Exhibit 13.1
STOCK PRICE HISTORY AND RELATED STOCKHOLDER MATTERS (unaudited)
The following table sets forth the range of high and low sales prices on the
National Association of Security Dealers Automatic Quotation ("Nasdaq") National
Market System under the Nasdaq symbol PEGA, for 1996 and 1997. The Company's
common stock has been traded on the Nasdaq National Market System since its
initial public offering in July 1996. Prior to that date, there was no public
market for the Company's common stock. As of February 6, 1998, the Company had
approximately 39 stockholders of record and approximately 2,600 beneficial
owners of the Company's common stock. On February 25, 1998, the closing sale
price of the common stock was $22.00. The Company has never declared or paid any
dividends on its common stock. The Company intends to retain its earnings to
finance future growth, and therefore does not anticipate paying any dividends in
the foreseeable future.
1997 High Low
- --------------------------------------- ------------ -------------
First Quarter $ 39.13 $ 19.38
Second Quarter $ 32.06 $ 16.75
Third Quarter $ 38.50 $ 26.81
Fourth Quarter $ 33.88 $ 15.13
1996 High Low
- --------------------------------------- ------------ ------------
Third Quarter (beginning July 19, 1996) $27.00 $10.00
Fourth Quarter $37.00 $26.13
Page 32
PEGASYSTEMS INC.
FIVE YEAR COMPARISON OF SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data presented below at December 31, 1993,
1994, 1995, 1996 and 1997 have been derived from the consolidated financial
statements of Pegasystems Inc. ("Pegasystems" or the "Company"). This data may
not be indicative of the Company's future condition or results of operations and
should be read in conjunction with the consolidated financial statements and
related notes included herein.
Years Ended December 31,
----------------------------------------------------------------------------
(in thousands, except per share data) 1993 1994 1995 1996 1997
----------- ----------- ----------- ------------ ------------
Consolidated Statement of Income Data:
Total revenue $10,212 $16,263 $22,247 $33,545 $44,361
Income (loss) from operations 793 2,236 3,257 10,019 (3,388)
License interest income 1,305 1,457 1,486 1,565 1,789
Net income 1,233 2,193 2,878 7,500
1,085
*Earnings per share:
Basic $ 0.05 $ 0.09 $ 0.12 $ 0.30 $ 0.04
Diluted $ 0.05 $ 0.09 $ 0.12 $ 0.28 $ 0.04
Weighted average number of
common shares outstanding:
Basic 22,501 23,407 23,490 24,802 28,284
Diluted 23,437 23,472 23,743 26,397 30,268
December 31,
----------------------------------------------------------------------------
(in thousands) 1993 1994 1995 1996 1997
----------- ----------- ----------- ------------ ------------
Consolidated Balance Sheet Data:
Cash and cash equivalents $ 435 $ 456 $ 511 $24,201 $ 52,005
Working capital 4,231 4,441 4,393 34,364 62,708
Long-term license installments, net 6,782 9,135 13,399 23,802 36,403
Total assets 17,057 20,787 25,876 66,855 127,520
Long-term debt 458 450 816 -- --
Stockholders' equity 9,676 11,872 14,674 52,385 108,649
Certain of these amounts have been restated in accordance with the adoption of
SFAS No. 128, "Earnings Per Share."
Page 33
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
The Company was founded in April 1983 to develop, market and support customer
management software solutions for financial services organizations. Product
development began immediately and by the end of the year the Company had secured
its first customer.
The Company's revenue is derived from two sources: software license fees and
services revenue. License fees, which have historically represented the majority
of the Company's total revenue, are generally payable on a monthly basis under
license agreements which typically have a five-year term and may be extended at
the customer's option for an additional fixed period. Such license agreements
are generally non-cancellable, although some may be terminated by the licensee
for a fee prior to the expiration of the initial term but after a minimum
specified period. The Company's licenses generally provide for annual license
fee increases (the "inflation adjustments") based on recognized inflation
indexes (sometimes subject to maximums). The Company believes that both it and
its customers derive substantial benefits from the recurring fee model because
it encourages the Company to be responsive to customer needs and provides the
Company with additional revenue opportunities through license renewals.
License revenue is generally recognized upon product acceptance. In the case of
license agreement renewals or extensions, revenue is recognized upon execution
of the renewal or the extension. The inflation adjustments are recognized
ratably over the periods to which they apply. The amount of software license
revenue recognized upon product acceptance or license renewal is equal to the
present value of the payments due during the minimum initial or renewal term, as
the case may be, plus the present value of any early termination fee. In 1995,
and the three months ended March 31, 1996, the discount rate for purposes of the
present value calculation was 7%; for the nine months ended December 31, 1996,
such discount rate was 6.75%. Commencing with the three months ended March 31,
1996, the Company established and intends to continue to establish the discount
rate quarterly as a function of the Company's current marginal borrowing rate.
In 1997, the discount rate for purposes of the present value calculation was 7%.
The imputed interest portion of the license fees, which is reported as license
interest income in the Company's consolidated statements of income, is
recognized over the minimum initial or the renewal term, as the case may be. To
date, a substantial majority of the Company's software licenses have been
renewed upon expiration. The fact that a portion of the Company's revenue is
derived from the renewal of license agreements with fixed expiration dates
assists the Company in anticipating future revenue.
The Company's services revenue is comprised of fees for implementation,
consulting, maintenance and training services. Software license customers are
offered the ability to enter into a maintenance contract requiring the customer
to pay a monthly maintenance fee over the term of the related license agreement
typically equal to approximately 18% of the license fee. Maintenance fees are
recognized ratably over the term of the maintenance agreement. The Company's
software implementation agreements typically require the Company to provide a
specified level of implementation services for a fixed fee, typically with
additional implementation services available at an hourly rate. Implementation
fees are payable upon the achievement of specified milestones. The Company
generally recognizes implementation as well as consulting and training fees as
the services are provided.
The Company's export revenue has fluctuated considerably in the past due to the
fact that such revenue has been largely attributable to a small number of
product acceptances during a given period. Export revenue declined from $3.9
million to $2.3 million in 1995 due to the lack of large product acceptances
during the year. In 1996, export revenue increased to $5.9 million, as a result
of new customers in the European marketplace. In 1997, export revenue increased
to $7.3 million as a result of new product acceptances and license renewals in
Europe, Canada and Mexico.
Most of the Company's contracts are denominated in U.S. dollars, although
several are denominated in other currencies, primarily British pounds sterling.
The Company expects that in the future more of its contracts will be denominated
in foreign currencies. The Company has not experienced any significant foreign
exchange gains or losses, and the Company does not expect that foreign currency
fluctuations will significantly affect either its revenue or costs in the near
term.
Page 34
The Company's business has experienced and is expected to continue to experience
significant seasonality. Historically, the Company has recognized a greater
percentage of its revenue in its third and fourth quarters than in its first and
second quarters due to the Company's sales commission structure and the impact
of that structure on the timing of product acceptances and license renewals by
customers. This pattern is reinforced by the Company's maintenance contracts,
which generally entitle customers to, among other things, a fixed number of
hours of service per calendar year. Once the annual allotment of service hours
is exhausted, customers pay for additional services on an hourly basis,
typically resulting in higher services revenue in the Company's second, third,
and fourth quarters.
RESULTS OF OPERATIONS
The following table sets forth for the years indicated the percentage of total
revenue represented by certain items reflected in the Statements of Income of
the Company:
Years Ended December 31,
------------------------------------------------------------
1995 1996 1997
------------ ------------ ---------------
(as a percentage of total revenue)
Revenue:
Software license 60.8% 66.4% 64.6%
Services 39.2 33.6 35.4
------------ ------------ ---------------
Total revenue 100.0 100.0 100.0
------------ ------------ ---------------
Cost of revenue:
Cost of software license 2.9 1.4 0.6
Cost of services 27.7 20.8 26.5
------------ ------------ ---------------
Total cost of revenue 30.6 22.2 27.1
------------ ------------ ---------------
Gross profit 69.4 77.8 72.9
------------ ------------ ---------------
Operating expenses:
Research and development 31.7 24.5 34.1
Selling and marketing 16.1 17.9 39.4
General and administrative 6.9 5.5 7.0
------------ ------------ ---------------
Total operating expenses 54.7 47.9 80.5
------------ ------------ ---------------
Income (loss) from operations 14.7 29.9 (7.6)
License interest income 6.7 4.7 4.0
Other interest income 0.1 1.8 7.5
Interest expense (0.5) (0.3) --
------------ ------------ ---------------
Income before provision for income taxes 21.0 36.1 3.9
Provision for income taxes 7.9 13.7 1.5
============ ============ ===============
Net income 13.1% 22.4% 2.4%
============ ============ ===============
Page 35
YEAR ENDED DECEMBER 31, 1997 COMPARED TO YEAR ENDED DECEMBER 31, 1996
The Company restated its consolidated financial statements for the unaudited
quarters ended March 31, 1997, June 30, 1997, and September 30, 1997. The
restatements reflect changes in the timing of revenue recognition and expense on
certain contracts and increased reserves for revenue and doubtful accounts. In
the opinion of management, all material adjustments necessary to correct the
financial statements have been made.
Revenue
Total revenue for 1997 increased 32.2% to $44.4 million from $33.5 million for
1996. The increase was primarily due to an increase in software license revenue.
Software license revenue for 1997 increased 28.7% to $28.7 million from $22.3
million for 1996. The increase in software license revenue was primarily
attributable to software license acceptances by new customers, software license
agreement renewals, expanded software usage by existing customers, the licensing
of standard product templates, and inflation-based increases in monthly license
fees.
Services revenue for 1997 increased 39.1% to $15.7 million from $11.3 million
for 1996. The increase in services revenue was primarily attributable to
increased demand for implementation and consulting services.
Cost of Revenue
Cost of software license consists of amortization expense related to stock
warrant and capitalized software costs, royalty payments to third party software
vendors, and costs of product media, duplication and packaging. Cost of software
license for 1997 decreased 46.4% to $0.3 million from $0.5 million for 1996, and
decreased as a percentage of total revenue from 1.4% for 1996 to 0.6% for 1997.
As a percentage of software license revenue, cost of software license decreased
from 2.1% for 1996 to 0.9% for 1997. Such decreases were due to decreased
amortization of purchased software costs partially offset by the costs
associated with a stock purchase warrant issued by the Company in June 1997,
which cost is being amortized through December 31, 2002.
Cost of services consists primarily of the costs of providing implementation,
consulting, maintenance, and training services. Cost of services for 1997
increased 68.9% to $11.8 million from $7.0 million for 1996. Cost of services as
a percentage of total revenue increased from 20.8% for 1996 to 26.6% for 1997,
and increased as a percentage of services revenue from 61.8% for 1996 to 75.0%
for 1997. These increases in cost of services were mainly due to increased
staffing in the Company's Client Services group worldwide.
Operating Expenses
Research and development expenses consist primarily of the cost of personnel and
equipment needed to conduct the Company's research and development efforts.
Research and development expenses for 1997 increased 83.8% to $15.1 million from
$8.2 million for 1996. The increase in research and development expenses was due
to the hiring of additional development personnel as well as the depreciation of
purchased capitalized software. As a percentage of total revenue, research and
development expenses increased from 24.5% for 1996 to 34.0% for 1997. The
Company has been increasing spending on sales and marketing more rapidly then
increases in development and intends to continue a strategy of leveraging
existing product functionality by balancing its historical focus on research and
development with an increased emphasis on sales and marketing.
Selling and marketing expenses for 1997 increased 191.4% to $17.5 million from
$6.0 million for 1996. As a percentage of total revenue, selling and marketing
expenses increased from 17.9% for 1996 to 39.4% for 1997 as the Company invested
in building its sales force. Such increases were attributable to the hiring of
additional direct sales and marketing personnel, increased sales commission
payments attributable to higher sales, and increased investment
Page 36
in marketing support activities and materials. During 1997, the Company
continued to build its sales and marketing infrastructure in its domestic and
international offices.
General and administrative expenses consist primarily of the salaries of the
Company's executive, administrative and financial personnel, and associated
expenses. General and administrative expenses for 1997 increased 68.2% to $3.1
million from $1.9 million for 1996 due to increased investment in the
infrastructure needed to support the Company's growth. Such expenses increased
as a percentage of total revenue from 5.5% for 1996 to 7.0% for 1997 due to the
Company's investment in infrastructure.
License Interest Income
License interest income represents the portion of all license fees due under
software license agreements which was not recognized upon product acceptance or
license renewal. License interest income for 1997 increased 14.3% to $1.8
million from $1.6 million for 1996 reflecting a larger installed product base.
Provision for Income Taxes
The provisions for federal, state and foreign taxes were $4.6 million and $0.7
million for 1996 and 1997, respectively. The effective tax rates were 38.1% for
1996 and 38.0% for 1997. At December 31, 1997, the Company had $9.1 million in
net operating loss and research and development tax credit carryforwards
available to offset future federal taxable income. See Note 8 of Notes to
Consolidated Financial Statements.
YEAR ENDED DECEMBER 31, 1996 COMPARED TO YEAR ENDED DECEMBER 31, 1995
Revenue
Total revenue for 1996 increased 50.8% to $33.5 million from $22.2 million for
1995. The increase was primarily due to an increase in software license revenue.
Software license revenue for 1996 increased 64.5% to $22.3 million from $13.5
million in 1995. The increase in software license revenue was primarily
attributable to software license acceptances by new customers, software license
agreement renewals, expanded software usage by existing customers, the licensing
of standard product templates, and inflation-based increases in monthly license
fees.
Services revenue for 1996 increased 29.5% to $11.3 million from $8.7 million for
1995. The increase in services revenue was primarily attributable to increased
demand for consulting and implementation services, and to a lesser extent,
increased maintenance revenue from a larger installed product base.
Cost of Revenue
Cost of software license for 1996 decreased 24.9% to $0.5 million from $0.6
million for 1995, and decreased as a percentage of total revenue from 2.9% for
1995 to 1.4% for 1996. As a percentage of software license revenue, cost of
software license decreased from 4.7% for 1995 to 2.1% for 1996. Such decreases
were due to decreased amortization expense related to capitalized software
development costs. No software development costs were capitalized in 1995 or
1996.
Cost of services for 1996 increased 13.2% to $7.0 million from $6.2 million for
1995, mainly due to increased staffing in the Company's Reengineering and Client
Services group in the United Kingdom and in the Company's domestic regional
offices to meet growing client commitments. Cost of services as a percentage of
total revenue declined from 27.7% for 1995 to 20.8% for 1996, and declined as a
percentage of services revenue from 70.7% for 1995 to 61.8% for 1996, in both
cases due to the growth in the Company's total revenue and increased utilization
of service personnel.
Page 37
Operating Expenses
Research and development expenses for 1996 increased 16.4% to $8.2 million from
$7.1 million for 1995. The increase in research and development expenses was due
to the hiring of additional development personnel. As a percentage of total
revenue, research and development expenses declined from 31.7% for 1995 to 24.5%
for 1996, reflecting the Company's strategy of leveraging existing product
functionality by balancing its historical focus on research and development with
an increased emphasis on sales and marketing. In addition, research and
development expenses declined as a percentage of total revenue due to the growth
in the Company's total revenue.
Selling and marketing expenses for 1996 increased 67.0% to $6.0 million from
$3.6 million for 1995. As a percentage of total revenue, selling and marketing
expenses increased from 16.1% for 1995 to 17.9% for 1996. Such increases were
attributable to the hiring of additional direct sales and marketing personnel,
increased sales commission payments attributable to higher sales, and increased
investment in marketing support activities and materials.
General and administrative expenses for 1996 increased 20.5% to $1.9 million
from $1.5 million for 1995 due to increased investment in the infrastructure
needed to support the Company's growth. Such expenses declined as a percentage
of total revenue from 6.9% for 1995 to 5.5% for 1996 due to the growth in the
Company's total revenue.
License Interest Income
License interest income for 1996 increased 5.3% to $1.6 million from $1.5
million for 1995, reflecting a larger installed product base.
Provision for Income Taxes
The provisions for federal, state and foreign taxes were $1.8 million and $4.6
million for 1995 and 1996, respectively. The effective tax rates were 38.0% for
1995 and 38.1% for 1996. At December 31, 1996, the Company had $0.8 million in
research and development tax credit carryforwards available to offset future
federal taxable income. See Note 8 of Notes to Consolidated Financial
Statements.
Page 38
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company had funded its operations primarily through
cash flow from operations and bank borrowings. In July 1996, the Company issued
and sold 2.7 million shares of Common Stock in connection with its initial
public offering. Net proceeds to the Company from such offering were
approximately $29.4 million. In January 1997, the Company issued and sold 1.8
million shares of Common Stock in connection with a second public offering. Net
proceeds to the Company from such second public offering were approximately
$51.9 million. At December 31, 1997, the Company had cash and cash equivalents
of approximately $52.0 million and working capital of approximately $62.7
million. The Company's approach of charging license fees payable in installments
over the term of its licenses has historically deferred the receipt of cash and,
prior to its initial public offering, had limited the availability of working
capital.
Net cash provided by operating activities for the year ended December 31, 1995
was $0.8 million. Net cash used in operating activities for the years ended
December 31, 1996 and 1997 was $2.9 million and $10.0 million, respectively. The
increase in cash used in operating activities was primarily due to a reduction
in net income, and an increase in accounts receivable, prepaid expenses and
other assets.
Net cash used by investing activities for the years ended December 31, 1995,
1996 and 1997 was $1.4 million, $2.0 million and $14.5 million, respectively.
This cash was used mainly to support the purchase of development software, in
addition to the purchase of property and equipment consisting mainly of computer
hardware and software and furniture and fixtures to support the Company's
growing employee base.
Page 39
Net cash provided by financing activities for the years ended December 31, 1995,
1996 and 1997 was $0.7 million, $28.5 million and $52.6 million, respectively.
This cash was provided mainly as a result of the Company completing an initial
public stock offering in 1996 and a second public stock offering in 1997.
The Company's capital commitments consist primarily of operating leases for
office space and equipment. At December 31, 1997, the Company's commitments
under non-cancellable operating leases for office space with terms in excess of
one year totaled $1.6 million, $0.8 million and $0.3 million for 1998, 1999 and
2000, respectively. The Company's total payments under such leases was $1.1
million, $1.4 million and $3.0 million for 1995, 1996 and 1997, respectively.
See Note 7 of Notes to Consolidated Financial Statements.
The Company's $5.0 million revolving credit line, which expired on June 30,
1997, was renewed with the same bank and has a maturity date of June 30, 1999.
At December 31, 1997, the Company had no borrowings under such facility. The
Company's credit agreement prohibits the payment of dividends, has profitability
requirements and requires maintenance of specified levels of tangible net worth
and certain financial ratios. The Company intends to renegotiate the term and
the covenant requirements under the existing line of credit with the same bank.
See Note 4 of Notes to Consolidated Financial Statements.
The Company recorded bad debt expense in the amounts of $0.8 million, $0.3
million and $1.9 million in 1995, 1996, and 1997, respectively, as a result of
indications that certain receivables relating primarily to consulting and
installation services rendered by the Company would not be collected in full.
The Company believes that the net proceeds from its initial public offering in
July of 1996, and its second public offering which was completed in January of
1997, together with cash generated by operations and availability under its bank
credit facility will be sufficient to fund the Company's operations for at least
the next year. However, there can be no assurance that additional capital beyond
the amounts currently forecasted by the Company will not be required or that any
such required additional capital will be available on reasonable terms, if at
all, at such time as required by the Company.
INFLATION
Inflation has not had a significant impact on the Company's operating results to
date, nor does the Company expect it to have a significant impact in the future
due to the fact that the Company's license and maintenance fees are typically
subject to annual increases based on recognized inflation indexes.
SIGNIFICANT CUSTOMERS
In 1995, the Company had three customers that accounted for 16.2%, 14.9% and
12.6%, respectively, of the Company's consolidated revenue. In 1996, the Company
had three customers that accounted for 14.5%, 11.4% and 10.5%, respectively, of
the Company's consolidated revenue. In 1997, the Company had two customers that
accounted for 13.7% and 10.0%, respectively, of the Company's consolidated
revenue.
FORWARD-LOOKING STATEMENTS
Certain statements contained in this Annual Report are "forward-looking
statements" as defined in the Private Securities Litigation Reform Act of 1995.
These statements involve various risks and uncertainties which could cause the
Company's actual results to differ from those expressed in such forward-looking
statements. These risks and uncertainties include the seasonal variation of the
Company's operations and fluctuations in the Company's quarterly results, rapid
technological change involving the Company's products, delays in product
development and implementation, the technological compatibility of the Company's
products with its customers' systems, the Company's dependence on customers in
the financial services market, intense competition in the markets for the
Company's products, risk of non-renewal by current customers, management of the
Company's growth, and other risks and uncertainties. Words such as "expects,"
"anticipates," "intends," "plans," "believes," "estimates," and "should" and
similar words and expressions are intended to identify the forward-looking
statements contained in this Annual Report. These statements are based on
estimates, projections, beliefs, and assumptions of the Company and its
management and are not guarantees of future performance. Further information
regarding those factors which could cause the Company's actual results to differ
materially from any forward-looking statements contained herein is included in
the Company's report on From 10-K for the year ended December 31, 1997, which
has been filed with the Securities and Exchange Commission.
Page 40
PEGASYSTEMS INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share-related data)
December 31,
--------------------------------------
Assets 1996 1997
------------------ ----------------
Current assets:
Cash and cash equivalents $24,201 $ 52,005
Trade and installment accounts receivable, net of
allowance for doubtful accounts of $939 in
1996 and $2,200 in 1997 14,582 20,319
Prepaid expenses and other current assets 1,235 1,514
--------------- ---------------
Total current assets 40,018 73,838
Long-term license installments, net 23,802 36,403
Equipment and improvements, net 3,035 5,578
Purchased software and other, net -- 11,701
=============== ===============
Total assets $66,855 $127,520
=============== ===============
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable and accrued expenses $ 2,697 $ 5,398
Deferred revenue 53 1,754
Deferred income taxes 2,904 3,978
--------------- ---------------
Total current liabilities 5,654 11,130
Deferred income taxes 8,816 3,669
Commitments (Note 7)
Stockholders' equity:
Preferred stock, $.01 par value, 1,000,000 shares
authorized; no shares issued and outstanding -- --
Common stock, $.01 par value, 45,000,000 shares
authorized; 26,392,200 shares and 28,545,100
shares issued and outstanding in 1996
and 1997, respectively 264 285
Additional paid-in capital 30,206 86,841
Deferred compensation (73) (55)
Stock warrant -- 2,897
Retained earnings 22,022 23,107
Cumulative foreign currency translation adjustment (34) (354)
--------------- ---------------
Total stockholders' equity 52,385 112,721
=============== ===============
Total liabilities and stockholders' equity $66,855 $127,520
=============== ===============
The accompanying notes are an integral part of these consolidated
financial statements
Page 41
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share amounts)
Years Ended December 31, 1995 1996 1997
-------------- -------------- --------------
Revenue:
Software license $13,528 $22,258 $28,657
Services 8,719 11,287 15,704
-------------- -------------- --------------
Total revenue 22,247 33,545 44,361
-------------- -------------- --------------
Cost of revenue:
Cost of software license 635 477 256
Cost of services 6,161 6,975 11,782
-------------- -------------- --------------
Total cost of revenue 6,796 7,452 12,038
-------------- -------------- --------------
Gross profit 15,451 26,093 32,323
Operating expenses:
Research and development 7,061 8,218 15,104
Selling and marketing 3,592 5,999 17,483
General and administrative 1,541 1,857 3,124
-------------- -------------- --------------
Total operating expenses 12,194 16,074 35,711
-------------- -------------- --------------
Income (loss) from operations 3,257 10,019 (3,388)
License interest income 1,486 1,565 1,789
Other interest income 16 619 3,348
Interest expense (118) (85) --
-------------- -------------- --------------
Income before provision for
income taxes 4,641 12,118 1,749
Provision for income taxes 1,763 4,618 664
============== ============== ==============
Net income $ 2,878 $ 7,500 $ 1,085
============== ============== ==============
Earnings per share:
Basic $ 0.12 $ 0.30 $ 0.04
============== ============== ==============
Diluted $ 0.12 $ 0.28 $ 0.04
============== ============== ==============
Weighted average number of common shares outstanding:
Basic 23,490 24,802 28,284
============== ============== ==============
Diluted 23,743 26,397 30,268
============== ============== ==============
The accompanying notes are an integral part of these consolidated
financial statements
Page 42
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(in thousands)
Common Stock
--------------------------
Number Additional
of Paid-in Deferred Stock
Shares Amount Capital Compensation Warrant
------------ ------------ ---------------- -------------------- ------------
Balance at December 31, 1994 23.490 $235 $15 $-- $--
Foreign currency
translation adjustment -- -- -- -- --
Issuance of stock options -- -- 91 (91) --
Net income -- -- -- -- --
------------ ------------ ---------------- -------------------- ------------
Balance at December 31, 1995 23,490 235 106 (91) --
Issuance of common
stock, net of issuance costs 2,700 27 29,339 -- --
Exercise of stock options 202 2 64 -- --
Tax benefit from exercise
of stock options -- -- 697 -- --
Foreign currency
translation adjustment -- -- -- -- --
Amortization of deferred
compensation -- -- -- 18 --
Net income -- -- -- -- --
------------ ------------ ---------------- -------------------- ------------
Balance at December 31, 1996 26,392 264 30,206 (73) --
Issuance of common
stock, net of issuance costs 1,837 18 51,925 -- --
Exercise of stock options 316 3 638 -- --
Tax benefit from exercise
of stock options -- -- 4,072 -- --
Foreign currency
translation adjustment -- -- -- -- --
Amortization of deferred
compensation -- -- -- 18 --
Issuance of stock warrant -- -- -- -- 2,897
Net income -- -- -- -- --
------------ ------------ ---------------- -------------------- ------------
Balance at December 31, 1997 28,545 $285 $86,841 ($55) $2,897
===================================================================================
Cumulative
Foreign
Currency Total
Retained Translation Stockholders'
Earnings Adjustment Equity
-------------- ---------------- --------------------
Balance at December 31, 1994 $11,644 ($22) $11,872
Foreign currency
translation adjustment -- (76) (76)
Issuance of stock options -- -- 0
Net income 2,878 -- 2,878
-------------- ---------------- --------------------
Balance at December 31, 1995 14,522 (98) 14,674
Issuance of common
stock, net of issuance costs -- -- 29,366
Exercise of stock options -- -- 66
Tax benefit from exercise
of stock options -- -- 697
Foreign currency
translation adjustment -- 64 64
Amortization of deferred
compensation -- -- 18
Net income 7,500 -- 7,500
-------------- ---------------- --------------------
Balance at December 31, 1996 22,022 (34) 52,385
Issuance of common
stock, net of issuance costs -- -- 51,943
Exercise of stock options -- -- 641
Tax benefit from exercise
of stock options -- -- 4,072
Foreign currency
translation adjustment -- (320) (320)
Amortization of deferred
compensation -- -- 18
Issuance of stock warrant -- -- 2,897
Net income 1,085 -- 1,085
-------------- ---------------- --------------------
Balance at December 31, 1997 $23,107 ($354) $112,721
=======================================================
Page 43
PEGASYSTEMS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
Years Ended December 31, 1995 1996 1997
------------- --------------- ----------------
Cash flows from operating activities:
Net income $ 2,878 $ 7,500 $ 1,085
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Provision for deferred income taxes 1,836 3,977 722
Depreciation and amortization 1,455 1,633 3,159
Provision for doubtful accounts 793 300 1,938
Change in operating assets and liabilities:
Trade and installment
accounts receivable (5,638) (16,389) (20,276)
Prepaid expenses and
other current assets (221) (810) (279)
Accounts payable and
accrued expenses (244) 950 1,978
Deferred revenue (25) (61) 1,701
------------- --------------- ----------------
Net cash provided by (used in) operating
activities 834 (2,900) (9,972)
Cash flows from investing activities:
Purchase of equipment and improvements (1,423) (2,005) (4,488)
Purchased software -- -- (10,000)
------------- --------------- ----------------
Net cash used in investing activities (1,423) (2,005) (14,488)
Cash flows from financing activities:
Repayment of note payable to stockholder (50) -- --
Proceeds from issuance of long-term debt 1,345 -- --
Repayments of long-term debt (575) (1,598) --
Issuance of common stock, net -- 29,366 51,943
Exercise of stock options -- 66 641
Tax benefit from exercise of stock options -- 697 --
------------- --------------- ----------------
Net cash provided by financing activities 720 28,531 52,584
------------- --------------- ----------------
Effect of exchange rate on cash and cash equivalents (76) 64 (320)
------------- --------------- ----------------
Net increase in cash and cash equivalents 55 23,690 27,804
------------- --------------- ----------------
Cash and cash equivalents, at beginning of year 456 511 24,201
------------- --------------- ----------------
Cash and cash equivalents, at end of year $ 511 $ 24,201 $ 52,005
============= =============== ================
Supplemental disclosures of cash flow information:
Cash paid during period:
Interest $ 119 $ 86 $ 7
============= =============== ================
Income Taxes $ 315 $ 90 $ 13
============= =============== ================
Non-cash financing activity:
Issuance of stock warrant -- -- $2,897
============= =============== ================
The accompanying notes are an integral part of these
consolidated financial statements.
Page 44
PEGASYSTEMS INC. - NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -
December 31, 1997
1. SIGNIFICANT ACCOUNTING POLICIES
(a.) Business
Pegasystems Inc. (the "Company") was incorporated on April 21, 1983 and develops
customer service management software used by large, transaction-intensive
organizations to automate and manage their customer interactions. Customers of
the Company include large banks and credit card processors and mutual fund
companies and more recently major companies in non-financial service industries.
The Company also offers consulting, training, and maintenance and support
services to facilitate the installation and use of its solutions.
The environment of rapid technological change and intense competition which is
characteristic of the software development industry results in frequent new
products and evolving industry standards. The Company's continued success
depends upon its ability to penetrate vertical markets, enhance current products
and develop new products on a timely basis that keep pace with the changes in
technology and competitors' innovations.
International revenue is subject to various risks, including imposition of
government controls, export license requirements, political and economic
conditions and instability, trade restrictions, currency fluctuations, changes
in taxes, difficulties in staffing and managing international operations, and
high local wage scales and other operating costs and expenses.
(b.) Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly-owned subsidiaries, Pegasystems Limited, Pegasystems Investment Inc.,
Pegasystems Worldwide Inc., and Pegasystems Pty Ltd. All intercompany accounts
and transactions have been eliminated in consolidation.
(c.) Foreign Currency Translation
The translation of assets and liabilities of the Company's foreign subsidiaries
is made at year-end rates of exchange, while revenue and expense accounts are
recorded at the average rates of exchange. The resulting translation adjustments
are excluded from net income and are charged or credited to "Cumulative foreign
currency translation adjustment" included as part of stockholders' equity.
Realized and unrealized exchange gains or losses from transaction adjustments
are reflected in operations and are not material.
(d.) Revenue Recognition
The Company recognizes revenue in accordance with Statement of Position (SOP)
91-1, "Software Revenue Recognition," issued by the American Institute of
Certified Public Accountants. Specifically, revenue from software licenses is
generally recognized upon product acceptance pursuant to non-cancellable license
agreements and is based on management's assessment that the collectibility on
the long-term license installments is probable. Upon acceptance, the Company has
no significant vendor obligations. The Company accrues the estimated cost of
warranty and product returns in the period in which product revenue is
recognized; historically these amounts have not been material. In the case of
license agreement renewals or extensions, revenue is recognized upon execution
of the renewal or the extension. Maintenance fees are recognized ratably over
the term of the maintenance agreement. The Company recognizes implementation as
well as consulting and training fees as the services are provided.
Page 45
Beginning in 1998, the Company will be required to adopt the provisions of SOP
97-2, "Software Revenue Recognition." The adoption of the statement is not
estimated to have a significant impact on the Company. Software license revenue
represents the present value of future payments under non-cancellable license
agreements which provide for payment in installments, typically over a five-year
period. A portion of the revenue from each agreement is recognized as interest
income over the term of the agreement.
The discount rate in effect for 1995 and the three months ended March 31, 1996
was 7%. The discount rate for the nine-month period ended December 31, 1996 was
6.75%. In 1997, the discount rate for purposes of the present value calculation
was 7%. The trade and installment accounts receivable recorded on the balance
sheet are net of $5.1 million and $6.8 million as of December 31, 1996 and 1997,
respectively, which represents the imputed interest portion of future payments
due under the Company's license agreements. Deferred revenue represents payments
from customers, primarily for maintenance services, which are recognized as
revenue as the related services are performed.
(e.) Cash and Cash Equivalents
Cash and cash equivalents are stated at cost, which approximates market, and
consist of short-term, highly liquid investments with original maturities of
three months or less.
(f.) Concentration of Credit Risk
Financial instruments that potentially subject the Company to a concentration of
credit risk consist of substantially all of the trade accounts receivable and
long-term license installments receivable. The Company records long-term license
installments in accordance with its revenue recognition policy, which results in
receivables from customers (primarily large financial service organizations with
strong credit ratings).
(g.) Equipment and Improvements
Equipment and improvements are recorded at cost. Depreciation is computed using
the straight-line method over the estimated useful lives of the assets, which
are three years for equipment and five years for furniture and fixtures.
Leasehold improvements are amortized over the life of the lease.
(h.) Software Costs
In compliance with Statement of Financial Accounting Standards (SFAS) No. 86,
"Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise
Marketed," certain software costs are capitalized in the accompanying
consolidated balance sheets. Capitalization of software costs begins upon the
establishment of technological feasibility, defined by the Company as a working
model or an operative version of the computer software product that is completed
in the same language and is capable of running on all of the platforms as the
product to be ultimately marketed. No costs were capitalized during 1995, 1996,
or 1997.
Amortization of capitalized software costs are included in cost of software
license revenue. Total amortization expense charged to cost of software was $0.6
million and $0.5 million during 1995 and 1996, respectively. No amortization
expense for capitalized software costs was charged to software license revenue
in 1997.
Page 46
(i.) Net Income Per Share
The Company adopted SFAS No. 128, "Earnings Per Share," effective December 15,
1997. SFAS No. 128 establishes standards for computing and presenting earnings
per share and applies to entities with publicly held common stock or potential
common stock. In accordance with the Securities and Exchange Commission's Staff
Accounting Bulletin (SAB) No. 98, the Company has determined that there were no
nominal issuances of common stock or potential common stock in the period prior
to the Company's initial public offering (IPO). The Company has applied the
provisions of SFAS No. 128 and SAB No. 98 retroactively to all periods
presented. Calculations of basic and diluted net income per share and potential
common share are as follows:
Years Ended December 31, 1995 1996 1997
---------- --------- ------------
(in thousands, except per share data)
Basic
Net income $ 2,878 $7,500 $ 1,085
========== ========= ============
Weighted average common shares outstanding 23,490 24,802 28,284
========== ========= ============
Basic earnings per share $ 0.12 $ 0.30 $0.04
========== ========= ============
Diluted
Net income $ 2,878 $7,500 $ 1,085
========== ========= ============
Weighted average common shares outstanding 23,490 24,802 28,284
Effect of:
Assumed exercise of stock options 253 1,595 1,984
---------- --------- ------------
Weighted average common shares outstanding,
assuming dilution 23,743 26,397 30,268
========== ========= ============
Diluted earnings per share $ 0.12 $ 0.28 $ 0.04
========== ========= ============
As of December 31, 1995, no outstanding options were excluded from the weighted
average common shares outstanding, assuming dilution. As of December 31, 1996
and 1997, 7,201 options and 185,481 options, respectively, were excluded from
the weighted average common shares outstanding, assuming dilution, as their
effect would be anti-dilutive.
(j.) New Accounting Standards
In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS No.
130, "Reporting Comprehensive Income." SFAS No. 130 requires disclosure of all
components of comprehensive income on an annual and interim basis. Comprehensive
income is defined as the change in equity of a business enterprise during a
period from transactions and other events and circumstances from nonowner
sources. SFAS No. 130 is effective for fiscal years beginning after December 15,
1997.
In June 1997, the FASB issued SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information." SFAS No. 131 requires certain financial and
supplemental information to be disclosed on an annual and interim basis for each
reportable segment of an enterprise. SFAS No. 131 is effective for fiscal years
beginning after December 15, 1997.
Page 47
(k.) Stock Options
The Company grants stock options for a fixed number of shares to employees with
an exercise price equal to the fair market value of the shares at the date of
the grant. The Company accounts for stock option grants in accordance with APB
Opinion No. 25, "Accounting for Stock Issued to Employees," and intends to
continue to do so. During 1995, the Company granted stock options for a fixed
number of shares to employees with an exercise price less than the then fair
market value of the shares at the date of the grant. For the difference between
the fair market value and the exercise price, the Company recorded deferred
compensation in the consolidated statements of stockholders' equity, which is
being expensed over the vesting period.
The Company has adopted the disclosure provisions only of SFAS No. 123,
"Accounting for Stock-Based Compensation," and will continue to account for its
stock option plans in accordance with the provisions of Accounting Principles
Board (APB) Statement No. 25, "Accounting for Stock Issued to Employees."
(l.) Use of Estimates
The preparation of the financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenue and
expenses during the reporting period. Actual results could differ from those
estimates.
2. EQUIPMENT AND IMPROVEMENTS
The cost and accumulated depreciation of equipment and improvements consist of
the following:
(in thousands) December 31,
------------------------------------
1996 1997
----------- ------------
Equipment $3,956 $7,243
Furniture and fixtures 1,005 1,895
Leasehold improvements 527 838
----------- ------------
5,488 9,976
Less: accumulated depreciation (2,453) (4,398)
=========== ============
Equipment and improvements, net $3,035 $5,578
=========== ============
Depreciation expense was approximately $0.8 million, $1.2 million and $2.0
million for the years ended December 31, 1995, 1996 and 1997, respectively.
Page 48
3. ACCOUNTS PAYABLE AND ACCRUED EXPENSES
Accounts payable and accrued expenses consist of the following:
December 31,
-------------------------------
(in thousands) 1996 1997
------------ ------------
Trade accounts payable $ 692 $ 863
Employee compensation and benefits 1,257 1,332
Accrued income taxes 160 754
Other accrued expenses 588 1,114
Sales return reserve -- 961
Accrued consulting costs -- 374
============ ============
$ 2,697 $ 5,398
============ ============
4. DEBT
The Company had no outstanding long-term debt at December 31, 1996 and December
31, 1997.
As of December 31, 1997, the Company had a line of credit with a bank allowing
for borrowings up to $5.0 million at the prime rate which will expire on June
30, 1999. The Company had no borrowings outstanding under the line of credit at
December 31, 1997. Borrowings are subject to various covenants which call for a
specified level of working capital and net worth, maintenance of certain
financial ratios and restrictions on the payments of dividends. As of December
31, 1997, the Company was in compliance with all covenants, except for the
profitability financial covenant, for which the Company received a
non-compliance waiver.
5. STOCKHOLDERS' EQUITY
(a.) Secondary Public Offering
On January 28, 1997, the Company issued and sold 1.8 million shares of common
stock in connection with its second public offering. Net proceeds to the Company
from this offering were approximately $51.9 million.
(b.) Recapitalization and Stock Split
On July 10, 1996, the Company increased the number of shares of common stock
authorized from 9.0 million to 45.0 million shares. The Company's Board of
Directors approved a three-for-one stock split in the form of a stock dividend
effective on July 10, 1996. The financial statements give effect to the stock
split for all periods presented.
Page 49
The Board of Directors is authorized, subject to certain limitations prescribed
by law, without further stockholder approval, to issue from time to time up to
an aggregate 1.0 million shares of preferred stock in one or more series and to
fix or alter the designations, preferences, rights and any qualifying
limitations or restrictions of the shares of each such series thereof, including
the dividend rights, dividend rates, conversion rights, voting rights, terms of
redemptions (including sinking fund provisions), redemption price or prices,
liquidation preferences and the number of shares constituting any shares or
designations of such series.
(c.) Long-Term Incentive Plan
In 1994, the Company adopted a Long-Term Incentive Plan (the "1994 Plan") to
provide employees, directors and consultants with opportunities to purchase
stock through incentive stock options and through options that do not qualify as
incentive stock options.
In addition to options, eligible participants under the 1994 Plan may be granted
stock appreciation rights, restricted stock and long-term performance awards. As
of December 31, 1997, a total of 5.0 million shares of common stock were
reserved for issuance under the 1994 Plan.
The option price per share is determined at the date of grant. For incentive
stock options, the option price may not be less than 100% of the fair market
value of the Company's common stock at the grant date. Incentive stock options
granted to a person having greater than 10% of the voting power of all classes
of stock must have an exercise price of at least 110% of fair market value of
the Company's common stock. Options granted under the 1994 Plan generally vest
over five years and expire no later than ten years from the date of grant.
(d.) 1996 Non-Employee Director Stock Option Plan
The 1996 Non-Employee Director Stock Option Plan (the "Director Plan") was
adopted by the Board of Directors on May 13, 1996 and approved by the
stockholders on June 26, 1996. The Director Plan provides for the grant of
options for the purchase of up to 250,000 shares of common stock of the Company.
As of December 31, 1997, options to purchase 90,000 shares were outstanding
under the Director Plan but no shares had been issued under the plan.
The Director Plan is administered by the Compensation Committee and provides
that each person who becomes a director of the Company after May 13, 1996, and
who is not also an employee of the Company, will receive upon initial election
to the Board of Directors an option to purchase 30,000 shares of common stock
vesting in equal annual installments over five years. The exercise price for all
options granted under the Director Plan is equal to the market price of the
common stock as of the date of grant.
(e.) 1996 Employee Stock Purchase Plan
The 1996 Employee Stock Purchase Plan (the "Stock Purchase Plan") was adopted by
the Board of Directors on May 13, 1996 and approved by the stockholders on June
26, 1996. An aggregate of 500,000 shares of common stock are reserved for
issuance pursuant to this plan. To date, there have been no offerings under the
Stock Purchase Plan and no shares of common stock have been issued thereunder.
Page 50
The following table presents the combined activity of the two option plans from
which options have been granted during the years ended December 31, 1995, 1996
and 1997:
1995 1996 1997
---------------------------- -------------------------- ------------------------------
Number Weighted Number Weighted Number Weighted
of Average of Average of Average
Options Exercise Options Exercise Options Exercise
(in thousands) Price (in thousands) Price (in thousands) Price
--------------- ---------- -------------------------- ---------------- ------------
Outstanding options
at beginning of year 1,672 $ 0.33 1,924 $ 0.34 $2,582 $ 5.04
Granted 335 $ 0.39 993 $13.19 1,214 $22.79
Exercised -- $ -- (202) $ 0.33 (316) $ 2.03
Cancelled (83) $ 0.48 (133) $ 4.94 (381) $20.52
-------- ------ ------- ------ ------- -------
Outstanding options at
end of year 1,924 $ 0.34 2,582 $ 5.04 3,099 $10.40
======== ====== ======= ====== ======= ======
Exercisable options at
end of year 606 $ 0.33 679 $ 0.33 822 $ 2.13
======== ====== ======= ====== ======== ======
Weighted average fair
value of options granted $ 0.09 $ 8.84 $11.38
during the year ====== ====== =======
In December 1995, the Company granted options to purchase 335,250 shares of
common stock at an exercise price of $.39 per share. The Company recorded an
increase to additional paid-in capital and a corresponding charge to deferred
compensation in the amount of $91,000 to recognize the aggregate difference
between the deemed fair value for accounting purposes of the stock options at
the date of grant and the exercise price. The deferred compensation will be
amortized over the option vesting period of five years.
The following table presents weighted average price and life information about
significant option groups outstanding at December 31, 1997:
Options Outstanding Options Exercisable
-------------------------------------- ------------------------
Weighted
Average Weighted Weighted
Number Remaining Average Number Average
Outstanding Contractual Exercise Exercisable Exercise
(in thousands) Life (years) Price (in thousands) Price
------------- ----------- -------- ------------- ---------
Range of exercise prices
$0.33 - $ 0.39 1,303 7.18 $ 0.34 698 $ 0.33
$6.00 - $10.00 615 8.37 $ 9.64 78 $10.00
$12.50 - $18.25 549 9.06 $17.37 46 $16.17
$20.56 - $31.88 632 9.51 $25.83 -- --
----- ---
3,099 822
===== ===
51
Pursuant to the requirements of SFAS 123, the following are the pro forma net
income and net income per share for 1995, 1996 and 1997, as if the compensation
expense for the option plans had been determined based on the fair value at the
grant date for grants in 1995, 1996 and 1997, consistent with the provisions of
SFAS 123:
1995 1996 1997
------------------------ ------------------------- ----------------------------
As Pro As Pro As Pro
Reported Forma Reported Forma Reported Forma
----------- ----------- ----------- --------- ------------- ---------
Net income (loss) (in thousands) $2,878 $2,878 $7,500 $7,122 $1,085 $ (774)
Basic net income (loss) per share $ 0.12 $ 0.12 $ 0.30 $ 0.29 $ .04 $(0.03)
Diluted net income (loss) per share $ 0.12 $ 0.12 $ 0.28 $ 0.26 $ .04 $(0.03)
A range of expected vesting percentages were given to each range of exercise
prices. In 1997, the range of exercise prices from $0.33 to $0.39, $6.00 to
$10.00, $12.50 to $18.25and $20.56 to $31.88, it is expected that 95 percent, 90
percent, 75 percent and 50 percent of those options will vest, respectively.
These ranges were based upon the Company's estimates that a more significant
number of lower priced options as compared to higher priced options will vest.
The fair value of options at the date of grant were estimated using the
Black-Scholes model with the following weighted-average assumptions:
Option
-----------------------------------------
1995 1996 1997
------------ ----------- ------------
Volatility 0.0 0.0 - 9.9 0.5
Expected option life (years) 5.0 5.0 5.0
Interest rate (risk free) 5.51% 5.38 - 6.69% 6.13 - 6.57%
Dividend yield 0.0% 0.0% 0.0%
Volatility for 1997 was calculated on a quarterly basis and was determined to be
0.5. Volatility for 1996 was calculated on a monthly basis. For 1996, exclusive
of one month's data where volatility was 9.9, volatility ranged from 0.0 to 1.4.
The Company has never declared nor paid dividends on any of its capital stock
and does not expect to in the foreseeable future.
The effects on 1995, 1996, and 1997 pro forma net income (loss) and net income
(loss) per share of expensing the estimated fair value of stock options and
shares are not necessarily representative of the effects on reporting the
results of operations for future years as the periods presented include only
one, two and three years of option grants under the Company's plan.
(6) Software License and Support and Warrant Agreements
On June 27, 1997, the Company entered into Software License and Support and
Warrant Agreements with First Data Resources, Inc. (FDR).
The provisions of the Software License and Support Agreement give FDR the right
to use the Company's software in connection with new products and also the
exclusive right to market, distribute and sublicense the Company's software and
new products to FDR customers and prospects. In addition to the granting of a
license to use its software, the Company will also provide services to FDR in
connection with the new products. For the right to the license and the services,
FDR is expected to pay the Company a base fee of $49.25 million. FDR paid $5.0
million in 1997 and remaining fees are expected to be paid on a monthly basis
over the term of the agreement. The initial term of this agreement commences on
June 27, 1997 and runs through December 31, 2002.
In accordance with the Software License and Support Agreement, the Company was
granted a license for access to and use of the designs, specifications and code
of FDR's ESP Product. As consideration for this right, the Company paid FDR
$10.0 million. This amount was recorded as purchased software on the
accompanying consolidated balance sheet.
In connection with the Software License and Support Agreement on June 27, 1997,
the Company committed to provide a Warrant to FDR. Pursuant to the Warrant
Agreement, the Company gave FDR the right to purchase 284,876 shares of the
Company's Common Stock at a purchase price of $28.25 per share which represented
the fair market value of the common stock on the date of the agreement The
warrant will become exercisable on June 27, 1998 and will expire on June 27,
2002. The warrant was valued at $2.9 million and the corresponding deferred
asset was capitalized and included in "purchased software and other" on the
accompanying consolidated balance sheet.
52
The Company will recognize the base fee revenue and also amortize the value of
the purchased software and the warrant on a pro rata basis over the initial
5-1/2 year term of the agreement. During the period from June 27, 1997 through
December 31, 1997, the Company recognized revenue of approximately $4.6 million
related to the Software License and Support Agreement and recorded amortization
expense of approximately $1.2 million related to the ESP software and warrant.
7. LEASES
The Company leases certain equipment and office space under non-cancellable
operating leases. Future minimum rental payments required under the operating
leases with non-cancellable terms in excess of one year at December 31, 1997 are
as follows:
Year ended December 31, (in thousands)
1998 $1,594
1999 797
2000 329
2001 329
2002 329
Thereafter 987
============
Total $4,365
============
Total rent expense under operating leases was approximately $1.1 million, $1.4
million and $3.0 million for the years ended December 31, 1995, 1996 and 1997,
respectively.
8. INCOME TAXES
Income before income taxes consists of the following:
(in thousands)
1995 1996 1997
---------- ----------- ----------
Domestic $4,318 $11,546 $1,392
Foreign 323 572 357
---------- ----------- ----------
Total $4,641 $12,118 $1,749
========== =========== ==========
53
The provision (benefit) for income taxes for the years ended December 31, 1995,
1996 and 1997 consisted of the following:
(in thousands)
1995 1996 1997
---------- ---------- ----------
Current:
Federal $(107) $6 $(149)
State (39) 212 (30)
Foreign 73 160 121
---------- ---------- ----------
Total current (73) 378 (58)
---------- ---------- ----------
Deferred:
Federal 1,563 3,662 688
State 273 578 34
---------- ---------- ----------
Total deferred 1,836 4,240 722
---------- ---------- ----------
$1,763 $4,618 $664
========== ========== ==========
The effective income tax rate differed from the statutory federal income tax
rate due to the following:
1995 1996 1997
-------- ---------- --------
Statutory federal income tax rate 34.0% 35.0% 34.0%
State income taxes, net of federal
benefit and tax credits 5.8% 4.2% 3.9%
Permanent differences 0.7% 0.3% 6.4%
Tax credits (2.5)% (0.6)% (8.6)%
Other -- (0.8)% 2.3%
-------- ---------- --------
Effective income tax rate 38.0% 38.1% 38.0%
======== ========== ========
Deferred income taxes at December 31, 1996 and 1997 reflect the net tax effects
of net operating loss and tax credit carryforwards and temporary differences
between the carrying amounts of assets and liabilities for financial statement
purposes and the amounts used for tax purposes. The approximate income tax
effect of the Company's net deferred tax liability as of December 31, 1996 and
1997 are as follows:
(in thousands) December 31,
----------------------------
1996 1997
----------- ----------
Software revenue $(14,103) $(18,195)
Depreciation (215) (76)
Deferred state taxes 836 --
Vacation accrual 380 184
Receivable and other reserves 367 1,198
Net operating loss carryforwards -- 8,195
Tax credits 798 864
Other 217 183
----------- ----------
Net deferred tax liabilities (11,720) (7,647)
Less current portion (2,904) (3,978)
----------- ----------
$(8,816) $(3,669)
=========== ==========
54
At December 31, 1997, the Company had alternative minimum tax (AMT) and research
and development (R&D) credit carryforwards of approximately $864,000, available
to offset future federal taxable income. The carryforward period for the AMT
credit is unlimited. The R&D credit carryforwards generally expire from 2004 to
2008.
As of December 31, 1997 the Company also has available net operating loss
carryforwards of approximately $20,932,000 expiring through 2012. These
carryforwards may be used to offset future income taxes payable, if any, and are
subject to review by the Internal Revenue Service.
The Company has recorded a deferred tax asset for the effect of its net
operating loss carryforward as management has concluded that it is more likely
than not that the tax benefit will be realized. However, approximately
$12,251,000 of the net operating loss carryforward relates to the excess tax
benefit of disqualifying dispositions and the exercise of non-qualified stock
options. Accordingly, approximately $4,769,000 of the deferred tax asset was
recorded in additional paid in capital.
9. LITIGATION
The Company is a defendant in two purported class action suits which have been
consolidated and in which the Company and several of its officers are alleged to
have violated Section 10(b) of the Securities Exchange Act of 1934, as amended
(the "1934 Act"), Rule 10(b) (5) promulgated thereunder and Section 20(a) of the
1934 Act. The consolidated complaint does not specify the amount of the damages
sought. Accordingly, the Company is unable to determine or estimate the outcome
at this time. The Company has not yet filed any responsive pleadings in this
litigation, but intends to defend the matter vigorously.
10. SIGNIFICANT CUSTOMERS
In 1995, the Company had three customers that accounted for 16.2%, 14.9% and
12.6%, respectively, of the Company's consolidated revenue. In 1996, the Company
had three customers that accounted for 14.5%, 11.4% and 10.5%, respectively, of
the Company's consolidated revenue. In 1997, the Company had two customers that
accounted for 13.7% and 10.0%, respectively, of the Company's consolidated
revenue.
11. INTERNATIONAL OPERATIONS
The Company's export sales from the United States for 1995, 1996 and 1997 are as
follows:
(in thousands) 1995 1996 1997
--------- ----------- ----------
United Kingdom $1,343 $3,698 $3,642
Europe 877 2,017 1,715
Other 114 232 1,973
========= =========== ==========
Total $2,334 $5,947 $7,330
========= =========== ==========
55
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors of
Pegasystems Inc.:
We have audited the accompanying consolidated balance sheet of Pegasystems Inc.
as of December 31, 1997 and the related consolidated statements of income,
stockholders' equity, and cash flows for the year then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Pegasystems Inc. at December 31, 1997, and the consolidated results of its
operations and its cash flows for the year then ended, in conformity with
generally accepted accounting principles.
Arthur Andersen LLP
Boston, Massachusetts
April 2, 1998
56
The Board of Directors
Pegasystems Inc.
We have audited the accompanying consolidated balance sheet of Pegasystems Inc.
as of December 31, 1996 and the related consolidated statements of income,
stockholders' equity, and cash flows for each of the two years in the period
ended December 31, 1996. These financial statements are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Pegasystems Inc. at December 31,1996, and the consolidated results of its
operations and its cash flows for each of the two years in the period ended
December 31, 1996, in conformity with generally accepted accounting principles.
Ernst & Young LLP
Boston, Massachusetts
February 24, 1997
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