1 EX-13 ANNUAL REPORT STOCK PRICE HISTORY (unaudited) The following table sets forth the high and low sales prices of the Company's Common Stock, which trades under the symbol "OPEN", as Reported on the NASDAQ Stock Market from January 1, 1997 to December 31, 1998. As of December 31, 1998, the Company had approximately 507 stockholders of record. The Company has paid no dividends on its Common Stock and anticipates that it will continue to reinvest earnings to finance future growth. For year ended December 31, 1998 High Low - ------------------------------------------------------------------------------------------------------------------- First Quarter 1 3/8 1 Second Quarter 1 21/32 1 1/32 Third Quarter 1 7/16 3/4 Fourth Quarter 1 29/32 11/16 For year ended December 31, 1997 High Low - ------------------------------------------------------------------------------------------------------------------- First Quarter 3 11/16 1 5/16 Second Quarter 2 15/16 1 7/16 Third Quarter 2 1/2 1 9/16 Fourth Quarter 3 1/2 1 1/32 2 EX-13 (Cont'd) ANNUAL REPORT SELECTED CONSOLIDATED FINANCIAL DATA CONSOLIDATED STATEMENT OF OPERATIONS DATA: - --------------------------------------------------------------------------------------------------------- Years ended December 31, (in thousands, except per share data) 1998 1997 1996 1995 1994 - --------------------------------------------------------------------------------------------------------- Net sales $ 14,326 $ 26,944 $ 45,296 $ 75,323 $ 93,912 Cost of sales 8,596 15,340 25,670 36,664 48,148 - --------------------------------------------------------------------------------------------------------- Gross profit 5,730 11,604 19,626 38,659 45,764 Operating expenses: Research and development 4,610 5,987 9,353 8,802 11,162 Selling and marketing 8,018 10,703 15,486 17,903 23,955 General and administrative 5,376 3,870 4,590 4,683 7,065 Restructure costs -- (241) 3,312 -- 6,330 - --------------------------------------------------------------------------------------------------------- Total operating expenses 18,004 20,319 32,741 31,388 48,512 - --------------------------------------------------------------------------------------------------------- (Loss) income from operations (12,274) (8,715) (13,115) 7,271 (2,748) Interest income (expense), net 589 1,052 1,261 1,437 455 Other income -- -- -- -- 1,205 - --------------------------------------------------------------------------------------------------------- (Loss) income before income taxes (11,685) (7,663) (11,854) 8,708 (1,088) Provision (benefit) for income taxes 175 184 160 488 251 - --------------------------------------------------------------------------------------------------------- Net (loss) income ($11,860) ($ 7,847) ($12,014) $ 8,220 ($ 1,339) - --------------------------------------------------------------------------------------------------------- Net (loss) income per share - basic and diluted ($ 0.77) ($ 0.51) ($ 0.77) $ 0.52 ($ 0.09) Weighted average number of common shares outstanding- basic and diluted 15,312 15,301 15,630 15,692 14,808 - --------------------------------------------------------------------------------------------------------- CONSOLIDATED BALANCE SHEET DATA: Working capital $ 12,436 $ 23,620 $ 30,597 $ 39,006 $ 27,550 Total assets 20,278 33,403 45,571 59,029 56,911 Stockholders' equity 15,151 26,892 35,191 47,323 37,679 3 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion and analysis should be read in conjunction with the consolidated financial statements and notes thereto. RESULTS OF OPERATIONS During 1998 the Company completed its corporate repositioning from the LAN business environment to the Internet Access marketplace. LAN revenues declined from 32.4% of total revenue in 1997 to 19.9% of total revenue in 1998. LAN units shipped was reduced from 73% in 1997 to 31% in 1998 of total units shipped. Internet Access products grew from 50.2 % of total revenue in 1997 to 52.8% of total revenue in 1998 and reached 71% of the Company's total revenue in the fourth quarter of 1998. Internet Access product unit shipments represented 27% of the total units shipped in 1997 and 68% in 1998 reflecting the focus of the Company in the growing Internet Access marketplace. Overall Internet Access product unit shipments increased by 12.7% in 1998 from 1997 while LAN unit shipments declined by 80.9%. NET SALES Product sales decreased by 53.2% to $10,416,000 in 1998 from $22,248,000 in 1997. This decline reflects the completion of OpenROUTE's planned corporate repositioning from LAN products to Internet Access products. Although overall product revenue declined in 1998, Internet Access product unit sales increased 12.7% from 1997. Internet Access product revenue declined by 44.7% in 1998 primarily due to a 75% drop in average selling prices of certain older Corporate Internet Access products. Average selling prices for the Company's GT Internet Access products, although declining 25% for the year, remained relatively stable after the first quarter of 1998. LAN product revenue declined to $2,858,000 in 1998 or by 67.2% from 1997 levels. Software licensing revenue in 1998 increased to $1,663,000 from $895,000 in 1997 primarily reflecting the revenue produced from a single software licensing agreement with a major international telecommunications company. The Company expects that it will continue to have software licensing revenue in the future, however at varying and uncertain levels since software licensing revenue is an ancillary component of the Company's core revenue stream but strategic in its promotion of OpenROUTE routing technology in the marketplace. Service and other sales in 1998 decreased by 40.9% to $2,247,000 from $3,801,000 in 1997. This decrease was primarily due to the reduction in service contracts and upgrade revenue worldwide resulting from the Company's transition to Internet Access products which require less support services. Product sales decreased by 30.9% to $22,248,000 in 1997 from $32,175,000 in 1996. This anticipated decline reflects OpenROUTE's continuing product transition from LAN products to Internet Access products. Although overall product revenue declined in 1997, GlobeTrotter product revenue increased 76.5% from 1996 as a result of increased unit sales. Corporate Enterprise and LAN product revenue declined in 1997 by 43.3% from 1996 levels. Software licensing revenue in 1997 decreased by 88.1% to $895,000 from $7,530,000 in 1996 reflecting the declining revenue produced from the IBM and Digital Equipment software licensing agreements. The Company expects that it will continue to have software licensing revenue in the future, however at varying and uncertain levels since software licensing revenue is an ancillary component of the Company's core revenue stream but strategic in its promotion of OpenROUTE routing technology in the marketplace. Service and other sales in 1997 decreased by 32.0% to $3,801,000 from $5,591,000 in 1996. This decrease was primarily due to the reduction in service contracts and upgrade revenue 4 worldwide resulting from the Company's transition to Internet Access products which require less support services. International sales accounted for approximately 30.9%,35.4%, and 38.3% of net sales in 1998, 1997, and 1996, respectively. GROSS PROFIT Total price gross profit margin decreased in 1998 to 40.0% from 43.1% in 1997. Gross margin on product revenue decreased to 34.4% in 1998 from 42.8% in 1997 principally due to the drop in the average selling prices of the Company's Internet Access products and certain inventory write downs. Gross margin on service and other revenues declined to 21.7% in 1998 from 31.1% in 1997 primarily due to a decline in service revenue. The decline in the service margin was offset by the highly profitable software licensing margins. Total gross profit margin decreased slightly in 1997 to 43.1% from 43.3% in 1996. Gross margin on product revenue improved significantly to 42.8% in 1997 from 35.3% in 1996 principally due to the expansion of the GT product line into a number of higher margin models as well as to reductions in manufacturing overhead expenses. Gross margin on service and other revenues also increased to 31.1% in 1997 from 23.0% in 1996 primarily due to improved efficiencies in the customer service area. However, these improvements were not sufficient to offset the substantial decline in software licensing revenue which is highly profitable. RESEARCH AND DEVELOPMENT The Company considers product development expenditures to be critical to future revenues. These activities are closely related to product enhancement and new product development. The Company's strategy also includes joint development partnerships to bring new technologies and products to market. All of the Company's research and development costs to date have been expensed as incurred. Research and development expenses were $4,610,000 or 32.2%, $5,987,000 or 22.2%, and $9,353,000 or 20.6% of net sales in 1998, 1997 and 1996, respectively. The decrease in expenses of $1,377,000 in 1998 from 1997 was primarily due to lower personnel and personnel-related costs. When comparing 1997 to 1996, the decrease in research and development expenses of $3,366,000 in 1997 from 1996 was primarily due to lower personnel and personnel-related costs as well as a more defined focus on the Internet Access products only. In 1998 the Company continued to focus its efforts on enhancement of existing products and the development of new products. Major efforts in 1997 included the continuing development of the GlobeTrotter series of products with the introduction of several new models during the year. SELLING AND MARKETING Selling and marketing expenses were $8,018,000 or 56.0%, $10,703,000 or 39.7%, and $15,486,000 or 34.2% of net sales in 1998, 1997 and 1996, respectively. The decrease in expenses in 1998 from 1997 of $2,685,000 was primarily the result of lower personnel and personnel-related costs including sales commissions due to the decline in revenues in 1998 from 1997. The Selling and marketing cost reduction in 1998 as compared to 1997 is also attributable to the Company's 5 repositioning to focus mainly on the Internet Access products which resulted in the achievement of marketing cost efficiencies. In 1997 sales and marketing expenses decreased by $4,783,000 when compared to 1996. This decrease was due mainly to lower personnel and personnel-related costs. GENERAL AND ADMINISTRATIVE General and administrative expenses were $5,376,000, $3,870,000, and $4,590,000 in 1998, 1997 and 1996, respectively. The increase in expenses of $1,506,000 in 1998 from 1997 was primarily due to severance payments and accruals that were made as a result of cost containment measures that were implemented during the year. Also, additional legal expenses were incurred during 1998 that resulted from an on-going lawsuit, initiated by OpenROUTE Networks, against two companies relating to the transfer of OpenROUTE software licensing rights without OpenROUTE's required consent. When comparing 1997 to 1996, the decrease in expenses of $720,000 was largely due to lower personnel and personnel-related costs. RESTRUCTURING OF OPERATIONS The Company's management continually reviews methods to reduce the Company's expense base in response to decreased revenue streams. As a result, the Company has implemented a series of restructurings, the most recent of which transpired in 1996. This restructuring of operations was necessary to reestablish the strategic direction of the Company and better align its operating expenses with anticipated revenues. In the fourth quarter of 1996, the Company recorded a $3,312,000 restructuring charge in connection with its strategic redirection of the Company's business to the Internet access marketplace. This charge included approximately $410,000 of severance costs, approximately $785,000 to reduce the Company's occupancy requirements, approximately $1,922,000 associated with the disposal of fixed assets, and $195,000 of other costs. During 1996 the cash impact for restructuring was insignificant and as of December 31, 1996 there was an accrual of $1,661,000 relating to future spending. During 1997, the Company incurred cash expenditures in connection with the 1996 restructuring of approximately $495,000 for severance and payroll related costs, approximately $672,000 as a result of reducing its occupancy costs and $253,000 in other restructuring related costs. Management has determined that all of the Company's obligations from the 1996 and prior restructurings have been settled. Accordingly, the Company reversed its remaining restructuring provision of $241,000 in the third quarter of 1997. PROVISION FOR INCOME TAXES In 1998, the Company recorded an income tax provision of $175,000 primarily due to foreign taxes on income earned outside the United States. The difference between the effective tax rate and the statutory tax rate for 1998 is mainly due to net operating loss carryforwards whose future realization is uncertain. In 1997, the Company recorded an income tax provision of $184,000 primarily due to foreign taxes on income earned outside the United States. The difference between the effective tax rate and the statutory tax rate for 1997 is mainly due to net operating loss carryforwards whose future realization is uncertain. 6 In 1996, the Company recorded an income tax provision of $160,000, primarily due to foreign taxes on income earned outside the United States. The difference between the effective tax rate and the statutory tax rate for 1996 is also due primarily to net operating loss carryforwards whose future realization is uncertain. YEAR 2000 The "Year 2000 Issue" is the result of computer programs that were written using two digits rather than four to define the applicable year. If computer programs with date sensitive functions are not Year 2000 compliant, they may recognize a date using "00" as the Year 1900 rather than the Year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in similar normal business activities. The Company has initiated a program to review the Year 2000 readiness of its internal systems, the Company's product line, and of third party suppliers and vendors. The program consists of: (i) inventory of products and suppliers to determine systems which may encounter date processing problems; (ii) assessment of the Year 2000 issues presented; (iii) remediation, if necessary, of products owned or manufactured by the Company; (iv) testing of systems; and (v) contingency plans. The program's implementation varies depending upon the problems or issues encountered, and their resolution. PRODUCTS MANUFACTURED BY THE COMPANY. The Company's main business since its formation has consisted primarily of the manufacture and sale of: (i) Remote Access Routers used to access the Internet; (ii) Local Area Network (LAN) equipment used to link together computers and peripheral devices; and (iii) Network Interface Cards (NIC), which connect computer workstations to a network. The Company has installed its own proprietary software in all of its manufactured Remote Access Routers and LANs, and at times has licensed this software to third parties. The Company's installed proprietary software and the products manufactured and sold by the Company, now and in the past, do not track or report dates, are not date dependent, and are Year 2000 compliant. The Company's manufactured NIC cards do not contain any date-dependent functions, and thus also are Year 2000 compliant. Therefore, the Company does not expect that Year 2000 processing problems will occur in products sold by the Company, or that Year 2000 product problems would have a material effect on the Company's business, financial condition, or the results of operations. INTERNAL BUSINESS SOFTWARE AND SYSTEMS. The Company in 1998 conducted an inventory of its internal business systems, to determine whether any Year 2000 processing problems existed in critical equipment or systems. As a result, and as part of a corporate program intended to reduce cycle time and improve efficiency, the Company purchased new business operations systems which operate the Company's financial, administrative, business, manufacturing, and customer service functions. The software vendor has indicated these systems are Year 2000 compliant. The Company has completed the installation of this system in January 1999 and has successfully closed the fiscal month of January and February 1999. The Company has a one year limited warranty on these systems commencing from the date of delivery, which would expire before January 1, 2000. The Company also has installed a new telephone system under a long-term lease which it understands is Year 2000 compliant. However, if testing demonstrates unexpected Year 2000 problems in these new systems, there would be no assurance that the Year 2000 problems would not have a material impact on the Company's internal operations and would not materially impact the Company's business, 7 financial conditions or results of operations. The Company expended $340,000 in Year 2000 system costs in 1998. Some of these costs have been capitalized under generally accepted accounting practices. The Company expects to incur additional expenditures of $175,000 in 1999 related to Year 2000 equipment purchases and leases, including consulting fees, license agreements and lease payments. READINESS OF THIRD PARTY SUPPLIERS AND VENDORS. The Company relies on third party suppliers, service providers, and contractors for critical services, including utility power and telephone, parts and supplies. In addition, the Company sells its products to customers, including Internet service providers and others, which are highly dependent on computers, and which could be adversely affected by their own or their suppliers' lack of Year 2000 readiness. The Company has conducted an inventory of its critical suppliers, service providers, and contractors to determine the extent to which the Company's operations could be affected by those third parties' failure to remedy their own Year 2000 issues. This exercise was substantially completed in March 1999. Most of the Company's critical suppliers, service providers, and contractors are also in the high technology field, thus year 2000 compliance has received intense attention throughout the vendors' base. OpenRoute's major contract manufacturer, U.S. Assemblies, has recently completed implementation of the year 2000 compliant version of MAPICS for their Material Resource Planning. Following completion of its inventory and assessment of third party readiness, the Company will determine whether testing, verification, or contingency plan procedures are necessary. The most reasonably likely worst case scenario if suppliers or customers were not Year 2000 compliant would be interruption in the Company's ability to manufacture or deliver its products through loss of power, supply shortages, or disruption of delivery systems, or a material decrease in the sale of products if customers lose substantial business or divert substantial resources to uncorrected Internet Year 2000 problems. The Year 2000 readiness of outside suppliers or customers is outside the Company's control. There can be no assurance that the failure of third party suppliers or the Company's customers to effectively remedy Year 2000 defects would not have a material adverse impact on the Company's business, results of operations, or financial condition. The above description contains "forward-looking" statements addressing uncertainties and future events relating to the Company's Year 2000 issues. These statements are based on assumptions and predictions which are difficult to verify and may change over time. The Company expects that future events and information, if known by the Company, may affect assessment of the Year 2000 issues potentially affecting the Company. NEWLY ISSUED ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, "Accounting for Derivatives Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 requires companies to recognize all derivatives contracts as either assets or liabilities in the balance sheet and to measure them at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge, the objective of which is to match the timing of gain or loss recognition on the hedging derivative with the recognition of (i) the changes in the fair value of the hedged assets or liability or (ii) the earnings effect of the hedged forecasted transaction. For a derivative not designated as a hedging instrument, the gain or loss is recognized in income in the period of change. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. 8 Historically, the Company has not entered into derivative contracts either to hedge existing risks or for speculative purposes. Accordingly, the Company does not expect adoption of the new standard to affect its financial statements. LIQUIDITY AND CAPITAL RESOURCES During 1998, the Company consumed $12,040,000 of cash from operating activities. This was due primarily to the net operating loss of $11,860,000, an increase in inventory of $2,836,000, and a decrease in accounts payable and accrued expenses of $1,384,000. This was offset by depreciation of $1,191,000 and a decrease in accounts receivable of $2,323,000. Working capital decreased to $12,436,000 in 1998 from $23,620,000 in 1997. Investing activities during 1998 generated net proceeds of $8,628,000 principally from the sales of marketable securities. The Company's management believes that if it achieves its twelve month operating plan, then current levels of cash, cash equivalent, and marketable securities will satisfy its expected working capital and capital expenditure requirements through the next twelve months. If the operating plan is not achieved, it is likely that it will be necessary to secure alternative forms of financing and there is no assurance that the financing would be available when needed or, on terms favorable to the Company. Accordingly, the Company's 1998 Report of Independent Certified Public Accountants includes a going concern explanatory paragraph. The Company is in the process of obtaining additional working capital financing to fund expected future growth. SAFE HARBOR FOR FORWARD-LOOKING STATEMENTS The 1998 Annual Report, including the President's Letter and the Management's Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management's current expectations and involve a number of risks and uncertainties. The Company's future results remain difficult to predict and may be affected by a number of factors including: business conditions within the networking industry; timing of orders from and shipments to major customers; timing of new products introductions; acceptance of products in the marketplace; increased competition; changes in manufacturing costs; changes in the mix of product sales and changes in world economic conditions. Other risk factors are listed from time to time in the required documents including the Company's Annual Report on Form 10-K, filed with the Securities and Exchange Commission (SEC). 9 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS - -------------------------------------------------------------------------------------------------------- December 31, 1998 1997 - -------------------------------------------------------------------------------------------------------- (In thousands) ASSETS CURRENT: Cash and cash equivalents $ 2,024 $ 5,317 Marketable securities (Note 3) 3,128 12,443 Accounts receivable less reserve for doubtful accounts of $1,424,000 and $927,000 at December 31, 1998 and 1997, respectively 3,356 6,224 Inventories (Note 4) 8,546 5,710 Deposits and other assets 509 437 - -------------------------------------------------------------------------------------------------------- Total current assets 17,563 30,131 PROPERTY AND EQUIPMENT, NET (Note 5) 2,715 3,272 - -------------------------------------------------------------------------------------------------------- Total assets $ 20,278 $ 33,403 - -------------------------------------------------------------------------------------------------------- LIABILITIES AND STOCKHOLDERS' EQUITY CURRENT LIABILITIES: Accounts payable $ 1,449 $ 2,292 Accrued compensation 353 765 Accrued expenses 2,743 2,779 Accrued warranty 582 675 - -------------------------------------------------------------------------------------------------------- Total current liabilities 5,127 6,511 - -------------------------------------------------------------------------------------------------------- COMMITMENTS AND CONTINGENCIES (NOTES 6,7 AND 11) STOCKHOLDERS' EQUITY: (NOTE 7) Preferred stock, par value $.01 per share, authorized 7,500,000 shares, none issued -- -- Common stock, par value $.01 per share, authorized 30,000,000 shares, issued 15,740,305 and 15,669,524 shares at December 31, 1998 and 1997, respectively 157 157 Capital in excess of par value 49,418 49,347 Accumulated deficit (33,526) (21,666) Accumulated other comprehensive income 112 110 Less treasury stock, at cost, 390,769 and 407,435 shares at December 31, 1998 and 1997, respectively (1,010) (1,056) - -------------------------------------------------------------------------------------------------------- Total stockholders' equity 15,151 26,892 - -------------------------------------------------------------------------------------------------------- Total liabilities and stockholders' equity $ 20,278 $ 33,403 - -------------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements. 10 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (NOTE 8) - ------------------------------------------------------------------------------------------------- Years ended December 31, 1998 1997 1996 - ------------------------------------------------------------------------------------------------- (In thousands, except per share data) SALES: Product $ 10,416 $ 22,248 $ 32,175 Service and other 2,247 3,801 5,591 Software licensing 1,663 895 7,530 - ------------------------------------------------------------------------------------------------- Net sales 14,326 26,944 45,296 - ------------------------------------------------------------------------------------------------- COST OF SALES: Product 6,836 12,722 20,825 Service and other 1,760 2,618 4,307 Software licensing -- -- 538 - ------------------------------------------------------------------------------------------------- Cost of sales 8,596 15,340 25,670 - ------------------------------------------------------------------------------------------------- GROSS PROFIT 5,730 11,604 19,626 - ------------------------------------------------------------------------------------------------- OPERATING EXPENSES: Research and development 4,610 5,987 9,353 Selling and marketing 8,018 10,703 15,486 General and administrative 5,376 3,870 4,590 Restructure costs (Note 9) -- (241) 3,312 - ------------------------------------------------------------------------------------------------- Total operating expenses 18,004 20,319 32,741 - ------------------------------------------------------------------------------------------------- LOSS FROM OPERATIONS (12,274) (8,715) (13,115) INTEREST INCOME, net of interest expense of $10,000 in 1996 589 1,052 1,261 - ------------------------------------------------------------------------------------------------- LOSS BEFORE PROVISION FOR INCOME TAXES (11,685) (7,663) (11,854) PROVISION FOR INCOME TAXES (NOTE 10) 175 184 160 - ------------------------------------------------------------------------------------------------- NET LOSS $(11,860) $ (7,847) $(12,014) - ------------------------------------------------------------------------------------------------- NET LOSS PER SHARE OF COMMON STOCK - BASIC AND DILUTED $ (.77) $ (.51) $ (.77) - ------------------------------------------------------------------------------------------------- WEIGHTED AVERAGE NUMBER OF COMMON SHARES OUTSTANDING - BASIC AND DILUTED 15,312 15,301 15,630 - ------------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements. 11 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY Accumulated Capital in Other Common Stock Excess of Accumulated Comprehensive Shares Amount Par Value Deficit Income - ------------------------------------------------------------------------------------------------------------------------ (In thousands) BALANCE, December 31, 1995 15,589 $ 156 $49,141 $(1,805) $118 Issuance of common stock 48 - 151 - - Repurchase of stock as treasury stock - - - - - Comprehensive income (loss): Foreign currency translation - - - - 59 Net loss - - - (12,014) - - ------------------------------------------------------------------------------------------------------------------------ Total comprehensive loss - - - - - - ------------------------------------------------------------------------------------------------------------------------ BALANCE, December 31, 1996 15,637 156 49,292 (13,819) 177 Issuance of common stock 33 1 55 - - Repurchase of stock as treasury stock - - - - - Comprehensive loss: Foreign currency translation - - - - (67) Net loss - - - (7,847) - - ------------------------------------------------------------------------------------------------------------------------ Total comprehensive loss - - - - - - ------------------------------------------------------------------------------------------------------------------------ BALANCE, December 31, 1997 15,670 157 49,347 (21,666) 110 Issuance of common stock 70 - 71 - - Issuance of treasury stock - - - - - Comprehensive income (loss): Foreign currency translation - - - - 2 Net loss - - - (11,860) - - ------------------------------------------------------------------------------------------------------------------------ Total comprehensive loss - - - - - - ------------------------------------------------------------------------------------------------------------------------ BALANCE, December 31, 1998 15,740 $ 157 $49,418 $(33,526) $112 - ------------------------------------------------------------------------------------------------------------------------ Total Treasury Stock Stockholders' Shares Amount Equity - ------------------------------------------------------------------------------------------- (In thousands) BALANCE, December 31, 1995 81 $ (287) $47,323 Issuance of common stock - - 151 Repurchase of stock as treasury stock 130 (328) (328) Comprehensive income (loss): Foreign currency translation - - 59 Net loss - - (12,014) - ------------------------------------------------------------------------------------------- Total comprehensive loss - - (11,955) - ------------------------------------------------------------------------------------------- BALANCE, December 31, 1996 211 (615) 35,191 Issuance of common stock - - 56 Repurchase of stock as treasury stock 196 (441) (441) Comprehensive loss: Foreign currency translation - - (67) Net loss - - (7,847) - ------------------------------------------------------------------------------------------- Total comprehensive loss - - (7,914) - ------------------------------------------------------------------------------------------- BALANCE, December 31, 1997 407 (1,056) 26,892 Issuance of common stock - - 71 Issuance of treasury stock (17) 46 46 Comprehensive income (loss): Foreign currency translation - - 2 Net loss - - (11,860) - ------------------------------------------------------------------------------------------- Total comprehensive loss - - (11,858) - ------------------------------------------------------------------------------------------- BALANCE, December 31, 1998 390 $(1,010) $15,151 - ------------------------------------------------------------------------------------------- The accompanying notes are an integral part of the consolidated financial statements. 12 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOWS Years ended December 31, 1998 1997 1996 - --------------------------------------------------------------------------------------------------------------------------- (In thousands) CASH FLOWS PROVIDED BY OPERATING ACTIVITIES: Net loss $(11,860) $ (7,847) $(12,014) Adjustments to reconcile net loss to net cash used by operating activities: Bad debt provision 545 439 - Inventory provision - - 2,374 Depreciation and amortization 1,191 1,550 3,401 Restructuring cost - - 1,922 Loss (gain) on disposition of fixed assets 53 198 (117) Changes in operating assets and liabilities: Accounts receivable 2,323 962 4,513 Inventories (2,836) 3,027 (6,686) Deposits and other assets (72) 768 372 Accounts payable and accrued expenses (1,384) (3,869) (1,326) - --------------------------------------------------------------------------------------------------------------------------- Net cash used by operating activities (12,040) (4,772) (7,561) - --------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM INVESTING ACTIVITIES: Proceeds from the sale of fixed assets 23 182 117 Capital expenditures (710) (728) (1,600) Marketable securities sales and maturities 16,980 19,428 15,456 Purchase of marketable securities (7,665) (24,953) (15,511) - --------------------------------------------------------------------------------------------------------------------------- Net cash provided (used) by investing activities 8,628 (6,071) (1,538) - --------------------------------------------------------------------------------------------------------------------------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from the issuance of common stock 71 56 151 Proceeds from issuance of treasury stock 46 - - Purchase of treasury stock - (441) (328) - --------------------------------------------------------------------------------------------------------------------------- Net cash provided (used) by financing activities 117 (385) (177) - --------------------------------------------------------------------------------------------------------------------------- EFFECT OF EXCHANGE RATE CHANGES ON CASH 2 (67) 59 - --------------------------------------------------------------------------------------------------------------------------- NET DECREASE IN CASH AND CASH EQUIVALENTS (3,293) (11,295) (9,217) CASH AND CASH EQUIVALENTS, at beginning of year 5,317 16,612 25,829 - --------------------------------------------------------------------------------------------------------------------------- CASH AND CASH EQUIVALENTS, at end of year $ 2,024 $ 5,317 $ 16,612 - --------------------------------------------------------------------------------------------------------------------------- SUPPLEMENTAL CASH FLOW INFORMATION: Cash paid for: Income taxes $ 69 $ 230 $ 321 Interest $ - $ - $ 10 Non-cash financing activities: Note receivable on sale of fixed assets $ 15 $ 120 $ - The accompanying notes are an integral part of the consolidated financial statements. 13 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. OPERATIONS AND OpenROUTE Networks, Inc. (formerly Proteon, Inc.) MANAGEMENTS PLANS and its subsidiaries (the "Company") develop, market, and support a wide range of networking products. The Company is engaged principally in one business segment in the computer networking industry having two lines of business; (i) Internet access and (ii) local area network access. The Company is positioned to focus on the Internet access market. The Company's principal geographic markets include the Americas, Europe and the Far East. The Company's consolidated financial statements have been prepared on the basis that it will continue as a going concern. The Company has incurred net losses of approximately $11,860,000, $7,847,000 and $12,014,000 for the years ended December 31, 1998, 1997 and 1996, respectively. The Company's current business strategy is focused on the emerging Internet access market. As such, success of future operations is subject to a number of risks. Principal among these risks are the successful marketing of its products, rapidly changing technology, reliance on significant customers, intense competition from substitute products and significantly larger companies, and the ability to obtain financing to fund future operations. The above factors raise substantial doubt about the Company's ability to continue as a going concern. Management's plans include a continued effort to gain market share and increase its Internet access product revenues. The Company has also continued to monitor cost containment and has a plan to implement further operating expense reductions as it deems necessary. Additionally, the Company is pursuing working capital financing to fund future operating activities. The Company's ability to continue as a going concern depends on the success of management's plans, including obtaining additional funding or establishing strategic relationships and achieving projected operating results. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. 14 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Principles of The consolidated financial statements Consolidation include the accounts of OpenROUTE Networks, Inc. and its subsidiaries. Proteon, Inc. changed its name to OpenROUTE Networks, Inc. on June 10, 1998. OpenROUTE Networks, Inc. was previously the name of a wholly-owned subsidiary of Proteon, Inc. All intercompany transactions and balances have been eliminated in consolidation. Use of Estimates The preparation of the 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. In particular, the Company records reserves for estimated product returns, collectibility of accounts receivable, estimated inventory obsolescence and estimated warranty obligations. All estimates are based upon experience and actual results could differ from the estimates and assumptions used by management. Revenue The Company recognizes revenue from product Recognition sales upon shipment of the product. Revenue from service agreements is recognized ratably over the term of the agreement. Revenue from software licensing is recognized upon performance of milestones when collectibility is reasonably assured. Translation of The Company has designated the local Foreign currency as the functional currency for all Currencies foreign locations. Accordingly, assets and liabilities of all foreign subsidiaries are translated at year-end rates of exchange, and income statement accounts are translated at the average rates of exchange during the year. The resulting translation adjustments are excluded from net earnings, and accumulated as a separate component of stockholders' equity. Foreign currency transaction gains and losses are included in results of operations in the periods in which they occur, and are immaterial for all periods presented. Comprehensive In 1998, the Company adopted Statement of Income (Loss) Financial Accounting Standards ("SFAS") No. 130 "Reporting Comprehensive Income". SFAS No. 130 establishes rules for the reporting of comprehensive income (loss) and its components. Comprehensive income (loss) consists of net income (loss) and foreign currency translation adjustments and is presented in the accompanying consolidated statements of stockholders' equity. The adoption of SFAS No. 130 had no impact on total stockholders' equity. Prior year financial statements have been reclassified to conform to the SFAS No. 130 requirements. 15 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Hedging In June 1998, the Financial Accounting Activities Standards Board issued SFAS No. 133, "Accounting for Derivatives Instruments and Hedging Activities" ("SFAS No. 133"). SFAS No. 133 requires companies to recognize all derivatives contracts as either assets or liabilities in the balance sheet and to measure them at fair value. If certain conditions are met, a derivative may be specifically designated as a hedge, the objective of which is to match the timing of gain or loss recognition on the hedging derivative with the recognition of (i) the changes in the fair value of the hedged assets or liability or (ii) the earnings effect of the hedged forecasted transaction. For a derivative not designated as a hedging instrument, the gain or loss is recognized in income in the period of change. SFAS No. 133 is effective for all fiscal quarters of fiscal years beginning after June 15, 1999. Historically, the Company has not entered into derivative contracts either to hedge existing risks or for speculative purposes. Accordingly, the Company does not expect adoption of the new standard to affect its financial statements. Cash Equivalents The Company considers all highly liquid and Marketable instruments purchased with a maturity of Securities three months or less to be cash equivalents. Marketable securities consist of highly liquid investments with maturities of more than three months when purchased. Investments are stated at cost, plus accrued interest, which approximates fair market value. In addition, the Company classified all investments as available-for-sale securities. Realized gains and losses are determined on the specific identification method. The marketable securities portfolio at December 31, 1998 matures at various dates through September 8, 1999. Inventories Inventories are stated at the lower of cost or market, with cost determined under the first-in, first-out method. 16 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Property and Property and equipment are stated at cost. Equipment Depreciation and amortization of property and equipment are computed principally using the straight-line method over the estimated useful lives of the assets as follows: Category Years -------------------------------------------------- Machinery and equipment 3-5 Furniture and fixtures 7 Leasehold improvements shorter of lease term or estimated useful life Maintenance and repairs are charged to expense as incurred. Upon retirement or sale, the cost of the disposed assets and the related accumulated depreciation are removed from the accounts and any resulting gain or loss is recorded in the consolidated statements of operations. Income Deferred tax assets and liabilities reflect Taxes the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. A valuation allowance is provided for the net deferred tax assets if it is more likely than not that some or all of the deferred tax assets will not be realized. Accrued The Company records a liability for future Warranty warranty costs based upon the relationship of prior years' sales to actual warranty costs which approximates expected future warranty costs. 17 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Research and Costs incurred in the research and Development development of software products are expensed as incurred until the technological feasibility of the product has been established. After technological feasibility is established, any additional costs would be capitalized. The Company believes the current process for developing software is essentially completed concurrently with the establishment of technological feasibility. Accordingly, no software development costs have been capitalized to date. Concentrations of Financial instruments, which potentially Credit Risk subject the Company to concentration of credit risk, are principally cash and cash equivalents, marketable securities, and accounts receivable. The Company places its investments in highly rated financial institutions and, by policy, limits the amount of credit exposure to any one financial institution. Concentration of credit risk with respect to accounts receivable is limited to certain customers with whom the Company makes substantial sales. Four customers accounted for approximately 35% of the Company's outstanding accounts receivable at December 31, 1998 and two customers accounted for approximately 28% of the Company's outstanding accounts receivable at December 31, 1997. To reduce credit risk, the Company performs ongoing credit evaluation, account monitoring procedures and maintains reserves for potential losses. These losses have been within management's expectations. 18 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Net Loss The Company follows SFAS No. 128 "Earnings per Share". Per Share Under SFAS No. 128, Basic Earnings Per Share (EPS) excludes the effect of any dilutive options, warrants or convertible securities and is computed by dividing the net income (loss) available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised. Diluted EPS is computed by dividing the net income (loss) available to common stockholders by the sum of the weighted average number of common shares and common share equivalents computed using the average market price for the period under the treasury stock method. The following table presents the numerator and the denominator of the basic and diluted EPS computations shown on the consolidated statements of operations: -------------------------------------------------------------------------------------- Years ended December 31, 1998 1997 1996 -------------------------------------------------------------------------------------- (In thousands, except per share data) Basic and diluted EPS computation: Numerator: Net loss $ (11,860) $ (7,847) $ (12,014) Denominator: Weighted average common shares outstanding 15,312 15,301 15,630 -------------------------------------------------------------------------------------- Basic and diluted EPS $ (.77) $ (.51) $ (.77) -------------------------------------------------------------------------------------- Outstanding stock options of 2,269,463, 1,758,605 and 1,272,009 as of December 31, 1998, 1997 and 1996, respectively, were not included in the diluted EPS computation because their effect would be antidilutive. 19 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued) Segment Information In 1998, the Company adopted SFAS No. 131, "Disclosure about Segments of an Enterprise and Related Information". SFAS No. 131 established standards for disclosures regarding products and services, geographic areas and major customers. Information for 1997 and 1996 has been restated to conform with the 1998 presentation (see Note 8). 3. MARKETABLE Marketable securities consists of the following: SECURITIES ------------------------------------------------------------- December 31, 1998 1997 ------------------------------------------------------------- (In thousands) Fixed income securities $ 3,128 $ 7,074 Repurchase agreements - 263 Certificates of deposit - 1,291 Commercial paper - 2,557 U.S. Government securities - 1,258 ------------------------------------------------------------- $ 3,128 $ 12,443 ------------------------------------------------------------- 4. INVENTORIES Inventories consist of the following: ------------------------------------------------------------- December 31, 1998 1997 ------------------------------------------------------------- (In thousands) Raw materials $2,270 $1,043 Work in process 15 373 Finished goods 6,261 4,294 ------------------------------------------------------------- $8,546 $5,710 ------------------------------------------------------------- 20 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 5. PROPERTY AND Property and equipment consist of the following: EQUIPMENT ------------------------------------------------------------------ December 31, 1998 1997 ------------------------------------------------------------------ (In thousands) Machinery and equipment $ 11,791 $ 11,492 Furniture and fixtures 593 554 Leasehold improvements 884 1,188 ------------------------------------------------------------------ 13,268 13,234 Less accumulated depreciation and amortization 10,553 9,962 ------------------------------------------------------------------ Property and equipment, net $ 2,715 $ 3,272 ------------------------------------------------------------------ 6. COMMITMENTS AND CONTINGENCIES Letter of Credit The Company has an outstanding letter of credit of approximately $288,000 at December 31, 1998, 1997 and 1996. This letter of credit which matures on April 30, 2002, automatically renews annually on December 31. This letter of credit collateralized the Company's obligation to a third party for a certain lease transaction. 21 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. COMMITMENTS AND CONTINGENCIES (Continued) Operating Leases The Company leases its office and manufacturing facilities under operating leases expiring at various dates through 2002. Under certain leases the Company is obligated to pay taxes, repairs, and other operating costs. The Company has the option to extend the term of the lease of its primary office and manufacturing facility for two five-year periods commencing on May 1, 2002 and May 1, 2007. Rental expense amounted to approximately $1,119,000, $1,128,000, $1,556,000 in 1998, 1997 and 1996, respectively. At December 31, 1998, future rental commitments are approximately as follows: Years ended December 31, Amount ------------------------------------------- 1999 $ 584,100 2000 547,700 2001 511,100 2002 162,200 ------------------------------------------- $ 1,805,100 ------------------------------------------- 7. CAPITAL STOCK Common Stock The Company has an Employee Stock Purchase Plan (the "Purchase Plan") available to most full time employees. Under this plan, 300,000 shares of common stock were reserved for issuance. Eligible employees may designate not more than 5% of their cash compensation to be deducted each pay period for the purchase of common stock under the Purchase Plan. The purchase price of the shares under the plan is equal to the lower of 85% of the fair market value per share of the stock on the grant date (first day of the exercise period) or 85% of the fair market value on the exercise date (the last day of the exercise period). The fair market value as of a given date is determined by averaging the last sales price of the stock for the ten trading days immediately proceeding the given date. 22 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. CAPITAL STOCK (Continued) Common Stock (Continued) The Company sold 66,084, 32,667 and 41,628 shares to employees in 1998, 1997 and 1996, respectively, under the Purchase Plan. At December 31, 1998, 186,316 shares remained unissued under the Purchase Plan. No compensation cost has been recognized for shares issued under the Purchase Plan in 1998, 1997 and 1996 since the amount was determined not to be material. Preferred Stock In 1991, the Shareholders approved the authorization of 7,500,000 shares of preferred stock. The Board of Directors is authorized, subject to any limitations prescribed by law, to issue from time to time such shares of preferred stock in one or more series. Each such series of preferred stock will have such number of shares, designations, preferences, voting power, qualifications, and special or private rights or privileges as shall be determined by the Board of Directors, which may include, among others, dividend rights, voting rights, preemptive and sinking fund provisions, liquidation preferences, conversion rights and preemptive rights. No such shares have been issued to date. Stock Options The Company's stock option plans generally provide for the granting to employees of incentive stock options to purchase shares of common stock at the fair market value as defined by the plan on the date of grant and of non-qualified stock options at no less than 50% of the fair market value as defined by the plan on the date of the grant. To date, the Company has never issued non-qualified stock options at an exercise price less than the fair market value on the date of the grant. Generally, options become exercisable at the rate of 25% at the end of each of the first four anniversaries of the grant. Options generally expire ten years from the date of grant, or ninety days from the date of termination of employment. At December 31, 1998, 2,545,083 shares of common stock were reserved under the plans and 275,620 shares were available for grant. 23 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. CAPITAL STOCK (Continued) Stock Options (Continued) In 1998 and 1996, the Compensation Committee of the Board of Directors, pursuant to the authority granted under the Company's 1991 Restated Stock Option Plan, voted to allow employees of the Company holding options with exercise prices greater than $1.90 and $3.625 per share in 1998 and 1996, respectively, to exchange those options for substitute options having an option exercise price of $1.90 and $3.625 per share in 1998 and 1996, respectively. In February 1998 and in 1996, 799,575 and 707,154 options, respectively, were surrendered by employees and exchanged for new options at the new option exercise price and vesting schedule. A summary of the status of the Company's stock plans as of December 31, 1998, 1997 and 1996, and changes during the years then ended is presented below: 1998 1997 1996 - ---------------------------------------------------------------------------------------------------------------------------- WEIGHTED- Weighted- Weighted- AVERAGE Average Average NUMBER EXERCISE Number Exercise Number Exercise OF OPTIONS PRICE of Options Price of Options Price - ---------------------------------------------------------------------------------------------------------------------------- Outstanding, at the beginning of year 1,758,605 $ 2.70 1,272,009 $ 3.34 1,237,649 $ 5.52 Granted 2,412,501 1.31 1,007,805 2.02 1,245,726 4.11 Exercised (4,687) 1.70 - - (6,712) 4.01 Cancelled (1,896,956) 2.51 (521,209) 3.18 (1,204,654) 6.23 - ---------------------------------------------------------------------------------------------------------------------------- Outstanding, at the end of year 2,269,463 $ 1.38 1,758,605 $ 2.70 1,272,009 $ 3.34 - ---------------------------------------------------------------------------------------------------------------------------- Options exercisable at year end 687,978 $ 1.87 685,270 $ 3.41 522,064 $ 3.41 - ---------------------------------------------------------------------------------------------------------------------------- Weighted average fair value of options granted during the year 2,412,501 $ 0.51 1,007,805 $ 1.34 1,245,726 $ 2.78 - ---------------------------------------------------------------------------------------------------------------------------- 24 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. CAPITAL STOCK (Continued) Stock Option (Continued) The following tables summarize information concerning outstanding and exercisable options at December 31, 1998. Options Outstanding -------------------------------------------------------------------------- Weighted- Average Weighted- Range of Remaining Average Exercise Number of Contractual Exercise Prices Outstanding Life Price -------------------------------------------------------------------------- $ .81-$ 1.17 1,264,926 9.5 $ .95 $ 1.23-$ 1.68 238,700 9.2 1.34 $ 1.70-$ 2.10 709,526 9.3 1.91 $ 2.56-$ 3.63 36,311 7.8 2.98 $ 6.00-$ 7.50 20,000 2.4 7.50 -------------------------------------------------------------------------- 2,269,463 9.3 $ 1.38 -------------------------------------------------------------------------- Options Exercisable -------------------------------------------------------------------------- Weighted- Average Weighted- Range of Remaining Average Exercise Number of Contractual Exercise Prices Exercisable Life Price -------------------------------------------------------------------------- $ .81-$ 1.17 137,890 9.5 $ .93 $ 1.23-$ 1.68 25,075 8.7 1.43 $ 1.70-$ 2.10 494,826 9.4 1.90 $ 2.56-$ 3.63 10,187 7.5 3.12 $ 6.00-$ 7.50 20,000 2.4 7.50 -------------------------------------------------------------------------- 687,978 9.2 $ 1.87 -------------------------------------------------------------------------- 25 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. CAPITAL STOCK (Continued) Stock Options SFAS No. 123 "Accounting for Stock-Based (Continued) Compensation" requires that companies either recognize compensation expense for grants of stock, stock options, and other equity instruments based on fair value, or provide pro forma disclosure of net income (loss) and net income (loss) per share in the notes to the financial statements. The Company adopted the disclosure provisions of SFAS No. 123 and has applied APB Opinion 25 and related interpretations in accounting for its plans. Accordingly, no compensation cost has been recognized for its stock-based plans in 1998, 1997 and 1996. The Company's net loss and net loss per share for the years ended December 31, 1998, 1997 and 1996 would have increased to the pro forma amounts indicated below, if compensation cost for stock-based plans were recorded based on the fair value at grant dates. 1998 1997 1996 --------------------- -------------------- -------------------- LOSS Loss Loss NET PER Net Per Net Per LOSS SHARE Loss Share Loss Share ---------- ------ -------- ------ ---------- ------ As reported $ (11,860) $ (.77) $ (7,847) $ (.51) $ (12,014) $ (.77) Pro forma $ (12,007) $ (.78) $ (8,140) $ (.53) $ (12,627) $ (.81) The fair value of each stock option is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions: an expected life of six years, expected volatility of 46% in 1998, 75% in 1997 and 65% in 1996, and no dividends assumed. The weighted average assumptions for the risk-free interest rates for 1998, 1997 and 1996 were 5.52%, 6.11% and 6.32%, respectively. The effects of applying SFAS No. 123 in the above pro forma disclosure are not indicative of future amounts. SFAS No. 123 does not apply to awards prior to 1995, and additional awards in the future years are anticipated. 26 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. SEGMENT The Company is engaged principally in one business INFORMATION segment having two lines of business; (i) Internet AND SIGNIFICANT access and (ii) local area network access. In 1998, 1997 CUSTOMERS and 1996, net sales to one customer accounted for approximately 12%, 11% and 14% of the Company's total net sales, respectively. A second significant customer accounted for approximately 10%, 8% and 14% of total net sales in 1998, 1997 and 1996, respectively. 27 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 8. SEGMENT The Company does not have an individual country INFORMATION that contributes to 10% or more of the total AND SIGNIFICANT operating data. The geographic distribution of CUSTOMERS (Continued) the Company's operating data is therefore summarized as follows: United Asia States Pacific Europe Total --------------------------------------------------------------------------------------- (In thousands) Year ended December 31, 1998: Net sales $ 9,894 $ 2,065 $ 2,367 $ 14,326 Loss from operations (10,914) (896) (464) (12,274) Loss before income taxes (10,325) (896) (464) (11,685) Total assets 19,698 827 203 20,728 Capital expenditures 673 26 11 710 Depreciation and amortization 1,104 66 21 1,191 Year ended December 31, 1997: Net sales $ 17,403 $ 4,182 $ 5,359 $ 26,944 Income (loss) from operations (9,472) (942) 1,699 (8,715) Income (loss) before income taxes (8,420) (942) 1,699 (7,663) Total assets 31,101 1,301 1,001 33,403 Capital expenditures 570 144 14 728 Depreciation and amortization 1,343 49 158 1,550 Year ended December 31, 1996: Net sales $ 27,941 $ 7,195 $ 10,160 $ 45,296 Income (loss) from operations (13,958) 757 86 (13,115) Income (loss before income taxes) (12,697) 757 86 (11,854) Total assets 41,420 2,386 1,765 45,571 Capital expenditures 1,387 137 76 1,600 Depreciation and amortization 2,853 141 407 3,401 28 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. RESTRUCTURING OF OPERATIONS During the fourth quarter of 1996, the Company's management announced a restructuring plan for the strategic redirection of the Company. The restructuring principally addressed the move toward the rapidly growing Internet/Intranet connectivity marketplace. As a result of the restructuring, the Company recorded a $3,312,000 charge in the fourth quarter of 1996. This included a reduction in the Company's work force of forty-two employees, or approximately 22%, accounting for approximately $410,000 of severance costs. The Company incurred a charge of approximately $785,000 in connection with the substantial reduction in its occupancy requirements. In addition, the charge included approximately $1,922,000 for disposal of fixed assets and approximately $195,000 of other costs. During 1997, the Company incurred cash expenditures relating to the 1996 restructuring of approximately $495,000 for severance and payroll related costs, approximately $672,000 as a result of reducing its occupancy costs and $253,000 in other restructuring related costs. Management has determined that all of the Company's obligations from the 1996 and prior restructurings have been settled. Accordingly, the Company reversed its remaining restructuring provision of $241,000 against operating expenses in the third quarter of 1997. 29 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. INCOME TAXES The provision for income taxes consists of the following: -------------------------------------------------------------------------------------- Years ended December 31, 1998 1997 1996 -------------------------------------------------------------------------------------- Current: Foreign $ 175 $ 156 $ 215 Federal - - (65) State - 28 10 -------------------------------------------------------------------------------------- $ 175 $ 184 $ 160 -------------------------------------------------------------------------------------- A reconciliation between the Company's effective tax rate and the U.S. statutory rate is as follows: -------------------------------------------------------------------------------------- Years ended December 31, 1998 1997 1996 -------------------------------------------------------------------------------------- U.S. statutory rate (34.0) % (34.0) % (34.0) % Foreign tax rate differential 1.5 2.4 .1 Change in valuation allowance 34.0 34.0 35.2 --------------------------------------------------------------------------------------- Effective tax rate 1.5 % 2.4 % 1.3 % --------------------------------------------------------------------------------------- 30 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. INCOME TAXES A valuation allowance of $17,841,000 and $13,210,000 (Continued) at December 31, 1998 and 1997, respectively has been recorded to offset the related net deferred tax assets due to the uncertainty of realizing the benefit of these assets. The following is a summary of the significant components of the Company's deferred tax assets and liabilities: -------------------------------------------------------------------------------------- December 31, 1998 1997 -------------------------------------------------------------------------------------- (In thousands) Deferred tax assets: Bad debt reserve $ 580 $ 360 Inventory reserves 678 533 Product warranty 270 262 Federal tax benefit of net operating loss carryforwards 11,256 7,889 State tax benefit of net operating loss carryforwards 2,301 1,827 Tax credit carryforwards 1,298 912 Alternative minimum tax credit 699 699 Depreciation 76 144 Other items 683 584 -------------------------------------------------------------------------------------- Total deferred tax assets 17,841 13,210 Valuation allowance for deferred tax assets (17,841) (13,210) -------------------------------------------------------------------------------------- Net deferred tax assets $ - $ - -------------------------------------------------------------------------------------- 31 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. INCOME TAXES As of December 31, 1998, the Company had net (Continued) operating loss carryforwards, subject to review by the Internal Revenue Service and state taxing authorities of approximately $33,000,000 and $48,000,000 for federal and state income tax purposes, respectively. The federal net operating losses begin to expire in 2010 and the state net operating losses began to expire in 1998. Similarly, research and development credit carryforwards of approximately $1,298,000 were available on December 31, 1998, expiring at various dates through 2005. 11. RETIREMENT Eligible employees are permitted to contribute to the SAVINGS PLAN 401(k) Plan through payroll deductions within statutory limitations and subject to any limitations included in the 401(k) Plan. The Plan provides for the matching contribution by the Company in an annual amount not to exceed 2% of a participant's compensation. The Company contributed approximately $116,000, $128,000 and $185,000 to the plan in 1998, 1997 and 1996, respectively. 12. SELECTED Selected quarterly financial data for the years ended QUARTERLY December 31, 1998 and 1997 is as follows: FINANCIAL DATA (Unaudited) Basic and Diluted Year ended Net Gross Net Net Loss December 31, 1998 Sales Profit Loss Per Share -------------------------------------------------------------------------------------- (In thousands, except per share data) First Quarter $ 4,188 $ 1,615 $ (2,513) $ (.17) Second Quarter 4,825 2,093 (3,876) (.25) Third Quarter 2,168 740 (3,573) (.23) Fourth Quarter 3,145 1,282 (1,898) (.12) -------------------------------------------------------------------------------------- $ 14,326 $ 5,730 $ (11,860) $ (.77) -------------------------------------------------------------------------------------- 32 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 12. SELECTED QUARTERLY FINANCIAL DATA (Unaudited) (Continued) Basic and Diluted Year ended Net Gross Net Net Loss December 31, 1997 Sales Profit Loss Per Share ----------------------------------------------------------------------------------- (In thousands, except per share data) First Quarter $ 9,125 $ 4,256 $ (313) $ (.02) Second Quarter 7,748 3,748 (1,133) (.07) Third Quarter 5,006 1,754 (2,894) (.19) Fourth Quarter 5,065 1,846 (3,507) (.23) -------------------------------------------------------------------------------------- $ 26,944 $ 11,604 $ (7,847) $ (.51) -------------------------------------------------------------------------------------- The 1997 fourth quarter operating loss reflects approximately $880,000 or $.06 per share of certain adjustments and accruals relating to business operations in the Asia Pacific region, as well as certain employee incentive programs. 13. VALUATION AND QUALIFYING ACCOUNTS Balance at Balance at Allowance for Beginning Provision End of Doubtful Accounts of Period for Bad Debt Write-offs Period ---------------------------- ---------- ------------ ---------- ---------- Year ended December 31, 1998 $926,608 $496,909 $ 0 $1,423,517 Year ended December 31, 1997 $671,755 $346,833 $ (91,980) $926,608 Year ended December 31, 1996 $889,276 -- $(217,521) $ 671,755 33 OPENROUTE NETWORKS, INC. (FORMERLY PROTEON, INC.) AND SUBSIDIARIES - -------------------------------------------------------------------------- REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS To the Board of Directors and Stockholders of OpenROUTE Networks, Inc. Westborough, Massachusetts We have audited the accompanying consolidated balance sheet of OpenROUTE Networks, Inc. (Formerly Proteon, Inc.) and subsidiaries as of December 31, 1998, and the related consolidated statements of operations, stockholders' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with 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 audit provides a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of OpenROUTE Networks, Inc. and subsidiaries at December 31, 1998, and the results of their operations and their cash flows for the year then ended, in conformity with generally accepted accounting principles. The accompanying 1998 consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the consolidated financial statements, the Company has incurred significant losses during each of the three years ended December 31, 1998. The Company's current business strategy is focused on the emerging Internet access market. As such, success of future operations is subject to a number of risks. Principal among these risks are the successful marketing of its Internet access products, rapidly changing technology, reliance on significant customers, intense competition from substitute products and significantly larger companies, and the ability to obtain financing to fund future operations. These factors raise substantial doubt about the Company's ability to continue as a going concern until the Company successfully obtains additional funding or establishes strategic relationships and achieves projected operating results. Management's plans are also described in Note 1. The accompanying consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty. BDO Seidman, LLP Boston, Massachusetts February 12, 1999 34 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of OpenROUTE Networks, Inc.: We have audited the accompanying consolidated balance sheet of OpenROUTE Networks, Inc. as of December 31, 1997, and the related consolidated statements of operations, stockholders' equity and cash flows for the years ended December 31, 1997 and 1996. 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 consolidated financial position of OpenROUTE Networks, Inc. as of December 31, 1997, and the consolidated results of its operations and its cash flows for the years ended December 31, 1997 and 1996 in conformity with generally accepted accounting principles. PricewaterhouseCoopers LLP Boston, Massachusetts February 11, 1998, except as to the segment information for the years ended December 31, 1997 and 1996 presented in Note 8, for which the date is March 26, 1999.