===============================================================================
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_____________________
Form 10-Q
[X] QURTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2001
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 000-27287
INTERTRUST TECHNOLOGIES CORPORATION
(Exact name of registrant as specified in its charter)
Delaware 52-1672106
(State of incorporation) (IRS Employer Identification No.)
4750 Patrick Henry Drive, Santa Clara, California 95054
(Address of principal executive offices, including ZIP code)
(408) 855-0100
(Registrant's telephone number, including area code)
None
(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) Yes X No ___, and (2) has
---
been subject to such filing requirements for the past 90 days. Yes X No ___.
---
The number of shares outstanding of the Registrant's Common Stock as of
June 30, 2001 was 94,062,181.
================================================================================
INTERTRUST TECHNOLOGIES CORPORATION
INDEX
Page No.
-------
Part I. Financial Information
Item 1. Condensed Consolidated Balance Sheets as of
June 30, 2001 and December 31, 2000 3
Consolidated Statement of Operations for the Three
and Six Months Ended June 30, 2001 and 2000 4
Consolidated Statements of Cash Flows for the
Six Months Ended June 30, 2001 and 2000 5
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 11
Item 3. Qualitative and Quantitative Disclosures About Market Risk 26
Part II. Other Information
Item 1. Legal Proceedings 27
Item 2. Changes in Securities and Use of Proceeds 27
Item 3. Defaults Upon Senior Securities 28
Item 4. Submission of Matters to a Vote of Security Holders 28
Item 5. Other Information 28
Item 6. Exhibits and Reports on Form 8-K 28
Signature 30
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
INTERTRUST TECHNOLOGIES CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
June 30, December 31,
2001 2000
---- ----
(unaudited) (Note 1)
ASSETS
Current assets:
Cash and cash equivalents $ 4,865 $ 23,811
Short-term investments 113,401 134,707
Accounts receivable, net of allowance of $1,900 in 2001 and
$178 in 2000 1,810 3,928
Other current assets 2,612 2,771
-------------- ---------------
Total current assets 122,688 165,217
Property and equipment, net 11,736 8,919
Restricted long-term investment 945 944
Long-term investments 39,201 16,783
Goodwill and other intangible assets, net 5,784 29,453
Other assets 2,576 5,557
-------------- ---------------
$ 182,930 $ 226,873
============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable $ 2,353 $ 2,728
Accrued compensation 2,533 2,155
Other accrued liabilities 3,490 1,110
Deferred revenue 4,163 5,915
-------------- ---------------
Total current liabilities 12,539 11,908
Deferred revenue--long-term portion 7,496 7,617
Other long-term liabilities 1,208 -
-------------- ---------------
$ 21,243 $ 19,525
Commitments
Stockholders' equity:
Common stock, $0.001 par value, 120,000,000 authorized
94,062,181 and 87,776,991 issued and outstanding
at June 30, 2001 and 2000 94 88
Additional paid-in capital 371,738 340,380
Deferred stock compensation (4,449) (3,274)
Notes receivable from stockholders (13) (516)
Accumulated other comprehensive income 813 376
Accumulated deficit (206,496) (129,706)
-------------- ---------------
Total stockholders' equity 161,687 207,348
-------------- ---------------
$ 182,930 $ 226,873
============== ===============
See accompanying notes.
3
INTERTRUST TECHNOLOGIES CORPORATION
CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands, except share and per share amounts)
(unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
------------------------ ------------------------
2001 2000 2001 2000
--------- -------- --------- ---------
Revenues:
Licenses $ 1,562 $ 889 $ 2,949 $ 1,576
Software support and training 428 632 1,158 1,292
Services 239 146 515 146
Hardware - - 12 -
--------- -------- --------- ---------
Total revenues 2,229 1,667 4,634 3,014
Cost of revenues:
Licenses 90 110 227 213
Software support and training (exclusive of amortization of
deferred compensation of $5 and $10 for the three months
ended June 30, 2001 and 2000 and $13 and $22 for the six
months ended June 30, 2001 and 2000, respectively) 475 182 913 329
Services 1,564 714 3,479 1,357
Hardware 423 - 840 -
--------- -------- --------- ---------
Total cost of revenues 2,552 1,006 5,459 1,899
--------- -------- --------- ---------
Gross (loss) profit (323) 661 (825) 1,115
Operating costs and expenses:
Research and development (exclusive of amortization of
deferred compensation of $79 and $263 for the three months
ended June 30, 2001 and 2000 and $342 and $548 for the six
months ended June 30, 2001 and 2000, respectively) 9,004 5,775 18,395 10,976
Sales and marketing (exclusive of amortization of deferred
compensation of $57 and $171 for the three months ended June
30, 2001 and 2000 and $214 and $361 for the six months ended
June 30, 2001 and 2000, respectively) 5,447 4,361 13,057 8,018
General and administrative (exclusive of deferred
compensation expense of $251 and $494 for the three months
ended June 30, 2001 and 2000 and $546 and $1,013 for the six
months ended June 30, 2001 and 2000, respectively) 4,529 2,273 8,475 4,501
Purchased in-process research and development - - - 6,100
Amortization of goodwill and other intangible assets 2,363 922 4,556 922
Amortization of deferred compensation 392 938 1,115 1,944
Impairment of long lived assets 31,086 - 31,086 -
Restructuring costs 1,170 - 1,170 -
--------- -------- --------- ---------
Total operating costs and expenses 53,991 14,269 77,854 32,461
--------- -------- --------- ---------
Loss from operations (54,314) (13,608) (78,679) (31,346)
Interest and other income, net 2,115 2,766 4,885 4,878
Loss on equity investments (2,996) - (2,996) -
--------- -------- --------- ---------
Net loss $(55,195) $(10,842) $(76,790) $ (26,468)
======== ======== ========= =========
Basic and diluted net loss per share $ (0.59) $ (0.13) $ (0.83) $ (0.32)
======== ======== ========= =========
Shares used in computing basic and diluted net loss per share 93,442 84,247 92,388 81,589
======== ======== ========= =========
See accompanying notes.
4
INTERTRUST TECHNOLOGIES CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Six Months
Ended June 30,
-----------------------
2001 2000
---- ----
Operating activities
Net loss $(76,790) $(26,468)
Adjustments to reconcile net loss to net cash used in operating activities:
Stock issued for services 122 -
Depreciation and amortization of property and equipment 1,696 838
Amortization of goodwill and other intangible assets 4,816 922
Amortization of deferred stock compensation 1,115 1,984
Compensation expense related to forgiveness of notes receivable
from stockholders 3 -
Impairment of long lived assets 31,086 -
Gain from sales of long-term investments (85) -
Purchased in-process research and development - 6,100
Loss on equity investments 2,996 -
Changes in operating assets and liabilities:
Accounts receivable 2,123 (3,440)
Other current assets 311 (1,682)
Accounts payable (758) (165)
Accrued compensation 378 1,357
Other accrued liabilities (189) 5,573
Deferred revenue (1,873) 697
-------- --------
Net cash used in operating activities (35,049) (14,284)
Investing activities
Capital expenditures (3,545) (2,427)
Business acquisition, net of cash acquired 53 -
Purchases of short-term investments (34,342) (33,072)
Sales and maturities of short-term investments 55,858 40,855
Purchases of long-term investments (46,333) (21,194)
Sales and maturities of long-term investments 24,226 -
Other noncurrent assets, net (289) (546)
-------- --------
Net cash used in investing activities (4,372) (16,384)
Financing activities
Payments of other long-term liabilities (800) -
Proceeds from issuance of common stock, net 19,963 95,313
Proceeds from exercise of stock options and warrants 947 -
Proceeds from purchases under employee stock purchase plan 365 -
Proceeds from repayment of notes receivable from stockholders - 63
-------- --------
Net cash provided by financing activities 20,475 95,376
Net increase (decrease) in cash and cash equivalents (18,946) 64,708
Cash and cash equivalents at beginning of period 23,811 98,286
-------- --------
Cash and cash equivalents at end of period $ 4,865 $162,994
======== ========
5
Intertrust Technologies Corporation
Consolidated Statements of Cash Flows-(Continued)
(in thousands)
(unaudited)
Supplemental schedule of noncash investing and financing activities:
Purchase of Publish One
Issuance of common stock and options $ 11,501 $ -
========= ========
Tangible assets acquired, net of cash received $ 1,529 $ -
========= ========
Goodwill and other intangible assets acquired $ 11,988 $ -
========= ========
Liability assumed $ 5,392 $ -
========= ========
Deferred stock compensation $ 3,323 $ -
========= ========
Purchase of Infinite Ink
Issuance of common stock $ - $ 24,516
========= ========
Assets acquired $ - $ 18
========= ========
Liabilities assumed $ - $ 17
========= ========
See accompanying notes.
6
INTERTRUST TECHNOLOGIES CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have
been prepared by us and reflect all adjustments, consisting of normal recurring
adjustments, an $31.1 million adjustment for the impairment of long-lived
assets, and a $1.2 million restructuring charge, which in the opinion of
management are necessary to present fairly the financial position and the
results of operations for the interim periods. The balance sheet at December 31,
2000 has been derived from audited financial statements at that date. The
financial statements have been prepared in accordance with the regulations of
the Securities and Exchange Commission, but omit certain information and
footnote disclosures necessary to present the statements in accordance with
generally accepted accounting principles. For further information, refer to the
Consolidated Financial Statements and Notes thereto included in our Annual
Report on Form 10K for the year ended December 31, 2000 filed with the
Securities and Exchange Commission on April 2, 2001 (the "Annual Report").
Results of operations for the three and six month periods ended June 30, 2001
are not necessarily indicative of operating results for the full year.
Net Loss Per Share
Basic and diluted net loss per share is computed using the weighted-average
number of shares of common stock outstanding during the period less shares
subject to repurchase. The following table presents the basic and diluted net
loss per share (in thousands, except per share amounts):
Three Months Ended Six Months Ended
June 30, June 30,
------------------ ----------------
2001 2000 2001 2000
------- ------- ------- -------
Net Loss $(55,195) $(10,842) $(76,790) $(26,468)
======== ======== ======== ========
Basic and diluted:
Weighted-average shares of common stock outstanding 93,877 84,567 92,755 82,017
Less weighted-average shares subject to repurchase (435) (320) (367) (428)
-------- -------- -------- --------
Weighted-average shares used in computing basic and
diluted net loss per common share 93,442 84,247 92,388 81,589
======== ======== ======== ========
Basic and diluted net loss per common share $ (0.59) $ (0.13) $ (0.83) $ (0.32)
======== ======== ======== ========
We excluded all outstanding warrants and stock options from the
calculation of diluted net loss per share because all such securities are
antidilutive for all periods presented. The total number of weighted average
shares excluded from the calculations of diluted net loss per share was
16,269,000 and 13,631,000 for the three months ended June 30, 2001 and 2000,
respectively, and 16,201,000 and 15,353,000 for the six months ended June 30,
2001 and 2000, respectively. Warrants and stock options, had they been dilutive,
would have been included in the computation of diluted net loss per share using
the treasury stock method.
Revenue Concentration
Three customers accounted for 10%, 19% and 25% of total revenues in the
second quarter of 2001. Three customers accounted for 24%, 22%, and 6% of total
revenues in the second quarter of 2000. International revenues
7
accounted for 57% of total revenues for the first six months of 2001 and 51% of
the revenues for the comparable period of 2000.
Goodwill and Other Intangible Assets
Intangible assets are primarily comprised of goodwill, purchased technology
and patent rights, assets related to acquired workforce in place, and
capitalized patent application costs related to internally developed technology.
These assets are amortized using the straight-line method over the estimated
useful lives of the assets, generally four to seventeen years.
During the second quarter of 2001, Company management identified indicators
of possible impairment of its long-lived assets, principally goodwill and other
acquired intangible assets. Such indicators included the slower than expected
development of the Digital Rights Management (DRM) market, aggressive marketing
efforts by the Company's principal competitors, an overall decline in industry
valuations and growth rates, and a strategy shift from the Company's existing
Commerce product platform to the new Rights|System product platform.
The Company determined that it had three categories of long-lived assets
with attributable and identifiable cash flows: Commerce and related technology,
Rights System technology, and PublishOne services. Commerce and related
technology long-lived assets include goodwill and other intangible assets
recorded in connection with the Company's acquisitions of Infinite Ink in March
2000 and PassEdge in December 2000. Rights|System technology assets primarily
consist of property and equipment, patents and acquired workforce. PublishOne
services assets consist of goodwill and other intangible assets recorded in
connection with the Company's acquisition of PublishOne in January 2001.
With the assistance of independent valuation experts, the Company performed
asset impairment tests for each of the three identified asset categories. The
tests were performed by comparing the expected undiscounted cash flows for a
five-year period, plus a terminal value for future cash flows to the total
carrying amount of goodwill, other intangible assets and property and equipment
for each asset category. The assumptions supporting the estimated cash flows,
and an estimated terminal value, reflect management's best estimates. Based on
the results of these tests, the Company determined that the carrying amounts of
the Commerce and related technology and PublishOne services long-lived assets
were impaired.
With the assistance of independent valuation experts, the Company
determined the fair value of the long-lived assets for the impaired asset
categories. Fair value was determined using the discounted cash flow method,
using a discount rate of 18% and an estimated residual value. The discount rate
was based upon the weighted average cost of capital for the Company and
comparable companies. A write-down of goodwill and intangible assets totaling
$31.1 million was recorded during the second quarter of 2001, reflecting the
amount by which the carrying amount of the assets exceed their respective fair
values. The write-down consisted of $20.9 million for goodwill and $10.2 million
for other acquired intangible assets.
Investment in Privately-held Companies
Investments in privately-held companies primarily consist of equity and
debt securities in which InterTrust owns less than a 20% interest. The Company
invests in entities based upon factors that include the size of the market
opportunity and the barriers to entering that market, the strength of the
entity's products, services, and intellectual property, the previous experience
of the management team and its ability to execute on its business plan, and the
financial projections of the prospect. Additionally, the Company also considers
the strategic importance of the entity's technology in furthering the adoption
of digital rights management technologies.
InterTrust does not have the ability to exercise significant influence over
any of the companies in which it invests and accordingly accounts for such
investments using the cost method. These investments are assessed for impairment
periodically through review of operations and indications of continued
viability, such as subsequent rounds of financing. As a result of the
deterioration of financial markets and the corresponding effect on private
company valuations and financing prospects, in the three months ended June 30,
2001, the Company recorded $3.0 million in losses as a result of other than
temporary declines in the value of investments in privately held companies. The
remaining investment in privately-held companies of $500,000 at June 30, 2001 is
included in other assets in the consolidated balance sheet. The Company has not
participated in subsequent financings for any of the companies in which it is
invested, and it is not obligated or committed in any way to participate in any
future financings of any of its investments.
Recent Accounting Pronouncements
On January 1, 2001, the Company adopted SFAS No. 133, "Accounting for
Derivative Instruments and Hedging Activities", which establishes accounting and
reporting standards for derivative instruments, including foreign exchange
contracts, and hedging activities. In June 200, the FASB issued SFAS No. 138,
"Accounting for Certain Derivative Instruments and Certain Hedging Activities",
which addresses implementation issues related to SFAS No. 133. SFAS No. 133, as
amended, and SFAS No. 138 are effective for fiscal years beginning after June
15, 2000. Because the Company currently holds no derivative financial
instruments and does not currently engage in hedging activities, the adoption of
SFAS 133 did not have a material impact on the Company's financial position or
results of operations.
In July 2001 the Financial Accounting Standards Board (FASB) issued SFAS
No. 141 "Business Combinations" and SFAS No. 142 "Goodwill and Other Intangible
Assets." SFAS No. 141 requires business
8
combinations initiated after June 30, 2001 to be accounted for using the
purchase method of accounting, and broadens the criteria for recording
intangible assets separate from goodwill. Recorded goodwill and intangible
assets will be evaluated against this new criteria and may result in certain
intangibles being subsumed into goodwill, or alternatively, amounts initially
recorded as goodwill may be separately identified and recognized apart from
goodwill. SFAS No. 142 requires the use of a nonamortization approach to account
for purchased goodwill and certain intangible assets. Under a nonamortization
approach, goodwill and certain intangible assets will not be amortized into
results of operations, but instead would be reviewed for impairment and written
down and charged to results of operations only in the periods in which the
recorded value of goodwill and certain intangible assets exceeds its fair value.
The provisions of each statement which apply to goodwill and intangible assets
acquired prior to June 30, 2001 will be adopted by the Company on January 1,
2002. The Company expects the adoption of these accounting standards may result
in certain intangible assets being subsumed into goodwill and will have the
impact of reducing amortization of goodwill and intangible assets commencing
January 1, 2002; however, impairment reviews may result in future periodic
write-downs.
2. BUSINESS COMBINATIONS
On January 30, 2001, the Company acquired the remaining 92.1% of the
outstanding shares and all of the outstanding options of PublishOne, Inc.
("PublishOne"), a privately-held company that develops online publishing
software solutions and distribution services for business information
publishers. Prior to the acquisition date, the Company owned approximately 7.9%
of PublishOne's outstanding stock. The transaction was accounted for as a
purchase and the results of PublishOne's operations have been included in the
condensed consolidated financial statements from the date of acquisition. The
purchase price was $16.9 million and consisted of 1,130,000 shares of InterTrust
common stock at a fair value of $5.31 per share, the assumption of options to
purchase 1,155,221 shares of InterTrust common stock at a fair value of $4.84
per share, assumed liabilities of $5.2 million, and acquisition costs of
approximately $250,000. The InterTrust options issued in connection with the
assumption of the PublishOne options were valued using the Black-Scholes option
pricing model assuming a volatility of 1.6, expected life of 4 years, risk-free
interest rate of 7%, expected dividend yield of 0% and stock price of $5.31.
Additionally, the agreement includes contingent consideration of 320,000 shares
of InterTrust common stock to be issued upon the achievement of certain
milestones. As of June 30, 2001, no milestones have been met.
The Company allocated PublishOne's purchase price based on the relative
fair value of the net tangible and intangible assets acquired. No amount was
allocated to in-process research and development. The purchase price was
allocated based on an independent valuation to tangible and intangible assets as
follows (in thousands):
Tangible assets $ 1,581
Purchased technology 1,671
Acquired workforce 1,452
Other intangible assets 610
Deferred compensation 3,323
Goodwill 8,255
-------
$16,892
=======
Goodwill, purchased technology and other intangible assets are being
amortized on a straight-line basis over four years. The acquired workforce is
being amortized on a straight-line basis over two years.
The fair value of the unvested common stock subject to restricted stock
agreements and the intrinsic value of the unvested options held by employees was
allocated to deferred stock compensation. The deferred stock compensation will
be amortized to compensation expense over the remaining vesting term using a
graded method.
The following pro forma data summarizes the results of operations for the
periods indicated as if PublishOne had been completed as of the beginning of the
periods presented. The pro forma data gives effect to actual operating results
prior to the acquisition. No effect has been given to cost reductions or
operating synergies in this presentation. Prior to the acquisition, PublishOne
was a customer of InterTrust. The pro forma amounts exclude revenues and
expenses recognized in transactions between PublishOne and InterTrust. These
pro forma amounts do not purport to be indicative of the results that would have
actually been obtained if the acquisition had occurred as of the beginning of
the periods presented or that may be obtained in the future.
9
Pro forma results for the three and six months ended June 30, 2001 and 2000
are as follows (in thousands, except per share amounts):
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- --------------------
2001 2000 2001 2000
---- ---- ---- ----
Revenues $ 2,229 $ 1,642 $ 4,637 $ 2,964
Net loss $(55,195) $(11,985) $(77,704) $(28,489)
Net loss per share - basic and diluted $ (0.59) $ (0.14) $ (0.84) $ (0.35)
3. SALE OF SECURITIES
On January 31, 2001, InterTrust sold 4,000,000 shares of common stock at
$5.00 per share to Nokia Corporation ("Nokia") for total cash consideration of
$20,000,000. The fair market value of the stock on that day was $4.6875 per
share. The Company accounted for the difference of $0.3125 per share as
additional paid-in capital. In connection with its investment, Nokia agreed to
license InterTrust DRM solutions and select InterTrust as its preferred DRM
technology. Additionally per agreement, InterTrust has appointed an executive
officer of Nokia to the InterTrust Board of Directors.
4. RESTRUCTURING COSTS
On April 30, 2001, the Company announced and formally adopted a program to
reduce its worldwide workforce. The reduction will result in the decrease of 43
regular employees across all business functions, operating units, and geographic
regions. The worldwide workforce reductions were substantially completed in the
second quarter of 2001. Of the 43 terminated employees, 41 had left the Company
by June 30, 2001 and the remaining 2 employees will leave at different dates
through September 2001. The Company recorded a non-recurring charge of
approximately $1.2 million relating primarily to severance and fringe benefits
and is included in non-recurring charges in the statement of operations.
A summary of workforce reduction costs is outlined as follows:
Balance at
Total Charge Cash Payments June 30, 2001
-------------------------------------------------------------------------
Severance $1,126,000 $901,000 $225,000
Other charges 44,000 1,000 43,000
-------------------------------------------------------------------------
Total $1,170,000 $902,000 $268,000
=========================================================================
Remaining cash expenditures will be paid in the quarter ended September 30,
2001.
5. COMPREHENSIVE INCOME
Total other comprehensive income (loss) was $269,000 and $(281,000) for the
three months ended June 30, 2001 and 2000, respectively and $437,000 and
$(529,000) for the six months ended June 30, 2001, respectively.
6. STOCK OPTION EXCHANGE PROGRAM
On May 24, 2001, the Company announced a voluntary stock option exchange
program for its employees. Under the program, the Company's employees were given
the opportunity to cancel outstanding stock options previously granted to them
in exchange for an equal number of new options to be granted at a future date
which will be at least six months and a day from the cancellation date, which
was June 22, 2001. Options to purchase 2,763,497 shares were returned and
cancelled. The exercise price of these new options will be equal to the fair
market value of InterTrust's common stock on the date of grant, which is not
expected to be later than January 31, 2002, and no earlier than December 23,
2001. Such new options will have terms and conditions that are substantially the
same as those of the canceled options. The exchange program is not expected to
result in any additional compensation charges or variable plan accounting.
Members of the Company's Board of Directors and its officers and senior
executives, were not eligible to participate in this program.
7. SHAREHOLDER RIGHTS PLAN
On June 8, 2001, the Company's board of directors approved a stockholders'
rights plan. Under the plan, rights were distributed as a dividend at the rate
of one preferred share purchase right for each share of InterTrust common stock
held by stockholders of record as of the close of business on June 28, 2001.
Each preferred share purchase right entitles the registered holder to purchase
from InterTrust one one-thousandth of a share of Series A Junior Participating
Preferred Stock, par value $.001 per share, at a price of $20.00 per one
one-thousandth, subject to adjustment. The description and terms of the rights
are set forth in a Rights Agreement dated as of June 8, 2001, as the same may be
amended from time to time, between InterTrust and Fleet National Bank, as Rights
Agent, filed as Exhibit 4.1 to our Form 8-K filed June 27, 2001.
8. LEGAL PROCEEDINGS
Between May 17, 2001 and July 3, 2001, complaints were filed in the United
States District Court for the Southern District of New York naming InterTrust,
certain of its current and former directors and the members of the underwriting
syndicate involved in InterTrust's initial public offering and/or secondary
public offering as defendants in multiple class action lawsuits. The lawsuits
seek unspecified monetary damages and certification of a plaintiff class
consisting of all persons who acquired shares of InterTrust between October 26,
1999 and May 16, 2001. The complaints allege, among other things, that
InterTrust and the individual defendants named in the complaints violated the
federal securities laws by issuing and selling InterTrust common stock in its
initial public offering in October 1999 and its secondary public offering in
April 2000 without disclosing to investors that certain of the underwriters in
the offering allegedly solicited and received excessive and undisclosed
commissions from certain investors. The Company believes that the claims against
it are without merit and intends to defend against the complaints vigorously.
9. SUBSEQUENT EVENTS
On August 2, 2001, the Company announced that as part of its on-going
efforts to reduce operating expense levels, it would reduce its workforce by 37
employees. The Company will record a charge related to the reduction in force
in the quarter ending September 30, 2001.
In August 2001, InterTrust signed a stock purchase agreement with the
stockholders of Zero Gravity Technologies Corporation, a developer of policy-
based messaging digital rights management software applications for enterprise
markets. Prior to the acquisition, InterTrust owned approximately 18.0% of Zero
Gravity's stock. Under the terms of the purchase agreement, InterTrust acquired
the remaining shares of Zero Gravity from the Zero Gravity stockholders in
exchange for 500,000 shares of InterTrust common stock with an approximate fair
value of $495,000 and approximately $500,000 in net cash and assumed all
outstanding options of Zero Gravity, which were converted into options to
purchase approximately 60,000 shares of InterTrust common stock. The transaction
will be accounted for as a purchase with an estimated purchase price of $1.1
million. InterTrust is currently evaluating the acquisition, including the value
of in-process research and development, in order to determine the allocation of
the purchase price for accounting purposes.
10
Item 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The information in this discussion contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Act of 1934, as amended. Such statements are based
upon current expectations that involve risks and uncertainties. Any statements
contained herein that are not statements of historical fact may be deemed to be
forward-looking statements. For example, the words "believes," "anticipates,"
"plans," "expects," "intends" and similar expressions are intended to identify
forward-looking statements. InterTrust's actual results and the timing of
certain events may differ significantly from the results discussed in the
forward-looking statements. Factors that might cause such a discrepancy include,
but are not limited to, those discussed in "Other Factors Affecting Operating
Results, Liquidity and Capital Resources" below. All forward-looking statements
in this document are based on information available to InterTrust as of the date
hereof and InterTrust assumes no obligation to update any such forward-looking
statements.
Overview
We have developed a general purpose digital rights management, or DRM,
platform to serve as a foundation for providers of digital information,
technology, and commerce services to participate in a global e-commerce system.
InterTrust was formed and incorporated in January 1990. From inception through
1998, our efforts were principally devoted to research and development, raising
capital, recruiting personnel, and establishing licensing relationships. As a
result, we were considered a development stage enterprise during this period.
The general availability version of our Commerce software was delivered to our
partners in December 1998, and some partners began using the technology on a
limited commercial basis in January 2000.
We license our DRM platform and software to companies to build digital
commerce services and applications. Our goal is to license to content,
technology, and commerce services partners to achieve widespread dissemination
of our technology, an expanding consumer base, and broad participation by
digital information providers. We currently derive our revenues from Commerce
software license fees, associated software support and training services,
TrustNet clearinghouse services, and professional services. In addition, our
existing license agreements generally require our partners to pay a transaction
fee that is a percentage of amounts paid by users or charged by our partners in
commercial transactions and services that use our technology, and for sales of
products incorporating our Commerce technology. Any future transaction fees are
dependent on the success of our Commerce licensees and their customers in
commercially deploying services and applications.
Our existing license agreements provide different rights and technology
depending on the commercial plans of our partners. Initial license fees received
from these agreements may vary in amount depending on factors such as partner
commitments, scope of the license as it relates to commercial markets,
territory, and term of agreement. Examples of partner commitments include
deploying licensed products within a specified time frame, exclusively using
portions of our technology, and using and publicly promoting us as the partner's
preferred digital rights management technology. We have in the past decided, and
may in the future decide, to reduce or eliminate initial license fees based on
these factors. We do not believe that we can determine the amount of foregone
revenue due to reduced or eliminated license fees with any reliable degree of
certainty. Our license fees are negotiated based on the terms and conditions of
each individual agreement and take into account the scope of the license, the
term, and the other commitments made by our partners that provide strategic
value to us. In addition, we have entered into a limited number of license
agreements which have varying license scopes and terms and which do not provide
11
adequate comparable data to determine the amount of foregone revenue. In
connection with our strategy to promote widespread use of our technology,
through June 30, 2001, we have on four occasions received initial license fees
for our Commerce software in the form of minority equity positions in non-public
licensees. Additionally, on five occasions we received initial license fees in
the form of convertible promissory notes from non-public entities. One of these
convertible promissory notes was already converted into 125,000 shares of common
stock, which we believe represented approximately 1% of the outstanding shares
of the licensee as of the conversion date. Because the entities were recently
formed, privately held companies, and InterTrust was unable to obtain sufficient
evidence of the fair value of the common stock of the entity or sufficient
evidence of the fair value of the convertible promissory notes and
collectibility was not probable, InterTrust did not record revenue or deferred
revenue from the license fees. InterTrust is obligated to provide unspecified
upgrades and new releases, on a when and if available basis, to the licensees
over a one to two year period under the agreements for additional fees.
InterTrust is not obligated to provide any funding to any licensee for the
development of the licensee's software. In the future, we may enter into other
equity payment arrangements.
Licenses of our Commerce software generally require the payment of an initial
license fee. Initial license revenue, net of any discounts granted, is
recognized upon execution of a license agreement and delivery of our software if
we have no remaining obligations relating to development, upgrades, new
releases, or other future deliverables, if the license fee is fixed or
determinable, and if collection of the fee is probable. Our Commerce license
agreements generally include the right to obtain access to upgrades and new
releases, on a when and if available basis, for a specified period. Under these
circumstances, the license payments received, net of any discounts granted, in
advance of revenue recognition are deferred and recognized on a subscription
basis over the period of obligation beginning upon delivery of the licensed
product. In addition, under license agreements where we are obligated to provide
a specified custom development deliverable and do not have vendor specific
objective evidence of fair value of the specified deliverable, all of the
license revenue is deferred until the specified upgrade has been delivered. Upon
delivery of the specified deliverable, license revenue is recognized using the
subscription method. We began recognizing revenue under some license agreements
in January 1999, after shipping the general availability version of our Commerce
software at the end of December 1998. At June 30, 2001, we had approximately
$11.7 million of deferred license revenue that will be recognized in future
periods.
Our Commerce license agreements also require the payment of a transaction fee
that is a percentage of revenues received by our partners from transactions and
services that use our Commerce technology and sales of products incorporating
our Commerce technology. Transactions involving the use of our Commerce
technology to conduct the sale, lease, rental, or licensing of commercial
content require the payment of a transaction fee based on the amounts paid by
users or charged by our partners for selling or distributing the content.
Transactions involving the use of our technology for commercial services
generally require the payment of a transaction fee based on the amounts paid by
users or charged by our partners for the services. Transactions involving the
sale, lease, rental, or licensing of products incorporating our Commerce
technology generally require the payment of a transaction fee based on the
amounts paid by users or charged by our partners for the product. Our partners
are required to pay all amounts due for transaction fees within specified
12
periods, depending on the licensing arrangement. Our revenue recognition policy
relating to transaction fees is to recognize the revenue when the amounts due
are known, which will generally be in the quarter after the transaction. Prepaid
transaction fees are recorded as deferred revenue and will be recognized when
the related transactions occur. We have received $1.5 million in prepaid
transaction fees, which are included in deferred revenue as of June 30, 2001.
Prepaid transaction fees may generally be offset against a portion of
transaction fee amounts due in any given quarter. To date, we have not
recognized any material transaction fees from commercial transactions or
services, or sales of products using our Commerce software.
Software support and training services, which typically include the right to
telephone and online support and customer training, are generally provided for
in the license agreements for an agreed-upon amount. Software support and
training service revenue is recognized over the period in which the services are
provided.
TrustNet clearinghouse service revenues represent primarily service fees from
our customers for the use of our TrustNet clearinghouse infrastructure to pilot
and test applications and services using our Commerce software. Service revenues
generally include consulting and system integration services provided to the
customer to establish an interface with the TrustNet clearinghouse and monthly
service fees to use TrustNet for the clearing of commercial transactions.
Consulting, system integration fees, and monthly service fees are recognized
over the term of the service period.
Professional services represent fees for consulting services provided to our
customers for development and system integration not essential to the
functionality of the software licensed. The revenue from these services is
recognized as services are performed.
In July 2001, we announced Rights|System, our next generation DRM platform for
content protection and management. The new platform is designed to be a
lightweight, flexible, multi-platform environment that easily integrates with
existing systems. It is also designed to provide the enterprise and business
information sector with a platform to automate policies and protect documents
beyond simple secure delivery and firewalls.
The Rights|System product suite consists of three components: packagers,
rights servers and clients. We believe we have optimized Rights|System for
content, service and technology providers seeking to deliver high-volume retail-
based and subscription services for music, video and documents. Rights|System is
designed to be efficient, scalable, and delivers transparent content management
and protection. Using a single server architecture, Rights|System is designed to
allow service providers to deliver secure content to a broad range of devices
including personal computers, set top boxes, video recorders, mobile
communicators and consumer electronics devices such as game stations and
portable devices. In turn, consumers should be able to easily access any type of
content with any device.
While we have only recently announced the Rights|System product suite, several
Rights|System components have been licensed to customers. These components were
licensed to Adobe, Nokia, Blockbuster and Enron, and others for use in portable
devices, phones, and other consumer electronic devices. We have not completed
any licenses of the new product suite. Our business development and sales
efforts are focussed on licensing the three basic components of the product
suite under terms that would require the payment of annual license fees for each
component and an annual support contract that is a percentage of the listed
annual license fee. We expect that the most material license revenue will come
from the licensing of server components, which are currently being offered on a
per central processing unit, or CPU, basis. We currently anticipate that the
initial product release will have two server components, the rights fulfillment
server and the retail services server. Customers will be able to license an
initial number of CPU licenses suitable for their anticipated service capacity
requirements and then can purchase additional CPU licenses as their demand
increases. We will also offer professional services to our customers and
partners to aid in implementation and integration of our Rights|System products
into their environments. We also expect that the Rights|System licenses will
require the payment of transaction fees, relating to the sale, lease, rental, or
licensing of commercial content using the Rights|System products. Currently, the
TrustNet clearinghouse does not support Rights|System customers and we do not
currently expect to derive any revenue from Rights|System related TrustNet
clearinghouse services.
PricewaterhouseCoopers, National Computer Systems of Singapore, and Magex
accounted for 19%, 25% and 10% of total revenues respectively, in the quarter
ended June 30, 2001. PricewaterhouseCoopers, National Computer Systems of
Singapore, and Bertelsmann accounted for 22%, 24%, and 1% of total revenues,
respectively, in the comparable period for 2000. Our success depends on
significantly increasing the number of companies that license our technology and
use it for the sale and management of digital content and services.
In view of the rapidly changing nature of our industry and our new and
unproven business model, we believe that period-to-period comparisons of
revenues and operating results are not necessarily meaningful and should not be
relied upon as indications of future performance. In addition, our business
model has not succeeded in generating sufficient revenue to sustain our
business. We also operate in an intensely competitive market for highly
qualified technical, sales and marketing, and management personnel and
periodically make salary and other compensation adjustments to retain and hire
employees. As a result, we will need to generate significant additional
revenue to achieve and maintain profitability. In addition, current economic
conditions and limited visibility into customer demand makes prediction of our
future revenues difficult. We expect to incur additional losses for at least the
next several years.
On January 30, 2001, we acquired the remaining 92.1% of the outstanding shares
and all of the outstanding options of PublishOne, Inc. ("PublishOne"), a
privately-held company that develops online publishing software solutions and
distribution services for business information publishers. Prior to the
acquisition date, we owned approximately 7.9% of PublishOne's outstanding stock.
The transaction was accounted for as a purchase and the results of PublishOne's
operations have been included in the condensed consolidated financial statements
from the date of acquisition. The purchase price was $16.9 million and consisted
of 1,130,000 shares of InterTrust common stock at a fair value of $5.31 per
share, the assumption of options to purchase 1,155,221 shares of InterTrust
common stock at a fair value of $4.84 per share, assumed liabilities of $5.2
million, and acquisition costs of approximately $250,000. The InterTrust options
issued in connection with the assumption of the PublishOne options were valued
using the Black-Scholes option pricing model assuming a volatility of 1.6,
expected life of 4 years, risk-free interest rate of 7%, expected dividend yield
of 0% and stock price of $5.31. Additionally, the agreement includes contingent
consideration of 320,000 shares of InterTrust common stock to be issued upon the
achievement of certain milestones. As of June 30, 2001, no milestones have been
met.
We allocated PublishOne's purchase price based on the relative fair value of
the net tangible and intangible assets acquired. No amount was allocated to in-
process research and development. The purchase price was allocated based upon an
independent valuation to tangible and intangible assets as follows (in
thousands):
13
Tangible assets $ 1,581
Purchased technology 1,671
Acquired workforce 1,452
Other intangible assets 610
Deferred compensation 3,323
Goodwill 8,255
-------
$16,892
=======
Goodwill, purchased technology and other intangible assets are being amortized
on a straight-line basis over four years. The acquired workforce is being
amortized on a straight-line basis over two years.
The fair value of the unvested common stock subject to restricted stock
agreements and the intrinsic value of the unvested options held by employees was
allocated to deferred stock compensation. The deferred stock compensation will
be amortized to compensation expense over the remaining vesting term using a
graded method.
Impairment Write-Down of Goodwill and Other Acquired Intangible Assets
During the second quarter of 2001, due to the slower than expected development
of the DRM market, aggressive marketing efforts by the Company's principal
competitors, an overall decline in industry valuations and growth rates, and a
strategy shift from the Company's existing Commerce product platform to the new
Rights|System product platform, we concluded that goodwill and intangible assets
might not be fully recoverable. An impairment assessment, test and measurement
resulted in the recording of a write-down of goodwill and intangible assets of
$31.1 million related to our Commerce and related technology and PublishOne
service asset categories.
Stock Option Exchange Program
On May 24, 2001, we announced a voluntary stock option exchange program for
our employees. Under the program, our employees were given the opportunity to
cancel outstanding stock options previously granted to them in exchange for an
equal number of new options to be granted at a future date which will be at
least six months and a day from the cancellation date, which was June 22, 2001.
Options to purchase 2,763,497 shares were cancelled and the Company is obligated
to grant an equivalent number of options in the future. The exercise price of
these new options will be equal to the fair market value of InterTrust's common
stock on the date of grant, which is not expected to be later than January 31,
2002 and not earlier than December 23, 2001. Such new options will have terms
and conditions that are substantially the same as those of the canceled options.
The exchange program is not expected to result in any additional compensation
charges or variable plan accounting. Members of our board of directors, 16(b)
officers, and other selected officers were not eligible to participate in this
program.
Shareholder Rights Plan
On June 8, 2001, our board of directors approved a stockholders' rights
plan. Under the plan, rights were distributed as a dividend at the rate of one
preferred share purchase right for each share of InterTrust common stock held by
stockholders of record as of the close of business on June 28, 2001. Each
preferred share purchase right entitles the registered holder to purchase from
InterTrust one one-thousandth of a share of Series A Junior Participating
Preferred Stock, par value $.001 per share, at a price of $20.00 per one one-
thousandth, subject to adjustment. The description and terms of the rights are
set forth in a Rights Agreement dated as of June 8, 2001, as the same may be
amended from time to time, between InterTrust and Fleet National Bank, as Rights
Agent, filed as Exhibit 4.1 to our Form 8-K filed June 27, 2001.
Litigation
Between May 17, 2001 and July 3, 2001, complaints were filed in the United
States District Court for the Southern District of New York naming us,
certain of its current and former directors and the members of the underwriting
syndicate involved in InterTrust's initial public offering and/or secondary
public offering as defendants in multiple class action lawsuits. The lawsuits
seek unspecified monetary damages and certification of a plaintiff class
consisting of all persons who acquired shares of InterTrust between October 26,
1999 and May 16, 2001. The complaints allege, among other things, that
InterTrust and the individual defendants named in the complaints violated the
federal securities laws by issuing and selling our common stock in our
initial public offering in October 1999 and its secondary public offering in
April 2000 without disclosing to investors that certain of the underwriters in
the offering allegedly solicited and received excessive and undisclosed
commissions from certain investors. We believe that the claims against us are
without merit and intends to defend against the complaints vigorously.
Results of Operations
Total revenues increased to approximately $2.2 million in the three months
ended June 30, 2001 from approximately $1.7 million in the comparable period of
2000. For the six months ended June 30, 2001, total revenues increased to
approximately $4.6 million from approximately $3.0 million in the comparable
period of 2000.
License revenues were approximately $1.6 million or 70% of total revenues for
the three months ended June 30, 2001 as compared to $889,000 or 53% of total
revenues in the three months ended June 30, 2000, and primarily represent the
amortization of deferred license fees. For the six months ended June 30, 2001,
license revenue increased to $2.9 million or 64% of total revenues, from $1.6
million, or 52% or total revenues, in the same six month period in 2000. These
increases were due to the growth in the number of partner licensing agreements
in place over the prior year. No significant new license agreements were entered
into during the quarter ended June 30, 2001, primarily due to our transition to
our new software platform, Rights|System.
Revenue from software support and training decreased to $428,000 in the three
months ended June 30, 2001 from approximately $632,000 in the three months ended
June 30, 2000 and decreased to approximately $1.2 million for the six months
ended June 30, 2001 from approximately $1.3 million for the comparable period in
2000. These decreases were due to the expiration of a number of partner support
agreements in the three months ended June 30, 2001, the inability of many of
our smaller licensees to pay amounts due under support agreements due to current
economic conditions, and the transition to our Rights|System Platform. Software
support and training services accounted for 19% and 38% of total revenues in the
three month periods ended June 30, 2001 and 2000, respectively, and 25% and 43%
for the six month periods ended June 30, 2001 and 2000, respectively.
Services revenues increased to approximately $239,000 for the three months
ended June 30, 2001 from $146,000 in the three months ended June 30, 2000 and
increased to approximately $515,000 for the six months ended June 30, 2001 from
approximately $146,000 for the comparable period in 2000 Services revenues
represent monthly service fees for TrustNet clearinghouse services, transaction
royalties, consulting and system integration
14
services. The increase in services revenue was due to a greater number of
consulting services performed during the six months ended June 30, 2001.
Services revenues accounted for 11% and 9% of total revenues in the three months
ended June 30, 2001 and 2000, respectively, and accounted for 11% and 5% of
total revenues in the six months ended June 30, 2001 and 2000, respectively.
There was no hardware revenue for the three months ended June 30, 2001.
Hardware revenue recognized in the six months ended June 30, 2001 was $12,000.
This revenue was the result of chips sold to one customer under the terms of a
purchase agreement to provide chips for testing and trial production. No
hardware revenue was recognized in the comparable periods in 2000.
Cost of Revenues
Cost of license revenue consists primarily of the costs incurred to
manufacture, package, and distribute our products, related documentation and the
amortization of purchased technology. Cost of license revenue was approximately
$90,000 during the three months ended June 30, 2001 and approximately $110,000
in the three months ended June 30, 2000. Cost of license revenue was
approximately $227,000 during the six months ended June 30, 2001 and
approximately $213,000 in the comparable period in 2000. Cost of license
revenue is expected to fluctuate from period to period depending on the number
of new partners, the number of software releases, and the amount of software
documentation provided to our partners during the period.
Cost of software support and training consists primarily of the cost of
personnel, travel related expenditures, and training materials. These
expenditures are incurred both at our facilities as well as at partner
locations. Cost of software support and training revenue increased to
approximately $475,000 for the three months ended June 30, 2001 from
approximately $182,000 for the three months ended June 30, 2000. In the first
six months of 2001, the cost of software support and training was approximately
$913,000 as compared to approximately $329,000 in the comparable period for
2000. The increase in cost of software support and training represents the
increase in support personnel required to provide technical assistance and
training to our partners. Software support and training services costs are
expected to fluctuate from period to period depending on the support
requirements of our partners.
Cost of services consists primarily of the outside services, personnel, and
equipment to operate our clearinghouse, as well as personnel costs to provide
professional and consulting services. Costs of services were approximately $1.6
million during the three months ended June 30, 2001 and approximately $714,000
during the three months ended June 30, 2000. Cost of services was approximately
$3.5 million during the six months ended June 30, 2001 and approximately $1.4
million in the comparable period in 2000. These increases are primarily
attributable to investment in clearinghouse infrastructure, personnel and the
costs of performing consulting engagements.
Cost of hardware was approximately $423,000 for the three months ended June
30, 2001 and approximately $840,000 for the six months ended June 30, 2001.
These costs are related to the purchase of chips from a third party,
customization, and transport of the chips. The costs include a reserve against
the value of inventory for purchase commitments of $823,000 following the
cancellation of a sales agreement with our sole customer for this product. There
were no hardware costs for the comparable periods in 2000.
Research and Development
Research and development expenses consist principally of salaries and related
personnel expenses, consultant fees, and the cost of software used in product
development. Research and development expenses are expensed to operations as
incurred. Research and development spending was approximately $9.0 million for
the three months ended June 30, 2001 and approximately $5.8 million for the
three months ended June 30, 2000. In the first six months of 2001, research and
development spending was approximately $18.4 million as compared to
approximately $11.0 million in the comparable period of 2000. These increases
were primarily attributable to increases in personnel costs, recent business
acquisitions, and consultant services associated with both product research and
development.
15
Sales and Marketing
Sales and marketing expenses consist of salaries and related expenses for
personnel engaged in direct sales, partner development, marketing, field service
support, consultant fees and advertising, promotional material, and trade show
expenses. Sales and marketing expenses increased to approximately $5.4 million
for the three months ended June 30, 2001 from $4.4 million for the three months
ended June 30, 2000. In the first six months of 2001, sales and marketing
expenses were approximately $13.1 million as compared to approximately $8.0
million in the comparable period of 2000. Increases in sales and marketing
expenses were due primarily to an increase in sales and marketing personnel,
consulting expenses, and to a lesser extent, public relations, promotional
costs, and travel costs. We expect sales and marketing expense to vary in future
periods based upon the implementation of marketing and promotional programs
related to the release of new products.
General and Administrative
General and administrative expenses consist primarily of salaries and related
expenses for executive, legal, accounting and administrative personnel,
professional service fees, and general corporate expenses. General and
administrative expenses increased to approximately $4.5 million for the three
months ended June 30, 2001 from approximately $2.3 million for the three months
ended June 30, 2000. General and administrative expenses were approximately $8.5
million for the six months ended June 30, 2001 and $4.5 million for the
comparable period in 2000. The increase was primarily attributed to increases in
legal expenses, consulting expenses, insurance, costs associated with being a
public company, and bad debt expense. We expect general and administrative
expenses to continue to increase as a result of litigation costs related to a
claim of patent infringement we filed against Microsoft in April 2001. See
further discussion in Risks Related to Our Business.
Amortization of Goodwill and Other Intangible Assets
Amortization of goodwill and other intangible assets was $2.4 million for the
three months ended June 30, 2001 and $922,000 for the three months ended June
30, 2000. We recognized approximately $4.6 million of amortization expense
during the six months ended June 30, 2001 as compared to $922,000 in the six-
month period ended June 30, 2000. Amortization of goodwill and intangible assets
is related to business acquisitions in 2000 and 2001 and the amortization of
capitalized patent costs. We expect amortization to be lower in future periods
due to the lower carrying value of goodwill resulting from the impairment
expense recognized in the three months ended June 30, 2001. We will stop
amortizing goodwill as well as certain intangible assets upon the adoption of
SFAS 141 and SFAS 142 on January 1, 2002.
Deferred Stock Compensation
Deferred compensation represents the difference between the exercise price of
options granted to employees and the deemed fair value of our common stock for
financial reporting purposes. Additionally, in conjunction with the acquisition
of PublishOne, the fair value of the unvested common stock subject to restricted
stock agreements and the intrinsic value of the unvested options held by
PublishOne employees was allocated to deferred stock compensation. Deferred
compensation is being amortized over the vesting periods of the options on a
graded vesting method. This compensation expense relates to options awarded to
individuals in all operating expense categories. In the three months ended June
30, 2001, we recorded an adjustment to the deferred compensation balance in
order to reflect a reduction of deferred compensation associated with employees
who have left InterTrust. This adjustment resulted in a decrease of $481,000 in
deferred compensation expense. We recognized approximately $392,000 of such
compensation expense during the three months ended June 30, 2001 and $938,000 in
the comparable period of 2000. We recognized approximately $1.1 million of
related compensation expense during the six months ended June 30, 2001 as
compared to $1.9 million in the six-month period ended June 30, 2000.
Restructuring Costs
On April 30, 2001, we announced and formally adopted a program to reduce our
worldwide workforce. The reduction resulted in the decrease of 43 regular
employees across all business functions, operating units, and geographic
regions. The worldwide workforce reductions were substantially completed in the
second quarter of 2001. Of the 43 terminated employees, 41 had left the Company
by June 30, 2001 and the remaining 2 employees will leave at different dates
through September 2001. We recorded a non-recurring charge of approximately $1.2
million relating primarily to severance and fringe benefits. See Note 7 to the
Condensed Consolidated Financial Statements for further information.
16
Interest and Other Income, net
Interest and other income consists primarily of interest earned on cash and
cash equivalents, and short and long-term investments. Interest and other income
decreased to $2.1 million during the three months ended June 30, 2001 from $2.8
million in the comparable period in 2000. We recognized approximately $4.9
million of interest and other income in the six months ended June 30, 2001 and
$4.9 million in the comparable period of 2000. The decrease in interest income
is due to lower cash and investment balances in the current period.
Impairment of Investments in Privately-held Companies
Investments in privately-held companies primarily consist of equity and debt
securities in companies in which we own less than a 20% interest. We invest in
entities based upon factors which include the size of the market opportunity and
the barriers to entering that market, the strength of the entity's products,
services and intellectual property, the experience of the management team and
its ability to execute on its business plan, and the financial projections of
the prospect. Additionally, we also consider the strategic importance of the
entity's technology in furthering the adoption of digital rights management
technologies.
We do not have the ability to exercise significant influence over any of the
companies in which we invest and accordingly account for such investments using
the cost method. These investments are assessed for impairment periodically
through review of operations and indications of continued viability, such as
subsequent rounds of financing. As a result of the deterioration of financial
markets and the corresponding effect on private company valuations and financing
prospects, in the three months ended June 30, 2001, we recorded $3.0 million in
losses as a result of other than temporary declines in the value of investments
in privately held companies. The remaining investment in privately-held
companies of $500,000 at June 30, 2001 is included in other assets in the
consolidated balance sheet. We have not participated in subsequent financings
for any of the companies in which we are invested, and we are not obligated or
committed in any way to participate in any future financings of any of these
companies.
Impairment of Goodwill and Other Acquired Intangible Assets
During the second quarter of 2001, we identified indicators of
possible impairment of our long-lived assets, principally goodwill and other
acquired intangible assets. Such indicators included the slower than expected
development of the DRM market, aggressive marketing efforts by our principal
competitors, an overall decline in industry valuations and growth rates, and a
strategy shift from our existing Commerce product platform to the new
Rights|System product platform.
We determined that we had three categories of long-lived assets with
attributable and identifiable cash flows: Commerce and related technology,
Rights|System technology, and PublishOne services. Commerce and related
technology assets include goodwill and other intangible assets recorded in
connection with our acquisitions of Infinite Ink in March 2000 and PassEdge in
December 2000. Rights|System technology intangible assets primarily consist of
property and equipment and acquired workforce. PublishOne services assets
consist of goodwill and other intangible assets recorded in connection with the
our acquisition of PublishOne in January 2001.
With the assistance of independent valuation experts, we performed asset
impairment tests for each of the three identified asset categories. The tests
were performed by comparing the expected undiscounted cash flows for a five-year
period, plus a terminal value for future cash flows to the total carrying amount
of goodwill, other intangible assets and property and equipment for each asset
category. The assumptions supporting the estimated cash flows, and an estimated
terminal value, reflect management's best estimates. Based on the results of
these tests, we determined that the carrying amounts of the Commerce and related
technology and PublishOne services long-lived assets were impaired.
With the assistance of independent valuation experts, we determined the fair
value of the long-lived assets for the impaired asset categories. Fair value was
determined using the discounted cash flow method, using a discount rate of 18%
and an estimated residual value. The discount rate was based upon our and other
comparable companies' weighted average cost of capital. A write-down of
goodwill and intangible assets totaling $31.1 million was recorded during the
second quarter of 2001, reflecting the amount by which the carrying amount of
the assets exceed their respective fair values. The write-down consisted of
$20.9 million for goodwill and $10.2 million for other acquired intangible
assets.
Liquidity and Capital Resources
Cash, cash equivalents and marketable and restricted investments totaled
$158.4 million at June 30, 2001, a decrease of $17.8 million from December 31,
2000. The change during the six months ended June 30, 2001 is primarily
attributable to $20.0 million of cash generated from the sale of 4.0 million
shares to Nokia Finance International B.V., a subsidiary of Nokia Corporation,
in January 2001 and from proceeds from the exercise of employee stock options
and employee stock purchases, offset by our net loss for the six months ended
June 30, 2001 of $76.8 million.
Net cash used in operating activities totaled $35.0 million in the six months
ended June 30, 2001. The cash used in the period is primarily attributable to
the net loss of $76.8 million, partially offset by various non-cash charges such
as depreciation and amortization of $1.7 million, amortization of goodwill and
other intangible assets
17
of $4.8 million, stock related compensation of $1.1 million, impairment of long-
lived assets of $31.1 million, and loss on equity investments of $3.0 million.
Net cash used in investing activities totaled $4.4 million in the six months
ended June 30, 2001. The cash used in the period is primarily attributable to
capital expenditures totaling $3.5 million principally comprised of computer
equipment and software used to support our product development and increased
employee base, and net investment activity of $591,000.
Net cash provided by financing activities was $20.5 million in the six months
ended June 30, 2001, due to cash generated from issuing common stock in
conjunction with our licensing agreement with Nokia Corporation and, to a lesser
extent, from the exercise of employee stock options.
At June 30, 2001, our principal source of liquidity was $158.4 million in
cash, cash equivalents, marketable and restricted investments. We believe that
our cash and cash equivalents will be sufficient to meet our working capital
needs for at least the next 12 months. In the future, we may require additional
funds to support our working capital requirements or for other purposes and may
seek to raise additional funds through public or private equity financing or
from other sources. Additional financing may not be available at all or, if
available, may not be obtainable on terms favorable to us. In addition, any
additional financing may be dilutive and new equity securities could have rights
senior to those of existing holders of our common stock. If we need to raise
funds and cannot do so on acceptable terms, we may not be able to respond to
competitive pressures or anticipated requirements or take advantage of future
opportunities.
Other Factors Affecting Operating Results, Liquidity and Capital Resources
In addition to the other information in this report, the following risk
factors should be considered carefully in evaluating our business and us:
Risks Related to Our Business
Our business model is new, evolving and unproven and we may not succeed in
generating sufficient revenue to sustain or grow our business.
Our business model is new and unproven and may not generate sufficient revenue
for us to be successful. The market for digital commerce services and
applications has not developed as quickly as anticipated and, as a result, we
might not meet analysts' expectations of our future operating results. The
success of our business has depended partly upon our ability to generate license
and support fees, and transaction fees in the form of a percentage of fees
charged by our licensees in commercial transactions using our Commerce software.
However, some of our licensees have just begun using our Commerce technology and
certain Rights|System components in the commercial distribution of their
products and we have not earned any material transaction fees under this
business model. With the announcement of our Rights|System software platform in
July 2001, we announced that we would continue to support the Commerce products,
but we would make no further enhancements to such products. As a result,
licensees of our Commerce products may choose not to continue using our Commerce
products which could significantly limit the future revenue from existing
licensees. In addition, we are not devoting any material business development or
sales resources to attracting new licensees for our Commerce software. The
volume of products and services distributed using our technology has been and
may continue to be too small to support or grow our business. In addition, the
success of our business now depends largely upon our ability to license our new
Rights|System product suite. Because we have not yet completed any Rights|System
product licenses, we may not generate sufficient revenue to support and grow our
business.
Our future revenue is significantly dependent on market acceptance of
Rights|System software products.
Our future revenue depends significantly on successful completion and market
acceptance of the Rights|System products we announced in July 2001. The
Rights|System products are not yet ready for shipment to customers and we have
not completed any licenses of these products, making it difficult to predict
both the amount of revenue we will generate and when we will be able to
recognize revenue from these products. In addition, the Rights|System products
may not meet the requirements of the market and we may not be able to license
the Rights|System products under desirable terms and conditions. Failure to
complete or license the Rights|System products may negatively impact our future
revenue.
Our quarterly operating results are volatile and difficult to predict. If we
fail to meet the expectations of public market analysts or investors, the market
price of our common stock may decrease significantly.
Our operating results have varied from period to period and, in some future
quarter or quarters, will likely fall below the expectations of securities
analysts or investors, causing the market price of our common stock to decline.
Our quarterly operating results may fail to meet these expectations for a number
of reasons, including:
. a lack of demand for, or slow customer adoption of, our Rights|System
software products
. the inability of our existing licensees and their customers to
commercialize our technology, or delays or deferrals in this
commercialization;
. the inability of our licensees to pay our license and other fees;
. our inability to develop or commercialize our technology to meet our
customers' requirements on a timely basis;
. a decline in the demand for digital goods and services;
18
. a decline in the demand for our Commerce software products;
. our failure to quickly reduce costs in the event of unanticipated declines in
revenues in a given period;
. expenses related to the issuance of stock to our partners;
. higher than expected operating expenses, including expenses related to the
patent infringement litigation we initiated against Microsoft;
. higher spending on deployment programs;
. customer budget cycles and changes in these budget cycles; and
. impairment charges recorded to reduce goodwill and other intangible assets
associated with our acquisitions to their estimated fair values.
We are dependent on international sales which subject us to a variety of risks.
We received approximately 57% of our total revenues in the six months ended
June 30, 2001, 51% of our total revenues in 2000 and 67% of our total revenues
in 1999 from sales to customers located outside the United States. Our
international business activities are subject to a variety of risks, including
the adoption and changes of laws, actions by third parties and political and
economic conditions that could restrict or eliminate our ability to do business
in certain jurisdictions. Although we currently transact business in U.S
dollars, if we transact business in foreign currencies in the future, we will
become subject to the risks associated with transacting in foreign currencies,
including potential negative effects of exchange rate fluctuations. To date, we
have not adopted a hedging program to protect from risks associated with foreign
currency fluctuations.
Government regulation and requirements influence our sales internationally.
Current or new government laws and regulations, or the application of existing
laws and regulations including those related to property ownership, content and
taxation, could expose us to significant liabilities, significantly slow our
growth or otherwise seriously harm our business and results of operations.
If we or third parties do not deploy our technology and create a market for
digital commerce, our business will be harmed.
Relationships with leading content, technology, and commerce service providers
are critical to our success. Our business and operating results would be harmed
to the extent we or our licensees fail, in whole or in part, to:
. deploy our technology;
. develop an infrastructure for the sale and delivery of digital goods and
services;
. generate transaction fees from the sale of digital content and services;
. develop and deploy new applications; and
. promote brand preference for InterTrust products and services and the
MetaTrust Utility.
We have a history of losses and we expect our operating losses and expenses to
increase significantly.
Our failure to increase our revenues significantly would seriously harm our
business. We derive most of our revenues from the sale of a small number of
licenses. As a result, any delay in the recognition of revenue from a license
would have a material adverse effect on our results of operations for subsequent
accounting periods. We have experienced operating losses in each quarterly and
annual period since inception, and we expect to incur significant and increasing
losses in the future. We incurred net losses of $76.8 million for the six months
ended June 30, 2001, $55.6 million for the year ended December 31, 2000 and
$28.6 million for the year-ended December 31, 1999. We expect to continue to
have significant research and development, sales and marketing, and general and
administrative expenses. In addition, we expect to incur significant expenses
related to the patent litigation we recently initiated against Microsoft. As a
result of these expenses, we must significantly increase our revenues to become
profitable. We expect to incur significant losses for at least the foreseeable
future.
We need to significantly increase the number of companies that license our
technology to sustain and grow our business.
We will not generate sufficient revenue to grow our business unless we
maintain relationships with existing Commerce software licensees and begin
licensing our Rights|System product suite to a significant number of partners
and customers.
19
We have not yet attracted, and may not in the future be able to attract, a
sufficient number of these companies. As of June 30, 2001, only 62 companies
have licensed our Commerce software and certain Rights|System components for
commercial use. As of June 30, 2001, approximately eight companies have been
involved in the limited commercial deployment of our Commerce software and
certain Rights|System components. Our ability to attract new licensees will
depend on a variety of factors, including the following:
. the performance, reliability and security of our Rights|System products and
services;
. the scalability of our Rights|System products and services--the ability to
rapidly increase deployment size from a limited number of end-users to a very
large number of end-users;
. the cost-effectiveness of our Rights|System products and services; and
. our ability to market our Rights|System products and services effectively.
Our ability to attract new licensees will also depend on the performance of
our initial licensees. Many potential licensees may resist working with us until
our and our initial licensees' applications and services have been successfully
introduced into the market and have achieved market acceptance. We may not be
able to attract a critical mass of licensees that will develop products and
services, and our licensees may not achieve the widespread deployment of users
we believe is necessary for us to become successful. In addition, we may not be
able to establish relationships with important potential customers if we have
already established relationships with their competitors. Therefore, it is
important that we are perceived as a neutral and trusted technology and service
provider.
Our operating results have been and may continue to be harmed if our licensees
or potential licensees suffer from downward economic cycles.
Our ability to license our technology depends on the economic strength and
budgetary cycles of potential licensees. Many of our licensees are Internet-
related and start-up companies that currently face unfavorable market conditions
and budgetary pressures. Recently, some of our licensees have defaulted on their
payment obligations to us and others might default in the future. This may be
disruptive to our business and may adversely affect our business, financial
condition and results of operations.
The long and complex process of licensing our software and hardware products
could delay the deployment of our technology and harm our business.
As Rights|System is a new DRH platform and product suite being introduced, the
process of licensing our Rights|System products may be long and complex, initial
license fees could be delayed or reduced as a result of this process, and our
future revenue and operating results could be impaired. Before committing to
license our products, our licensees must generally consider a wide range of
issues including product benefits, installation and infrastructure requirements,
ability to work with existing computer systems, ability to support a large user
base, functionality, security, and reliability. The process of entering into a
licensing agreement with a company has typically involved lengthy negotiations,
but we do not know the length of the sales cycle relating to our new products as
we have not completed any Rights|System licenses. As a result it is difficult
for us to predict the quarter in which a particular prospect might sign a
license agreement. In addition, in some cases we develop specific software
applications for our licensees. We cannot predict if we will deliver these
applications in a timely manner or at all.
Because our technology must be integrated into the products and services of
our licensees, there could be significant delay between our licensing the
software and our licensees' commercial deployment of their products and
services, which in part will delay our receipt of transaction fee revenue.
Our success depends upon the deployment of our technology by a potential
licensee in the use and sale of digital content. Our licensees may undertake a
lengthy process of integrating our technology into their existing systems or a
new system. The integration often receives re-engineering of these business
processes, which may delay the deployment of our technology. Until a licensee
deploys our technology, we do not receive transaction fees from that licensee.
20
We expect that the period between entering into a licensing arrangement and
the time our licensee commercially deploys applications based on our software
could be lengthy and will vary, which makes it difficult for us to predict when
transaction revenue will be recognized.
Our software and hardware products have only recently been used by our licensees
in limited commercial deployment, making evaluation of our business and
prospects difficult.
We began offering the general availability release of our Commerce software in
December 1998, and released version 1.5 in April 2001. Our and our licensees'
applications and services based on our Commerce and other software and hardware
products are in development or have only been released for evaluation in very
limited commercial launches. It is still possible that we or our licensees may
uncover serious technical and other problems resulting in the delay or failure
of the commercial deployment of our licensees' implementation of our Commerce
software, including problems relating to security, the ability to support a
large user base, and interoperability of our software or the combination of our
software with our licensees' software. Our new Rights|System product has not
been released to any customers. Once we complete the develoment of the
Right|System products it is possible that we or one of our partners or customers
may uncover serious technical and other problems with those products. We may not
successfully address any of these problems and the failure to do so would
seriously harm our business and operating results.
Protection of our intellectual property is limited and efforts to protect our
intellectual property may be inadequate, time consuming, and expensive.
Our success and ability to compete are substantially dependent on our
proprietary technology and trademarks, which we attempt to protect through a
combination of patent, copyright, trade secret, and trademark laws, as well as
confidentiality procedures and contractual provisions. These legal protections
afford only limited protection and may be time consuming and expensive.
Furthermore, despite our efforts, we may be unable to prevent third parties from
infringing upon or misappropriating our intellectual property. Also, our
competitors may independently develop similar, but not infringing, technology,
duplicate our products, or design around our patents or our other intellectual
property.
Our patent applications or trademark registrations may not be approved.
Moreover, even if approved, the resulting patents or trademarks may not provide
us with any competitive advantage or may be challenged by third parties. If
challenged, our patents might not be upheld or their claims could be narrowed.
Any litigation surrounding our rights could force us to divert important
financial and other resources away from our business operations. In addition, we
license our products internationally, and the laws of many countries do not
protect our proprietary rights as well as the laws of the United States.
In April 2001, we filed a claim against Microsoft Corporation alleging that
certain of their technology infringes our United Stated Patent No. 6,185,683.
We have subsequently amended our claim to also allege infringement by Microsoft
Corporation of our United States Patent No. 6,253,193, United States Patent No.
5,920,861and United States Patent No. 5,940,504. The claim is in the early
stages and while the litigation is pending, significant financial resources and
management attention will be diverted for that purpose. There is no assurance
that we will be successful in this claim, and an unfavorable result would have a
significant adverse affect on our results of operations by reducing the value of
our proprietary technology and reducing demand for our products.
Security breaches of our software and our licensees' software could result in
decreased demand for our technology by our licensees or their customers or in
litigation.
The secure transmission and trusted management of proprietary or confidential
information over the Internet are essential to establishing and maintaining
confidence in our Commerce and other software and hardware and the software and
services developed using our software. Without this confidence, potential or
current licensees may not use our technology and their customers may not trust
and use our licensees' products. Therefore, security concerns and security
breaches of our and our licensees' software could harm our business and
operating results. Advances in computer capabilities, new discoveries, or other
developments could result in a compromise or breach of the security technology,
including cryptography technology, that we and our licensees use to protect
customer digital content and transaction data. Security breaches could damage
our reputation and expose us to a risk of loss or litigation. Our insurance
policies have low coverage limits that may not be adequate to reimburse us for
losses caused by security breaches. We cannot guarantee that our security
measures will prevent security breaches.
21
Defects in our software and the software of our licensees could delay deployment
of our technology and reduce our revenues.
Defects or errors in current or future products could result in delayed or
failed deployment of our technology, lost revenues, or a delay in or failure to
achieve market acceptance, any of which could seriously harm our business and
operating results. Complex software products like ours often contain errors or
defects, including errors relating to security, particularly when first
introduced or when new versions or enhancements are released. Because this is a
system used for commerce, we believe the standards for reliability and
performance will be very high.
If our or our licensees' products and services contain errors or defects not
discovered in the process of development and pilot programs, it could seriously
undermine the perceived trust and security needed for a commercial system and
could delay or prevent market acceptance of digital commerce resulting in
serious harm to our business and operating results.
The deployment and use of our products expose us to substantial risks of
product liability claims because our products are expected to be used in
sensitive and valuable digital commerce transactions and because we require our
partners to comply with our specifications. Although our license agreements
typically contain provisions designed to limit our exposure to product liability
claims, it is possible that these limitations of liability provisions may not be
effective as a result of existing or future laws or unfavorable judicial
decisions. A product liability claim brought against us, even if not successful,
would likely be time consuming and costly to defend and could significantly harm
our business and operating results.
If we are unable to continue obtaining third-party software and applications, we
could be forced to change our product offering or find alternative suppliers,
which could delay shipment of our product.
We integrate third-party software with our software. We would be seriously
harmed if the providers from which we license software ceased to deliver and
support reliable products, enhance their current products, or respond to
emerging industry standards. In addition, the third-party software may not
continue to be available to us on commercially reasonable terms or at all. The
loss of, or inability to maintain or obtain this software, could result in
shipment delays or reductions, or could force us to limit the features available
in our current or future product offerings. Either alternative could seriously
harm our business and operating results.
The market for digital rights management will be subject to rapid technological
change and new product introductions and enhancements that we may not be able to
address. We need to develop and introduce new products, technologies, and
services.
The market for digital rights management solutions is fragmented and marked by
rapid technological change, frequent new product introductions and enhancements,
uncertain product life cycles, and changes in customer demands. To succeed, we
must develop and introduce, in response to customer and market demands, new
releases of our software and other products that offer features and
functionality that we do not currently provide. Any delays in our ability to
develop and release enhanced or new products could seriously harm our business
and operating results. In the past we have experienced delays in new product
releases, and we may experience similar delays in the future.
In particular, we are currently increasing our focus on our new Rights|System
platform, which we believe is important to meeting our customer and market
demands. Delays in our ability to develop and release the Rights|System software
could seriously harm our operating results.
Our markets are highly competitive and we may not be able to compete
successfully against current or potential competitors, reducing our market share
and revenue growth.
Our markets are new, rapidly evolving, and highly competitive, and we expect
this competition to persist and intensify in the future. Our failure to maintain
and enhance our competitive position could reduce our market share and cause our
revenues to grow more slowly than anticipated or not at all. We encounter
current or potential competition from a number of sources, including:
22
. providers of secure digital distribution technology like Adobe, IBM,
Microsoft, and Real Networks;
. providers of hardware-based content metering and copy protection systems,
including Sony and the 4C Entity, comprised of IBM, Intel, Matsushita, and
Toshiba; and
. operating system manufacturers, including Microsoft or Sun Microsystems, that
may develop or license digital rights management solutions for inclusion in
their operating systems.
Potential competitors may bundle their products or incorporate a digital
rights management component into existing products in a manner that discourages
users from purchasing our products. For example, Microsoft's Windows operating
system, which manages the programs on a computer, includes components addressing
limited digital rights management functions. Furthermore, new competitors or
alliances among competitors may emerge and rapidly acquire significant market
share. Our competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements than we do.
Some of our competitors have longer operating histories and significantly
greater financial, technical, marketing, and other resources than we do. Many of
these companies have more extensive customer bases and broader partner
relationships that they could leverage, including relationships with many of our
current and potential partners. These companies also have significantly more
established customer support and professional services organizations than we do.
In addition, these companies may adopt aggressive pricing policies.
Any acquisitions that we make could disrupt our business and harm our operating
results.
We have made acquisitions of and investments in other companies in the past
and we may continue to acquire or make investments in complementary companies,
products or technologies. In the event of any such investments, acquisitions or
joint ventures, we could:
. issue stock that would dilute our current stockholders' percentage ownership;
. incur debt;
. assume liabilities;
. incur amortization expenses related to goodwill and other intangible assets;
or
. incur large and immediate write-offs.
These investments, acquisitions or joint ventures also involve numerous risks,
including:
. problems combining the purchased operations, technologies or products with
ours;
. unanticipated costs;
. division of management's attention from our core business;
. adverse effects on existing business relationships with suppliers and
customers;
. potential loss of key employees, particularly those of the acquired
organizations; and
. reliance to our disadvantage on the judgement and decisions of third parties
and lack of control over the operations of a joint venture partner.
Any acquisition or joint venture may cause our financial results to suffer as
a result of these risks.
We and our licensees may be found to infringe proprietary rights of others,
resulting in litigation, redesign expenses, or costly licenses.
Digital rights management is an emerging field in which our competitors may
obtain patents or other proprietary rights that would prevent, or limit or
interfere with, our, or our licensees', ability to make, use, or sell products.
Furthermore, companies in the software market are increasingly bringing suits
alleging infringement of their proprietary rights, particularly patent rights.
We and our licensees could incur substantial costs to defend or settle any
litigation, and intellectual property litigation could force us to do one or
more of the following:
. cease selling, incorporating, or using products or services that incorporate
the infringed intellectual property;
23
. obtain a license from the holder of the infringed intellectual property
right; or
. redesign products or services to avoid infringement.
Our or our licensees' products and services may be subject to a claim of patent
infringement independent of any infringement by our software.
In the past, we have received notices alleging potential infringement by us of
the proprietary rights of others. In January 1996, we received a letter from an
attorney representing E-Data Corporation containing an allegation of
infringement of a patent E-Data allegedly owns. We exchanged correspondence with
E-Data's attorneys ending in September 1996. We have not heard from any
representative of E-Data since that time. In November 1997, we received a letter
from representatives of TAU Systems Corporation informing us of two patents held
by TAU Systems. In the letter, the representatives stated their opinion that our
Commerce software contained various elements recited in the two patents and
requested that we discuss licensing the technology of these patents. We
responded to the letter stating that, although we had not undertaken a detailed
review of the patents, 23 we were unaware of any of our products having one of
the elements required by the patent claims. We have not received any further
correspondence from TAU Systems. In May 1999, we received a letter from
representatives of TechSearch LLC offering us a license to a patent held by
TechSearch. We have reviewed the patent and do not believe that we need to
obtain a license to this patent. In the future, however, we or our licensees
could be found to infringe upon the patent rights of E-Data, TAU Systems,
TechSearch, or other companies.
To successfully license our product and grow our business, we must retain and
attract key personnel; competition for these personnel is intense.
Our success depends largely on the skills, experience, and performance of the
members of our senior management and other key personnel, including our chairman
of the board and chief executive officer, Victor Shear. None of our senior
management or other key personnel must remain employed for any specific time
period. If we lose key employees, our business and operating results could be
significantly harmed. In addition, our future success will depend largely on our
ability to continue attracting, integrating, and retaining highly skilled
personnel. Further, competition for qualified sales and marketing personnel is
intense. We may not be able to hire enough qualified individuals in the future
or in a timely manner. New employees require extensive training and typically
take at least four to six months to achieve full productivity. Although we
provide compensation packages that include stock options, cash incentives, and
other employee benefits, the volatility and current market price of our stock
may make it difficult for us to attract, assimilate, and retain highly qualified
employees. For example, due to the current volatility of our stock price, many
of our employees hold options with exercise prices well above the current fair
market value of our stock.
Failure to appropriately manage our growth and expansion could seriously harm
our business and operating results.
Our historical growth has placed, and any further growth is likely to continue
to place, a significant strain on our resources. Any failure to manage growth
effectively could seriously harm our business and operating results. We have
grown from 87 employees at December 31, 1997 to approximately 324 employees at
June 30, 2001. On April 30, 2001 and August 2, 2001, we announced plans to
reduce our workforce by approximately 15% and 12%, respectively, in order to
reduce costs and increase efficiency. To be successful, we will need to
implement additional management information systems, improve our operating,
administrative, financial and accounting systems and controls, train new
employees, and maintain close coordination among our executive, engineering,
accounting, finance, marketing, and operations organizations.
Our stock price has been volatile in the past and is likely to continue to be
volatile.
The market price of our common stock has been volatile in the past and is
likely to continue to be volatile. In addition, the securities markets in
general, and Internet stocks in particular, have experienced significant price
volatility and accordingly the trading price of our common stock is likely to be
affected by this activity.
24
We are subject to securities class action litigation which may harm our business
and results of operations.
In the past, securities class action litigation has often been brought against
a company following periods of volatility in the market price of its securities.
We are a party to the securities class action litigation described in Part II,
Item 1 - "Legal Proceedings" of this report. The defense of the litigation
described in Part II, Item 1 may increase our expenses and divert our
management's attention and resources, and an adverse outcome in this litigation
could seriously harm our business and results of operations. In addition, we may
in the future be the target of other securities class action or similar
litigation.
We have implemented anti-takeover provisions that could make it more difficult
to acquire us.
Our sixth amended and restated certificate of incorporation, our amended and
restated bylaws, and Delaware law contain provisions that could make it more
difficult for a third party to acquire us, even if its doing so would be
beneficial to our stockholders. These provisions include:
. authorizing the issuance of shares of undesignated preferred stock without a
vote of stockholders;
. prohibiting stockholder action by written consent; and
. limitations on stockholders' ability to call special stockholder meetings.
In addition, on June 8, 2001, our board of directors approved a stockholders'
rights plan. Under the plan, rights were distributed as a dividend at the rate
of one right for each share of InterTrust common stock held by stockholders of
record as of the close of business on June 28, 2001. The plan is designed to
protect stockholders in the event of an unsolicited attempt to acquire
InterTrust and could make it more difficult for a third party to acquire us,
even if its doing so would be beneficial to our stockholders.
Stockholders may incur dilution as a result of future equity issuances.
We have in the past and may in the future issue equity securities to our
partners. If we issue additional equity securities, stockholders may experience
dilution, and the new equity securities could have rights senior to those of
existing holders of our common stock.
Industry-Related Risks
We may not receive sufficient revenues to be successful and our stock price will
decline if use of the Internet for commercial distribution of digital content is
not widely accepted.
Acceptance and use of the Internet for commercial distribution of digital
content may not continue to develop at recent rates, and a sufficiently broad
base of consumers may not adopt, and continue to use, the Internet and other
online services as a medium for digital commerce. Because our transaction fees
are derived from digital commerce transactions, if digital commerce is not
accepted for any reason, our revenues would not grow sufficiently and our
business and operating results would be significantly harmed.
We depend on the widespread acceptance of commerce in digital information over
the Internet, through wireless and cable networks, and other means. These
methods for distribution of digital information may not be commercially accepted
for a number of reasons, including:
. failure to develop the necessary infrastructure for communication of digital
information and for payment processing;
. failure to develop or deploy enabling technologies, including compression or
broadband technology necessary for distribution of particular digital content
over the Internet;
. reduced demand for paid digital content due to the widespread availability of
free content online and the ability to use and distribute this content
without restriction; and
. insufficient speed, access, and server reliability, as well as lengthy
download time for content.
25
If standards for digital rights management are not adopted, confusion among
content providers, distributors, and consumers may depress the level of digital
commerce, which would reduce our revenues.
If standards for digital rights management are not adopted or complied with,
content providers may delay distributing content until they are confident that
the technology by which the content is to be distributed will be commercially
accepted. Standards for the distribution of various digital content might not
develop or might be found to violate antitrust laws or fair use of copyright
policies. In addition, the failure to develop a standard among device
manufacturers may affect the market for digital goods and services. As a result,
consumers may delay purchasing products and services that include our technology
if they are uncertain of commercial acceptance of the standards with which our
technology complies. There is uncertainty in the market as to the best way to
offer music digitally. For example, there are a number different software
formats available and it is possible that not all music will play on the same
devices. Consumer acceptance of digital delivery of music depends upon the
ability of the various software formats to work together. Consequently, if a
standard format for the secure delivery of content on the Internet is not
adopted, or if the standards are not compatible with our digital rights
management technology, our business and operating results would likely be
harmed.
We may face increased governmental regulation and legal uncertainties that could
increase our costs and provide a barrier to doing business.
Exports of software products utilizing encryption technology are generally
restricted by the United States and various foreign governments. Although we
have obtained approval to export our Commerce software, changes in export laws
and regulations may impose restrictions that affect our ability to distribute
products and services internationally, limiting our ability to gain revenue and
grow our business.
It is also possible that Congress or individual states could enact laws
regulating or taxing Internet commerce. In addition, several telecommunications
companies have petitioned the Federal Communications Commission to regulate
Internet service providers in a manner similar to long distance telephone
carriers and to impose access fees on these companies. Access fees, sales taxes
or any other taxes or fees could increase the cost of transmitting data over the
Internet and reduce the number or amount of transactions from which we get our
transaction fees.
Item 3. Qualitative and Quantitative Disclosures about Market Risk
We develop products in the United States and license our products to partners
in North America, Europe, Asia and Australia. As a result, our financial results
could be affected adversely by various factors, including foreign currency
exchange rates or weak economic conditions in foreign markets.
Our interest income is sensitive to changes in the general level of United
States interest rates, particularly since the majority of our investments are in
short-term instruments. Due to the nature of our investments in marketable
securities, we have concluded that there is no material market risk exposure.
Therefore, no quantitative tabular disclosures are required. At June 30, 2001
and December 31, 2000, our cash and cash equivalents consisted primarily of
demand deposits and money market funds held by two large institutions in the
United States.
26
PART II. OTHER INFORMATION
INTERTRUST TECHNOLOGIES CORPORATION
Item 1. Legal Proceedings.
On April 26, 2001, we filed a patent infringement complaint against Microsoft
Corporation in the United States District Court for the Northern District of
California. In the complaint, we have alleged that certain of Microsoft's
products infringe our United States Patent No. 6,185,683 and we are seeking an
injunction in addition to monetary damages. We have subsequently amended our
complaint to also allege infringement by Microsoft Corporation of our United
States Patent No. 6,253,193, United States Patent No. 5,920,861and United States
Patent No. 5,940,504.
On May 17, 2001, June 6, 2001, June 7, 2001 and July 3, 2001, complaints were
filed in the United States District Court for the Southern District of New York
naming InterTrust, certain of its current and former directors and the members
of the underwriting syndicate involved in InterTrust's initial public offering
and/or secondary public offering as defendants in multiple class action
lawsuits. The lawsuits seek unspecified monetary damages and certification of a
plaintiff class consisting of all persons who acquired shares of InterTrust
between October 26, 1999 through May 16, 2001. The complaints allege, among
other things, that InterTrust and the individual defendants named in the
complaints violated the federal securities laws by issuing and selling
InterTrust common stock in our initial public offering in October 1999 and our
secondary public offering in April 2000 without disclosing to investors that
certain of the underwriters in the offering allegedly solicited and received
excessive and undisclosed commissions from certain investors.
Item 2. Changes in Securities and Use of Proceeds.
(a) Changes in Securities.
On June 8, 2001, our board of directors approved a stockholders' rights plan.
Under the plan, rights were distributed as a dividend at the rate of one
preferred share purchase right for each share of InterTrust common stock held by
stockholders of record as of the close of business on June 28, 2001. Each
preferred share purchase right entitles the registered holder to purchase from
InterTrust one one-thousandth of a share of Series A Junior Participating
Preferred Stock, par value $.001 per share, at a price of $20.00 per one one-
thousandth, subject to adjustment. The description and terms of the rights are
set forth in a Rights Agreement dated as of June 8, 2001, as the same may be
amended from time to time, between InterTrust and Fleet National Bank, as Rights
Agent, filed as Exhibit 4.1 to our Form 8-K filed June 27, 2001.
(b) Use of Proceeds.
On April 12, 2000 we completed a public offering in which we sold 2,820,244
shares of common stock at $35 per share pursuant to a Registration Statement on
Form S-1 (File No. 333-32484) that was declared effective on April 6, 2000. The
total aggregate proceeds from these transactions were $98.7 million.
Underwriters' discounts and other related costs were approximately $6.5 million
resulting in net proceeds $92.2 million.
On November 1, 1999, we completed our initial public offering, in which we
sold 13,000,000 shares of common stock at $9 per share pursuant to a
Registration Statement on Form S-1 (File No. 333-84033) that was declared
effective on October 26, 1999. Additionally, we sold 1,950,000 shares of common
stock at $9 per share in connection with the exercise of the underwriters' over-
allotment option. The total aggregate proceeds from these transactions were
$134.6 million. Underwriters' discounts and other related costs were
approximately $11.2 resulting in net proceeds $123.4 million.
The net proceeds were used for working capital and general corporate purposes.
Remaining proceeds were predominantly held in cash, cash equivalents and
marketable securities at June 30, 2001.
27
Item 3. Defaults Upon Senior Securities.
None.
Item 4. Submission of Matters to a Vote of Security Holders.
None.
Item 5. Other Information.
None.
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
Exhibit
No. Description
- --------------- -------------
3.1 Sixth Amended and Restated Certificate of Incorporation filed with the Secretary of State of
Delaware on November 1, 1999 -- incorporated herein by reference to Exhibit 3.2 to the
Registrant's Registration Statement on Form S-1 (File No. 333-84033).
3.2*** Amended and Restated Bylaws of the Registrant.
4.1 Reference is made to Exhibits 3.1 and 3.2.
4.2* Form of Registrant's Common Stock certificate.
4.3* Form of Registration Rights under select Convertible Promissory Notes.
4.4* Form of Registration Rights under select Class A Common Stock Purchase Agreements.
4.5* Form of Series A Preferred Stock Registration Rights.
4.6* Form of Series B, C, D and E Preferred Stock Registration Rights.
4.7* Form of Registration Rights found in a Class B Non-Voting Common Stock Warrant.
4.8 Stockholder Rights Agreement, by and between the Registrant and Nokia Finance International B.V.,
dated January 31, 2001 -- incorporated herein by reference to Exhibit 4.1 to the Registrant's Form
8-K filed February 20, 2001.
4.9 Rights Agreement dated June 8, 2001 -- incorporated herein by reference to Exhibit 4.1 to the
Registrant's Form 8-K filed June 27, 2001.
10.1* Form of Indemnification Agreement entered into by the Registrant with each of its directors and
executive officers.
10.2* 1999 Equity Incentive Plan and forms of agreements thereunder.
10.3* 1999 Employee Stock Purchase Plan.
10.4* 1999 Non-Employee Directors Option Plan.
10.5 Lease between Mission West Properties, L.P. and the Registrant dated July 21, 1999 --
incorporated herein by reference to Exhibit 10.11 to the Registrant's Registration Statement on
Form S-1 (File No. 333-84033).
10.6+ Technology Development, Marketing, and License Agreement by and between the Registrant and
National Westminster Bank PLC dated August 18, 1998 -- incorporated herein by reference to Exhibit
10.12 to the Registrant's Registration Statement on Form S-1 (File No. 333-84033).
10.7+ Technology Development and License Agreement by and between the Registrant and Universal Music
Group, Inc. dated April 13, 1999 -- incorporated herein by reference to Exhibit 10.13 to the
Registrant's Registration Statement on Form S-1 (File No. 333-84033).
10.8+ Technology Development and License Agreement by and between the Registrant and Upgrade Corporation
of America dated August 7, 1996 -- incorporated herein by reference to Exhibit 10.14
28
Exhibit
No. Description
- --------------- -------------
to the Registrant's Registration Statement on Form S-1 (File No. 333-84033).
10.9+ Technology Development and License Agreement by and between the Registrant and Mitsubishi
Corporation dated October 7, 1996 -- incorporated herein by reference to Exhibit 10.15 to the
Registrant's Registration Statement on Form S-1 (File No. 333-84033).
10.10 Warrant for the purchase of Class A Voting Common Stock made by the Registrant and held by Allen &
Company Incorporated, dated September 7, 1999 -- incorporated herein by reference to Exhibit 10.16
to the Registrant's Registration Statement on Form S-1 (File No. 333-84033).
10.11 Amendment to Technology, Development, Marketing and License Agreement by and between the
Registrant and National Westminster Bank dated August 18, 1998 -- incorporated herein by reference
to Exhibit 10.17 to the Registrant's Registration Statement on Form S-1 (File No. 333-84033).
10.12 Amendment to Technology Development and License Agreement by and between the Registrant and
Universal Music Group, Inc. dated April 13, 1999 -- incorporated herein by reference to Exhibit
10.18 to the Registrant's Registration Statement on Form S-1 (File No. 333-84033).
10.19** Building Lease Agreement by and between First State Realty of America, Inc. and the Registrant
dated January 24, 2000.
10.20*** Employment Agreement by and between the Company and David Ludvigson dated August 4, 2000.
10.21**** 2000 Supplemental Option Plan.
10.22**** Full-Recourse Promissory Note dated December 7, 2000 from Bruce Fredrickson to the Company.
* Incorporated herein by reference to the exhibit of the same number in the
Registrant's Registration Statement on Form S-1 (File No. 333-84033).
** Incorporated herein by reference to the exhibit of the same number in the
Registrant's Registration Statement on Form S-1 (File No. 333-32484).
*** Incorporated herein by reference to the exhibit of the same number of the
Registrant's Form 10-Q for the quarter ended September 30, 2001.
**** Incorporated herein by reference to the exhibit of the same number of the
Registrant's Form 10-K for the year ended December 31, 2000.
+ Confidential treatment requested.
(b) Reports on Form 8-K.
On July 26, 2001, the Company filed a report on Form 8-K in which it
disclosed that the Company appointed Patrick S. Jones to its Board of
Directors.
On June 27, 2001, the Company filed a report on Form 8-K in which it
disclosed that the Board of Directors of the Company adopted a stockholder
rights plan on June 8, 2001.
On June 12, 2001, the Company filed a report on Form 8-K in which it
disclosed that the Company had been named as a defendant in several class
action law suits.
On May 1, 2001, the Company filed a report on Form 8-K in which it
disclosed that the Company had filed a claim against Microsoft Corporation
alleging patent infringement.
29
INTERTRUST TECHNOLOGIES CORPORATION
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
INTERTRUST TECHNOLOGIES CORPORATION
By: /s/ Victor Shear
----------------
Victor Shear
Chairman of the Board and Chief Executive Officer
(Principal Executive Officer)
Date: August 17, 2001 By: /s/ Gregory S. Wood
-------------------
Gregory S. Wood
Chief Financial Officer
(Principal Financial and Accounting Officer)
30