on preferred stock ..................... -- 318,500 862,074 -- -- Exercise of stock options ............. -- -- -- 84,137 842 Net loss .............................. -- -- -- -- -- ------------------------------------------------------------------------------ BALANCE, DECEMBER 28, 1996 ............. 4,460,789 4,871,117 14,477,729 844,482 8,445 Issuance of common stock, net of issuance costs of $ 955,359 ......... -- -- -- 2,735,000 27,350 Accretion of dividends on preferred stock ..................... -- 159,250 441,557 -- -- Conversion of redeemable convertible preferred stock to common stock ...................... (4,460,789) (5,030,367) (14,919,286) 8,108,258 81,083 Exercise of stock options ............. -- -- -- 331,448 3,315 Deferred compensation related to grants of stock options ............ -- -- -- -- -- Amortization of deferred compensation related to grants of stock options .................... -- -- -- -- -- Unrealized gains on available-for- sale securities ..................... -- -- -- -- -- Net income ............................ -- -- -- -- -- ------------------------------------------------------------------------------ Comprehensive Income ................. BALANCE, DECEMBER 31, 1997 ............. 12,019,188 120,193 Shares issued in connection with employee stock plans ............... -- -- -- 1,021,186 10,212 Tax Benefit associated with employee stock options ...................... -- -- -- -- -- Amortization of deferred compensation related to grants of stock options .................... -- -- -- -- -- Unrealized gains on available-for- sale securities ..................... -- -- -- -- -- Net income ............................ -- -- -- -- -- ------------------------------------------------------------------------------ Comprehensive Income ................. BALANCE, DECEMBER 31, 1998 ............. $ $ 13,040,374 $130,405 ============ ========== =========== ========== ======== STOCKHOLDERS' EQUITY (DEFICIT) --------------------------------------------------------------------------------- UNREALIZED ACCUMULATED ADDITIONAL GAIN ON OTHER PAID-IN DEFERRED MARKETABLE ACCUMULATED COMPREHENSIVE CAPITAL COMPENSATION SECURITIES DEFICIT INCOME ----------- ------------- ---------- ----------- ------------- BALANCE, DECEMBER 30, 1995 ............. $18,089,332 $ -- $ -- $(27,223,023) $ -- Accretion of dividends on preferred stock ..................... -- -- -- (862,074) -- Exercise of stock options ............. 7,713 -- -- -- -- Net loss .............................. -- -- -- (5,054,863) -- --------------------------------------------------------------------------------- BALANCE, DECEMBER 28, 1996 ............. 18,097,045 -- -- (33,139,960) -- Issuance of common stock, net of issuance costs of $ 955,359 ......... 34,626,991 -- -- -- -- Accretion of dividends on preferred stock ..................... -- -- -- (441,557) -- Conversion of redeemable convertible preferred stock to common stock ...................... 14,838,203 -- -- -- -- Exercise of stock options ............. 188,594 -- -- -- -- Deferred compensation related to grants of stock options ............. 191,875 (191,875) -- -- -- Amortization of deferred compensation related to grants of stock options .................... -- 42,718 -- -- -- Unrealized gains on available-for- sale securities ..................... -- -- 19,750 -- 19,750 Net income ............................ -- -- -- 130,755 -- --------------------------------------------------------------------------------- Comprehensive Income ................. 19,750 BALANCE, DECEMBER 31, 1997 ............. 67,942,708 (149,157) 19,750 (33,450,762) -- Shares issued in connection with employee stock plans ............... 1,495,421 -- -- -- -- Tax Benefit associated with employee stock options ...................... 500,000 -- -- -- -- Amortization of deferred compensation related to grants of stock options .................... -- 47,968 -- -- -- Unrealized gains on available-for- sale securities ..................... -- -- 129,856 -- 129,856 Net income ............................ -- -- -- 78,571 -- --------------------------------------------------------------------------------- Comprehensive Income ................. $149,606 ======== BALANCE, DECEMBER 31, 1998 ............. $69,938,129 $(101,189) $149,606 $(24,372,191) =========== ========= ======== ============ STOCKHOLDERS' EQUITY (DEFICIT) ------------------------------ COMPREHENSIVE TOTAL INCOME ------------ ------------- BALANCE, DECEMBER 30, 1995 ............. $ (9,126,088) $ -- Accretion of dividends on preferred stock ..................... (862,074) -- Exercise of stock options ............. 8,555 -- Net loss .............................. (5,054,863) -- --------------------------- BALANCE, DECEMBER 28, 1996 ............. (15,034,470) -- Issuance of common stock, net of issuance costs of $ 955,359 ......... 34,654,341 -- Accretion of dividends on preferred stock ..................... (441,557) -- Conversion of redeemable convertible preferred stock to common stock ...................... 14,919,286 -- Exercise of stock options ............. 191,909 -- Deferred compensation related to grants of stock options ............. -- -- Amortization of deferred compensation related to grants of stock options .................... 42,718 -- Unrealized gains on available-for- 19,750 sale securities ..................... 19,750 Net income ............................ 130,755 130,755 --------------------------- Comprehensive Income ................. 150,505 BALANCE, DECEMBER 31, 1997 ............. 34,482,732 -- Shares issued in connection with employee stock plans ............... 1,505,633 -- Tax Benefit associated with employee stock options ...................... 500,000 -- Amortization of deferred compensation related to grants of stock options .................... 47,968 -- Unrealized gains on available-for- sale securities ..................... 129,856 129,856 Net income ............................ 9,078,571 9,078,571 --------------------------- Comprehensive Income ................. $9,208,427 ========== BALANCE, DECEMBER 31, 1998 ............. $ 45,744,760 ============ The accompanying notes are an integral part of these financial statements. F-4 27 CONCORD COMMUNICATIONS, INC. STATEMENTS OF CASH FLOWS YEAR ENDED ------------------------------------------------- DECEMBER 31, DECEMBER 31, DECEMBER 28, 1998 1997 1996 ------------ ------------- ------------ Cash Flows from Operating Activities: Net income (loss) ................................ $ 9,078,571 $ 130,755 $(5,054,863) Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities -- Depreciation and amortization .................. 873,368 592,936 409,484 Changes in current assets and liabilities-- Accounts receivable ......................... (2,008,028) (767,595) (1,254,453) Prepaid expenses and other current assets ... (227,495) (133,377) (8,472) Accounts payable ............................ 1,789,093 204,268 373,464 Accrued expenses ............................ 1,580,409 1,043,658 1,646,087 Deferred revenue ............................ 2,998,377 966,801 957,625 ------------ ------------- ----------- Net cash provided by (used in) operating activities ............................... 14,084,295 2,037,446 (2,931,128) ------------ ------------- ----------- Cash Flows from Investing Activities: Purchases of equipment and improvements ............ (1,857,058) (1,103,537) (734,571) Purchases of investments in marketable securities .. (53,139,637) (116,402,905) -- Sales of investments in marketable securities ...... 42,712,930 87,741,538 -- ------------ ------------- ----------- Net cash used in investing activities ..... (12,283,765) (29,764,904) (734,571) ------------ ------------- ----------- Cash Flows from Financing Activities: Proceeds from bank borrowings ...................... -- 583,707 924,502 Repayments of bank borrowings ...................... -- (1,508,209) -- Proceeds from issuance of common stock ............. -- 34,654,341 -- Proceeds from shares issued in connection with employee stock plans .............................. 1,505,633 191,909 8,555 ------------ ------------- ----------- Net cash provided by financing activities.. 1,505,633 33,921,748 933,057 ------------ ------------- ----------- Net Increase (Decrease) in Cash and Cash Equivalents.. 3,306,163 6,194,290 (2,732,642) Cash and Cash Equivalents, beginning of year ......... 7,858,186 1,663,896 4,396,538 ------------ ------------- ----------- Cash and Cash Equivalents, end of year ............... $ 11,164,349 $ 7,858,186 $ 1,663,896 ============ ============= =========== Supplemental Disclosure of Cash Flow Information: Cash paid for interest ............................. $ -- $ 126,836 $ 48,564 ============ ============= =========== Cash paid for taxes ................................ $ 46,159 $ 1,539 $ -- ============ ============= =========== Supplemental Disclosure of Noncash Transactions: Accretion of dividends on preferred stock .......... $ -- $ 441,557 $ 862,074 ============ ============= =========== Deferred compensation related to grants of stock options .......................................... $ -- $ 191,875 $ -- ============= =========== Conversion of redeemable convertible preferred stock to common stock .................................. $ -- $ 14,919,286 $ -- ============ ============= =========== Unrealized gain on available-for-sale securities ... $ 129,856 $ 19,750 $ -- ============ ============= =========== Tax benefit associated with employee stock options.. $ 500,000 $ -- $ -- ============ ============= =========== Retirement of fully depreciated fixed assets ....... $ 4,330,000 $ -- $ -- ============ ============= =========== The accompanying notes are an integral part of these financial statements. F-5 28 CONCORD COMMUNICATIONS, INC. NOTES TO FINANCIAL STATEMENTS DECEMBER 31, 1998 (1) ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Concord Communications, Inc. (the Company) is primarily engaged in the development and sale of automated network reporting software to companies principally in the United States and Europe. The Company is subject to the risks associated with emerging, technology-oriented companies. Primary among these risks are competition from substitute products and the ability to successfully develop and market its current and future products. (a) Fiscal Year-End Through fiscal 1996, the Company's fiscal year was the 52- or 53-week period ended on the Saturday closest to December 31. References to 1996 are for the 52-week period ended December 28, 1996. Beginning in 1997, the Company has changed to a calendar year-end. (b) Cash, Cash Equivalents and Marketable Securities The Company follows the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. The Company has classified its cash equivalents and marketable securities as available-for-sale and recorded them at fair value, with the unrealized gains and losses reported as a separate component of stockholders' equity. The Company considers cash and highly liquid investments, purchased with an original maturity of 90 days or less, to be cash and cash equivalents. Cash and cash equivalents are $11,164,349 and $7,858,186 at December 31, 1998 and December 31, 1997. (c) Revenue Recognition The Company's revenues consist of software license revenues and service revenues. Software license revenues for periods subsequent to December 31, 1997, are recognized in accordance with the American Institute of Certified Public Accountants' Statement of Position ("SOP") 97-2, Software Revenue Recognition. Under SOP 97-2, software license revenues are recognized upon execution of a contract and delivery of software, provided that the license fee is fixed and determinable, no significant production, modification or customization of the software is required and collection is considered probable by management. For periods prior to December 31, 1997, software license revenues were recognized in accordance with SOP 91-1, Software Revenue Recognition. Under SOP 91-1, software license revenues were recognized upon execution of a contract and shipment of the software, provided that no significant vendor obligations remained outstanding, amounts were due within one year and collection was considered probable by management. The application of SOP 97-2 did not have any impact on the Company's consolidated financial statements for the year ended December 31, 1998. In 1999, software license revenues will be recognized in accordance with SOP 97-2, as modified by SOP 98-9, Modification of SOP 97-2,Software Revenue Recognition with respect to Certain Transactions. The Company believes it is currently in compliance with SOP 97-2, as modified by SOP 98-9. Service revenues are recognized as the services are performed. Maintenance revenues are derived from customer support agreements generally entered into in connection with initial license sales and subsequent renewals. Maintenance revenues are recognized ratably over the term of the maintenance period. Payments for maintenance fees are generally made in advance. F-6 29 (d) Equipment and Improvements Equipment and improvements are recorded at cost. Depreciation is provided for on a straight-line basis over the useful lives of the assets, which are estimated to be three to five years for all assets except leasehold improvements, which are amortized over the life of the lease. (e) Use of Estimates in the Preparation of Financial Statements The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (f) Concentration of Credit Risk and Significant Customers SFAS No. 105, Disclosure of Information About Financial Instruments with Off-Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk, requires disclosure of any significant off-balance-sheet and credit risk concentrations. The Company has no significant off-balance-sheet concentration of credit risk such as foreign exchange contracts, option contracts or other foreign hedging arrangements. The Company maintains its cash, cash equivalent and marketable securities with established financial institutions. The Company does not believe it has accounts receivable collection risk in excess of existing reserves. For the years ended December 31, 1998, December 31, 1997 and December 28, 1996, no individual customer accounted for more than 10% of revenue. (g) Software Development Costs SFAS No. 86, Accounting for the Costs of Computer Software To Be Sold, Leased or Otherwise Marketed, requires the capitalization of certain computer software development costs incurred after technological feasibility is established. The Company believes that once technological feasibility of a software product has been established, the additional development costs incurred to bring the product to a commercially acceptable level are not significant. There were no capitalized software development costs at December 31, 1998 and December 31, 1997. (h) Net Income (Loss) per Share In 1997, the Company adopted SFAS No. 128, Earnings Per Share, effective December 15, 1997. SFAS No. 128 establishes 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 retroactively to all periods presented. In accordance with Staff Accounting Bulletin (SAB) No. 98, the Company has determined that there were no nominal issuances of common stock or potential common stock in the period prior to the Company's initial public offering (IPO). The dilutive effect of potential common shares in 1998 consisting of outstanding stock options and in 1997 consisting of outstanding stock options and redeemable convertible preferred stock, is determined using the treasury method and the if-converted method, respectively, in accordance with SFAS No. 128. Diluted weighted average shares outstanding for 1996 excludes the potential common shares from stock options and redeemable convertible preferred stock outstanding because to do so would have been antidilutive for the years presented. Pro forma diluted net income (loss) per common and potential common share assumes that all series of redeemable convertible preferred stock had been converted to common stock as of the original issuance dates. Calculations of basic, diluted and pro forma diluted net income (loss) per common share and potential common share are as follows: F-7 30 1998 1997 1996 ---- ---- ---- Net income (loss) ................................ $ 9,078,571 $ 130,755 $(5,054,863) ----------- ----------- ----------- Weighted average common shares outstanding ................................... 12,642,247 3,069,667 760,971 Potential common shares pursuant to stock options .............................. 1,434,743 1,830,774 -- Potential common shares pursuant to conversion of redeemable convertible preferred stock ........ -- 6,419,038 -- ----------- ----------- ----------- Diluted weighted average shares ................. 14,076,990 11,319,479 760,971 Pro forma conversion of redeemable convertible preferred stock ................... -- -- 8,108,258 ----------- ----------- ----------- Pro forma diluted weighted average shares outstanding ............................ 14,076,990 11,319,479 8,869,229 ----------- ----------- ----------- Basic net income (loss) per common share ......... $ 0.72 $ 0.04 $ (6.64) =========== =========== =========== Diluted net income (loss) per common and potential common share .................... $ 0.64 $ 0.01 $ (6.64) =========== =========== =========== Pro forma diluted net income (loss) per common and potential common share ............. $ 0.64 $ 0.01 $ (0.57) =========== =========== =========== (2) MARKETABLE SECURITIES It is the Company's intent to maintain a liquid investment portfolio to support current operations and to take advantage of investment opportunities; therefore, all marketable securities are considered to be available-for-sale and are classified as current assets. The amortized cost, unrealized gains (losses) and fair value of marketable securities available-for-sale as of December 31, 1998 with maturity dates from January 1, 1999 through September 15, 2003, are as follows: AMORTIZED COST UNREALIZED GAINS (LOSSES) FAIR VALUE -------------- ------------------------ ----------- US government obligations $ 9,423,374 $ 11,559 $ 9,434,933 Corporate bonds and notes 31,949,720 138,047 32,087,767 ----------- ----------- ----------- 41,373,094 149,606 41,522,700 Less: Amounts classified as cash-equivalents 2,285,020 -- 2,285,020 ----------- ----------- ----------- Available-for-sale marketable securities $39,088,074 $ 149,606 $39,237,680 =========== =========== =========== The amortized cost, unrealized gains (losses) and fair value of marketable securities available-for-sale as of December 31, 1997 with maturity dates from January 1, 1998 through December 1, 2000, are as follows: AMORTIZED COST UNREALIZED GAINS (LOSSES) FAIR VALUE -------------- ------------------------ ----------- US government obligations $ 7,450,812 $ (924) $ 7,449,888 Corporate bonds and notes 22,317,923 22,455 22,340,378 Asset-backed securities 5,402,979 (1,781) 5,401,198 ----------- ------------ ----------- 35,171,714 19,750 35,191,464 Less: Amounts classified as cash-equivalents 6,510,435 (88) 6,510,347 ----------- ------------ ----------- Available-for-sale marketable securities $28,661,279 $ 19,838 $28,681,117 =========== ============ =========== (3) LINE OF CREDIT AND LONG-TERM DEBT During 1996, the Company entered into an agreement for an equipment line of credit in the amount of $1.0 million (the "Equipment Line") with Silicon Valley Bank. The Equipment Line, as amended, bore interest at the bank's prime plus 2% and was collateralized by substantially all of the Company's assets. In December 1997, the Company paid off all outstanding principal and interest due under this agreement. F-8 31 The Company had a revolving working capital line of credit with Silicon Valley Bank. Borrowings outstanding under the line were limited to the lesser of $2.5 million or 90% of eligible accounts receivable. The Company's line of credit expired on April 2, 1998. The Company also entered into a new equipment line of credit with Fleet National Bank during June of 1997 for up to $1.0 million. In December, 1997, the Company paid off all outstanding principal and interest under this agreement. (4) STOCKHOLDERS' EQUITY (DEFICIT) In December 1995, the Company's Board of Directors approved a one-for-three reverse stock split of its common and redeemable convertible preferred stock. On October 9, 1997, the Company amended its certificate of incorporation to authorize a 1-for-2 reverse stock split of the Company's common stock and increase the number of authorized shares of common stock to 50,000,000. The stock splits have been retroactively reflected in the accompanying financial statements and notes for all periods presented. In October 1997, the Company completed an initial public offering (the IPO) of 2,735,000 shares of its common stock, inclusive of 435,000 shares exercised to cover over-allotments. The sale of common stock resulted in net proceeds to the Company of approximately $34,650,000, after deducting all expenses related to the IPO. (5) PREFERRED STOCK In connection with the IPO, the Company's redeemable convertible preferred stock was converted into 8,108,258 shares of common stock. Thereafter, the Company's certificate of incorporation was amended to authorize 1,000,000 shares of preferred stock in one or more series and to fix or alter the designations, preferences, rights and any qualifications, limitations or restrictions of the shares of each such series thereof, including the dividend rights and rates, conversion rights, voting rights, terms of redemption, redemption prices, liquidation preferences and the number of shares constituting any series or designation of such series. At December 31, 1998, the Company has no issued or outstanding shares of preferred stock. (6) STOCK OPTION PLANS In 1995, the Company's Board of Directors (the Board) approved the 1995 Stock Plan, which provides for the granting of incentive stock options (ISOs) and nonqualified stock options. Prior to the adoption of the 1995 Stock Plan, the Board granted options under the 1982 Employee Incentive Stock Option Plan, the 1986 Nonqualified Stock Option Plan and the 1986 Stock Plan. Following the completion of the IPO, the Company adopted the 1997 Stock Plan, the 1997 Employee Stock Purchase Plan and the 1997 Nonemployee Director Stock Option Plan, for which the Company reserved 750,000, 375,000 and 95,000 shares of common stock, respectively, for future issuance. In April 1998, the Shareholders approved the amended 1997 Stock Plan to increase the aggregate number of shares of Common Stock reserved for issuance thereunder by 750,000 shares to 1,500,000 shares and to make certain minor modifications. Under the 1995 and 1997 Stock Plans (the Plans), the Company may issue options to purchase up to 2,519,239 shares of common stock, of which 845,450 options are available for grant as of December 31, 1998. ISOs may be granted at an exercise price not less than the fair market value per share of common stock on the date of grant, as determined by the Board. The price per share relating to each nonqualified option granted under the Plans shall not be less than the lesser of (i) the book value per share of common stock as of the end of the Company's fiscal year immediately preceding the date of grant or (ii) 50% of the fair market value per share of common stock on the date of grant. Vesting of the options is determined by the Board, and the options expire 8 years from the date of grant. An employee may convert his or her unexercised ISOs into nonqualified options at any time prior to the expiration of such ISOs. In October 1995, the Financial Accounting Standards Board issued SFAS No. 123, Accounting for Stock-Based Compensation, which requires the measurement of the fair value of stock options or warrants to be included in the statement of operations or disclosed in the notes to the financial statements. As permitted by SFAS No. 123, the Company will continue to account for stock-based compensation for employees under Accounting Principles Board Opinion No. 25 and has elected the disclosure-only alternative under SFAS No. 123 for options granted using the Black-Scholes option pricing model prescribed by SFAS No. 123. The weighted average fair value per share of options granted during 1998, 1997 and 1996 was $31.08, $5.64 and $.17, respectively. The weighted average assumptions are as follows: F-9 32 1998 1997 1996 ------- ---------- ------- Risk-free interest rate......................... 6.0% 5.1 - 6.0% 6.3% Expected dividend yield......................... -- -- -- Expected lives.................................. 7 years 7 years 7 years Expected volatility............................. 80% 80% 80% Had compensation cost for these plans been determined consistent with SFAS No. 123, the Company's net income (loss) and basic, diluted and pro forma diluted net income (loss) per common and potential common share would have been as follows: 1998 1997 1996 ---------- ---------- ------------ Net income (loss), as reported ........... $9,078,571 $ 130,755 $(5,054,863) ========== ========= =========== Net income (loss), pro forma ............. $6,260,432 $(320,629) $(5,105,339) ========== ========= =========== Net income (loss) per share, as reported Basic ................................... $ 0.72 $ 0.04 $ (6.64) ========== ========= ========== Diluted ................................. $ 0.64 $ 0.01 $ (6.64) ========== ========= ========== Pro forma diluted ....................... $ 0.64 $ 0.01 $ (0.57) ========== ========= ========== Net income (loss) per share, pro forma Basic ................................... $ 0.50 $ (0.10) $ (6.71) ========== ========= ========== Diluted ................................. $ 0.44 $ (0.03) $ (6.71) ========== ========= ========== Pro forma diluted ....................... $ 0.44 $ (0.03) $ (0.58) ========== ========= ========== Because the method prescribed by SFAS No. 123 has not been applied to options granted prior to January 1, 1995, the resulting pro forma compensation may not be representative of that to be expected in future years. The following table summarizes information about options outstanding at December 31, 1998: OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------------------- ----------------------------- WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE RANGE OF NUMBER REMAINING EXERCISE PRICE NUMBER EXERCISE PRICE EXERCISE PRICE OUTSTANDING CONTRACTUAL LIFE PER SHARE OUTSTANDING PER SHARE -------------- ----------- ---------------- ---------------- ----------- ---------------- $ .10 - 1.90 735,553 5.40 $ .62 100,831 $ .58 4.10 - 10.00 207,722 6.32 4.71 35,212 4.53 17.06 - 24.75 625,014 7.11 20.42 28,914 19.46 25.19 - 56.75 105,500 7.70 36.23 -- --------- ------- 1,673,789 164,957 ========= ======= The following schedule summarizes the activity under the stock option plans for the three-year period ended December 31, 1998: WEIGHTED AVERAGE NUMBER OF PRICE PER PRICE SHARES SHARE PER SHARE ---------- ------------- ---------------- Outstanding at December 30, 1995 ... 426,022 .60 .60 Granted ....................... 1,881,259 .10--1.90 .22 Exercised ..................... (84,137) .10--.60 .10 Terminated .................... (518,802) .10--.60 .51 --------- ------------- ------ Outstanding at December 28, 1996.... 1,704,342 .10--1.90 .23 Granted ....................... 784,700 1.90--21.88 7.29 Exercised ..................... (331,448) .10--1.90 .58 Terminated .................... (26,494) .10--8.50 2.56 --------- ------------- ------ Outstanding at December 31, 1997.... 2,131,100 .10--21.88 2.76 Granted ....................... 563,750 17.06--56.75 23.71 Exercised ..................... (984,473) .10--21.38 .98 Terminated ................... (36,588) .10--41.00 6.73 --------- ------------- ------ Outstanding at December 31, 1998 ... 1,673,789 $ .10--56.75 $10.79 ========= ============= ====== Exercisable at December 31, 1998.... 164,957 $ .10--21.38 $ 4.73 ========= ============= ====== F-10 33 In 1997, the Company granted one officer and one director options to purchase in total 143,750 shares of common stock at an exercise price of $1.90 per share. At the date of grant, the estimated fair value per share of the Company's common stock exceeded the exercise price of the options, and accordingly, the Company has recorded deferred compensation of $191,875 related to this difference at the date of grant. For the years ended December 31, 1998 and 1997, the Company has recorded compensation expense of $47,968 and $42,718, respectively, related to these options grants. The exercise price of all other options outstanding represents the fair market value per share of common stock as of the date of grant. (7) INCOME TAXES The Company accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. This standard requires, among other things, recognition of future tax effects, measured by enacted tax rates, attributable to deductible temporary differences between the financial statement and income tax bases of assets and liabilities. The approximate income tax effects of these temporary differences are as follows: DECEMBER 31, DECEMBER 31, 1998 1997 ------------ ------------ Net operating loss and federal tax credit carryforwards ........................................ $ 12,719,000 $ 10,689,000 Reserves not yet deductible for tax purposes .......... 1,027,000 344,000 Depreciation .......................................... 92,000 101,000 Deferred revenue ...................................... 1,373,000 174,000 Capitalized research and development expenses ......... 2,088,000 2,284,000 Valuation allowance ................................... (17,299,000) (13,592,000) ------------ ------------ $ -- $ -- ============ ============ The Company has available net operating loss carryforwards of approximately $27,000,000 and federal research and development tax credit carryforwards of approximately $1,730,000 as of December 31, 1998 to reduce future income tax liabilities. These carryforwards are subject to review and possible adjustment by the appropriate taxing authorities and expire from 1999 through 2013 as follows: RESEARCH AND NET OPERATING LOSS DEVELOPMENT TAX FISCAL YEAR CARRYFORWARDS CREDIT CARRYFORWARDS - -------------- ------------------ -------------------- 1999 .... $ 3,358,000 $ -- 2000 .... 3,659,000 -- 2001 .... 2,870,000 1,252,000 2002-2006 1,369,000 150,000 2007-2013 15,744,000 328,000 ----------- ---------- $27,000,000 $1,730,000 =========== ========== Pursuant to the Tax Reform Act of 1986, the utilization of net operating loss carryforwards for tax purposes may be subject to an annual limitation if a cumulative change of ownership of more than 50% occurs over a three-year period. As a result of the Company's 1995 preferred stock financings, such a change in ownership has occurred. As a result of this ownership change, the use of the net operating loss carryforwards will be limited. The Company has determined that its initial public offering did not cause another ownership change. The Company has deferred tax assets of approximately $17.3 million comprised primarily of net operating loss carryforwards and research and development credits. The Company has fully reserved for these deferred tax assets by recording a valuation allowance of $17.3 million, as the Company believes that it is more likely than not that it will not be able to realize this asset. Pursuant to paragraphs 20 to 25 of Statement of Financial Accounting Standards No. 109, the Company considered both positive and negative evidence in assessing the need for a valuation allowance at December 31, 1997 and 1998. The factors that weighed most heavily on the Company's decision to record a full valuation allowance were (i) the Company's history of losses, (ii) the substantial restrictions on the use of its existing net operation loss (NOL) carryforwards and (iii) the uncertainty of future profitability. F-11 34 As a result of the ownership change described above, the future use of approximately $16.6 million of the Company's NOL carryforwards are limited to only $330,000 per year; the substantial majority of such NOL carryforwards will expire before they can be used. Pursuant to the provisions of SFAS No. 109, the Company used all of its remaining unrestricted NOL and credit carryforwards in computing the 1998 tax provision. The Company is also subject to rapid technological change, competition from substantially larger competitors, a limited family of products and other related risks, as more thoroughly described in the "Risk Factors" section of the Company's Form 10-K, for the fiscal year ended December 31, 1998. The Company's limited operating success in late 1997 and 1998 and its dependence on a single product family in an emerging market makes the prediction of future results difficult, if not impossible, especially in the highly competitive software industry. As a result, the Company found the evidence described above to be the most reliable objective evidence available in determining that a full valuation allowance against its tax assets would be necessary. The Company's net operating loss deferred tax asset includes approximately $4.3 million pertaining to the benefit associated with the exercise and subsequent disqualifying disposition of incentive stock options by the Company's employees. When and if the Company realizes this asset, the resulting change in the valuation allowance will be credited directly to additional paid-in capital, pursuant to the provisions of SFAS No. 109. The difference between the Company's 1998 effective tax rate of approximately 5.5% and the applicable statutory rate can be attributed to the use of the NOL and credit carryforwards described above. In addition, the Company received a tax benefit of approximately $500,000 pursuant to the exercise of employee stock options. The Company recorded this benefit as a component of additional paid in capital. (8) COMMITMENTS AND CONTINGENCIES (a) Leases The Company leases facilities under an operating lease that expires in September 2003. The approximate future minimum rental payments under this lease, as amended, are as follows: AMOUNT ---------- 1999.................................................. $ 619,000 2000.................................................. 684,000 2001.................................................. 698,000 2002.................................................. 373,000 2003.................................................. 25,000 ---------- $2,399,000 ========== Rent expense was approximately $464,000, $346,000 and $244,000 for the years ended December 31, 1998, December 31, 1997 and December 28, 1996, respectively. (b) Royalties The Company has entered into several software license agreements that provide the Company with exclusive worldwide licenses to distribute or utilize certain patented computer software. The Company is required to pay royalties on all related sales. Under one software license agreement, as amended, the Company is obligated to make minimum quarterly royalty payments from 1995 through 1999. The minimum payments are noncancelable and nonrefundable, but any minimum payments in excess of amounts due for actual license sales in any quarter may be used as a credit against future royalty fees in excess of the specified minimum payments. The minimum royalty payment due under this agreement for 1999 is $450,000. Royalty expense under royalty agreements was approximately $665,000, $903,000 and $735,000 for fiscal 1998, 1997 and 1996, respectively. F-12 35 (c) Legal Proceedings From time to time, the Company may be exposed to litigation relating to its products and operations. The Company is not engaged in any legal proceedings that are expected, individually or in the aggregate, to have a material adverse effect on the Company's financial conditions or results of operations. (9) ACCRUED EXPENSES Accrued expenses consist of the following: DECEMBER 31, DECEMBER 31, 1998 1997 ------------ ------------ Payroll and payroll-related........................................... $1,268,845 $ 681,923 Royalties............................................................. 412,656 372,853 Outside commissions................................................... 568,450 143,543 Customer deposits..................................................... 254,340 1,085,521 Other................................................................. 1,582,692 1,084,745 ---------- ---------- $4,086,983 $3,368,585 ========== ========== (10) EMPLOYEE BENEFIT PLAN The Company maintains an employee benefit plan under Section 401(k) of the Internal Revenue Code covering all eligible employees, as defined. The Plan allows for employees to defer a portion of their salary up to 15% of pretax compensation. While the Company has the discretion to make contributions to the plan, no such contributions were made in 1998, 1997 or 1996. (11) VALUATION AND QUALIFYING ACCOUNTS The following table sets forth activity in the Company's accounts receivable reserve account: BALANCE AT BALANCE AT BEGINNING CHARGES TO END OF OF YEAR EXPENSES DEDUCTIONS YEAR ---------- ---------- ---------- ---------- 1996................... $130,000 $135,000 $(54,884) $210,116 1997................... $210,116 $ 70,000 $ -- $280,116 1998................... $280,116 $169,884 $ -- $450,000 (12) SEGMENT REPORTING AND INTERNATIONAL INFORMATION The Company adopted SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information in the fiscal year ended December 31, 1998. SFAS 131 establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information for those segments to be presented in interim financial reports issued to stockholders. SFAS 131 also establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions how to allocate resources and assess performance. The Company's chief decision making group, as defined under SFAS 131, is the Executive Management Committee. To date, the Executive Management Committee has viewed the Company's operations as principally one segment, software sales and associated services. As a result, the financial information disclosed herein, materially represents all of the financial information related to the Company's principal operating segment. Revenues from international locations were $7.1 million, $2.4 million and $1.0 million in 1998, 1997 and 1996, respectively. The Company's revenues from international locations were primarily generated from customers located in Europe. Revenues from customers located in Europe accounted for 13.2%, 10.3% and 10.1% of total revenues in 1998, 1997 and 1996, respectively. Substantially all of the Company's assets are located in the United States. F-13 36 CONCORD COMMUNICATIONS, INC. FORM 10-K, December 31, 1998 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized this 22nd day of March, 1999. Concord Communications, Inc. /s/ Gary E. Haroian --------------------------------- Name: Gary E. Haroian Title: Vice President of Finance and Chief Financial Officer (Principal Financial Officer and Principal Accounting Officer) Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. SIGNATURE TITLE DATE --------- ----- ---- /s/ John A. Blaeser Chief Executive Officer, 03/22/99 - ------------------------------ President and Director John A. Blaeser (Principal Executive Officer) /s/ Gary E. Haroian Chief Financial Officer, Vice 03/22/99 - ------------------------------ President of Finance, Gary E. Haroian Treasurer and Clerk (Principal Financial and Accounting Officer) /s/ Frederick W.W. Bolander Director 03/22/99 - ------------------------------ Frederick W.W. Bolander /s/ Richard M. Burnes, Jr. Director 03/22/99 - ------------------------------ Richard M. Burnes, Jr. /s/ Robert C. Hawk Director 03/22/99 - ------------------------------ Robert C. Hawk /s/ John Robert Held Director 03/22/99 - ------------------------------ John Robert Held /s/ Deepak Kamra Director 03/22/99 - ------------------------------ Deepak Kamra /s/ Robert M. Wadsworth Director 03/22/99 - ------------------------------ Robert M. Wadsworth 37 EXHIBIT INDEX The following designated exhibits are either filed herewith or, where information is provided under the SEC Document Reference heading corresponding to such exhibit, incorporated by reference to such filing. EXHIBIT NO. DESCRIPTION SEC DOCUMENT REFERENCE ------- ----------- ---------------------- 3.01 Restated Articles of Organization of the Company Exhibit No. 3.01 on Form 10-K, for the period ended December 31, 1997 * 3.02 Restated By-laws of the Company 10.01 Working Capital Loan Agreement between the Company and Silicon Exhibit No. 10.01 to Registration Statement on Valley Bank dated April 3, 1997 Form S-1 (No. 333-33227) 10.02 Revolving Promissory Note made by the Company in favor of Silicon Exhibit No. 10.02 to Registration Statement on Valley Bank Form S-1 (No. 333-33227) 10.03 Equipment Line of Credit Letter Agreement between the Company and Exhibit No. 10.03 to Registration Statement on Fleet Bank dated as of June 9, 1997 Form S-1 (No. 333-33227) 10.04 1995 Stock Plan of the Company Exhibit No. 10.04 to Registration Statement on Form S-1 (No. 333-33227) 10.05 1997 Stock Plan of the Company Exhibit No. 10.01 on Form 10-Q, for the period ended June 30, 1998 10.06 1997 Employee Stock Purchase Plan of the Company Exhibit No. 10.06 to Registration Statement on Form S-1 (No. 333-33227) 10.07 1997 Non-Employee Director Stock Option Plan of the Company Exhibit No. 10.02 on Form 10-Q, for the period ended June 30, 1998 10.08 The Profit Sharing/401(K) Plan of the Company Exhibit No. 10.08 to Registration Statement on Form S-1 (No. 333-33227) 10.09 Lease Agreement between the Company and John Hancock Mutual Life Exhibit No. 10.09 to Registration Statement on Insurance Company dated March 17, 1994, as amended on March Form S-1 (No. 333-33227) 25,1997 10.10 First Amendment to Lease Agreement between the Company and John Exhibit No. 10.10 to Registration Statement on Hancock Mutual Life Insurance Company dated March 25, 1997 Form S-1 (No. 333-33227) 10.11 Form of Indemnification Agreement for directors and officers of Exhibit No. 10.11 to Registration Statement on the Company Form S-1 (No. 333-33227) 10.12 Restated Common Stock Registration Rights Agreement between the Exhibit No. 10.12 to Registration Statement on Company and certain investors dated August 7, 1986 Form S-1 (No. 333-33227) 10.13 Amended and Restated Registration Rights Agreement between the Exhibit No. 10.13 to Registration Statement on Company and certain investors dated December 28, 1995 Form S-1 (No. 333-33227) 10.14 Management Change in Control Agreement between the Company and Exhibit No. 10.14 to Registration Statement on John A. Blaeser dated as of August 7, 1997 Form S-1 (No. 333-33227) 10.15 Management Change in Control Agreement between the Company and Exhibit No. 10.15 to Registration Statement on Kevin J. Conklin dated as of July 23, 1997 Form S-1 (No. 333-33227) 10.16 Management Change in Control Agreement between the Company and Exhibit No. 10.16 to Registration Statement on Ferdinand Engel dated as of July 23, 1997 Form S-1 (No. 333-33227) 10.17 Management Change in Control Agreement between the Company and Exhibit No. 10.17 to Registration Statement on Gary E. Haroian dated as of July 23, 1997 Form S-1 (No. 333-33227) 10.18 Management Change in Control Agreement between the Company and Exhibit No. 10.18 to Registration Statement on Daniel D. Phillips, Jr. dated as of July 23, 1997 Form S-1 (No. 333-33227) 10.19 Stock Option Agreement dated January 1, 1996 between the Company Exhibit No. 10.19 to Registration Statement on and John A. Blaeser Form S-1 (No. 333-33227) 10.20 Stock Option Agreement dated January 1, 1996 between the Company Exhibit No. 10.20 to Registration Statement on and John A. Blaeser Form S-1 (No. 333-33227) 10.21 Letter Agreement between the Company and Silicon Valley Bank Exhibit No. 10.21 to Registration Statement on dated March 25, 1996 together with the Loan Modification Form S-1 (No. 333-33227) Agreement dated November 14, 1996 10.22 Form of Shrink-Wrap License Exhibit No. 10.22 to Registration Statement on Form S-1 (No. 333-33227) * 13.01 Pages 15-20 of the Registrant's 1998 Annual Report to Stockholders * 21.01 Subsidiaries of the Company * 23.01 Consent of Arthur Andersen LLP * 27.01 Financial Data Schedule - --------------------------- * filed herewith