As filed with the Securities and Exchange Commission on June 10, 1998
Registration No. 333-
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM S-1
REGISTRATION STATEMENT
UNDER
THE SECURITIES ACT OF 1933
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NETCOM SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE 3825287 95-4312521
(State or other jurisdiction of (Primary Standard Industrial (I.R.S. Employer
incorporation or organization) Classification Code Number) Identification Number)
20550 NORDHOFF STREET
CHATSWORTH, CA 91311
(818) 700-5100
(Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices)
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BARRY PHELPS
CHIEF EXECUTIVE OFFICER
20550 NORDHOFF STREET
CHATSWORTH, CA 91311
(818) 700-5100
(Name, address, including zip code, and telephone number, including area code,
of agent for service)
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COPIES TO:
STEVEN E. BOCHNER DONALD M. KELLER, JR.
WILSON SONSINI GOODRICH & ROSATI VENTURE LAW GROUP
PROFESSIONAL CORPORATION A PROFESSIONAL CORPORATION
650 PAGE MILL ROAD 2800 SAND HILL ROAD
PALO ALTO, CALIFORNIA 94304 MENLO PARK, CALIFORNIA 94025
(650) 493-9300 (650) 854-4488
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APPROXIMATE DATE OF COMMENCEMENT OF PROPOSED SALE TO THE PUBLIC: As soon as
practicable after the effective date of this Registration Statement.
If any of the securities being registered on this Form are to be offered on
a delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. / /
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act, please check the following box
and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. / /
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act, check the following box and list the Securities Act of
1933 registration statement number of the earlier effective registration
statement for the same offering. / /
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act, check the following box and list the Securities Act
registration number of the earlier effective registration statement for the same
offering. / /
If delivery of the prospectus is expected to be made pursuant to Rule 434,
please check the following box. / /
CALCULATION OF REGISTRATION FEE
PROPOSED PROPOSED
AMOUNT MAXIMUM MAXIMUM
TITLE OF EACH CLASS OF TO BE OFFERING PRICE AGGREGATE AMOUNT OF
SECURITIES TO BE REGISTERED REGISTERED PER SHARE(2) OFFERING PRICE(2) REGISTRATION FEE
Common Stock, $0.001 par value................. 14,260,000 shares(1) $13.00 $185,380,000 $54,688
(1) Includes Shares that the Underwriters have the option to purchase solely to
cover over-allotments.
(2) Estimated solely for the purpose of calculating the amount of the
registration fee pursuant to Rule 457(a) under the Securities Act of 1933.
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THE REGISTRANT HEREBY AMENDS THIS REGISTRATION STATEMENT ON SUCH DATE OR
DATES AS MAY BE NECESSARY TO DELAY ITS EFFECTIVE DATE UNTIL THE REGISTRANT SHALL
FILE A FURTHER AMENDMENT WHICH SPECIFICALLY STATES THAT THIS REGISTRATION
STATEMENT SHALL THEREAFTER BECOME EFFECTIVE IN ACCORDANCE WITH SECTION 8(A) OF
THE SECURITIES ACT OF 1933 OR UNTIL THIS REGISTRATION STATEMENT SHALL BECOME
EFFECTIVE ON SUCH DATE AS THE COMMISSION, ACTING PURSUANT TO SAID SECTION 8(A),
MAY DETERMINE.
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SUBJECT TO COMPLETION, DATED JUNE , 1998
INFORMATION CONTAINED HEREIN IS SUBJECT TO COMPLETION OR AMENDMENT. A
REGISTRATION STATEMENT RELATING TO THESE SECURITIES HAS BEEN FILED WITH THE
SECURITIES AND EXCHANGE COMMISSION. THESE SECURITIES MAY NOT BE SOLD NOR MAY
OFFERS TO BUY BE ACCEPTED PRIOR TO THE TIME THE REGISTRATION STATEMENT BECOMES
EFFECTIVE. THIS PROSPECTUS SHALL NOT CONSTITUTE AN OFFER TO SELL OR THE
SOLICITATION OF AN OFFER TO BUY NOR SHALL THERE BE ANY SALE OF THESE SECURITIES
IN ANY STATE IN WHICH SUCH OFFER, SOLICITATION OR SALE WOULD BE UNLAWFUL PRIOR
TO REGISTRATION OR QUALIFICATION UNDER THE SECURITIES LAWS OF ANY SUCH STATE.
12,400,000 SHARES
[LOGO]
COMMON STOCK
(PAR VALUE $0.001 PER SHARE)
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Of the 12,400,000 shares of Common Stock offered, 9,920,000 shares are being
offered hereby in the United States and 2,480,000 shares are being offered in a
concurrent international offering outside the United States. The initial public
offering price and aggregate underwriting discount per share will be identical
for both offerings (the "Offerings"). See "Underwriting".
Of the 12,400,000 shares of Common Stock offered hereby, 10,000,000 shares
are being sold by the Company and 2,400,000 shares are being sold by the Selling
Stockholders. See "Principal and Selling Stockholders". The Company will not
receive any proceeds from the sale of shares by the Selling Stockholders.
Prior to the Offerings, there has been no public market for the Common Stock
of the Company. It is currently estimated that the initial public offering price
will be between $11.00 and $13.00 per share. For factors to be considered in
determining the initial public offering price, see "Underwriting".
SEE "RISK FACTORS" BEGINNING ON PAGE 6 FOR CERTAIN CONSIDERATIONS RELEVANT
TO AN INVESTMENT IN THE COMMON STOCK.
Application has been made to have the Common Stock approved for quotation on
the Nasdaq National Market under the symbol "NTCM".
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THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS
THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES
COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS.
ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
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PROCEEDS TO
INITIAL PUBLIC UNDERWRITING PROCEEDS TO SELLING
OFFERING PRICE DISCOUNT(1) COMPANY(2) STOCKHOLDERS
----------------- ----------------- ----------------- -----------------
Per Share........................... $ $ $ $
Total(3)............................ $ $ $ $
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(1) The Company and the Selling Stockholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act of 1933, as amended. See "Underwriting".
(2) Before deducting expenses payable by the Company estimated at $850,000.
(3) The Company and certain Selling Stockholders have granted to the U.S.
Underwriters an option for 30 days to purchase up to an additional 1,488,000
shares of Common Stock at the initial public offering price per share, less
the underwriting discount, solely to cover over-allotments. Additionally,
the Company and certain Selling Stockholders have granted the International
Underwriters a similar option with respect to an additional 372,000 shares
as part of the concurrent international offering. If such options are
exercised in full, the total initial public offering price, underwriting
discount, proceeds to Company and proceeds to Selling Stockholders will be
$ , $ , $ and $ , respectively. See
"Underwriting".
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The shares offered hereby are offered severally by the U.S. Underwriters, as
specified herein, subject to receipt and acceptance by them and subject to their
right to reject any order in whole or in part. It is expected that the shares
will be ready for delivery in New York, New York on or about , 1998,
against payment therefor in immediately available funds.
GOLDMAN, SACHS & CO. NATIONSBANC MONTGOMERY SECURITIES LLC
BT ALEX( BROWN
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The date of this Prospectus is , 1998.
EDGAR COLORWORK DESCRIPTION:
INSIDE FRONT COVER OF PROSPECTUS:
Graphic depicts a series of arrows arranged point-to-tail in a circle
traveling clockwise. The arrows are labeled as follows: "Network Equipment
Manufacturers", "Service Providers and Corporate End-Users", "New Product
Design", "Production", "Sales", "Proof of Product", and "Proof of Service". The
arrows emerge from and terminate at the corporate logo of Netcom Systems, which
is situated at the base of the circle created by the arrows. Above the arrows is
the heading, in large type, "The first link in the network". Below the logo is
the caption, "Netcom Systems' SmartBits products verify network performance to
create the first link in a new network. Netcom Systems reduces the risks and
costs associated with network failures. SmartBits proactively measures the
limits of network devices and complex network configurations before they 'go
live.' From initial product design to first end-user deployment, Netcom Systems
helps new technology take its place in today's evolving network world".
INSIDE GATEFOLD:
Graphic depicts a series of arrows arranged point-to-tail emerging from a
picture of SmartBits at the base of the graphic, traveling clockwise in a
circle, and terminating back at the picture of SmartBits. The arrows are labeled
"Network Equipment Manufacturers", "Service Providers and Corporate End-Users",
"New Product Design", "Production", "Sales", "Proof of Product", and "Proof of
Service".
Above the circle that is created by the arrows is the corporate logo of
NetCom Systems followed by "Network Performance Analysis".
Emerging from the picture of the products and filling the space in the
center of the circle is a diagram detailing SmartBits interconnected with
network equipment.
Under the lower left area of the circle are two pictures of computer screens
showing the graphical user interface of SmartBits. There are three similar
pictures under the lower right area of the circle.
At the bottom of the graphic is the following caption: "SmartBits recreates
and generates the traffic of thousands of network connected computers, then
analyzes the results to accurately measure the performance of network equipment.
SmartBits' product family breadth addresses both existing and new networking
technologies: 10/100 Mpbs and Gigabit Ethernet, Token Ring, ATM and Frame Relay,
xDSL, Cable Modem, Multi-Layer applications and Quality of Service measurement.
Corporate end-users, carriers and service providers use SmartBits to validate
the implementation and service levels of their networks. Network equipment
manufacturers use SmartBits to develop new technologies, accelerate time to
market and prove that products work for their customers. Netcom Systems works
with network experts and standards bodies to create independent testing for the
network industry. SmartBits has been used to determine the viability of new
technology by leading network laboratories and trade publications."
INSIDE BACK COVER OF PROSPECTUS:
Graphic depicts a rectangle rotated clockwise approximately 20 degrees
bearing the words "Tested with SmartBits". Also inside the rectangle, in smaller
type at the bottom, is "Netcom Systems". The rectangle is superimposed over a
list of companies. The companies listed are: 3Com Corporation - 3M
Corporation - Abbott Laboratories - Accton Technology Corporation - Allied
Telesis - Ascend Communications, Inc. - AT&T - Bay Networks, Inc. - Bell
Atlantic Network Integration - BellSouth Business Systems - Cabletron
Systems, Inc. - Cigna Systems - Cisco Systems, Inc. - Delta Electronics,
Inc. - D-Link Corporation - FORE Systems, Inc. - Fujitsu Group - GTE
Laboratories, Inc. - Hewlett-Packard Company - Hitachi Computer Products,
Inc. - John Hancock Life Insurance Company - Lucent Technologies,
Inc. - Matsushita - MCI Telecommunications
Corporation - MFS/Worldcom - Microsoft Corporation - NationsBanc
Corporation - Naval Command Control and Ocean Surveillance Center RDT&E
Division - NEC Corporation - Newbridge Networks Corporation - Northern
Telecom Canada Limited - Pacific Bell Networks Integration - PaineWebber,
Inc. - PSINet, Inc. - Raytheon Service Company - Southwestern Bell
Technology Resources - Sprint Corporation - The Boeing Company - Xylan
Corporation.
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CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS THAT
STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK OF THE
COMPANY, INCLUDING OVER-ALLOTMENT, STABILIZING AND SHORT-COVERING TRANSACTIONS
IN SUCH SECURITIES, AND THE IMPOSITION OF A PENALTY BID, IN CONNECTION WITH THE
OFFERING. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING".
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"SMARTBITS-TM-" IS A TRADEMARK OF THE COMPANY. ALL RIGHTS RESERVED. ALL
OTHER TRADE NAMES AND TRADEMARKS APPEARING IN THIS PROSPECTUS ARE THE PROPERTY
OF THEIR RESPECTIVE HOLDERS.
PROSPECTUS SUMMARY
THE FOLLOWING SUMMARY SHOULD BE READ IN CONJUNCTION WITH, AND IS QUALIFIED
IN ITS ENTIRETY BY, THE MORE DETAILED INFORMATION AND THE FINANCIAL STATEMENTS
AND NOTES THERETO APPEARING ELSEWHERE IN THIS PROSPECTUS. PROSPECTIVE INVESTORS
SHOULD CONSIDER CAREFULLY THE INFORMATION DISCUSSED UNDER "RISK FACTORS". THIS
PROSPECTUS CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE
ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS,
INCLUDING THOSE SET FORTH UNDER "RISK FACTORS" AND ELSEWHERE IN THIS PROSPECTUS.
SEE "GLOSSARY OF TERMS" FOR DEFINITIONS OF VARIOUS ACRONYMS AND TECHNICAL TERMS
USED IN THIS PROSPECTUS.
THE COMPANY
Netcom Systems is a leading provider of network performance measurement
systems. The Company's flagship platform, SmartBits, evaluates performance,
reliability, quality of service and proof of service of networking equipment,
such as routers and switches, before deployment on the network. SmartBits also
allows users to measure network performance criteria by emulating complex,
multi-protocol networks through generation of accurate, customizable, high speed
flows of network traffic. By offering a robust, scalable, and modular network
performance solution, the Company has established relationships with several
prominent industry experts and multiple technology publications in the field of
network performance. The Company's customer base of over 600 accounts includes
leading Network Equipment Manufacturers ("NEMs"), such as Ascend Communications,
Bay Networks, Cisco Systems, Cabletron, Lucent Technologies, Nortel and 3Com,
telecommunications carriers and internet service providers ("Service
Providers"), such as AT&T, Bell Atlantic, GTE, MCI, Sprint and WorldCom and
Fortune 1000 companies, financial institutions, and systems integrators and
government entities ("End Users"), such as 3M, Boeing, Fujitsu, John Hancock,
Microsoft, NEC and U.S. Naval Command Control. Netcom Systems has been
profitable in each of its last three fiscal years and for the Company's last
thirteen fiscal quarters, revenues have increased over the prior quarter's
results.
In recent years, businesses have migrated from mainframe-based computing
environments to distributed, client/server computing networks capable of sharing
bandwidth intensive applications. The widespread adoption of this computing
paradigm has resulted in an increasing need for network equipment capable of
transmitting bandwidth intensive, mission critical traffic at extremely fast
speeds across progressively larger and heterogeneous networks. Growth in network
size, proliferation of multi-protocol networks and increasing levels of
multimedia traffic across networks have exacerbated network equipment
complexity. These trends have driven NEMs, End Users and Service Providers to
require robust performance measurement equipment to evaluate network equipment
performance, reliability and interoperability. For NEMs, performance measurement
solutions have become mission critical for the successful and timely
introduction of new products that are fully interoperable in multi-vendor and
multi-protocol environments. For End Users and Service Providers that rely on
critical network traffic for their business, performance measurement equipment
evaluates the reliability, accuracy, availability and performance of network
equipment before deployment on the network.
Utilizing SmartBits, NEMs ensure proper network equipment performance while
efficiently allocating their scarce engineering resources to product
development. In addition, End Users and Service Providers use SmartBits to make
better cost/performance purchasing decisions on new equipment, reduce the risk
of network "meltdowns", and ensure that critical applications perform correctly.
The SmartBits platform enables customers to analyze parameters such as
reliability, packet loss, throughput, latency, jitter, traffic flow performance
and bandwidth per connection.
The modular SmartBits platform enables users to easily add or substitute
protocol specific interface cards or SmartCards within a common SmartBits
chassis, thus allowing performance measurement over a wide variety of networking
protocols and interfaces simultaneously. SmartBits is also scalable, allowing
for the addition of multiple SmartCards within a single chassis and linkage of
multiple SmartBits
3
chassis for performance measurement of network equipment replicating the demands
of up to 640 simultaneous connections. The Company's SmartBits chassis and
SmartCards are used in conjunction with a versatile suite of software
applications that address the performance measurement requirements of End Users
and Service Providers and the more complex measurement needs of NEMs.This robust
solution establishes offers a common platform and language that enables NEMs,
End Users, Service Providers, and industry test labs to measure network
performance in a common language.
The Company's strategy is to strengthen and expand its market leadership in
developing, manufacturing and marketing network performance measurement systems.
Key elements of this strategy include: (i) capitalizing on rapid technological
change by creating network performance measurement systems for new network
technologies as they emerge; (ii) leveraging its key relationships with industry
test labs, networking publications, and NEM customers to be first to market with
new industry standard performance measurement solutions; (iii) further
penetrating its existing NEM customer base by increasing sales to multiple
functional departments within its installed base and (iv) further expanding its
customer base into the End User and Service Provider markets, as well as into
new international markets by increasing the Company's promotional and marketing
efforts.
The Company's offices are located at 20550 Nordhoff Street, Chatsworth,
California 91311, and its telephone number is (818) 700-5100. The Company was
incorporated in California on August 7, 1989 and reincorporated in Delaware in
June 1998. Unless the context otherwise requires the terms "Netcom" and the
"Company" refer to Netcom Systems, Inc. and its wholly-owned subsidiaries,
Netcom Systems Europe S.A.R.L. ("Netcom Systems Europe") and Netcom (Barbados)
Limited. Information contained on the Company's Web site does not constitute
part of this prospectus.
EXCEPT AS SET FORTH IN THE FINANCIAL STATEMENTS AND THE NOTES THERETO OR AS
OTHERWISE INDICATED, ALL INFORMATION IN THIS PROSPECTUS ASSUMES (I) A
TWO-FOR-ONE FORWARD STOCK SPLIT OF THE COMPANY'S COMMON STOCK TO BE EFFECTED
PRIOR TO THE CLOSING OF THE OFFERINGS, INCLUDING SHARE AND PER SHARE
INFORMATION, (II) THE FILING AND EFFECTIVENESS UPON CLOSING THE OFFERINGS OF THE
COMPANY'S RESTATED CERTIFICATE OF INCORPORATION AUTHORIZING A CLASS OF
UNDESIGNATED PREFERRED STOCK, (III) THE AUTOMATIC CONVERSION OF ALL OUTSTANDING
SHARES OF THE COMPANY'S CLASS B CONVERTIBLE PREFERRED STOCK INTO COMMON STOCK
UPON THE CLOSING OF THE OFFERINGS, (IV) THE REDEMPTION OF ALL OUTSTANDING SHARES
OF THE COMPANY'S CLASS A REDEEMABLE PREFERRED STOCK UPON THE CLOSING OF, AND
WITH THE PROCEEDS OF, THE OFFERINGS, AND (V) NO EXERCISE OF THE UNDERWRITERS'
OVER-ALLOTMENT OPTIONS. SEE "DESCRIPTION OF CAPITAL STOCK" AND "UNDERWRITING".
4
THE OFFERINGS
The offering of 9,920,000 shares initially being offered in the United
States (the "U.S. Offering") and the concurrent offering of 2,480,000 shares of
Common Stock initially being offered outside the United States (the
"International Offering") are collectively referred to herein as the
"Offerings". The closing of the International Offering is conditioned upon the
closing of the U.S. Offering and vice versa. See "Underwriting".
Common Stock offered by the Company
U.S. Offering.................................... 8,000,000
International Offering........................... 2,000,000
Common Stock offered by the Selling Stockholders
U.S. Offering.................................... 1,920,000
International Offering........................... 480,000
Common Stock to be outstanding after the 60,929,218 shares(1)
Offerings........................................
Use of Proceeds.................................... For repayment of senior debt, redemption of redeemable
preferred stock and working capital and other general
corporate purposes, including sales and marketing,
manufacturing and capital expenditures. See "Use of
Proceeds".
Proposed Nasdaq National Market symbol............. "NTCM"
SUMMARY FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE
MONTHS
ENDED
MARCH 31,
YEAR ENDED DECEMBER 31, (UNAUDITED)
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1993 1994 1995 1996 1997 1997
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CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenues................................................... $ 663 $ 2,080 $ 9,053 $ 27,454 $ 56,273 $ 10,115
Gross profit............................................... 361 1,744 7,787 24,198 49,025 8,952
Operating expenses:
Research and development................................. 151 446 833 1,681 3,527 748
Sales and marketing...................................... 65 193 844 1,466 3,713 540
General and administrative............................... 143 365 1,262 1,342 3,452 753
Income from operations..................................... 5 740 4,848 19,709 38,333 6,911
Net income................................................. $ 3 $ 483 $ 2,958 $ 11,811 $ 22,796 $ 4,296
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Pro forma basic net income per common share(2)............. $ 0.72
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Pro forma weighted average number of common shares
outstanding(2)........................................... 31,837
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Pro forma diluted net income per common share(2)........... $ 0.68
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Pro forma weighted average number of common shares and
common equivalent shares outstanding(2).................. 33,657
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1998
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CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenues................................................... $ 18,011
Gross profit............................................... 14,963
Operating expenses:
Research and development................................. 1,662
Sales and marketing...................................... 2,271
General and administrative............................... 776
Income from operations..................................... 10,254
Net income................................................. $ 5,648
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Pro forma basic net income per common share(2)............. $ 0.11
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Pro forma weighted average number of common shares
outstanding(2)........................................... 50,925
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Pro forma diluted net income per common share(2)........... $ 0.10
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Pro forma weighted average number of common shares and
common equivalent shares outstanding(2).................. 58,772
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MARCH 31, 1998 (UNAUDITED)
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ACTUAL AS ADJUSTED(3)
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CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents.............................................................. $ 24,390 $ 33,840
Working capital........................................................................ 28,836 40,786
Total assets........................................................................... 42,805 52,255
Long-term debt, net of current portion................................................. 47,500 --
Redeemable preferred stock............................................................. 50,255 --
Stockholders' equity (deficit)......................................................... (66,111) 44,639
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(1) Based on the number of shares outstanding as of March 31, 1998. Excludes
16,329,462 shares of Common Stock reserved for issuance under the Company's
1993 Stock Plan, 1997 Stock Plan and 1998 Stock Plan, and an additional
1,600,000 shares of Common Stock reserved for issuance under options granted
outside of the Company's stock plans. As of March 31, 1998, options to
purchase 12,069,462 shares at a weighted average exercise price of $0.78
were outstanding. See "Management-Stock Plans" and Note 12 of Notes to
Consolidated Financial Statements included elsewhere in this Prospectus.
(2) See Note 14 of Notes to Consolidated Financial Statements included elsewhere
in this Prospectus for an explanation of the determination of the number of
shares used in computing per share data. The pro forma data is unaudited.
(3) As adjusted reflects the conversion of all outstanding shares of Class B
Preferred Stock to Common Stock and the redemption of all outstanding shares
of Class A Redeemable Preferred Stock upon the closing of the Offerings, the
sale of Common Stock offered by the Company hereby and the application of
the estimated net proceeds therefrom.
5
RISK FACTORS
AN INVESTMENT IN THE SHARES OF COMMON STOCK OFFERED BY THIS PROSPECTUS
INVOLVES A HIGH DEGREE OF RISK. IN ADDITION TO THE OTHER INFORMATION IN THIS
PROSPECTUS, THE FOLLOWING FACTORS SHOULD BE CONSIDERED CAREFULLY IN EVALUATING
AN INVESTMENT IN THE SHARES OF COMMON STOCK OFFERED HEREBY. THIS PROSPECTUS
CONTAINS FORWARD-LOOKING STATEMENTS WHICH INVOLVE RISKS AND UNCERTAINTIES. THE
COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE
FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS, INCLUDING THOSE SET
FORTH BELOW AND ELSEWHERE IN THIS PROSPECTUS. SEE "GLOSSARY OF TERMS" FOR
DEFINITIONS OF VARIOUS ACRONYMS AND TECHNICAL TERMS USED IN THIS PROSPECTUS.
DEPENDENCE ON SALES TO NETWORK EQUIPMENT MANUFACTURERS
To date, the Company has sold a substantial majority of its products to a
limited number of NEMs and has derived the majority of its sales from repeat NEM
customers. For 1997, 89.7% of the Company's domestic revenues were from sales to
NEMs. In each of 1995, 1996 and 1997, the Company's four largest customers were
Bay Networks, Cisco, 3Com and Cabletron, although the relative ordering of these
four customers has varied from year to year. For 1995, 1996 and 1997, these four
customers collectively accounted for 56.6%, 48.9% and 42.7%, respectively, of
the Company's revenues. The Company believes that sales to a limited number of
NEMs, such as Bay Networks, Cisco, 3Com and Cabletron, will continue to
represent a significant portion of its future revenues. There are only a small
number of NEMs, and the number of these manufacturers may decrease due to
industry consolidation. Accordingly, the loss of any significant NEM customer,
or the reduction, delay or cancellation of orders or a delay in shipment of the
Company's products to any such customer would have a material adverse effect on
the Company's business, results of operations or financial condition.
The Company's dependence on substantial orders from a limited number of NEMs
makes the relationship between the Company and each such manufacturer critical
to the Company's business. As relationships evolve over time, adjustments to
product specifications, forecasts and delivery timetables may be required in
response to customer demands and expectations. The inability of the Company to
satisfy customer requirements or manage its customer relationships successfully
would have a material adverse effect on the Company's business, results of
operations and financial condition. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Business-- Sales and
Marketing".
RISKS ASSOCIATED WITH RAPID TECHNOLOGICAL CHANGE
The market for the Company's products is characterized by rapidly changing
technologies, evolving industry standards, frequent competitive product
introductions and short product life cycles. The Company's success will depend
to a substantial degree upon its ability to enhance its existing products and to
develop and introduce, on a timely and cost-effective basis, new products and
features that meet changing customer requirements and emerging industry
standards. The Company budgets for research and development expenditures based
on planned product introductions and enhancements; however, due to the factors
described above, actual expenditures may significantly differ from budgeted
expenditures. Inherent in the product development process are a number of risks.
The development of new, technologically advanced products is a complex and
uncertain process requiring high levels of innovation, as well as the accurate
anticipation of technology and market trends. The failure of the Company to
develop, in a timely and cost-effective manner, new products or product
enhancements which are responsive to new technologies would result in loss of
revenue or a substantial increase in research and development expense. As a
result, any such failure could have a material adverse effect on the Company's
business, results of operations and financial condition. See "--Fluctuations in
Quarterly Operating Results", "--Risks Associated with New Product
Introductions", "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Business--Research and Development".
6
RISKS ASSOCIATED WITH NEW PRODUCT INTRODUCTIONS
The Company's introduction of new or enhanced products requires it to
effectively manage the transition from older products to newer generation
products in order to minimize disruption in customer ordering patterns, avoid
excessive levels of older product inventories and ensure that adequate supplies
of new products can be delivered to meet customer demand. In the past, the
Company has experienced problems with product transitions. For example, the
Company experienced a decrease in revenues from its layer 2 Fast Ethernet
SmartCards in the three month period ended March 31, 1998, primarily as a result
of the pre-announcement of the Company's new Multi-layer 10/100 Mbps SmartCard.
The Company believes that the pre-announcement of new products is an advisable
practice to preserve customer relationships and, accordingly, expects to
pre-announce products in the future, a practice which may adversely affect sales
of existing products. The inability of the Company to effectively manage future
new product introductions could have a material adverse effect on the Company's
business, results of operations and financial condition.
The Company's new product strategy includes the development of enhanced
functionality for the SmartBits system, including the development of measurement
functionality at higher layers of the OSI protocol stack and greater port
densities. For example, in the first quarter of 1998, the Company introduced its
new ML-7710 SmartCard, as well as new asynchronous transfer mode ("ATM")
products. The Company expects that it will be increasingly dependent upon sales
of these products to sustain or grow its revenues. There can be no assurance
that these products will achieve market acceptance or that sales of these
products will be sufficient to sustain and grow the Company's revenues. The
failure of these products to achieve market acceptance would have a material
adverse effect on the Company's business, results of operations and financial
condition. There can be no assurance that the Company will be successful in new
product development and introductions, that the Company will not experience
delays or unexpected costs in connection with such efforts or that any
enhancements to the SmartBits system will achieve market acceptance. Any failure
of the Company to develop such enhancements or additional new products on a
timely and cost-effective basis or any failure of any such enhancements or
additional new products to achieve market acceptance would have a material
adverse effect on the Company's business, results of operations and financial
condition. In addition, such new enhancements or any new products could have
lower gross margins than existing products, which could have a material adverse
effect on the Company's business, results of operations and financial condition.
See "--Risks Associated with Rapid Technological Change" and "Business--Research
and Development".
The Company's introduction of new or enhanced products may contain
undetected or unresolved software or hardware defects when they are first
introduced or as new versions are released. There can be no assurance that,
despite extensive testing by the Company, design defects will not be found in
new products or upgrades after commencement of commercial shipments, resulting
in additional costs to the Company, reduced acceptance of the Company's products
or damage to the Company's reputation and relationships with its customers and
industry experts. Future delays in the introduction or shipment of new or
enhanced products, the inability of such products to gain market acceptance or
problems associated with new product transitions or introductions could have a
material adverse effect on the Company's business, results of operations and
financial condition.
DEPENDENCE ON SMARTBITS PLATFORM AND NETWORKING INDUSTRY
The Company's SmartBits platform presently provides virtually all of the
Company's revenues. The Company does not presently intend to develop any
products other than network performance measurement equipment and software or to
take any other action to reduce the risks associated with any softening or
slowdown in the demand for network performance measurement. Accordingly, a
softening or slowdown in demand for performance measurement tools and, in
particular, the Company's SmartBits system, by NEMs, End Users and Service
Providers would have a material adverse effect on the Company's business,
results of operations and financial condition.
7
The network performance measurement market is heavily influenced by
fluctuations in the networking market. The market for network equipment is
evolving rapidly and is subject to rapid technology and market fluctuations.
There can be no assurance that the increased competition among and escalating
demand for new networking technologies and services will continue in a manner
favorable to the Company or its business strategies. Any increase in competition
in the networking market could result in increased pressure on the Company to
reduce prices and could result in a reduction in the Company's revenues or a
decrease in the Company's margins, each of which could have a material adverse
effect on the Company's business, results of operations and financial condition.
FLUCTUATIONS IN QUARTERLY OPERATING RESULTS
Due to the emerging and evolving nature of the markets for the Company's
products and the likelihood of increased competition, there can be no assurance
that growth of the Company's revenues will continue or that the Company will
sustain its gross margin or profitability in the future. As a result of changes
in computer networking technology, the Company believes that sales of its
existing products and, in particular, its layer 2 Ethernet and Token Ring
performance measurement products, will decline in future periods. To the extent
that a decline in revenues of these products is not offset by sales of newer and
future products, the Company's business, operating results and financial
condition would be materially and adversely affected. The Company's quarterly
operating results could also be adversely affected by a wide variety of factors
including the following: (i) changes in the demand for the Company's products;
(ii) the timing, composition and size of orders from the Company's customers,
including the possibility that significant bookings will occur in the last month
of each quarter; (iii) spending patterns and budgetary resources of the
Company's customers; (iv) the success or failure of the Company's efforts to
create new customers; (v) introductions or enhancements of products, or delays
in the introductions or enhancements of products, by the Company, its
competitors or NEMs; (vi) price competition; (vii) the ability of the Company to
provide product features required by NEMs and other customers; (viii) product
flaws that cannot be detected or remedied in a timely manner; (ix) shortages of
critical components; (x) the growth or decline of network usage; (xi) the
ability of the Company to hire and retain additional sales and marketing
personnel and technical employees such as development and support engineers;
(xii) consolidation in the computer networking industry; (xiii) the mix of
distribution channels employed by the Company; (xiv) seasonality and general
economic conditions; (xv) the publication of opinions about the Company and its
products, or its competitors and their products, by industry analysts or others
and (xvi) pricing pressure from NEMs due to competition and pricing pressure
from NEM customers. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."
DIFFICULTY FORECASTING SALES
The Company typically operates with little or no backlog. In addition, the
sales cycle for the Company's products is generally not longer than sixty days
and can be only a few days. Furthermore, customers may cancel orders or change
delivery schedules without significant penalties. As a result, quarterly sales
and operating results generally depend on the volume and timing of, and ability
to fulfill, orders received within the quarter, which are difficult to forecast.
A significant portion of the Company's spending, including rent, headcount and
capital lease expenditures, is relatively fixed in advance based on the
Company's forecasts of future sales. If sales are below expectations in any
given quarter, the adverse impact of the shortfall on the Company's quarterly
operating results may be magnified by the Company's inability to adjust spending
to compensate for the shortfall. The Company anticipates that its operating
expenses will substantially increase. In the absence of a corresponding increase
in sales of the Company's products, this increase would have an adverse effect
on the Company's quarterly operating results. Accordingly, there can be no
assurance that the Company will be able to sustain profitability in the future,
particularly on a quarter-to-quarter basis or that the Company will not
experience material fluctuations in quarterly operating results. As a result, it
is possible that the Company's
8
future quarterly operating results may fall below the expectations of analysts
and investors which, in turn, would likely have a material adverse effect on the
price of the Company's Common Stock. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations".
RISKS ASSOCIATED WITH ENTRY INTO NEW AND UNFAMILIAR CUSTOMER MARKETS
The Company's future growth is dependent upon sales to End Users and Service
Providers from which the Company derived 10.3% of its domestic revenues in 1997.
To enter into and compete in the performance measurement markets for End Users
and Service Providers, the Company will be required to develop new products and
enhancements to existing products and to expand its sales, marketing and
customer support capabilities, each of which will result in substantial
increases in operating expenses. Many of the Company's potential competitors
have substantially greater resources, name recognition and experience than the
Company, as well as established relationships with many of the Company's
potential End User and Service Provider customers. Failure of the Company to
increase sales in these new markets would have a material adverse effect on the
Company's business, results of operations and financial condition. See
"--Competition".
COMPETITION
The Company's principal and potential competitors include NEMs that develop
in-house products; test equipment manufacturers such as The Hewlett-Packard
Company ("Hewlett-Packard"), Fluke Corporation and Tekelec; new start-up
enterprises focused on network performance measurement such as IXIA
Communications; companies specializing in ATM (LAN and/or WAN) performance
testing such as Adtech, Inc. and RADCOM Ltd.; software based network traffic
simulators such as Ganymede Software Inc. and Optimal Networks Corporation; and
other companies that sell networking products with functionality complementary
to SmartBits, such as Network Associates, Inc. Competitive factors in the
network performance testing and measurement market include the breadth of
product features, conformity to industry-standard protocols, pricing, product
quality, reliability and functionality, marketing and sales resources, customer
service and support and reputation. Many of the Company's competitors and
potential competitors have greater resources, name recognition and sales
capabilities than the Company. Increased competition could result in price
reductions, reductions in gross margins, the inability of the Company to
increase market share, or a loss of market share by the Company, any of which
would adversely affect the Company's business, results of operations and
financial condition. There can be no assurance that the Company's current and
future competitors will not develop or market technologies and products that
offer higher performance and are more cost-effective than the Company's current
or future products, thereby rendering the Company's technologies and products
obsolete.
DEPENDENCE ON RELATIONSHIPS WITH INDUSTRY EXPERTS
The Company has established relationships with several industry experts in
the field of network performance. These experts have established standard
testing methodologies that evaluate new network equipment products and
technologies. Accordingly, the Company believes that these relationships are
critical for maintaining its industry credibility and developing new products
reflecting new technologies and testing methodologies in a timely fashion. There
can be no assurance that the Company will be able to maintain these
relationships or that the Company's competitors, including new entrants, will
not seek and obtain relationships with these or other industry experts, any of
which could have a material adverse effect on the Company's business, results of
operations and financial condition.
9
RISKS ASSOCIATED WITH RELIANCE ON DISTRIBUTORS
For the year ended December 31, 1997 and for the three months ended March
31, 1998, sales through international distributors generated approximately 20.4%
and 17.6%, respectively, of the Company's revenues. Accordingly, the Company is
dependent upon the continued viability and financial stability of its
distributors. While the Company maintains contractual relationships with most of
its distributors, these contracts generally do not require a distributor to
purchase the Company's products and, in some cases, may be terminated by a
distributor at any time without penalty. There can be no assurance that any of
the Company's distributors will continue to market the Company's products. In
addition, the Company may, from time to time, terminate some of its
relationships with distributors and any such termination could have a negative
impact on the Company's business and result in threatened or actual litigation.
There can be no assurance that any future termination of a distributor would not
have a negative impact on the Company's business, that such termination would
not result in a lawsuit or that the Company would be successful in defending
itself in such a lawsuit. Certain of the Company's distributors manufacture
products with functionality complementary in some respects to SmartBits, and, as
such, are potential competitors of the Company's. These distributors may, in the
future, enhance such products or develop new products to compete directly with
the Company. In such event, these distributors would likely cease to distribute
the Company's products. In addition, these distributors possess confidential
information concerning the Company's products, product release schedules, and
sales, marketing and distribution operations. Although the Company's contracts
with its distributors contain confidentiality provisions, there can be no
assurance that any such distributor would not use such information in
competition with the Company or otherwise. Any failure of the Company's
distributors to successfully market and sell the Company's products for these or
any other reasons would have a material adverse effect on the Company's
business, financial condition and results of operation. See "-- Risks Associated
with International Sales" and "Business--Sales and Marketing".
DEPENDENCE ON CONTRACT MANUFACTURERS AND SINGLE-SOURCE SUPPLIERS
The Company's manufacturing operations consist primarily of materials
planning and procurement, quality control, final assembly and testing of its
products. The Company designs all of the hardware subassemblies for its products
and uses the services of contract manufacturers to build these subassemblies and
certain products to the Company's specifications. The Company also is dependent
upon single or limited source suppliers for a number of components and parts
used in the Company's products, including certain key microprocessors and
integrated circuits. There can be no assurance that these contract manufacturers
and suppliers will be able to meet the Company's future requirements for
manufactured products, components and subassemblies. The Company generally
purchases single or limited source components pursuant to purchase orders and
has no guaranteed supply arrangements with these suppliers. The availability of
many of these components is dependent in part on the Company's ability to
provide its suppliers with accurate forecasts of its future requirements. The
Company's ability to make accurate forecasts is complicated by the typically
short product life cycles and customer lead times for its products. The Company
purchases certain components from foreign suppliers, the supply of which could
be adversely affected by changing tariff and regulatory structures, particularly
those affecting the import and export of electronics and technology. Any
interruption in the supply of any of the key components currently obtained from
a single or limited source could disrupt the Company's operations and have a
material adverse effect on the Company's business, results of operations and
financial condition in any given period. In addition, any increases in component
costs could also have a material adverse effect on the Company's business,
results of operations and financial condition. See "Business--Manufacturing".
10
RISKS ASSOCIATED WITH THE MANAGEMENT OF EXPANDING OPERATIONS
The Company has recently experienced rapid growth and a significant
expansion in the number of its employees and the scope and complexity of its
operating and financial systems. Netcom Systems increased the number of its
employees from 48 to 140 individuals during the 12 months ended April 30, 1998.
Such growth has placed and, if sustained, will continue to place, a significant
strain upon the Company's management, operations, financial systems and
resources. The Company believes that it must expand its manufacturing, research
and development, marketing, sales and customer support capabilities in order to
effectively serve the evolving needs of its present and future customers. In
particular, the Company needs to hire additional sales and technical personnel.
The failure by the Company to hire additional qualified personnel in a timely
manner and on reasonable terms could have a material adverse effect on the
Company's business, results of operations and financial condition. In addition,
if the Company is to achieve its business objectives in the future, it must both
successfully train and retain the members of its existing sales force, research
and development staff and customer support staff, as well as recruit additional
such personnel. Competition for such persons is intense and there can be no
assurance that the Company will be able to either retain and adequately train
its current staff or attract qualified personnel in the future. See
"--Dependence on Key Personnel".
RISKS ASSOCIATED WITH INTERNATIONAL SALES
International sales accounted for approximately 26.1% and 26.3% of the
Company's revenues in 1997 and the three month period ended March 31, 1998,
respectively. The Company expects that international sales will continue to
account for a significant portion of its revenues in future periods. Although
the Company sells products directly in certain European countries, the Company
is substantially dependent on distributors for its international sales. The loss
of certain distributors could have a material adverse effect on the Company's
business, results of operations and financial condition. In addition, sales in
many foreign markets are adversely affected by local holidays and customary
vacation times, such as during the third quarter in Europe, which cause
customers in such markets to reduce their business activities. The Company
intends to enter into additional international markets and to continue to expand
its operations outside of the United States by adding resellers and
international sales and support personnel and pursuing additional strategic
relationships which will require significant management attention and
expenditure of significant financial resources. To the extent that the Company
is unable to make additional international sales in a timely manner, the
Company's growth, if any, in international sales will be limited, and the
Company's business, financial condition and results of operations would be
materially and adversely affected. Sales to international customers are subject
to additional risks including longer receivables collection periods, increased
exposure to bad debt write-offs, political and economic instability,
nationalization, trade restrictions, the impact of possible recessionary
environments in economies outside the United States, reduced protection for
intellectual property rights in some countries, currency fluctuations and tariff
regulations and requirements for export licenses. To the extent the export or
import of the Company's products is prohibited by the domestic laws of the
United States or any foreign country in which the Company does business, or
uncertainty relating to such laws limit the Company's ability to market its
products internationally, the Company could lose a substantial portion of its
international sales. There can be no assurance that foreign intellectual
property laws will adequately protect the Company's intellectual property
rights. In addition, effective copyright and trade secret protection may be
unavailable or limited in certain foreign countries. These international factors
could have a material adverse effect on future sales of the Company's products
to international customers and, consequently, the Company's business, results of
operations and financial condition. See "--Dependence on Proprietary
Technology".
Portions of the Company's international sales are currently denominated in
French francs. Accordingly, fluctuations in currency exchange rates could cause
the Company's products to become relatively more expensive to customers in a
particular country, leading to a reduction in sales or profitability in that
11
country. The Company does not engage in any hedging activities to reduce its
currency exposure. These factors could have a material adverse effect on the
Company's business, results of operations and financial condition. See "--Risks
Associated with Reliance on Distributors", "Management's Discussion and Analysis
of Financial Condition and Results of Operations" and "Business--Marketing and
Sales".
DEPENDENCE ON KEY PERSONNEL
The Company's success depends on the continuing contributions of its key
personnel, all of whom would be difficult to replace. The Company's future
success will depend, in part, upon its ability to attract and retain highly
qualified personnel. There can be no assurance that the Company will be
successful in hiring or retaining qualified personnel. Loss of, or the inability
to hire, key personnel or consultants could have a material adverse effect on
the Company's business, results of operations and financial condition. See
"--Risks Associated with the Management of Expanding Operations" and
"Management".
DEPENDENCE ON PROPRIETARY TECHNOLOGY
The Company's future success and ability to compete is dependent in part
upon its proprietary technology. The Company relies on a combination of
contractual rights, trade secrets and copyright laws to establish and protect
its proprietary technology. The Company generally enters into confidentiality
agreements with its employees, consultants, resellers, customers and potential
customers, strictly limits access to and distribution of its source code, and
further limits the disclosure and use of other proprietary information. There
can be no assurance that the steps taken by the Company in this regard will be
adequate to prevent misappropriation of its technology or that the Company's
competitors will not independently develop technologies that are substantially
equivalent or superior to the Company's technology. In addition, the laws of
some foreign countries do not protect the Company's proprietary rights to the
same extent as do the laws of the United States.
The Company is also subject to the risk of adverse claims and litigation
alleging infringement of the intellectual property rights of others. There can
be no assurance that third parties will not assert infringement claims in the
future with respect to the Company's current or future products. Any such
assertion, regardless of its merit, could require the Company to pay damages or
settlement amounts and could require the Company to develop non-infringing
technology or acquire licenses to the technology that is the subject of asserted
infringement, resulting in product delays, increased costs or both. In addition,
the cost of any such litigation and the resulting distraction of the Company's
management resources could have a material adverse effect on the Company's
business, results of operations or financial condition. No assurance can be
given that any necessary licenses will be available or that, if available, such
licenses can be obtained on commercially reasonable terms. The failure of the
Company to adequately obtain such licenses, or to protect its own proprietary
technology through contractual rights, trade secrets, patent and copyrights
laws, could have a material adverse effect on the Company's business, results of
operations and financial condition. See "Business--Proprietary Rights".
CONTROL BY EXISTING STOCKHOLDERS
Following the Offerings, certain holders of the Company's outstanding
capital stock associated with the Company's recapitalization in the third
quarter of 1997 will beneficially own approximately 79.6% of the Company's
Common Stock (approximately 76.6% if the Underwriters' over-allotment options
are exercised in full). In addition, these holders, who include certain members
of the Company's senior management team, have entered into a Shareholder's
Agreement pursuant to which they have agreed to vote their shares together to
elect certain representatives to the Company's Board of Directors and to
maintain the number of the Company's authorized directors at six. Accordingly,
these stockholders will be able to elect all of the Company's directors, will
retain the voting power to approve all matters requiring stockholder approval
and will continue to have significant influence over the affairs of the
12
Company. This concentration of ownership could have the effect of delaying or
preventing a change in control of the Company. See "Principal and Selling
Stockholders" and "Certain Transactions".
RISKS ASSOCIATED WITH YEAR 2000 PROBLEM
Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field. These date code fields
will need to accept four digit entries to distinguish 21st century dates from
20th century dates. As a result, in less than two years, computer systems or
software used by many companies may need to be upgraded to become compliant with
such "Year 2000" requirements. The Company generally warrants and has
represented to its customers that its products are free from Year 2000 defects.
There can be no assurance that the Company's products or third party computer
products used by the Company are Year 2000 compliant. Any failure of the
Company's products to be Year 2000 compliant could result in the loss of or
delay in market acceptance of the Company's products and services, increased
service and warranty costs to the Company or payment by the Company of
compensatory or other damages. In addition, any failure of third party computer
products used by the Company, including the Company's key accounting, inventory
and payroll systems, to be Year 2000 compliant could interrupt and disrupt the
Company's business. To fix such systems could require the Company to invest
substantially in its operating systems and to hire additional personnel. Any
failure of the Company's products or internal systems to address the issues
associated with the Year 2000 could have a material adverse effect on the
Company's business, results of operations and financial condition.
RISKS ASSOCIATED WITH POSSIBLE ACQUISITIONS
As a part of its business strategy, the Company expects to make acquisitions
of, or significant investments in, complementary companies, products or
technologies, although no such acquisitions or investments are currently
pending. Any such future acquisitions would be accompanied by the risks commonly
encountered in acquisitions of companies. Such risks include, among other
things, the difficulty of assimilating the operations and personnel of the
acquired companies, the potential disruption of the Company's ongoing business,
the inability of management to maximize the financial and strategic position of
the Company through the successful incorporation of acquired technology and
rights into the Company's products and services, additional expense associated
with amortization of acquired intangible assets, the maintenance of uniform
standards, controls, procedures and policies and the impairment of relationships
with employees and customers as a result of any integration of new management
personnel. There can be no assurance that the Company would be successful in
overcoming these risks or any other problems encountered in connection with any
such acquisitions. In addition, the Company cannot presently account for any
acquisition as a pooling of interests. As a result, should the Company complete
any acquisition it would likely be required to amortize goodwill related to such
acquisition which could adversely affect the Company's results of operations. In
addition, the fact that the Company cannot be a party to an acquisition
transaction accounted for as a pooling of interests could discourage a third
party from attempting to acquire control of the Company. See "--Certain Anti-
Takeover Provisions" and "Use of Proceeds".
PROCEEDS TO BE USED TO REDEEM PREFERRED STOCK AND REPAY INDEBTEDNESS
The net proceeds to the Company from the sale of the 10,000,000 shares of
Common Stock being offered by the Company hereby are estimated to be
approximately $110.8 million ($111.7 million if the Underwriters' over-allotment
options are exercised in full), assuming the shares offered hereby are sold at a
public offering price of $12.00 per share and after deduction of the estimated
underwriting discount and estimated offering expenses. The Company will not
receive any of the proceeds from the sale of the shares of Common Stock offered
by the Selling Stockholders. The Company intends to use approximately $50.0
million of the proceeds of the initial public offering to repay indebtedness
under the
13
Company's term credit facility and intends to use an additional approximately
$51.3 million of such proceeds to redeem all outstanding shares of the Company's
Class A Redeemable Preferred Stock. The Company will use any remaining proceeds
from the Offerings for general corporate purposes, including working capital and
as a result, the Company's management will have broad discretion to allocate
this portion of the proceeds of the Offerings and to determine the timing of
expenditures. See "Use of Proceeds".
NO DIVIDENDS
Although the Company has paid dividends on its Common Stock in the past, it
does not anticipate paying any dividends upon its Common Stock in the
foreseeable future. See "Dividend Policy".
NO PRIOR PUBLIC TRADING MARKET
Prior to the Offerings, there has been no public market for the Common
Stock, and there can be no assurance that an active trading market will develop
or, if one does develop, that it will be maintained. The initial public offering
price, which will be established by negotiations between the Company and the
Underwriters, may not be indicative of the market price of the shares of Common
Stock after the Offerings. See "Underwriting".
POSSIBLE VOLATILITY OF STOCK PRICE
The equity markets, particularly the market for technology corporations,
recently have experienced significant price and volume fluctuations that are
unrelated to the operating performance of individual companies. These broad
market fluctuations may adversely affect the market price of the Common Stock.
In addition, the market price of the shares of Common Stock is likely to be
highly volatile. Factors such as fluctuations in the Company's operating
results, announcements of technological innovations or new products by the
Company or its competitors, developments with respect to patents or proprietary
rights, announcement of litigation by or against the Company, changes in stock
market analyst recommendations regarding the Company or its competitors, and
general market conditions may have a significant effect on the market price of
the Common Stock.
CERTAIN ANTI-TAKEOVER PROVISIONS
Certain provisions of the Company's Certificate of Incorporation and Bylaws
may have the effect of making it more difficult for a third party to acquire, or
of discouraging a third party from attempting to acquire, control of the
Company. Such provisions could limit the price that certain investors might be
willing to pay in the future for shares of the Company's Common Stock. Certain
of these provisions provide for a classified board of directors, eliminate
cumulative voting in the election of directors and restrict the Company's
stockholders from acting by written consent. In addition, upon completion of
this offering, the Company's Board of Directors will have the authority to issue
up to 10,000,000 shares of preferred stock and to determine the price, rights,
preferences, privileges and restrictions, including voting rights, of those
shares without any further vote or action by the stockholders. The rights of the
holders of Common Stock will be subject to, and may be adversely affected by,
the rights of the holders of any preferred stock that may be issued in the
future. The issuance of preferred stock, while providing flexibility in
connection with possible financings or acquisitions or other corporate purposes,
could have the effect of making it more difficult for a third party to acquire a
majority of the outstanding voting stock of the Company. The Company has no
current plans to issue shares of preferred stock. The Company's Certificate of
Incorporation, Bylaws and indemnity agreements provide that the Company will
indemnify officers and directors against losses they may incur in legal
proceedings resulting from their service to the Company. These provisions may
make it more difficult for stockholders to take certain corporate actions and
could have the effect of delaying or preventing a change in control of the
Company. In addition, the Company cannot presently be a party to an acquisition
transaction accounted for as a
14
pooling of interests which could discourage a third party from attempting to
acquire control of the Company. See "--Risks Associated with Possible
Acquisitions".
SHARES ELIGIBLE FOR FUTURE SALE
Sales of Common Stock (including shares issued upon the exercise of
outstanding options) in the public market after the Offerings could materially
and adversely affect the market price of the Common Stock. Such sales also might
make it more difficult for the Company to sell equity securities or equity-
related securities in the future at a time and price that the Company deems
appropriate. Upon completion of the Offerings (based on shares outstanding at
March 31, 1998), the Company will have outstanding an aggregate of 60,929,218
shares of Common Stock, assuming no exercise of the Underwriters' over-allotment
options and no exercise of outstanding options. Of these shares, all of the
shares sold in the Offerings will be freely tradeable without restriction or
further registration under the Securities Act of 1933, as amended (the
"Securities Act"), unless such shares are purchased by "affiliates" of the
Company as that term is defined in Rule 144 under the Securities Act (the
"Affiliates"). The remaining 48,529,218 shares of Common Stock held by existing
stockholders and 938,666 shares subject to outstanding vested options (as of
March 31, 1998) are "restricted securities" as that term is defined in Rule 144
under the Securities Act ("Restricted Shares"). Restricted Shares may be sold in
the public market only if registered or if they qualify for an exemption from
registration under Rules 144 or 701 promulgated under the Securities Act. As a
result of the contractual restrictions described below and the provisions of
Rules 144 and 701, the Restricted Shares will be available for sale in the
public market as follows: (i) no shares will be eligible for immediate sale on
the date of this Prospectus; and (ii) 52,880,198 shares will be eligible for
sale upon expiration of the lock-up agreements 180 days after the date of this
Prospectus. All officers, directors, stockholders and certain option holders of
the Company have agreed not to offer, pledge, sell, contract to sell, grant any
option, right or warrant to purchase, or otherwise transfer or dispose of,
directly or indirectly (or enter into any swap or other arrangement that
transfers to another, in whole or in part, any of the economic consequences of
ownership of), any shares of Common Stock or any securities convertible into or
exercisable or exchangeable for shares of Common Stock, for a period of 180 days
after the date of this Prospectus, without the prior written consent of the
Underwriters. The Company intends to file a registration statement on Form S-8
which would allow shares issuable upon exercise of options previously granted to
be freely tradeable following release of such lock-up obligations, subject to
compliance with Rule 144 in the case of affiliates of the Company. See "Shares
Eligible for Future Sale".
IMMEDIATE AND SUBSTANTIAL DILUTION
Purchasers of the Common Stock offered hereby will suffer an immediate and
substantial dilution of $11.27 per share in the net tangible book value of the
Common Stock from the initial public offering price of $12.00 per share. To the
extent outstanding options to purchase the Company's Common Stock are exercised,
there will be further dilution. See "Dilution".
15
USE OF PROCEEDS
The net proceeds to the Company from the sale of the 10,000,000 shares of
Common Stock being offered by the Company hereby are estimated to be
approximately $110.8 million assuming the shares offered hereby are sold at a
public offering price of $12.00 per share and after deduction of the estimated
underwriting discount and estimated offering expenses ($111.7 million if the
Underwriters' over-allotment options are exercised in full). The Company will
not receive any of the proceeds from the sale of the shares of Common Stock
offered by the Selling Stockholders.
The Company intends to use approximately $50.0 million of the proceeds of
the Offerings to repay indebtedness under the Company's term credit facility and
intends to use an additional approximately $51.3 million of such proceeds to
redeem all outstanding shares of the Company's Class A Redeemable Preferred
Stock. Following the proposed redemption, none of such shares will be
outstanding. The other purposes of the Offerings are to obtain additional
working capital, to create a public market for the Common Stock, to facilitate
future access by the Company to public capital markets and to enhance the
Company's ability to use its Common Stock as consideration for acquisitions and
as a means of attracting and retaining key employees. Following the repayment of
debt and redemption described above, the Company expects to use the remaining
net proceeds of the Offerings for general corporate purposes including sales and
marketing, hiring of additional consultants and staff, and working capital. The
Company may also use a portion of such net proceeds to fund capital expenditures
and acquisitions of products, technologies or businesses that are related, or
complementary to the Company's business. Although the Company has no present
agreements or commitments and is not currently engaged in any negotiations with
respect to any such transactions, the Company from time to time evaluates such
opportunities. Pending use of such net proceeds for the foregoing purposes, the
Company intends to invest such net proceeds in investment grade interest bearing
marketable securities. See "Risk Factors--Risks Associated with Possible
Acquisitions" and "--Proceeds to be Used to Redeem Preferred Stock and Repay
Indebtedness".
DIVIDEND POLICY
Although the Company declared a $2.7 million dividend on its Common Stock in
1996 and repurchased shares of its Common Stock in connection with its
recapitalization in the third quarter of 1997, in the future, the Company
intends to retain earnings, if any, and will not pay cash dividends for the
foreseeable future. See "Certain Transactions". In addition, the Company's
credit facility limits the ability of the Company to declare and pay dividends.
Any future determination to pay cash dividends will be at the discretion of the
Board of Directors and will be dependent upon the Company's financial condition,
results of operations, capital requirements, general business conditions and
such other factors as the Board of Directors may deem relevant. See "Risk
Factors--No Dividends" and "Certain Transactions".
16
CAPITALIZATION
The following table sets forth as of March 31, 1998, (i) on an actual basis
and (ii) as adjusted to reflect the conversion of all outstanding shares of
Class B Convertible Preferred Stock into 45,806,872 shares of Common Stock, the
redemption of all outstanding shares of Class A Redeemable Preferred Stock upon
the closing of the Offerings and the sale of 10,000,000 shares of Common Stock
offered by the Company hereby and the application of the estimated net proceeds
therefrom. This table should be read in conjunction with the Company's Financial
Statements and Notes thereto appearing elsewhere in this Prospectus.
MARCH 31, 1998
--------------------------
ACTUAL AS ADJUSTED
------------ ------------
(IN THOUSANDS)
Long-term debt, net of current portion................................................ $ 47,500 $ --
Class A redeemable preferred stock, $0.001 par value:
Authorized--485,184 shares; Issued and outstanding--485,184 (actual); no shares (as
adjusted)......................................................................... 50,255 --
Stockholders' equity (deficit):.......................................................
Class B convertible preferred stock, $0.001 par value: Authorized-- 45,806,874
shares; Issued and outstanding--45,806,872 shares (actual); no shares (as
adjusted)......................................................................... 48,518 --
Common stock, $0.001 par value: Authorized--200,000,000 shares; Issued and
outstanding--5,122,346 shares (actual); 60,929,218 shares (as adjusted)(1)........ 5 61
Additional paid-in capital.......................................................... 10,092 169,304
Deferred compensation............................................................... (116) (116)
Note receivable for stock purchase.................................................. (120) (120)
Retained deficit.................................................................... (124,443) (124,443)
Cumulative translation adjustments.................................................. (47) (47)
------------ ------------
Total stockholders' equity (deficit).................................................. (66,111) 44,639
------------ ------------
Total capitalization.................................................................. $ 31,644 $ 44,639
------------ ------------
------------ ------------
- ------------------
(1) Excludes 16,329,462 shares of Common Stock reserved for issuance under the
Company's 1993 Stock Plan, 1997 Stock Plan and 1998 Stock Plan, and an
additional 1,600,000 shares of Common Stock reserved for issuance under
options granted outside of the Company's stock plans. As of March 31, 1998,
options to purchase 12,069,462 shares at a weighted average exercise price
of $0.78 were outstanding. See "Management--Stock Plans" and Note 12 of
Notes to Consolidated Financial Statements included elsewhere in this
Prospectus.
17
DILUTION
Pro forma net tangible book value (deficit) per share represents total
assets, less intangible assets and total liabilities, divided by the number of
shares outstanding as of March 31, 1998 (assuming the conversion into Common
Stock of all of the Company's outstanding shares of Class B Convertible
Preferred Stock and the redemption of all of the Company's outstanding shares of
Class A Redeemable Preferred Stock). The Company's pro forma net tangible book
value (deficit) at March 31, 1998 was approximately $(66.1 million) or
approximately $(1.30) per share. Without taking into account any changes in such
net tangible book value per share after March 31, 1998, other than to give
effect to the sale of the shares of Common Stock offered hereby at an assumed
initial public offering price of $12.00 per share and the receipt of the net
proceeds of such sale, the pro forma net tangible book value at March 31, 1998
would have been approximately $44.6 million or approximately $0.73 per share.
This represents an immediate increase in net tangible book value per share of
$2.03 to existing stockholders and an immediate dilution of $11.27 per share to
new investors. The following table sets forth this per share dilution:
Assumed initial public offering price per share...... $ 12.00
Pro forma net tangible book value (deficit) per share
as of March 31, 1998............................... $ (1.30)
Increase per share attributable to new investors..... 2.03
---------
Pro forma net tangible book value per share after the
Offerings.......................................... 0.73
---------
Dilution per share to new investors.................. $ 11.27
---------
---------
The following table summarizes, on a pro forma basis as of March 31, 1998,
the differences between existing stockholders and new investors with respect to
the total number of shares of Common Stock and Class B Convertible Preferred
Stock (all of which Class B Convertible Preferred Stock will be converted into
Common Stock upon the closing of the Offerings) purchased from the Company, the
total consideration paid and the average price per share paid (assuming the sale
of 10,000,000 shares of Common Stock at an initial public offering price of
$12.00 per share).
SHARES PURCHASED TOTAL CONSIDERATION AVERAGE
--------------------------- ----------------------------- PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
-------------- ----------- ---------------- ----------- -----------
Existing stockholders.......................... 50,929,218 83.6% $ 51,197,422 29.9% $ 1.01
New investors.................................. 10,000,000 16.4 120,000,000 70.1 $ 12.00
-------------- ----- ---------------- -----
Total........................................ 60,929,218 100.0% $ 171,197,422 100.0%
-------------- ----- ---------------- -----
-------------- ----- ---------------- -----
The above calculations do not give effect to the exercise of outstanding
options to purchase 12,069,462 shares of Common Stock at a weighted average
exercise price of $0.78 per share outstanding on March 31, 1998. To the extent
that these options become exercisable and are exercised, there will be further
dilution to new investors. See "Risk Factors--Immediate and Substantial
Dilution", "Management--Stock Plans" and "Description of Capital
Stock--Options".
18
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data at December 31, 1996 and
1997 and for each of the years in the three-year period ended December 31, 1997
are derived from consolidated financial statements of the Company that have been
audited by Arthur Andersen LLP, independent public accountants, and are included
elsewhere in this Prospectus. The balance sheet data at December 31, 1995 is
derived from the audited financial statements of the Company that are not
included herein. The statements of operations data for the years ended December
31, 1993 and 1994 and the balance sheet data at December 31, 1993 and 1994 are
derived from unaudited consolidated financial statements not included herein.
The consolidated statement of operations data for the three months ended March
31, 1997 and 1998 and the consolidated balance sheet data at March 31, 1998 are
derived from unaudited consolidated financial statements included elsewhere in
this Prospectus. The historical results are not necessarily indicative of the
operating results to be expected in the future. The following selected
consolidated financial data should be read in conjunction with "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
the Consolidated Financial Statements and Notes thereto included elsewhere in
this Prospectus.
THREE
MONTHS
ENDED
YEAR ENDED DECEMBER 31, MARCH 31,
------------------------------------------------------- ---------
1993 1994 1995 1996 1997 1997
----- --------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenues.................................................. $ 663 $ 2,080 $ 9,053 $ 27,454 $ 56,273 $ 10,115
Cost of goods sold........................................ 302 336 1,266 3,256 7,248 1,163
----- --------- --------- --------- --------- ---------
Gross profit.............................................. 361 1,744 7,787 24,198 49,025 8,952
----- --------- --------- --------- --------- ---------
Operating expenses:
Research and development................................ 151 446 833 1,681 3,527 748
Sales and marketing..................................... 65 193 844 1,466 3,713 540
General and administrative.............................. 143 365 1,262 1,342 3,452 753
----- --------- --------- --------- --------- ---------
Total operating expenses.................................. 359 1,004 2,939 4,489 10,692 2,041
----- --------- --------- --------- --------- ---------
Income from operations.................................... 2 740 4,848 19,709 38,333 6,911
Other income (expense), net............................... 3 6 65 244 (662) 189
----- --------- --------- --------- --------- ---------
Income before provision for income taxes.................. 5 746 4,913 19,953 37,671 7,100
Provision for income taxes................................ 2 263 1,955 8,142 14,875 2,804
----- --------- --------- --------- --------- ---------
Net income................................................ $ 3 $ 483 $ 2,958 $ 11,811 $ 22,796 $ 4,296
----- --------- --------- --------- --------- ---------
----- --------- --------- --------- --------- ---------
Pro forma basic net income per common share(1)............ $ 0.72
---------
---------
Pro forma weighted average number of common shares
outstanding(1).......................................... 31,837
---------
---------
Pro forma diluted net income per common share(1).......... $ 0.68
---------
---------
Pro forma weighted average number of common shares and
common equivalent shares outstanding(1)................. 33,657
---------
---------
1998
---------
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Revenues.................................................. $ 18,011
Cost of goods sold........................................ 3,048
---------
Gross profit.............................................. 14,963
---------
Operating expenses:
Research and development................................ 1,662
Sales and marketing..................................... 2,271
General and administrative.............................. 776
---------
Total operating expenses.................................. 4,709
---------
Income from operations.................................... 10,254
Other income (expense), net............................... (682)
---------
Income before provision for income taxes.................. 9,572
Provision for income taxes................................ 3,924
---------
Net income................................................ $ 5,648
---------
---------
Pro forma basic net income per common share(1)............ $ 0.11
---------
---------
Pro forma weighted average number of common shares
outstanding(1).......................................... 50,925
---------
---------
Pro forma diluted net income per common share(1).......... $ 0.10
---------
---------
Pro forma weighted average number of common shares and
common equivalent shares outstanding(1)................. 58,772
---------
---------
DECEMBER 31,
------------------------------------------------------- MARCH 31,
1993 1994 1995 1996 1997 1998
----- --------- --------- --------- --------- -----------
(IN THOUSANDS)
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents................................ $ 79 $ 469 $ 2,885 $ 9,314 $ 17,708 $ 24,390
Working capital.......................................... 230 716 3,735 12,505 23,767 28,836
Total assets............................................. 370 986 5,683 18,110 34,129 42,805
Long-term debt, net of current portion................... -- -- -- -- 47,500 47,500
Redeemable preferred stock............................... -- -- -- -- 49,520 50,255
Stockholders' equity (deficit)........................... 294 777 3,854 13,014 (71,004) (66,111)
- ------------------
(1) See Note 14 of Notes to Consolidated Financial Statements.
19
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF
OPERATIONS OF THE COMPANY SHOULD BE READ IN CONJUNCTION WITH THE FINANCIAL
STATEMENTS AND THE NOTES THERETO INCLUDED ELSEWHERE IN THIS PROSPECTUS. THIS
PROSPECTUS CONTAINS, IN ADDITION TO HISTORICAL INFORMATION, FORWARD-LOOKING
STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS
COULD DIFFER MATERIALLY FROM THE RESULTS DISCUSSED IN THE FORWARD-LOOKING
STATEMENTS. FACTORS THAT COULD CAUSE OR CONTRIBUTE TO SUCH DIFFERENCES INCLUDE
THOSE DISCUSSED BELOW, AS WELL AS THOSE DISCUSSED ELSEWHERE IN THIS PROSPECTUS.
SEE "RISK FACTORS". SEE "GLOSSARY OF TERMS" FOR DEFINITIONS OF VARIOUS ACRONYMS
AND TECHNICAL TERMS USED IN THIS PROSPECTUS.
OVERVIEW
The Company has been profitable in each of the three years for which its
financial statements were audited. In addition, for each of the Company's 13
quarters for which its financial statements were audited, its revenues have
increased over the prior quarter's results. For the year ended December 31, 1997
and the three months ended March 31, 1998, the Company's revenues were $56.3
million and $18.0 million, respectively.
Netcom Systems is a leading provider of network performance measurement
systems. The Company's flagship platform, SmartBits, evaluates the performance,
reliability, quality of service and proof of service of networking equipment,
such as routers and switches, before deployment on the network. SmartBits allows
users to measure network performance criteria by emulating complex,
multi-protocol networks through generation of accurate, customizable, high speed
flows of network traffic.
The Company realizes revenues primarily from sales of hardware, as well as
from the licensing of related software and software maintenance contracts.
Revenues from hardware and software are generally recognized at the time of
shipment to customers or distributors, net of estimated allowances for product
returns. Maintenance contracts typically call for the Company to provide
technical support and software updates to customers. Maintenance revenues are
deferred and recognized ratably over the term of the maintenance period,
typically one year. Post-contract support obligations are insignificant and are
accrued for at the time of the sale.
The Company markets and sells its products and services through a direct
sales force in the United States, Denmark, U.K., France and Ireland and
indirectly through distributors in Canada, China, Germany, Israel, Italy, Japan,
Korea, the Netherlands, Sweden and Taiwan. Typically, distributors receive a
commission or sales discount off of the international sales price of the
Company's products. Commissions to distributors are payable only after the
Company's receipt of the revenues for such sale. For the year ended December 31,
1997 and for the three month period ended March 31, 1998, approximately 20.4%
and 17.6%, respectively, of the Company's revenues were generated through
distributors. To date, the Company has incurred no bad debt write-offs based on
sales to distributors although there can be no assurance that this will be the
case in the future. See "Risk Factors--Risks Associated with Reliance on
Distributors".
Historically, the Company has sold a substantial majority of its products to
NEMs and has derived the majority of its sales from repeat customers. In
addition, a significant amount of the Company's revenues were historically
generated by the Company's largest customers. For example, in each of 1995, 1996
and 1997, the Company's four largest customers were Bay Networks, Cisco, 3Com
and Cabletron, although the relative ordering of these four customers has varied
from year to year. For 1995, 1996 and 1997, these four customers collectively
accounted for 56.6%, 48.9% and 42.7%, respectively, of the Company's revenues.
Sales to Bay Networks and 3Com accounted for approximately 22.0% and 12.4% of
revenues, respectively, in the year ended December 31, 1995. Sales to Bay
Networks and Cisco accounted for approximately 14.4% and 10.9% of revenues,
respectively, in the year ended December 31, 1996, approximately 10.9% each of
revenues in the year ended December 31, 1997, and approximately 12.8% and 12.1%
of revenues, respectively, in the three month period ended March 31,
20
1998. The Company anticipates that its results of operations in any given period
will continue to depend to a significant extent upon sales to a small number of
customers. As a result of this customer concentration, the Company's revenues
from quarter to quarter may be subject to substantial period-to-period
fluctuations which could have a material adverse effect on the Company's
business, results of operations and financial condition. See "Risk
Factors--Dependence on Sales to Network Equipment Manufacturers."
"--Fluctuations in Quarterly Operating Results" and "--Entry into New and
Unfamiliar Customer Markets".
The Company derives a portion of its revenues from international sales,
which represented approximately, 17.9%, 16.7% and 26.1% of the Company's
revenues in 1995, 1996 and 1997, respectively, and 26.3% during the three month
period ended March 31, 1998. A significant portion of the Company's
international sales currently are United States dollar-denominated. As a result,
an increase in the value of the United States dollar relative to foreign
currencies could make the Company's products and services less competitive in
international markets. See "Risk Factors--Risks Associated with International
Sales".
The Company generally operates with little or no backlog. In addition, the
sales cycle for the Company's products is typically not longer than sixty days
and can be only a few days. As a result, quarterly sales and operating results
generally depend on the volume and timing of, and ability to fulfill, orders
received within the quarter, which are difficult to forecast. A significant
portion of the Company's spending is relatively fixed in advance based on the
Company's forecasts of future sales. If sales are below expectations in any
given quarter, the adverse impact of the shortfall on the Company's quarterly
operating results may be magnified by the Company's inability to adjust spending
to compensate for the shortfall. See "Risk Factors--Difficulty Forecasting
Sales".
In September 1997, the Company acquired Netcom Systems Europe, formerly a
distributor of the Company's products, and the Company's consolidated financial
statements contained within the Prospectus reflects this acquisition.
RESULTS OF OPERATIONS
The following table presents for the periods indicated certain consolidated
statement of operations data as a percentage of the Company's revenues:
THREE MONTHS
ENDED
YEAR ENDED MARCH 31,
DECEMBER 31, (UNAUDITED)
------------------------------- --------------------
1995 1996 1997 1997 1998
--------- --------- --------- --------- ---------
AS A PERCENTAGE OF TOTAL REVENUES:
Revenues............................................................... 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold..................................................... 14.0 11.9 12.9 11.5 16.9
--------- --------- --------- --------- ---------
Gross profit......................................................... 86.0 88.1 87.1 88.5 83.1
--------- --------- --------- --------- ---------
Operating expenses:
Research and development............................................. 9.2 6.1 6.3 7.4 9.3
Sales and marketing.................................................. 9.3 5.3 6.6 5.4 12.6
General and administrative........................................... 13.9 4.9 6.1 7.4 4.3
--------- --------- --------- --------- ---------
Total operating expenses........................................... 32.4 16.3 19.0 20.2 26.2
--------- --------- --------- --------- ---------
Income from operations................................................. 53.6 71.8 68.1 68.3 56.9
Other income (expense), net............................................ 0.7 0.9 (1.2) 1.9 (3.8)
--------- --------- --------- --------- ---------
Income before provision for income taxes............................... 54.3 72.7 66.9 70.2 53.1
--------- --------- --------- --------- ---------
Provision for income taxes............................................. 21.6 29.7 26.4 27.7 21.8
--------- --------- --------- --------- ---------
Net Income............................................................. 32.7% 43.0% 40.5% 42.5% 31.3%
--------- --------- --------- --------- ---------
--------- --------- --------- --------- ---------
21
THREE MONTHS ENDED MARCH 31, 1998 COMPARED WITH THREE MONTHS ENDED MARCH 31,
1997
REVENUES. The Company recognized $18.0 million in revenues for the three
month period ended March 31, 1998, as compared to $10.1 million for the three
month period ended March 31, 1997, an increase of $7.9 million or 78.2%. The
increase was due primarily to market acceptance of new products, increased
international sales and further penetration of the SmartBits solutions into the
Company's existing customer base.
GROSS PROFIT. Cost of goods sold consists primarily of direct materials,
labor, customer support, warranty provisions and manufacturing overhead. Gross
profit was $15.0 million for the three month period ended March 31, 1998, as
compared to $9.0 million for the three month period ended March 31, 1997, an
increase of $6.0 million. Gross margin was 83.1% for the three month period
ended March 31, 1998, as compared to 88.5% for the three month period ended
March 31, 1997. The decrease in gross margin was due primarily to the increase
in manufacturing and customer support personnel to support expanding operations,
as well as increased volume purchase discounts given to customers. The Company
expects future gross margins to decrease over the next 12 months due to factors
including the product mix of sales, price erosion, increases in overhead and
customer support, new competition, changes in the networking industry and
related technologies and increases in component and contract manufacturing
costs.
RESEARCH AND DEVELOPMENT. Research and development expense consists
primarily of salaries and wages relating to research and development, consulting
fees, certain software development costs and costs of prototype materials and
supplies. The Company expenses research and development costs as incurred.
Research and development expense was $1.7 million for the three month period
ended March 31, 1998, as compared to $0.7 million for the three month period
ended March 31, 1997, an increase of $1.0 million. Research and development
expense was 9.3% of revenues for the three month period ended March 31, 1998, as
compared to 7.4% for the three month period ended March 31, 1997. The increase
in research and development expense in absolute dollars and as a percentage of
revenues was due primarily to increased staffing levels and to increased
purchases of materials used in the development of new products and product
enhancements. The Company expects that research and development expenditures
will continue to increase in absolute dollars for at least the next 12 months to
support continued development of new products and product enhancements.
SALES AND MARKETING. Sales and marketing expense consists primarily of
salaries and wages, commissions, travel and other sales expenses, trade shows
and other marketing programs. Sales and marketing expense was $2.3 million for
the three month period ended March 31, 1998, as compared to $0.5 million for the
three month period ended March 31, 1997, an increase of $1.8 million. Sales and
marketing expense was 12.6% of revenues for the three month period ended March
31, 1998, as compared to 5.4% for the three month period ended March 31, 1997.
The increase in sales and marketing expense in absolute dollars and as a
percentage of revenues was due primarily to increased staffing levels and
related compensation, travel and other sales expenses, and various marketing and
promotional programs. The Company expects that sales and marketing expenditures
will increase in absolute dollars for at least the next 12 months as additional
personnel are hired, field offices are opened and promotional expenditures are
increased as the Company attempts to increase its market penetration and to
pursue new market opportunities.
GENERAL AND ADMINISTRATIVE. General and administrative expense consists
primarily of salaries and wages, and legal and accounting fees relating to
finance, administration and executive management activities. General and
administrative expense was $0.8 million for the three month periods ended March
31, 1998 and 1997. General and administrative expense was 4.3% of revenues for
the three month period ended March 31, 1998, as compared to 7.4% for the three
month period ended March 31, 1997. The decrease as a percentage of revenues was
due to the significant increase in revenues as compared
22
to the increase in general and administrative expense. The Company expects that
general and administrative expenditures will continue to increase in absolute
dollars for at least the next 12 months as the Company's administrative staff
and internal systems grow to support expanding operations and the Company's
status as a public company.
OTHER INCOME (EXPENSE), NET. In August 1997, the Company entered into a
credit agreement with two banks under which the Company borrowed $50,000,000
through a term loan facility. Interest expense relating to the borrowings was
$0.9 million during the three month period ended March 31, 1998. There was no
interest expense for the three month period ended March 31, 1997. Interest
income was $0.2 million during the three month period ended March 31, 1998 and
during the three month period ended March 31, 1997. The Company expects interest
expense relating to its term loan facility to cease following repayment of the
term loan with the proceeds of the Offerings, although the Company intends to
maintain a credit facility and may borrow again in the future. The Company
presently has a $10 million revolving credit facility which has not yet been
utilized.
PROVISION FOR INCOME TAXES. The Company's effective tax rate was 41.0% for
the three month period ended March 31, 1998, as compared to 39.5% for the three
month period ended March 31, 1997. The increase in the effective tax rate
resulted primarily from the effect of foreign taxes combined with the decreased
benefit of research and development tax credits as a percentage of pre-tax
income due to the significant increase in pre-tax income. Also, during the
fourth quarter of 1997, the Company established a foreign sales corporation that
slightly decreased the effective tax rate during the three month period ended
March 31, 1998.
YEAR ENDED DECEMBER 31, 1997 COMPARED WITH YEAR ENDED DECEMBER 31, 1996
REVENUES. The Company recognized $56.3 million in revenues for the year
ended December 31, 1997, as compared to $27.5 million for the year ended
December 31, 1996, an increase of $28.8 million or 105%. The increase was due
primarily to the introduction of new products and further market acceptance of
existing products.
GROSS PROFIT. Gross profit was $49.0 million for the year ended December
31, 1997, as compared to $24.2 million for the year ended December 31, 1996, an
increase of $24.8 million. Gross margin was 87.1% for the year ended December
31, 1997, as compared to 88.1% for the year ended December 31, 1996. The
decrease in gross margin was due primarily to the increase of manufacturing
personnel to support expanding operations as well as increased volume discounts
to certain customers.
RESEARCH AND DEVELOPMENT. Research and development expense was $3.5 million
for the year ended December 31, 1997, as compared to $1.7 million for the year
ended December 31, 1996, an increase of $1.8 million. Research and development
expense was 6.3% of revenues for the year ended December 31, 1997, as compared
to 6.1% for the year ended December 31, 1996. The increase in research and
development expense in absolute dollars and as a percentage of revenues was due
primarily to increased staffing levels and to increased purchases of materials
used in the development of new products and product enhancements.
SALES AND MARKETING. Sales and marketing expense was $3.7 million for the
year ended December 31, 1997, as compared to $1.5 million for the year ended
December 31, 1996, an increase of $2.2 million. Sales and marketing expense was
6.6% of revenues for the year ended December 31, 1997, as compared to 5.3% for
the year ended December 31, 1996. The increase in sales and marketing expense in
absolute dollars and as a percentage of revenues was due primarily to increased
staffing levels and increased commissions.
GENERAL AND ADMINISTRATIVE. General and administrative expense was $3.5
million for the year ended December 31, 1997, as compared to $1.3 million for
the year ended December 31, 1996, an
23
increase of $2.2 million. General and administrative expense was 6.1% of
revenues for the year ended December 31, 1997, as compared to 4.9% for the year
ended December 31, 1996. The increase in general and administrative expense in
absolute dollars and as a percentage of revenues was due primarily to increased
staffing levels and the related compensation to support expanding operations.
OTHER INCOME (EXPENSE), NET. Interest expense relating to outstanding
borrowings under the Company's term loan facility was $1.2 million for the year
ended December 31, 1997. Interest income increased approximately $0.4 million
for the year ended December 31, 1997 compared to the year ended December 31,
1996, due to increased cash and cash equivalent balances.
PROVISION FOR INCOME TAXES. The Company's effective tax rate was 39.5% for
the year ended December 31, 1997, as compared to 40.8% for the year ended
December 31, 1996. The decrease in the effective tax rate was primarily due to
the increase in research and development tax credits utilized in 1997. This
increase in research and development tax credits and certain other tax benefits
were caused primarily by the exercise of a substantial number of employee stock
options in connection with the Company's recapitalization in the third quarter
of 1997. Accordingly, the Company does not expect these tax benefits to recur to
the same extent in future periods. See "Certain Transactions".
YEAR ENDED DECEMBER 31, 1996 COMPARED WITH YEAR ENDED DECEMBER 31, 1995
REVENUES. The Company recognized $27.5 million in revenues for the year
ended December 31, 1996, as compared to $9.1 million for the year ended December
31, 1995, an increase of $18.4 million or 202%. The increase was due primarily
to the introduction of new products and further market acceptance of the
SmartBits solution.
GROSS PROFIT. Gross profit was $24.2 million for the year ended December
31, 1996, as compared to $7.8 million for the year ended December 31, 1995, an
increase of $16.4 million. Gross margin was 88.1% for the year ended December
31, 1996, as compared to 86.0% for the year ended December 31, 1995. The
increase in gross margin was primarily due to the significant increase in
revenues as compared to the increase in overhead costs.
RESEARCH AND DEVELOPMENT. Research and development expense was $1.7 million
for the year ended December 31, 1996, as compared to $0.8 million for the year
ended December 31, 1995, an increase of $0.9 million. Research and development
expense was 6.1% of revenues for the year ended December 31, 1996, as compared
to 9.2% for the year ended December 31, 1995. The increase in research and
development expense in absolute dollars was due primarily to increased staffing
levels and to increased purchases of materials used in the development of new or
enhanced products. The decrease as a percentage of revenues was due to the
significant increase in revenues as compared to the increase in research and
development expense.
SALES AND MARKETING. Sales and marketing expense was $1.5 million for the
year ended December 31, 1996, as compared to $0.8 million for the year ended
December 31, 1995, an increase of $0.7 million. Sales and marketing expense was
5.3% of revenues for the year ended December 31, 1996, as compared to 9.3% for
the year ended December 31, 1995. The increase in sales and marketing expense in
absolute dollars was due primarily to increased staffing levels and related
compensation and travel. The decrease as a percentage of revenues was due to the
significant increase in revenues as compared to the increase in sales and
marketing expense.
GENERAL AND ADMINISTRATIVE. General and administrative expense was $1.3
million for the years ended December 31, 1996 and 1995. General and
administrative expense was 4.9% of revenues for the year ended December 31,
1996, as compared to 13.9% for the year ended December 31, 1995. The decrease as
a percentage of revenues was due to the significant increase in revenues as
compared to the increase in general and administrative expense.
24
OTHER INCOME (EXPENSE), NET. Interest income was $0.2 million for the year
ended December 31, 1996, as compared to $0.1 million for the year ended December
31, 1995, an increase of approximately $0.1 million. The increase was due to
increased cash and cash equivalent balances. There was no interest expense
during the years ended December 31, 1995 and 1996.
PROVISION FOR INCOME TAXES. The Company's effective tax rate was 40.8% for
the year ended December 31, 1996, as compared to 39.8% for the year ended
December 31, 1995. The increase in the effective tax rate was primarily due to
the increase in the federal tax rate from 34% in 1995 to 35% in 1996, combined
with the decreased benefit of research and development tax credits as a
percentage of pre-tax income due to the significant increase in pre-tax income.
25
SELECTED QUARTERLY RESULTS OF OPERATIONS
The following tables present statement of operations data in dollars and as
a percentage of the Company's revenues. This quarterly information is unaudited
but has been prepared on a basis consistent with the Company's audited financial
statements presented elsewhere herein, and in the Company's opinion, includes
all adjustments (consisting only of normal recurring adjustments), necessary for
a fair presentation of the information for the quarters presented. The results
of operations for any quarter are not necessarily indicative of results that may
be expected for any subsequent periods. See "Risk Factors--Potential
Fluctuations in Quarterly Operating Results".
QUARTER ENDED
-----------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30,
1996 1996 1996 1996 1997 1997 1997
----------- ----------- ----------- ----------- ----------- ----------- -----------
(IN THOUSANDS)
CONSOLIDATED STATEMENT OF OPERATIONS
DATA:
Revenues................................. $ 5,141 $ 5,263 $ 7,722 $ 9,328 $ 10,115 $ 12,958 $ 15,912
Cost of goods sold....................... 623 642 896 1,095 1,163 1,575 2,017
----------- ----------- ----------- ----------- ----------- ----------- -----------
Gross profit........................... 4,518 4,621 6,826 8,233 8,952 11,383 13,895
----------- ----------- ----------- ----------- ----------- ----------- -----------
Operating expenses:
Research and development............... 327 408 432 514 748 589 805
Sales and marketing.................... 272 310 480 404 540 761 1,090
General and administrative............. 239 256 452 395 753 965 805
----------- ----------- ----------- ----------- ----------- ----------- -----------
Total operating expenses............. 838 974 1,364 1,313 2,041 2,315 2,700
----------- ----------- ----------- ----------- ----------- ----------- -----------
Income from operations................... 3,680 3,647 5,462 6,920 6,911 9,068 11,195
Other income (expense), net.............. 28 44 59 113 189 167 (107)
----------- ----------- ----------- ----------- ----------- ----------- -----------
Income before provision for income
taxes.................................. 3,708 3,691 5,521 7,033 7,100 9,235 11,088
Provision for income taxes............... 1,509 1,502 2,267 2,864 2,804 3,628 4,459
----------- ----------- ----------- ----------- ----------- ----------- -----------
Net Income............................... $ 2,199 $ 2,189 $ 3,254 $ 4,169 $ 4,296 $ 5,607 $ 6,629
----------- ----------- ----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- ----------- ----------- -----------
DEC. 31, MAR. 31,
1997 1998
----------- -----------
CONSOLIDATED STATEMENT OF OPERATIONS
DATA:
Revenues................................. $ 17,288 $ 18,011
Cost of goods sold....................... 2,493 3,048
----------- -----------
Gross profit........................... 14,795 14,963
----------- -----------
Operating expenses:
Research and development............... 1,385 1,662
Sales and marketing.................... 1,322 2,271
General and administrative............. 929 776
----------- -----------
Total operating expenses............. 3,636 4,709
----------- -----------
Income from operations................... 11,159 10,254
Other income (expense), net.............. (911) (682)
----------- -----------
Income before provision for income
taxes.................................. 10,248 9,572
Provision for income taxes............... 3,984 3,924
----------- -----------
Net Income............................... $ 6,264 $ 5,648
----------- -----------
----------- -----------
QUARTER ENDED
-----------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30,
1996 1996 1996 1996 1997 1997 1997
----------- ----------- ----------- ----------- ----------- ----------- -----------
AS A PERCENTAGE OF TOTAL REVENUES:
Revenues................................. 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of goods sold....................... 12.1 12.2 11.6 11.7 11.5 12.1 12.7
----- ----- ----- ----- ----- ----- -----
Gross profit........................... 87.9 87.8 88.4 88.3 88.5 87.9 87.3
----- ----- ----- ----- ----- ----- -----
Operating expenses:
Research and development............... 6.4 7.7 5.6 5.5 7.4 4.5 5.1
Sales and marketing.................... 5.3 5.9 6.2 4.4 5.4 5.9 6.8
General and administrative............. 4.6 4.9 5.9 4.2 7.4 7.5 5.1
----- ----- ----- ----- ----- ----- -----
Total operating expenses............. 16.3 18.5 17.7 14.1 20.2 17.9 17.0
----- ----- ----- ----- ----- ----- -----
Income from operations................... 71.6 69.3 70.7 74.2 68.3 70.0 70.3
Other income (expense), net.............. 0.5 0.8 0.7 1.2 1.9 1.3 (0.6)
----- ----- ----- ----- ----- ----- -----
Income before provision for income
taxes.................................. 72.1 70.1 71.4 75.4 70.2 71.3 69.7
Provision for income taxes............... 29.3 28.5 29.3 30.7 27.7 28.0 28.0
----- ----- ----- ----- ----- ----- -----
Net Income............................... 42.8% 41.6% 42.1% 44.7% 42.5% 43.3% 41.7%
----- ----- ----- ----- ----- ----- -----
----- ----- ----- ----- ----- ----- -----
DEC. 31, MAR. 31,
1997 1998
----------- -----------
AS A PERCENTAGE OF TOTAL REVENUES:
Revenues................................. 100.0% 100.0%
Cost of goods sold....................... 14.4 16.9
----- -----
Gross profit........................... 85.6 83.1
----- -----
Operating expenses:
Research and development............... 8.0 9.3
Sales and marketing.................... 7.6 12.6
General and administrative............. 5.4 4.3
----- -----
Total operating expenses............. 21.0 26.2
----- -----
Income from operations................... 64.6 56.9
Other income (expense), net.............. (5.3) (3.8)
----- -----
Income before provision for income
taxes.................................. 59.3 53.1
Provision for income taxes............... 23.1 21.8
----- -----
Net Income............................... 36.2% 31.3%
----- -----
----- -----
Revenues have increased in each of the quarters presented, from $5.1 million
for the three month period ended March 31, 1996 to $18.0 million for the three
month period ended March 31, 1998. Gross margins remained relatively consistent
until the three month periods ended December 31, 1997 and
26
March 31, 1998, when the margin decreased primarily due to the effects of
increased manufacturing personnel and increased volume purchase discounts given
to customers. Research and development expenditures increased in each of the
quarters presented, except for the quarter ended June 30, 1997, in which the
decrease was primarily due to decreased purchases of prototype materials. Sales
and marketing expenditures increased in each of the quarters presented, except
for the quarter ended December 31, 1996, in which the decrease was primarily due
to decreased travel and other selling costs. Sales and marketing expense
increased significantly in the quarter ended March 31, 1998 due to more
pronounced increases in headcount and promotional efforts. General and
administrative expenses increased or remained relatively constant, in each of
the quarters presented, except for the quarter ended September 30, 1997, in
which the decrease was primarily due to decreased legal and other administrative
costs and for the quarter ended March 31, 1998, in which the decrease was
primarily due to changes in management that resulted in lower overall
compensation expense.
The Company's quarterly revenues and operating results may vary
significantly as a result of a number of factors, including the size and timing
of orders, product mix and shipment of products. Operating results may also
fluctuate on a quarterly basis based upon factors such as demand for the
Company's current and future product offerings, the introduction of product
enhancements by the Company or its competitors and market acceptance of new
products offered by the Company or its competitors. The Company's quarterly
operating results are also affected by the budgeting cycles of customers, the
relative percentages of products sold through the Company's direct and indirect
sales channels, product pricing and competitive conditions in the industry. Any
unfavorable changes in these or other factors could have a material adverse
effect on the Company's business, financial condition and results of operations.
Accordingly, the Company believes that period-to-period comparisons of its
results of operations may not be meaningful and should not be relied upon as in
indication of future performance. Furthermore, there can be no assurance that
the Company will be able to sustain profitability on a quarterly or annual
basis. See "Risk Factors--Fluctuation in Quarterly Operating Results".
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its operations to date primarily through cash
provided by operating activities. At March 31, 1998, the Company's principal
source of liquidity was its cash and cash equivalents of $24.4 million. In
August 1997, the Company established an unsecured $10.0 million revolving line
of credit with two banks. At March 31, 1998, there were no borrowings
outstanding under the revolving line of credit.
In the third quarter of 1997, the Company effected a recapitalization (the
"Recapitalization"). In connection with the Recapitalization, the Company
received net proceeds of $141.0 million from the issuance and sale of preferred
stock and borrowings under a term loan facility. The Company used these
proceeds, together with $14.7 million from its existing cash balances to
repurchase 20,431,288 shares of its Common Stock for $155.7 million. See
"Certain Transactions".
Cash provided by operating activities during the years ended December 31,
1995, 1996 and 1997 was $2.5 million, $9.5 million and $24.7 million,
respectively. Cash provided by operating activities during the three month
periods ended March 31, 1997 and 1998 was $4.4 million and $7.4 million,
respectively. Cash generated from operations for all of these periods was
principally attributable to net income adjusted for certain non-cash charges
such as depreciation and amortization and provisions for doubtful accounts.
Additionally, in 1997, the Company received a $6.9 million tax benefit from the
exercise of stock options associated with the Recapitalization.
Investing activities have consisted solely of the acquisition of property
and equipment, except for the year ended December 31, 1997. In September 1997,
the Company acquired all of the outstanding common shares of Netcom Systems
Europe, a research and development, sales and distribution
27
company located near Paris, France. The purchase price was $3.0 million plus
$0.1 million of acquisition related costs. Cash used for the acquisition, net of
cash acquired, was $2.4 million.
Cash used in financing activities have consisted solely of $2.7 million used
for Common Stock dividends paid from retained earnings during 1996 and the net
$14.7 million used in connection with the Recapitalization in 1997. Cash
provided by financing activities have consisted solely of the exercise of
employee stock options, providing cash of $2.2 million for the year ended
December 31, 1997 and $2,000 for the three month period ended March 31, 1998.
The Company believes that the net proceeds from the Offerings, together with
its current balances, cash provided by future operations and available
borrowings under its line of credit, will be sufficient to meet its working
capital and anticipated capital expenditure requirements for at least the next
12 months. Although operating activities may provide cash in certain periods, to
the extent the Company experiences continued growth in the future, its operating
and investing activities may require significant cash. Consequently, any such
future growth may require the Company to obtain additional equity or debt
financing. See "Risk Factors--Proceeds to be Used to Redeem Preferred Stock and
Repay Indebtedness", and "Use of Proceeds".
RISKS ASSOCIATED WITH YEAR 2000 PROBLEM
Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field. These date code fields
will need to accept four digit entries to distinguish 21st century dates from
20th century dates. As a result, in less than two years, computer systems and/or
software used by many companies may need to be upgraded to become compliant with
such "Year 2000" requirements. The Company generally warrants and has
represented to its customers that its products are free from Year 2000 defects.
There can be no assurance that the Company's products or third party computer
products used by the Company are Year 2000 compliant. Any failure of the
Company's products to be Year 2000 compliant could result in the loss of or
delay in market acceptance of the Company's products and services, increased
service and warranty costs to the Company or payment by the Company of
compensatory or other damages. In addition, any failure of third party computer
products used by the Company to be Year 2000 compliant could interrupt and
disrupt the Company's business.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standard ("SFAS") No. 130, "Reporting
Comprehensive Income". SFAS No. 130 applies to all companies and is effective
for fiscal years beginning after December 15, 1997. SFAS No. 130 establishes
standards for the reporting and display of comprehensive income in a set of
financial statements. Comprehensive income is defined as the change in net
assets of a business enterprise during a period from transactions generated from
non-owner sources. It includes all changes in equity during a period except
those resulting from investments by owners and distributions to owners.
Management believes that the adoption of SFAS No. 130 will not have a material
impact on the Company's financial statements.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information". SFAS No. 131 applies to all public
companies and is effective for fiscal years beginning after December 15, 1997.
SFAS No. 131 requires that businesses segment financial information reported in
the financial statements utilizing the management approach. The management
approach is defined as the manner in which management organizes the segment
within the enterprise for making operating decisions and assessing performance.
The Company's management believes the adoption of SFAS No. 131 will not have a
material impact on financial statements.
28
BUSINESS
THE FOLLOWING CONTAINS FORWARD-LOOKING STATEMENTS WHICH INVOLVE RISKS AND
UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE
ANTICIPATED IN THESE FORWARD-LOOKING STATEMENTS AS A RESULT OF CERTAIN FACTORS,
INCLUDING THOSE SET FORTH ABOVE UNDER "RISK FACTORS" AND ELSEWHERE IN THIS
PROSPECTUS. SEE "GLOSSARY OF TERMS" FOR DEFINITIONS OF VARIOUS ACRONYMS AND
TECHNICAL TERMS USED IN THIS PROSPECTUS.
OVERVIEW
Netcom Systems is a leading provider of network performance measurement
systems. The Company's flagship platform, SmartBits, evaluates the performance,
reliability, quality of service and proof of service of networking equipment,
such as routers and switches, before deployment on the network. SmartBits also
allows users to measure network performance criteria by emulating complex,
multi-protocol networks through the generation of accurate, customizable, high
speed flows of network traffic. By offering a robust, scalable, and modular
network performance solution, the Company has established relationships with
several prominent industry experts and multiple technology publications in the
field of network performance measurement. The Company's customer base of over
600 accounts includes leading network equipment manufacturers ("NEMs"),
telecommunications carriers and internet service providers ("Service
Providers"), and Fortune 1000 companies, financial institutions, systems
integrators and government entities ("End Users").
INDUSTRY BACKGROUND
In recent years, businesses have migrated from mainframe-based computing
environments to distributed, client/server computing networks capable of sharing
bandwidth intensive applications. The widespread adoption of this computing
paradigm has resulted in an increasing need by End Users and Service Providers
for network equipment capable of transmitting bandwidth intensive, mission
critical traffic at extremely fast speeds across progressively larger and more
heterogeneous networks. Growth in usage of the Internet, intranets and
extranets, coupled with the escalating aggregation of voice, video and other
multimedia traffic over networks has exacerbated demands for high speed, high
performance network equipment. As the rate of technological change in networking
has grown and the performance of network equipment has improved, the need for a
robust performance measurement solution to evaluate network equipment
performance, reliability, accuracy and interoperability has become acute.
Historically, solutions have existed to troubleshoot problems after
deployment of equipment on the network. These products analyze the data
transmitted across networks, including packets of data that contain complex
network protocols. While these products are adequate for monitoring data
integrity problems of a "live" network, they were not designed to measure the
performance of network products such as switches and routers prior to network
deployment or to measure performance statistics such as throughput (i.e., the
"speed" of the network), latency (i.e., the time required to process data) and
jitter (i.e., the variation in the latency). In addition, historical solutions
were designed neither to transmit network traffic simulating multiple users
simultaneously using the network nor to capture and measure the performance of
network equipment under such "stressed" conditions.
To emulate traffic on networks, performance measurement equipment has
increased in technological complexity over time. Performance measurement
solutions must increasingly be able to measure the performance of network
equipment for multiple local area network ("LAN") and wide area network ("WAN")
protocols and connections, increasing port density, multiple layers of the OSI
protocol stack and the adoption of packet-based technologies across all
networks. New protocols, such as ATM and Gigabit Ethernet, have been developed
to transmit increasingly diverse types of traffic, such as voice, video and
graphics, faster, more reliably and more efficiently across networks. In
addition, as networks are increasingly deployed across global operations, there
is a need for end-to-end performance measurement equipment that not only
analyzes how network equipment handles traffic within a LAN at a central
location, such as a company's headquarters, but also how traffic is handled over
WANs when
29
data is transmitted over distances, such as to branch offices. As a result,
effective performance measurement equipment must stress test the ability of
network equipment to perform under multi-protocol, multi-media environments over
LANs and WANs. In addition, as networks grow in size and complexity, performance
measurement equipment that emulates greater port density, corresponding to
greater numbers of network connections, is needed to effectively measure the
performance of network equipment under growing traffic conditions. Furthermore,
the performance of network equipment at higher layers of the OSI protocol stack
must be measured for quality of service or prioritization of time sensitive
network traffic, such as voice and video. While current solutions offer analysis
solely at a single layer, such as the application layer or the network layer,
network professionals are seeking to measure network equipment on multiple
layers of the OSI protocol stack concurrently. Simultaneous layer measurement
involves analyzing more than the performance of a single unit of network
equipment but analysis of the entire network. Finally, as adoption of the
Internet and the Internet Protocol ("IP") increases, performance measurement
equipment must have strong packet measurement abilities to analyze
multi-protocol traffic over IP. All of these factors complicate network
performance analysis.
For NEMs, performance measurement solutions have become mission critical for
the successful and timely introduction of new products that are fully
interoperable in multi-vendor and multi-protocol environments. Historically,
NEMs created in-house, proprietary solutions to measure the performance of their
new products. However, NEMs found their in-house performance analysis solutions
consuming scarce and expensive research and development resources that could be
better utilized creating new products. In addition, NEMs found it increasingly
difficult to develop and maintain "state of the art" in-house performance
measurement solutions as the pace of technological change and the complexity of
equipment interoperability hastened in networking, particularly as new protocols
were developed and adopted. The disadvantages of in-house solutions were
accentuated by industry consolidation among NEMs which resulted in a need by
acquiring companies to quickly evaluate and understand newly acquired technology
and its interoperability with legacy products, performance measurement that
their in-house solutions were not designed to perform. Moreover, because
in-house network performance solutions lacked independence, they were not widely
adopted by third-party industry test labs and thus were not well suited for use
by NEMs to certify the performance of new products to potential equipment
purchasers. As a result, End Users and Service Providers did not widely adopt
NEM in-house solutions and, accordingly, in-house solutions could not be widely
used as a shared means of communication among NEMs, End Users and Service
Providers after a purchase to improve customer service and troubleshoot customer
configuration problems.
For End Users and Service Providers that rely on mission critical network
traffic for their business, performance measurement equipment evaluates the
reliability, accuracy, availability and performance of network equipment before
deployment on the network. End Users and Service Providers increasingly require
credible, industry recognized performance measurement tools to independently
evaluate multiple vendors' network solutions. By measuring the performance,
reliability and compliance to industry standards of new products prior to
deployment, network managers can optimize network configuration and performance
and maximize scarce resources. End Users and Service Providers deploy these
solutions to stress test their networks and proactively identify potential
network problem areas prior to network deployment and performance degradation.
Using the results of these stress tests, End Users and Service Providers can
communicate existing and potential problems to NEM customer service centers who
use the same performance analysis equipment to emulate, understand and solve
these problems. As a result, NEMs, End Users and Service Providers require
performance analysis equipment that emulates progressively larger, more complex,
multi-protocol networks and that provides a common basis for communication among
users, manufacturers and suppliers of network equipment.
THE NETCOM SYSTEMS SOLUTION
Netcom Systems is a leading provider of network performance measurement
systems. Netcom Systems' flagship platform, SmartBits, enables NEMs, End Users
and Service Providers to measure the performance, reliability, quality of
service and proof of service of network equipment before deployment
30
on the network. SmartBits also generates accurate, customizable, high speed
flows of network traffic for measuring performance criteria such as reliability,
throughput, jitter, latency and packet loss. As a result, NEMs can ensure proper
network equipment performance while better allocating their scarce engineering
resources to new product development. In addition, End Users and Service
Providers can make better cost/performance purchasing decisions on new
equipment, reduce the risk of network "meltdowns" and ensure that mission
critical applications perform correctly. To date, SmartBits has an installed
base of over 600 accounts, including leading NEMs, End Users and Service
Providers. The Netcom Systems solution incorporates the following features:
- EMULATE COMPLEX, MULTI-PROTOCOL NETWORKS. The SmartBits platform was
designed to emulate and test large, complex networks to measure network
performance under "stressed" traffic conditions. The modular SmartBits
platform enables users to easily add or substitute protocol specific
interface cards, or SmartCards, within a common SmartBits chassis. As a
result, a single SmartBits chassis can measure the performance of network
equipment over a wide variety of networking protocols and interfaces,
including Ethernet, Fast Ethernet, Gigabit Ethernet, Token Ring, ATM and
Frame Relay. SmartBits also measures performance across multiple protocols
simultaneously, enabling LAN-to-LAN, LAN-to-WAN, and LAN-to-ATM
performance measurement. The platform enables extremely accurate (to
within 100 nanoseconds), reliable, repeatable and customizable traffic
generation, capture and analysis at speeds that exceed the maximum
performance specifications for analyzed protocols. Additionally, the
SmartBits platform is scalable, allowing for the addition of multiple
SmartCards in a single chassis and linkage of multiple SmartBits chassis
for performance measurement of network equipment replicating the demands
of up to 640 simultaneous connections (each of which can include multiple
streams of traffic) to allow for high density, multi-protocol performance
measurement. As a result, the SmartBits platform provides a common
solution addressing the diverse needs of NEMs, End Users and Service
Providers.
[GRAPHIC]
[Graphic depicting interconnection of SmartBits with an Ethernet Switch, two
Gigabit Ethernet switches, two Frame Relay switches, two ATM switches and a
Token Ring.]
- INDEPENDENCE AND INDUSTRY RECOGNITION. The Company has established
relationships with several prominent industry experts in the field of
network performance measurement, including Robert Mandeville of European
Network Laboratories, Scott Bradner of Harvard University, The Tolly
Group, John Streck of Centennial Networking Lab and Barry Reinhold of the
University of New Hampshire. In addition, Netcom Systems has been
recognized for its independent, multi-protocol, high port density
performance measurement capabilities, by widely recognized technology
publications such as DATACOMMUNICATIONS MAGAZINE, ATM WORLD, INTERNET
WEEK, LAN TIMES, NETWORK COMPUTING and PC WEEK. These experts and
publications drive the standards setting
31
process and establish testing methodologies that evaluate new products and
new technologies. The Company works closely with these experts and
publications in order to develop a SmartBits solution to implement these
tests when industry standards are released. In addition, Netcom Systems
believes use of SmartBits by leading NEMs, such as Cisco, Bay Networks and
3Com, is also critical to the Company's industry recognition. The Company
believes the use of SmartBits by such independent industry standard
testing experts and leading NEMs provides the Company with recognition
among potential customers and is an important endorsement of the Company's
position in the performance measurement market.
- COMMON SOLUTION FOR NEMS, END USERS, SERVICE PROVIDERS AND INDUSTRY TEST
LABS. The SmartBits solution enables NEMs, End Users, Service Providers
and test labs to evaluate and measure the performance of networking
equipment in a common language.
NEMS. NEMs rely on SmartBits as an independent means of validating
the performance of their network equipment performance to End Users
and Service Providers. NEMs also increasingly utilize SmartBits as
a common platform for facilitating communication with End Users and
Service Providers to troubleshoot and replicate problems on their
networks before deployment.
END USERS AND SERVICE PROVIDERS. End Users and Service Providers
use SmartBits to perform industry standard tests, verify network
equipment performance and evaluate new products prior to
deployment. As SmartBits is widely accepted by leading NEMs and has
an installed base of over 600 accounts, End Users and Service
Providers increasingly utilize the common SmartBits platform to
troubleshoot network equipment problems with NEM customer service
centers.
INDUSTRY TEST LABS. Industry experts use SmartBits to evaluate
network equipment from multiple vendors and work closely with
Netcom Systems to develop standard tests for new technologies.
NEMs, End Users and Service Providers use these standardized tests
and product evaluations to measure network equipment performance
using common parameters.
32
[GRAPHIC]
[Graphic depicts two boxes. The first is labeled "Market Need" and shows three
sub-boxes labeled "NEMs", "Industry Test Labs", and "End User and Service
Provider" interconnected with arrows. Captions read, (a) below "NEMS",
"Marketing claims unvalidated by third parties -- No means of
communicating/replicating problems -- Inability to independently evaluate NEM
products", (b) next to "Industry Test Labs", "Inability to address performance
measurement tests" and (c) above "End User and Service Providers", "Inability to
replicate standard tests". The second box depicts the three sub-boxes in the
first box radially interconnected to the Netcom Systems logo. Captions read
"Third party validation of marketing claims -- Common language to explain
performance problems -- Means of evaluating performance claims of multiple NEMs
- -- Means for NEMS, End Users and Service Providers to perform standard tests and
analysis".]
- VERSATILE PERFORMANCE MEASUREMENT SUITE. Netcom Systems' suite of software
performance measurement applications addresses the performance measurement
requirements of End Users and Service Providers and the more complex
measurement needs of NEMs. The Company's software programs run tests
across multiple protocols, providing turnkey performance analysis for
network equipment such as switches and routers. The Company also offers
more sophisticated software solutions enabling NEMs, End Users and Service
Providers to customize their test sequences. The Company's software runs
on Windows-based personal computers, as well as the HP-UX and Solaris UNIX
platforms.
NETCOM SYSTEMS' STRATEGY
Netcom Systems' strategy is to strengthen and expand its market leadership
in developing, manufacturing and marketing network performance measurement
systems to become the industry standard for network performance measurement.
Important elements of the Company's strategy are to:
- CAPITALIZE ON RAPID TECHNOLOGICAL CHANGE. The Company believes that each
new technological advance in network computing represents a new market for
its performance
33
measurement equipment. Netcom Systems intends to develop performance
measurement solutions for next generation LAN and WAN products and new
chassis technology scalable to larger port counts to enable SmartBits to
emulate denser and more complex networks. The Company also intends to
leverage its extensive IP knowledge to capitalize on the increasing
deployment of IP-centric networks. In addition, the Company plans to
develop new software applications to measure performance features such as
packet sequencing and prioritization for the performance measurement of
time sensitive network traffic such as voice and video.
- LEVERAGE KEY RELATIONSHIPS. Netcom Systems intends to leverage its key
relationships with prominent industry test labs, networking publications
and industry leading NEMs to be first to market with new industry standard
tests that measure the performance of new networking technologies.
Additionally, Netcom Systems is a member of a number of standard setting
bodies, such as the Gigabit Ethernet, ATM, Frame Relay, Cable Modem and
ADSL forums. By playing an active role in aiding industry leading
companies in their efforts to determine how performance of new
technologies should be measured, Netcom Systems believes it is well
positioned to rapidly introduce new, industry endorsed and accepted
performance analysis solutions on a timely basis. The Company believes
that its role as an industry recognized provider of performance analysis
for next generation technologies is critical to its continued leadership
and success.
- FURTHER PENETRATE EXISTING NEM CUSTOMER BASE.Netcom Systems believes there
is a significant opportunity for additional sales to existing NEMs. Netcom
Systems plans to increase sales to new development and quality assurance
engineers as NEMs continue to grow their research and development
operations and introduce new products. Similarly, the Company believes
NEMs are increasingly adopting the SmartBits platform in new functional
operations, such as manufacturing, customer support and sales and
marketing. Netcom Systems believes networking industry consolidation also
represents a growth opportunity as NEMs require SmartBits to quickly
evaluate and understand newly acquired technology and its interoperability
with current networking product lines. The Company also plans to increase
sales to its NEM customer base through the introduction of performance
equipment with new functionality and features, including support of new
WAN technologies and higher density systems.
- EXPAND CUSTOMER BASE. Netcom Systems also intends to further expand into
the End User and Service Provider markets, which are increasingly
requiring solutions for analyzing and optimizing network equipment
performance before deployment on their mission critical networks. To
increase awareness of SmartBits among these potential new customers,
Netcom Systems intends to promote its performance measurement solutions
through widely recognized publications and seminars. Netcom Systems
believes it can leverage its leadership in performance measurement
equipment, relationships with leading NEMs and industry experts and its
promotional efforts to penetrate these End Users and Service Provider
markets. In addition, the Company intends to continue expanding
relationships with strategic partners and distributors in order to enter
new international territories in Europe, Asia and Latin America.
TECHNOLOGY
The Company's integrated software and hardware system provides users with a
robust performance measurement solution. Key features of the Company's
technology include:
- MODULAR AND SCALABLE. SmartBits' modular and scalable design supports high
density multi-protocol stress testing of dense networking equipment (up to
640 ports with 1000 streams per port). Each SmartBits SMB-2000 chassis can
measure the performance of new networking protocols through add-on
SmartCards and software updates.
- MULTI-PROTOCOL. The SmartBits platform supports a wide variety of
networking protocols including Ethernet, Fast Ethernet, Gigabit Ethernet,
Token Ring, ATM and Frame Relay, that enable
34
customers to measure packet-to-packet and packet-to-cell performance for
LAN-to-LAN, LAN-to-WAN and LAN-to-ATM connections.
- MULTI-LAYER. SmartBits' multi-layer performance measurement enables
customers to analyze layer 2 parameters such as packet loss, throughput
and packet latency and layer 3 parameters such as stream latency, jitter,
traffic flow performance and bandwidth per connection, all in a multi-
protocol environment. The SmartBits architecture allows traffic
generation, capture and measurement at speeds that exceed the maximum
performance specifications for analyzed protocols, thus stress testing
equipment and networks beyond established performance parameters.
- IP COMPETENCY. Since inception, the Company has focused on the development
of packet-based performance measurement equipment and, as a result, the
Company has an extensive understanding of IP and frame generation,
tracking and measurement. The Company's proprietary field programmable
gate array technology reflects this competency and differentiates the
SmartBits platform from other traffic generating devices because it also
tracks the frame through to the receiving device, which permits
measurements such as throughput, packet loss, latency and jitter.
SmartBits measures frame performance through multiple network interfaces
and enables performance measurement of multi-protocol traffic over IP.
- ROBUST SOFTWARE CAPABILITIES. The SmartBits platform's robust software
solutions enable the user to configure the transmission, triggers, and
monitoring of SmartCards, either individually or in groups, and to perform
tests between any port or group of ports quickly and accurately. The
Company's SmartApplications and Advanced Switch Test software enables
customers to measure the performance of networking hardware for layer 2
switches under industry standard tests (RFCs 1242, 1944 and 2285). The
Company also offers its SmartLibrary software, which allows more demanding
users to develop custom testing methodologies for controlling SmartCards
using a variety of computer platforms such as Microsoft Windows and UNIX
and multiple programming languages such as TCL, C/C++, Java, Visual Basic,
Delphi, Perl and LabView.
35
PRODUCTS
SMARTBITS SYSTEMS
SmartBits, the Company's flagship performance measurement system,
incorporates a set of chassis, SmartCards and software applications that enable
performance measurement for multiple LAN and WAN technologies. SmartBits
generates the traffic of thousands of PC/workstation clients and servers, thus
analyzing the impact of such traffic on the performance of network equipment.
SmartBits can help customers identify the performance boundaries of network
equipment, optimize bandwidth, manage migrations to new technologies and analyze
a network's ability to sustain current and anticipated user populations.
SmartBits enables NEMs, End Users and Service Providers to ensure that network
equipment products meet industry standards by utilizing SmartApplications and
Advanced Switch Test software applications. SmartBits systems are scalable, and
include SmartCards that provide performance measurement functionality enabled by
a family of software programs for different test requirements and skill levels.
A stand-alone SmartBits SMB-2000 chassis, which comes bundled with
SmartWindow, SmartApplications and SmartLibrary software, lists for $15,900 and
an SMB-10 expansion chassis lists for $4,995. The list price for SmartCards
ranges from $995 for a 10 Mbps layer 2 Ethernet card to $19,995 for a 622 Mbit
ATM card with an OC-12 interface, while the list price of software applications
for the platform range from $1,995 for the Advanced Switch Test to $2,995 for
SmartLibrary.
THE SMARTBITS CHASSIS
CHASSIS DESCRIPTION
SMB-2000 SMARTBITS SMB-2000, the Company's second generation performance measurement
MASTER CHASSIS system, is part of a performance measurement platform using
proprietary network controllers designed to analyze and monitor
inter-networking equipment, devices or networks at maximum
performance. The SMB-2000 is a 20 port performance measurement
system for developing, and analyzing routers, bridges, switches,
repeaters, transceivers, multiport devices and live networks for
Ethernet, Fast Ethernet, Gigabit Ethernet, ATM, Frame Relay and
Token Ring traffic. The SMB-2000 measures statistics such as packet
throughput, latency, jitter, traffic flow performance and bandwidth
per connection. The SMB-2000 acts as the master chassis that can
drive up to 3 SMB-10s (or 3 SMB-2000's) to form an 80 port system or
it can act as a standalone system that accommodates 20 ports. One
SmartBits system is fully scalable up to 80 ports and 8 total
systems can be linked together to analyze up to 640 ports
simultaneously. The SMB-2000 can be controlled and managed with the
SmartWindow, SmartApplications, Advanced Switch Test, VAST,
SmartSignaling, or SmartLibrary software.
SMB-10 SMARTBITS The SMB-10 is part of the SmartBits system and is a 20 slot
EXPANSION expansion chassis driven by an external SMB-2000 master chassis.
35
SMARTCARDS
The modular SmartBits system allows mixtures of the following SmartCards to
test single technology devices or networks of inter-working technologies:
CARD DESCRIPTION
10MBPS AND 100 MBPS A family of Ethernet Smartcards that generates and monitors
SMARTCARDS (ST-6410, both 10 Mbps and 100 Mbps Ethernet traffic in half or full
SE-6205, SE-6305, duplex modes.
SX-7410 and SX-7210)
GIGABIT ETHERNET Provides performance measurement functions for Gigabit Ethernet
SMARTCARD(GX-1405) with data rates of 1.0 Gbps Ethernet traffic in full-duplex
mode. Complies with IEEE Gigabit Ethernet specifications for
full-duplex and flow control functions.
MULTI-LAYER SMARTCARD Measures performance and interoperability of layer 3 devices
(ML-7710) for 10/100 Mbps Ethernet traffic. Also incorporates the layer 2
functionality and performance of the 10Mbps and 100 Mbps
SmartCards. Each ML-7710 can generate, monitor and capture the
equivalent traffic of one fully loaded LAN with up to 1000 end
devices.
LAYER 3 SMARTCARD Measures performance and interoperability of layer 3 devices
(L3-6710) for 10 Mbps Ethernet traffic in half duplex mode.
ATM SMARTCARDS (AT-9015, A family of SmartCards that generate and monitor ATM network
AT-9020, AT-9025, traffic from 1.544 Mbps to 622 Mbps. Applications include
AT-9034, AT-9045, performance measurement of ATM-to-LAN inter-networking and for
AT-9155 and AT-9622) an ATM edge device's ability to accept and sustain switched
virtual circuits.
FRAME RELAY SMARTCARD Performs frame level performance measurement at up to 6 Mbps
(WN-3405) for Frame Relay assemblers/disassemblers, routers and switches
operating over V.35 WAN links.
TOKEN RING SMARTCARD Provides a single port UTP interface for generating and
(TR-8405) monitoring both 4 and 16 Mbps. Can send and receive over 40,000
frames/second (by sending multiple frames per token).
36
SOFTWARE APPLICATIONS
Netcom Systems also offers a suite of software products and test
applications designed to simplify the operation of SmartBits which can be
further customized using SmartLibrary. A typical SMB-2000 chassis comes bundled
with SmartWindow, SmartApplications and SmartLibrary.
APPLICATION DESCRIPTION
SMARTWINDOW A Microsoft Windows-TM-graphical user interface "soft front panel"
used to control all functions of all types of SmartCards as well as
control and set up SmartBits tests.
SMARTAPPLICATIONS Performance measurement applications for Ethernet, Frame Relay and
ATM bridges, switches and routers. Based on industry standard tests
(RFCs 1242 and 1944) for measuring throughput, latency and packet
loss and back-to-back performance. The tests were developed in
cooperation with Scott Bradner of Harvard University.
SMARTLIBRARY A software package that enables the user to create custom tests. A
SmartBits system can be programmed with SmartLibrary using Visual
Basic, C/C++, Java, LabView, Delphi, Perl or TCL programming
languages. SmartLibrary also runs on Microsoft Windows-TM- and the
HP-UX and Solaris UNIX platforms.
ADVANCED SWITCH A suite of 10 tests designed to exercise particular functions as
TESTS ("AST") AND well as determine overall switch performance. The tests were
AST FOR TOKEN RING developed in cooperation with Robert Mandeville, Director of
European Network Laboratories located in Paris, France. AST fully
supports all requirements of RFC 2285.
VLAN ADVANCED SWITCH A suite of 10 tests that use the ML-7710 and L3-6710 SmartCards to
TEST ("VAST") measure the performance and capabilities of virtual LAN enabled
switch devices.
SMARTSIGNALING TESTS Pre-programmed tests that measure the capabilities of ATM switch
devices and ATM/LAN edge devices to accept and sustain switched
virtual circuit calls.
SALES AND MARKETING
The Company markets and sells its products through a direct sales force in
the United States, Denmark, the U.K. and France and through distributors in
Canada, China, Germany, Israel, Italy, Japan, Korea, the Netherlands, Sweden and
Taiwan. As of April 30, 1998, the Company employed a direct sales team composed
of 16 sales professionals and 7 systems engineers worldwide. Systems engineers
are important to the sales process, since they are the primary vehicles through
which the Company looks to provide value-added services to customers such as
training and troubleshooting. Netcom Systems is dedicated to establishing new
distributor relationships and servicing the needs of current distributors.
International revenues represented 17.9%, 16.7% and 26.1% of revenues for 1995,
1996 and 1997, respectively.
The Company's marketing strategy is to target NEMs, End Users and Service
Providers. Netcom Systems' marketing team creates the product roadmap, defines
innovative products to address the business needs of the Company's markets, and
works to ensure timely delivery of products to meet and exceed customer
expectations. Creation of user awareness and demand for Netcom Systems' products
includes partnering with key trade publications and all leading industry test
laboratories. Awareness and
37
educational initiatives also include trade shows, seminars, white papers,
application notes, mailing pieces, trade publications and advertising. The
Company maintains knowledge of new technology innovations by participating in
technology forums and industry standard bodies such as the IEEE, the IETF and
Gigabit, ATM and Frame Relay forums. As of April 30, 1998, the marketing group
employed nine people with extensive experience in the test, measurement and
network equipment marketplace and also uses the services of outside consultants.
CUSTOMERS
Netcom Systems has a customer base of over 600 accounts. The Company
believes that most industry-leading NEMs are customers, as well as many End
Users and Service Providers. Each of the Company's target markets has different
uses for the SmartBits platform and different purchasing practices.
Currently, NEMs represent a significant amount of repeat business for the
Company. NEMs typically purchase an entire SmartBits system consisting of one or
more chassis, SmartCards and software. NEM demand for subsequent system
purchases and add-on SmartCards is driven by the need to continually develop new
network protocols and technologies, the quality assurance and manufacturing
units' requirement to analyze new, improved or acquired products lines for
interoperability and standards compliance, and the growth in the NEM
engineering, customer service and marketing divisions. The Company also offers
an upgrade program for its NEM customers. For 1997, 89.7% of the Company's
domestic revenues were from sales to NEMs. See "Risk Factors--Dependence on
Sales to Network Equipment Manufacturers".
Conversely, End Users and Service Providers purchase SmartBits to ensure
that equipment from NEMs conforms to industry standards and is fully
interoperable in multi-vendor and multi-protocol environments before network
deployment. These customers also use SmartBits to proactively identify potential
network problem areas before performance degradation occurs and to communicate
network problems to vendors for resolution. The nature of the End User or
Service Provider sale is significantly different than that of the NEMs. Usually,
an End User or Service Provider will purchase between one and four SmartBits
systems and then buy additional stand-alone SmartCards as it has the need to
measure the performance of new technologies, rather than purchasing an entirely
new system. See "Risk Factors--Risks Associated with Entry into New and
Unfamiliar Customer Markets".
A significant amount of the Company's revenues were historically generated
by the Company's largest customers. For example, in each of 1995, 1996 and 1997,
the Company's four largest customers were Bay Networks, Cisco, 3Com and
Cabletron although the relative ordering of these four customers has varied from
year to year. For 1995, 1996 and 1997, these four customers collectively
accounted for 56.6%, 48.9% and 42.7%, respectively, of the Company's revenues.
Sales to Bay Networks and 3Com accounted for approximately 22.0% and 12.4% of
revenues, respectively, in the year ended December 31, 1995. Sales to Bay
Networks and Cisco accounted for approximately 14.4% and 10.9% of revenues,
respectively, in the year ended December 31, 1996, approximately 10.9% each of
revenues in the year ended December 31, 1997, and approximately 12.8% and 12.1%
of revenues, respectively, in the three month period ended March 31, 1998. The
Company anticipates that its results of operations in any given period will
continue to depend to a significant extent upon sales to a small number of
customers. As a result of this customer concentration, the Company's revenues
may be subject to substantial period-to-period fluctuations which could have a
material adverse effect on the Company's business, results of operations and
financial condition. See "Risk Factors--Dependence on Sales to Network Equipment
Manufacturers", "--Fluctuations in Quarterly Operating Results" and "--Entry
into New and Unfamiliar Customer Markets".
38
Set forth below are the Company's 10 largest NEM, End User, Service Provider
and international customers, based on 1997 revenues.
NEMS END USERS
- -------------------------------------------------------- --------------------------------------------------------
3Com Corporation 3M Corporation
Ascend Communications, Inc. Abbott Laboratories
Bay Networks, Inc. The Boeing Company
Cabletron Systems, Inc. Cigna Systems
Cisco Systems, Inc. John Hancock Mutual Life Insurance Company
FORE Systems, Inc. Microsoft Corporation
Hewlett-Packard Company NationsBanc Corporation
Hitachi Computer Products, Inc. Naval Command Control and Ocean Surveillance Center
RDT&E Division
Lucent Technologies, Inc. PaineWebber, Inc.
Xylan Corporation Raytheon Service Company
SERVICE PROVIDERS INTERNATIONAL
- -------------------------------------------------------- --------------------------------------------------------
AT&T Corporation 3Com Corporation
Bell Atlantic Network Integration Accton Technology Corporation
BellSouth Business Systems Allied Telesis
GTE Laboratories, Inc. Delta Electronics, Inc.
MCI Telecommunications Corporation D-Link Corporation
MFS/Worldcom Fujitsu Group
Pacific Bell Networks Integration Matsushita
PSINet, Inc. NEC Corporation
Southwestern Bell Technology Resources Newbridge Networks Corporation
Sprint Corporation Northern Telecom Canada Limited
CUSTOMER SUPPORT AND QUALITY ASSURANCE
Netcom Systems believes that superior technical services and support are
critical to customer satisfaction and the development of customer relationships.
The Company also believes that achieving high levels of customer satisfaction
through, among other things, the development of a robust quality assurance
infrastructure can be a key differentiator for the Company and can serve as a
barrier to entry in the performance measurement market. Netcom Systems has
divided its customer support organization into three distinct units, customer
service, support engineering and quality assurance, to better meet customer
needs. All three units of the customer service organization are responsible for
providing ongoing technical support and training for the Company's customers.
Customers receive telephone and e-mail support, and for a fee, receive new
releases of the Company's software and firmware. As of April 30, 1998, the
Company employed 14 customer support and quality assurance personnel. The
Company believes that customer feedback obtained through technical support is
critical to its research and development efforts.
The Company's customer service unit consists of a toll free customer support
line available during business hours, Monday through Friday. Support personnel
answer the technical support calls and generally provide same-day responses to
questions that cannot be resolved during the initial call. All calls are logged,
opened, tracked and closed with a focus on keeping customers informed on
progress. The Company's support engineering unit concentrates on supporting
major accounts such as the larger NEMs and supports sales engineers and sales
representatives. This unit also resolves more sophisticated customer problems
that cannot be solved over the telephone by identifying the problem,
communicating with the Company's research and development team to develop a
solution, testing the solution
39
and delivering it to the customer. This group does on-site customer visits when
necessary and develops new product training programs for customer service
representatives, systems engineers and sales professionals. The Company's
quality assurance unit not only ensures products are functioning according to
specifications prior to release but also works with customer service to
determine which customer issues are product flaws that should be fixed. Quality
assurance then communicates these issues to the research and development team
and manages the process of fixing the product. The Company provides support to
its direct customers and its distributors.
RESEARCH AND DEVELOPMENT
The Company believes that research and development is critical to its
business. Netcom Systems' research and development efforts are focused on
developing new products for the network performance measurement market and
further enhancing existing products. The Company is currently developing a new
higher density platform that will also be used to measure the performance of
next generation technologies as well as new SmartCards and new software test
suites. Netcom Systems' development efforts include addressing and anticipating
the performance measurement needs of NEMs, End Users and Service Providers;
focusing on emerging high growth networking technologies; emphasizing
performance measurement for higher layers of the OSI protocol stack and
improving the ease of use of SmartBits and enhancing the scalability of
SmartBits. The Company's future success depends on its ability to continue to
enhance its existing products and to develop new products that solve the needs
of its customers. The Company closely monitors changing customer needs by
communicating directly with its customer base and distributors. Netcom Systems
also receives input from active participation in industry groups responsible for
establishing technical standards.
Netcom Systems' research and development organization is composed of three
related engineering groups: hardware, firmware and software. Hardware engineers
design, develop and debug complex logic designs using field programmable gate
arrays and hardware description language, multiple microprocessors, memories and
high speed components to create cost efficient hardware designs that enable
complete flexibility in transmitted data. Firmware engineers create
implementations of real-time sensitive network traffic and protocol generators.
These software components are the engines of the SmartBits platform. The
products developed by this group do not interact with the user, but interact at
the data layer for the many physical interfaces Netcom Systems supports.
Software engineers include application engineers and application user interface
engineers. Application engineers use compilers to produce software applications
that are used by NEMs to rapidly create tailored tests for their unique needs in
manufacturing, quality assurance, and customer support.
Development schedules for technology products are inherently difficult to
predict, and there can be no assurance that the Company will introduce any
proposed new products in a timely fashion. Also, there can be no assurance that
the Company's product development efforts will result in commercially successful
products or that the Company's products will not contain "bugs" or other
performance problems or be rendered obsolete by changing technology or new
product announcements by other companies. Additionally, if the Company is to
successfully introduce new products in the future, it must successfully recruit
additional personnel, competition for whom is intense. See "Risk Factors--Risks
Associated with Rapid Technological Changes", "--Risks Associated with New
Product Introductions".
The Company has made and will continue to make significant investment in
research and development. The Company's research and development expenditures
were $0.8 million, $1.7 million and $3.5 million in 1995, 1996 and 1997,
respectively. As of April 30, 1998, Netcom Systems' research and development
staff consisted of 39 employees.
40
MANUFACTURING
Netcom Systems' manufacturing operations consist primarily of materials
planning and procurement, warehousing, distribution, quality control, logistics,
final assembly and test. The Company outsources the assembly of printed circuit
boards to third party contract electronic manufacturers. The Company presently
uses a variety of independent third party contract assembly companies to perform
printed circuit board assembly. The manufacturing process enables the Company to
satisfy specific customer demands with minimal capital and human resources. To
date, the Company has not experienced any significant product defects or product
returns. As of April 30, 1998, there were 37 employees in manufacturing.
The Company is dependent upon single or limited source suppliers for certain
key components and parts used in the Company's products, including certain
microprocessors and integrated circuits. The Company generally purchases single
or limited source components pursuant to purchase orders and has no guaranteed
supply arrangements with these suppliers. In addition, the availability of many
of these components is dependent in part on the Company's ability to provide its
suppliers with accurate forecasts of its future requirements. Any extended
interruption in the supply of any of the key components currently obtained from
a single or limited source, or in the time necessary to transition to a
replacement supplier's product or replacement component into the Company's
products, could disrupt its operations and have a material adverse effect on the
Company in any given period. The Company purchases certain components from
foreign suppliers, the supply of which could be adversely affected by changing
tariff and regulatory structures, particularly those affecting the import and
export of electronics and technology. The Company may also be subject to
increases in component costs, which could also have a material adverse effect on
the Company's business, results of operations and financial condition. See "Risk
Factors--Dependence on Contract Manufacturers and Single-Source Suppliers".
Lead times for materials and components ordered by the Company vary and
depend on factors such as the specific supplier, contract terms and demand for a
component at a given time. Currently, the Company acquires materials, completes
certain standard subassemblies and assembles fully-configured systems based on
the Company's forecasts. If orders do not match forecasts, the Company may have
excess or inadequate inventory of certain materials and components.
COMPETITION
The Company's principal and potential competitors include NEMs that develop
in-house products; test equipment manufacturers such as Hewlett-Packard, Fluke
Corporation and Tekelec; new start-up enterprises focused on network performance
measurement such as IXIA Communications; companies specializing in ATM (LAN
and/or WAN) performance testing such as Adtech, Inc. and RADCOM Ltd.; software
based network traffic simulators such as Ganymede Software Inc. and Optimal
Networks Corporation; and other companies that sell networking products with
functionality complementary to SmartBits, such as Network Associates, Inc.
Competitive factors in the network performance testing and measurement market
include the breadth of product features, conformity to industry-standard
protocols, pricing, product quality, reliability and functionality, marketing
and sales resources, customer service and support and reputation. Many of the
Company's competitors and potential competitors have greater resources, name
recognition and sales capabilities than the Company. Increased competition could
result in price reductions, reductions in gross margins, the inability of the
Company to increase market share, or a loss of market share by the Company, any
of which would adversely affect the Company's business, results of operations
and financial condition. There can be no assurance that the Company's current
and future competitors will not develop or market technologies and products that
offer higher performance and are more cost-effective than the Company's current
or future products, thereby rendering the Company's technologies and products
obsolete. See "Risk Factors--Competition".
41
PROPRIETARY RIGHTS
Although the Company believes that its success is more dependent upon its
technical expertise than its proprietary rights, the Company's future success
and ability to compete is dependent in part upon its proprietary technology. The
Company relies on a combination of contractual rights, trade secrets and
copyright laws to establish and protect its proprietary technology. The Company
generally enters into confidentiality agreements with its employees,
consultants, resellers, customers and potential customers, and strictly limits
access to, and distribution of its source code, and further limits the
disclosure and use of other proprietary information. There can be no assurance
that the steps taken by the Company in this regard will be adequate to prevent
misappropriation of its technology or that the Company's competitors will not
independently develop technologies that are substantially equivalent or superior
to the Company's technology. In addition, the laws of some foreign countries do
not protect the Company's proprietary rights to the same extent as do the laws
of the United States.
The Company is also subject to the risk of adverse claims and litigation
alleging infringement of the intellectual property rights of others. There can
be no assurance that third parties will not assert infringement claims in the
future with respect to the Company's current or future products. Any such
assertion, regardless of its merit, could require Netcom Systems to pay damages
or settlement amounts and could require the Company to develop non-infringing
technology or acquire licenses to the technology that is the subject of asserted
infringement, resulting in product delays or increased costs or both. In
addition, the cost of any such litigation and the distraction of the Company's
management resources in connection therewith could have a material adverse
effect on the Company. No assurance can be given that any necessary licenses
will be available or that, if available, such licenses can be obtained on
commercially reasonable terms. The failure of the Company to adequately obtain
such licenses, or to protect its own proprietary technology through contractual
rights, trade secrets, patent and copyrights laws, could have a material adverse
effect on the Company. See "Risk Factors--Dependence on Proprietary Technology".
FACILITIES
The Company's principal operations are conducted out of one leased building
located in Chatsworth, California with a total of 50,000 square feet of office
and manufacturing space. The Company also maintains 6 branch offices in the
United States. The Company's European operations are headquartered in Plaisir,
France.
The Company believes that its current Chatsworth facilities will be adequate
to meet the anticipated level of operations only through the first half of 1999.
EMPLOYEES
On April 30, 1998, Netcom Systems employed 140 individuals on a full-time
equivalent basis. Of these, 39 were involved in engineering, 46 in sales,
marketing, and customer support, 37 in manufacturing, and 18 in administration.
The Company believes that it maintains good relations with its employees and has
not experienced any interruption of operations as a result of labor
disagreements.
LEGAL PROCEEDINGS
The Company is not currently a party to any material legal proceedings.
42
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
The directors and executive officers of the Company are as follows:
NAME AGE POSITION
- --------------------------------------- --- ------------------------------------------------------------------
Barry Phelps........................... 51 President, Chief Executive Officer and Director
Gil Cabral............................. 50 Vice President, Finance, Chief Financial Officer and Secretary
James Jordan........................... 61 Vice President, Sales
Gene Zhang............................. 42 Vice President, Engineering
Mark Fishburn.......................... 51 Vice President, Marketing
Dwight Olson........................... 46 Vice President, Operations
Henry Hamon............................ 40 General Manager, Netcom Systems Europe
Stephane Johnson....................... 42 Vice President, International Sales
Walter Kortschak (1)(2)................ 39 Chairman of the Board
Marc Hamon (1)......................... 45 Director
Richard Moley (1)...................... 59 Director
Robert Sheridan III (2)................ 35 Director
Michael West (2)....................... 48 Director
- ------------------
(1) Member of the Compensation Committee
(2) Member of the Audit Committee
BARRY PHELPS has served as President and Chief Executive Officer since
November 1997 and has served as a director since January 1998. From November
1996 to November 1997, Mr. Phelps served as the Vice President, Finance and
Chief Financial Officer of the Company. Prior to joining Netcom Systems, Mr.
Phelps served as Chairman and Chief Executive Officer of MICOM Communications
Corporation ("MICOM") from February 1992 to November 1996 and Vice President,
Chief Financial Officer from August 1988 to January 1992. MICOM was acquired by
Northern Telecom, Ltd. in June 1996. Prior to serving as Vice President, Chief
Financial Officer of MICOM, he served as Controller of MICOM from July 1987 to
August 1988. From 1973 to 1987, Mr. Phelps served in various financial
management positions at Burroughs Corporation and its successor, Unisys
Corporation.
GIL CABRAL has served as Vice President, Finance, Chief Financial Officer
and Secretary since October 1997. Prior to joining Netcom Systems, Mr. Cabral
served as President and Chief Operations Officer of MICOM from August 1988 to
September 1997. From August 1985 to August 1988, he served as Vice President,
Operations and Vice President Finance and Administration for MICOM. Prior to
that, Mr. Cabral spent 13 years with GTE Corporation in various financial
management positions and served four years as General Manager and Vice
President, Operations for International Cheese Company. He sits on the Board of
Directors of Connected Systems, Inc., a privately held company in Santa Barbara,
California.
JAMES JORDAN has served as Vice President, Sales since December 1994. Prior
to joining the Company, Mr. Jordan managed the Southern California sales region
for Network General Corporation from January 1991 to October 1994. From January
1986 to December 1990, Mr. Jordan ran his own sales representation firm, Jordan
Electronics. From 1959 to 1985, Mr. Jordan held various sales and management
positions at Moxon Electronics Corporation, including President from 1973 to
1985.
GENE ZHANG has served as Vice President, Engineering since April 1996. From
January 1988 to April 1996, Mr. Zhang held various positions at Wandel &
Goltermann Technologies, Inc., including
43
Director of Engineering from June 1995 to April 1996, Business Unit Manager from
May 1993 to May 1995 and Engineering Manager from January 1988 to April 1993.
From 1984 to 1987, Mr. Zhang was a senior engineer at Atlantic Research
Corporation.
MARK FISHBURN has served as Vice President, Marketing since March 1997. From
July 1993 until he joined Netcom Systems, Mr. Fishburn founded and was President
of Achieve, Inc. From October 1984 through July 1993, Mr. Fishburn held various
management positions at Retix, including UK Managing Director and Vice
President, General Manager of OSI Software Products. Mr. Fishburn also held
technical support and marketing management positions at Xerox Corporation and
Systems Engineering Labs from 1974 to 1984.
DWIGHT OLSON has served as Vice President, Operations since September 1997.
From January 1997 to August 1997, Mr. Olson was Vice President of Operations at
Whisper Communications, Inc. From July 1984 to January 1997, Mr. Olson held
various operations management positions at MICOM, including Vice President
Operations from 1988 to 1997.
HENRY HAMON has served as General Manager, Netcom Systems Europe since
February 1996. From August 1995 to September 1997, Mr. Hamon served as a
consultant to the Company. Mr. Hamon was an independent consultant in software
engineering for six years from February 1990 to February 1996. Prior to that, he
was a technical marketing manager for Quotron Systems, Inc. from 1987 to 1989.
Mr. Hamon also spent four years as a software architecture manager for Dassault
Systemes S.A. from 1983 to 1987.
STEPHANE JOHNSON has served as Vice President, International Sales since
September 1996. From January 1993 to August 1996, Mr. Johnson was with Experdata
France, a subsidiary of Philips Communication Systems B.V., serving as Directeur
General. From March 1987 to December 1993, Mr. Johnson was the President and CEO
of Experdata, Inc. Prior to Experdata, Inc., from September 1981 to February
1987, Mr. Johnson held various technical, sales and operations management
positions at TITN, Inc., a subsidiary of Alcatel N.V.
WALTER KORTSCHAK has been Chairman of the Board since August 1997. Mr.
Kortschak is a General Partner of Summit Partners, L.P., a private equity
investment firm, where he has been employed since June 1989. Summit Partners and
its affiliates manage a number of venture capital funds, including Summit
Ventures IV, L.P. and Summit Investors III, L.P., which are stockholders of the
Company. Mr. Kortschak also serves as a director of Aspec Technology, Inc., HMT
Technology Corporation, and SteriGenics International, Inc.
MARC HAMON has served as a director since January 1989. Mr. Hamon founded
Netcom Systems in 1988 and served as President and Chief Executive Officer of
the Company from 1988 through November 1997.
RICHARD MOLEY has served as a director since September 1997. Mr. Moley was
Senior Vice President, Wide Area Business Unit, of Cisco from July 1996 to July
1997. He served as President and Chief Executive Officer of StrataCom, Inc. from
June 1986 to July 1996, when Stratacom was acquired by Cisco. Mr. Moley serves
on the Board of Directors of Linear Technology, Inc., CMC Industries, Inc. and
Cidco, Inc.
ROBERT SHERIDAN III has served as a director since August 1997. Mr. Sheridan
is a Managing Director of NationsBank Capital Investors, the principal
investment group within NationsBank Corporation, and a Senior Vice President of
NationsBanc Capital Corp., NationsBanc Investment Corporation and NationsBank,
N.A. NationsBanc Capital Corp. is a stockholder of the Company. Prior to joining
NationsBank Capital Investors in January 1994, Mr. Sheridan worked in the
corporate bank division of NationsBank Corporation and its predecessor from June
1989 to January 1994. Prior to joining NationsBank Corporation, Mr. Sheridan
worked in investment banking and capital markets positions at
44
PaineWebber, Inc. from 1986 to 1988. Mr. Sheridan serves as a director of
Cumulus Media, Inc., a radio broadcasting company.
MICHAEL WEST has served as a director since March 1998. From September 1997
to January 1998, Mr. West served as an Executive Vice President at Lucent
Technologies. Prior to that, Mr. West was employed by Octel Communications
Corporation from September 1986 to September 1997, serving as President and
Chief Operating Officer from December 1995 to September 1997, Vice Chairman from
February 1995 to December 1995 and Executive Vice President for sales and
marketing from September 1986 to February 1995. Mr. West also served as a
director of Octel Communications Corporation from February 1995 to September
1997.
BOARD COMPOSITION
The Company currently has authorized six directors. In accordance with the
terms of the Company's Certificate of Incorporation, the terms of office of the
Board of Directors will be divided into three classes: Class I, whose term will
expire at the annual meeting of stockholders to be held in 1999, Class II, whose
term will expire at the annual meeting of stockholders to be held in 2000 and
Class III, whose term will expire at the annual meeting of stockholders to be
held in 2001. The Class I directors are Messrs. Hamon and Sheridan, the Class II
directors are Messrs. Kortschak and Moley and the Class III directors are
Messrs. Phelps and West. At each annual meeting of stockholders after the
initial classification, the successors to directors whose terms will then expire
will be elected to serve from the time of election and qualification until the
third annual meeting following election. Any additional directorships resulting
from an increase in the number of directors will be distributed among the three
classes so that, as nearly as possible, each class will consist of one-third of
the directors. This classification of the Board of Directors may have the effect
of delaying or preventing changes in control or management of the Company.
Directors may be removed for cause by the affirmative vote of the holders of a
majority of the Common Stock.
In connection with the recapitalization of the Company in the third quarter
of 1997, the Company and certain of the Company's directors, executive officers
and stockholders became parties to a Shareholders Agreement pursuant to which
they have agreed to vote their shares of stock to preserve the number of
authorized directors of the Company at six and to elect certain representatives
to serve as directors of the Company. Together, these persons and entities will
hold 48,513,538 shares, or 79.6% of the Company's outstanding Common Stock
following consummation of the Offerings assuming no exercise of the
Underwriters' over-allotment options and assuming no exercise of options after
March 31, 1998). Accordingly, the parties to this Shareholders Agreement will be
empowered to control the election of directors of the Company. The provisions of
the Shareholders Agreement will survive the Offerings and will remain in effect
until terminated by a vote of investors in the recapitalization owning
two-thirds of shares held by all such investors.
The Company's executive officers are appointed by the Board of Directors and
serve until their successors are elected or appointed.
Except for Marc Hamon, a director of the Company, and Henry Hamon, an
executive officer of the Company, who are brothers, there are no family
relationships among any of the Company's directors or executive officers.
BOARD COMMITTEES
The Board of Directors has two committees, an Audit Committee and a
Compensation Committee. Since May 1998, the Board's Audit Committee has
consisted of Messrs. Sheridan, West and Kortschak. The Audit Committee reviews
the Company's annual audit and meets with the Company's independent auditors to
review the Company's internal accounting procedures and financial management
practices. Since May 1998 the Compensation Committee has consisted of Messrs.
Moley, Kortschak and Hamon.
45
The Compensation Committee makes determinations concerning salaries, incentives
and other forms of compensation for directors, officers and other employees of
the Company. The Compensation Committee also administers the Company's various
stock plans. Prior to the creation of the Compensation Committee, all decisions
concerning salaries, incentives and other forms of compensation for directors,
officers and other employees of the Company were made by the whole Board of
Directors.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
None of the members of the Compensation Committee of the Board of Directors
is currently or has been, at any time since the formation of the Company, an
officer or employee of the Company except that Marc Hamon served as an officer
of the Company prior to November 1997. No executive officer of the Company
serves as a member of the board of directors or compensation committee of any
entity that has one or more executive officers serving on the Company's Board of
Directors or Compensation Committee.
DIRECTOR COMPENSATION
Outside directors currently receive no cash compensation for services
provided in that capacity but are reimbursed for out-of-pocket expenses they
incur in connection with their attendance at meetings of the Board. Directors
are eligible to participate in the Company's stock plans and, beginning in 1998,
employee directors will also be eligible to participate in the Company's 1998
Purchase Plan. Upon closing of the Offerings, each non-employee director
("Outside Director") will be granted options to purchase Common Stock under the
1998 Stock Plan as follows: (i) each Outside Director shall automatically be
granted a nonstatutory stock option to purchase 60,000 shares of Common Stock
(the "First Option") on the date which such person first becomes an Outside
Director and (ii) each Outside Director shall automatically be granted an option
to purchase 12,000 shares (the "Subsequent Option") on the date of the Company's
annual meeting of stockholders, if on such date he or she shall have served on
the Board for at least six months. Each option shall have a term of 10 years.
The shares subject to the First Option shall vest as to 20% of the optioned
stock one year from the date of grant, and 1/48th of the remaining optioned
stock shall vest each month thereafter, provided the person continues to serve
as a director on such dates. The shares subject to the Subsequent Option shall
vest as to 100% of the optioned stock on the first anniversary of the date of
grant, provided the person continues to serve as a director on such date. The
exercise price of each First Option and each Subsequent Option shall be 100% of
the fair market value per share of the Common Stock on the date of grant. See
"--Stock Plans".
EMPLOYMENT CONTRACTS AND TERMINATION OF EMPLOYMENT AND CHANGE-IN-CONTROL
AGREEMENTS
The Company routinely delivers written offer letters containing provisions
on salary bonuses, benefits and stock option grants to prospective members of
management and other employees. In addition, the Company has entered into
employment and change-in-control agreements as described below.
The Company entered into a written employment agreement with James Jordan,
Vice President, Sales, in December 1994. The agreement, as amended over time,
sets forth Mr. Jordan's base salary, sales commissions and bonuses as well as
certain benefits to which Mr. Jordan is entitled. The agreement has a one year
renewable term. If not renewed by November 30 of any year, the agreement will
automatically terminate on December 1 of such year. Pursuant to such agreement,
Mr. Jordan agreed not to directly or indirectly compete with the Company in the
manufacture or sale of products which are identical or similar to those of the
Company for one year following termination of his employment.
By letter agreement in September 1996, the Company entered into a written
employment agreement with Barry Phelps, the President and Chief Executive
Officer of the Company. The letter agreement, as amended over time, provided for
certain bonuses and acceleration of options, each of which has
46
been paid or effected to date. In addition, the agreement with Mr. Phelps
provides that termination of
Mr. Phelps' employment for convenience by the Company requires three months'
prior notice.
The Company entered into a written employment agreement with Stephane
Johnson, Vice President, International Sales, in September 1996. The agreement
sets forth Mr. Johnson's base salary, sales commissions and bonuses as well as
certain benefits to which Mr. Johnson is entitled. The agreement has a one year
renewable term. If not renewed by August 31 of any year, the agreement will
automatically terminate on September 1 of such year. The agreement with Mr.
Johnson provides for partial acceleration of certain options upon the
dissolution, liquidation merger or consolidation of the Company before September
1998. In addition, the agreement with Mr. Johnson provides that if Mr. Johnson
is involuntarily terminated without cause at any time after September 1, 1997,
the Company shall continue to pay Mr. Johnson's salary and car allowance and
shall continue to pay the premium cost of Mr. Johnson's group insurance for
three months following the effective date of such termination. Pursuant to such
agreement, Mr. Johnson agreed not to directly or indirectly compete with the
Company in the manufacture or sale of products which are identical or similar to
those of the Company for one year following termination of Mr. Johnson's
employment.
In June 1997, the Company entered into a written employment agreement with
Netcom Systems Europe and Netcom Systems Europe's General Manager, Henry Hamon.
The agreement with Mr. Hamon sets forth his base salary, sales commissions and
bonuses. The term of employment covered by the agreement extends to February 1,
1999. After February 1, 1999, the Company may terminate the agreement for cause,
as defined under French law, subject to a three month notice period. Pursuant to
such agreement, Mr. Hamon agreed not to engage in any other employment,
occupation, consulting or other business activity directly related to the
business of the Company for a period of six months following termination.
In May 1998, the Company entered into Change-in-Control Agreements with each
of its executive officers. Such agreements provide that if the executive
officer's employment with the Company is involuntarily terminated at any time
within 24 months after a Change of Control other than for Cause (each as defined
therein), then the executive officer shall be entitled to (i) acceleration of
all options and (ii) a severance payment equal to one year of the executive
officer's base compensation for the Company's fiscal year then in effect plus
the executive officer's bonus calculated at one hundred percent of target for
the Company's fiscal year then in effect. Any severance payments are payable in
a lump sum on or prior to the termination date. In addition, for a period of 12
months following such termination, the executive officer shall continue to
participate in the Company's health and dental insurance benefit plans in
accordance with the rules established for individual participation in such
plans, as such rules may be amended from time to time.
Pursuant to such Change-in-Control Agreements, a "Change-in-Control" is
defined as (i) the acquisition by a third party of beneficial ownership of
securities of the Company representing 50% or more of the total voting power
represented by the Company's then outstanding voting securities; or (ii) a
change in the composition of the Board of Directors of the Company as a result
of which fewer than a majority of the directors are incumbent directors of the
Company or who are elected, or nominated for election, to the Board with the
affirmative votes of at least a majority of the incumbent directors at the time
of such election or nomination; or (iii) a merger or consolidation of the
Company with any other corporation, other than a merger or consolidation which
would result in the voting securities of the Company outstanding immediately
prior thereto continuing to represent at least 50% of the total voting power
represented by the voting securities of the Company or such surviving entity
outstanding immediately after such merger or consolidation; or (iv) the approval
by the stockholders of the Company of a plan of complete liquidation of the
Company or of an agreement for the sale or disposition by the Company of all or
substantially all the Company's assets.
47
EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE. The following table sets forth the compensation
paid by the Company during the fiscal year ended December 31, 1997 to each
person serving as Chief Executive Officer during such year and its four other
most highly compensated executive officers (the Chief Executive Officer and such
other executive officers are hereinafter referred to as the "Named Executive
Officers"):
SUMMARY COMPENSATION TABLE
LONG TERM
COMPENSATION
AWARDS
--------------
NUMBER OF
ANNUAL COMPENSATION SECURITIES
-------------------------------------------------- UNDERLYING
NAME AND PRINCIPAL POSITION SALARY BONUS OTHER (1) OPTIONS
- --------------------------------------------- ------------- ---------------------- ----------- --------------
Barry Phelps................................. $ 155,782 $ 250,000 -- 860,000
President and Chief Executive Officer
Marc Hamon................................... 1,200,007 -- -- 60,000
Former President and Chief Executive
Officer
Henry Hamon.................................. 114,996 -- $ 290,000(2) 264,000
General Manager, Netcom Systems Europe
James Jordan................................. 158,493 50,000 333,895(2) --
VP, Sales
Stephane Johnson............................. 152,889 -- 163,963(2) 264,000
VP, International Sales
Gene Zhang................................... 146,869 40,000 -- 360,000
VP, Engineering
- ------------------
(1) Other annual compensation in the form of perquisite and other personal
benefits, securities or property has been omitted in those cases where the
aggregate amount of such compensation is the lesser of either $50,000 or 10%
of the total of annual salary and bonus reported for the Named Executive
Officer.
(2) Represents sales commission.
48
STOCK OPTION INFORMATION. The following table sets forth certain
information for the fiscal year ended December 31, 1997 with respect to each
grant of stock options to the Named Executive Officers:
OPTION GRANTS DURING YEAR ENDED DECEMBER 31, 1997
POTENTIAL REALIZABLE
VALUE
INDIVIDUAL GRANTS AT ASSUMED ANNUAL
----------------------------------------------------
NUMBER OF RATES OF STOCK PRICE
SECURITIES % OF TOTAL APPRECIATION FOR
UNDERLYING OPTIONS EXERCISE OPTION TERM(4)
OPTIONS GRANTED IN PRICE PER EXPIRATION --------------------
NAME GRANTED(1) 1997(2) SHARE(3) DATE 5% 10%
- ----------------------------------------------------- ----------- ------------- ----------- ----------- --------- ---------
Barry Phelps......................................... 360,000 7.26% $ 0.75 9/10/07 $ 169,802 $ 430,310
500,000 10.09 0.75 11/13/07 235,835 597,663
Marc Hamon........................................... 60,000 1.21 0.75 9/10/07 28,300 71,718
Henry Hamon.......................................... 264,000 5.33 0.75 9/10/07 124,521 315,561
James Jordan......................................... -- -- -- -- -- --
Stephane Johnson..................................... 264,000 5.33 0.75 9/10/07 124,521 315,561
Gene Zhang........................................... 360,000 7.26 0.75 9/10/07 169,802 430,310
- ------------------
(1) The options granted to Messrs. Phelps, Henry Hamon, Johnson and Zhang have
vesting schedules based on time and milestones. For each such option, 50% of
the shares vest over time as follows: 20% vest on the first anniversary of
the date of grant and the remainder vest 1/48 per month thereafter. The
remaining 50% vest based on milestones as follows: 1/3 vest upon the closing
of this offering, 1/3 vested if the Company achieves certain revenue and
profit benchmarks for 1998, and 1/3 vest if the Company achieves certain
revenue and profit benchmarks for 1999; provided, that, in any event, all
shares will be fully vested on the fifth anniversary of the date of grant.
The option granted to Mr. Marc Hamon has a vesting schedule as follows: 20%
vest on the first anniversary of the date of grant and the remainder vest
1/48 per month thereafter.
(2) In 1997, the Company granted employees, consultants and directors options to
purchase an aggregate of 4,957,100 shares of Common Stock, excluding certain
options to purchase shares of Common Stock regranted upon the cancellation
of other options in connection with the repricing of options.
(3) The exercise price per share of each option was equal to the fair value of
the Common Stock on the date of grant as determined in good faith by the
Board of Directors on such date based upon such factors as the purchase
price paid by investors for shares of the Company's preferred stock, the
absence of a trading market for the Company's securities and the Company's
financial outlook and results of operations.
(4) In accordance with the rules of the SEC, shown are the gains or "option
spreads" that would exist for the respective options granted. These gains
are based on the assumed rates of annual compound stock price appreciation
of 5% and 10% from the date the option was granted over the full option
term. These assumed annual compound rates of stock price appreciation are
mandated by the rules of the Commission and do not represent the Company's
estimate or projection of future Common Stock prices.
49
AGGREGATE OPTION EXERCISE AND OPTION VALUES. The following table sets forth
information with respect to the Named Executive Officers concerning option
exercises for the fiscal year ended December 31, 1997 and exercisable and
unexercisable options held as of December 31, 1997:
AGGREGATE OPTION EXERCISES IN 1997 AND YEAR-END OPTION VALUES
NUMBER OF SECURITIES
UNDERLYING UNEXERCISED VALUE OF UNEXERCISED IN-
OPTIONS AT THE-MONEY OPTIONS
DECEMBER 31, 1997 AT DECEMBER 31, 1997 (1)
---------------------------- ----------------------------
SHARES
ACQUIRED
ON VALUE
NAME EXERCISE REALIZED EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---------------------------------- --------- -------------- ------------ -------------- ------------ --------------
Barry Phelps...................... 119,998 $ 376,057(2) -- 1,340,002 -- $ 351,667
Marc Hamon........................ -- -- -- 60,000 -- 15,000
Henry Hamon....................... 213,334 1,590,938(3) -- 850,666 -- 242,667
James Jordan...................... 1,700,000 12,171,500(4) 300,000 -- $ 75,000 --
Stephane Johnson.................. 53,332 374,391(5) 13,334 797,334 5,000 216,000
Gene Zhang........................ 200,000 1,128,200(6) -- 760,000 -- 190,000
- ------------------
(1) The fair market value of the Company's Common Stock at the close of business
on December 31, 1997 was estimated to be approximately $1.00 per share.
(2) Based on the exercise of options to acquire 53,332 shares, which shares were
repurchased by the Company in the Recapitalization at a price of $7.646 per
share, and the exercise of options to acquire 66,666 shares with a deemed
fair market value of $0.75 per share on October 13, 1997.
(3) Based on the exercise of options to acquire 213,334 shares, which shares
were repurchased by the Company in the Recapitalization at a price of $7.646
per share.
(4) Based on the exercise of options to acquire 1,700,000 shares, which shares
were repurchased by the Company in the Recapitalization at a price of $7.646
per share.
(5) Based on the exercise of options to acquire 53,332 shares, which shares were
repurchased by the Company in the Recapitalization at a price of $7.646 per
share.
(6) Based on the exercise of options to acquire 160,000 shares, which shares
were repurchased by the Company in the Recapitalization at a price of $7.646
per share, and the exercise of options to acquire 40,000 shares with a
deemed fair market value of $0.75 per share on October 23, 1997.
STOCK PLANS
1993 STOCK PLAN
A total of 7,844,000 shares of Common Stock have been reserved for issuance
under the Company's Amended and Restated 1993 Non-Statutory Stock Option and
Purchase Plan, as amended (the "1993 Stock Plan"). Under the 1993 Stock Plan, as
of March 31, 1998, options to purchase an aggregate of 4,645,774 shares were
outstanding, 3,198,226 shares of Common Stock had been purchased pursuant to
exercises of stock options and no shares were available for future grant.
The 1993 Stock Plan provides for the grant of nonqualified stock options
(not intended to qualify within the meaning of Section 422 of the Internal
Revenue Code of 1986, as amended (the "Code")) to key employees of the Company.
The 1993 Stock Plan is administered by the Board of Directors or a committee
appointed by the Board of Directors, which determines the terms of options
granted, including the exercise price and the number of shares subject to each
option. The Board of Directors also determines the schedule upon which options
become exercisable. The exercise price of stock options granted under the 1993
Stock Plan must be at least equal to the fair market value of the Company's
50
Common Stock on the date of grant. However, for any employee holding more than
10% of the voting power of all classes of the Company's stock, the exercise
price will be no less than 110% of the fair market value. The term of options
granted under the 1993 Stock Plan is 10 years (five years in the case of an
employee holding more than 10% of the voting power of all classes of the
Company's stock).
Options granted under the 1993 Stock Plan are not transferable by the
optionee, and each option is exercisable during the lifetime of the optionee
only by such optionee. Options granted under the 1993 Stock Plan must generally
be exercised within three months after the end of optionee's status as an
employee of the Company, or within one year after such optionee's termination by
disability or death, respectively. If the optionee dies within 90-days following
termination of employment, the person to whom the optionee's rights pass by will
or the laws of descent or distribution may exercise the option for a period of
one year. In no event may the option be exercised later than the expiration of
the option's term.
The option agreements pursuant to the 1993 Stock Plan provide that in the
event of a merger of the Company with or into another corporation, or a sale of
substantially all of the Company's assets, each outstanding option shall be
assumed or an equivalent option substituted for by the successor corporation. If
the outstanding options are not assumed or substituted for by the successor
corporation, the administrator shall provide for the optionee to have the right
to exercise the option as to all of the optioned stock, including shares as to
which it would not otherwise be exercisable. If the administrator makes an
option exercisable in full in the event of a merger or sale of assets, the
administrator shall notify the optionee that the option or stock purchase right
("SPR") shall be fully exercisable for a period of 15 days from the date of such
notice, and the option or SPR will terminate upon the expiration of such period.
In addition, in the event of a change of control of the Company whereby the
stockholders of the Company immediately prior to the change of control event
fail to hold at least 50% of the outstanding capital stock of the Company
following the change of control event or any sale of all or substantially all of
the Company's assets, then, immediately prior to any such change of control
event, the vesting of options under this plan will accelerate by one year.
1997 STOCK PLAN
A total of 7,919,100 shares of Common Stock have been reserved for issuance
under the Company's Second Amended and Restated 1997 Stock Plan, as amended (the
"1997 Stock Plan"). Under the 1997 Stock Plan, as of March 31, 1998, options to
purchase an aggregate 5,823,688 shares were outstanding, 235,412 shares of
Common Stock had been purchased pursuant to exercises of stock options and
1,860,000 shares were available for future grant.
The 1997 Stock Plan provides for the grant of incentive stock options within
the meaning of Section 422 of the Code, nonstatutory stock options and SPRs to
employees, directors and consultants of the Company. Nonstatutory stock options
and SPRs may be granted to employees, directors and consultants of the Company.
Incentive stock options may be granted only to employees. The 1997 Stock Plan is
administered by the Board of Directors, or a committee appointed by the Board of
Directors, which determines the terms of options granted, including the exercise
price and the number of shares subject to each option. The Board of Directors
also determines the schedule upon which options become exercisable. The exercise
price of incentive stock options granted under the 1997 Stock Plan must be at
least equal to the fair market value of the Company's Common Stock on the date
of grant. However, for any employee holding more than 10% of the voting power of
all classes of the Company's stock ("10% stockholder"), the exercise price may
be no less than 110% of the fair market value. The exercise price of a
nonstatutory stock option may not be less than 85% of the fair market value of
the Common Stock on the date such option is granted; provided, however, the
exercise price of a nonstatutory stock option granted to a 10% shareholder may
not be less than 110% of the fair market value of the Common Stock on the date
such option is granted. The maximum term of options granted under the Stock Plan
is 10 years.
51
Options and SPRs granted under the 1997 Stock Plan are not transferable by
the optionee, and each option and SPR is exercisable during the lifetime of the
optionee only by such optionee. Options granted under the 1997 Stock Plan must
generally be exercised within three months after the end of optionee's status as
an employee, director or consultant of the Company, or within twelve months
after such optionee's termination by disability or death, respectively, to the
extent the optionee is vested on the date of termination, but in no event later
than the expiration of the option's term.
The 1997 Stock Plan provides that in the event of a merger of the Company
with or into another corporation, or a sale of substantially all of the
Company's assets, each outstanding option and SPR shall be (i) assumed, (ii)
exchanged for an equivalent option or right, or (iii) substituted by the
successor corporation or a parent or subsidiary of the successor corporation. If
the outstanding options and SPRs are not assumed or substituted for by the
successor corporation, the Administrator shall provide for the optionee to vest
and have the right to exercise the option or SPR as to an additional 20% of the
optioned stock. If the Administrator makes an option or SPR exercisable as to an
additional 20% of the unvested shares in the event of a merger or sale of
assets, the Administrator shall notify the optionee that such additional shares
shall be fully exercisable for a period of 15 days from the date of such notice,
and the option or SPR will terminate upon the expiration of such period. In the
event of a change of control of the Company whereby the stockholders of the
Company immediately prior to the change of control event fail to hold at least
50% of the outstanding capital stock of the Company following the change of
control event or any sale of all or substantially all of the Company's assets,
then, immediately prior to any such change of control event, 20% of any option
granted within one year from the date of the change of control event shall
become immediately vested and exercisable. In addition, in the event of a change
of control of the Company whereby the stockholders of the Company immediately
prior to the change of control event fail to hold at least 50% of the
outstanding capital stock of the Company following the change of control event
or any sale of all or substantially all of the Company's assets, then,
immediately prior to any such change of control event, the vesting of options
under this plan will accelerate by one year.
1998 STOCK PLAN
The Company's 1998 Stock Plan (the "1998 Plan") was adopted by the Board of
Directors in May 1998 and will be submitted for approval by the stockholders in
June 1998. A total of 4,000,000 shares of Common Stock, plus annual increases
(beginning in 2000) equal to the lesser of (i) 8,000,000 shares, (ii) 4% of the
outstanding shares, or (iii) a lesser amount determined by the Board of
Directors, are currently reserved for issuance pursuant to the 1998 Plan. Unless
terminated sooner, the 1998 Plan will terminate automatically in May 2008.
The 1998 Plan provides for the (i) discretionary grant of incentive stock
options, within the meaning of Section 422 of the Internal Revenue Code of 1986,
as amended (the "Code"), to employees and for the grant of nonstatutory stock
options and SPRs to employees, directors and consultants, and (ii) automatic
grant of nonstatutory stock options to non-employee directors.
The 1998 Plan may be administered by the Board of Directors or a committee
of the Board (as applicable, the "Administrator"). The Administrator has the
power to determine the terms of the options or SPRs granted, including the
exercise price of the option or SPR, the number of shares subject to each option
or SPR, the exercisability thereof, and the form of consideration payable upon
such exercise. In addition, the Administrator has the authority to amend,
suspend or terminate the 1998 Plan, provided that no such action may affect any
share of Common Stock previously issued and sold or any option previously
granted under the 1998 Plan.
The exercise price of all incentive stock options granted under the 1998
Plan must be at least equal to the fair market value of the Common Stock on the
date of grant. The exercise price of nonstatutory stock options and SPRs granted
under the 1998 Plan is determined by the Administrator, but with
52
respect to nonstatutory stock options intended to qualify as "performance-based
compensation" within the meaning of Section 162(m) of the Code, the exercise
price must be at least equal to the fair market value of the Common Stock on the
date of grant. With respect to any participant who owns stock possessing more
than 10% of the voting power of all classes of the Company's outstanding capital
stock, the exercise price of any incentive stock option granted must be at least
equal 110% of the fair market value on the grant date and the term of such
incentive stock option must not exceed five years. The term of all other options
granted under the 1998 Plan may not exceed ten years.
In the case of SPRs, unless the Administrator determines otherwise, the
Restricted Stock Purchase Agreement shall grant the Company a repurchase option
exercisable upon the voluntary or involuntary termination of the purchaser's
employment or consulting relationship with the Company for any reason (including
death or disability). The purchase price for shares repurchased pursuant to the
Restricted Stock Purchase Agreement shall be the original price paid by the
purchaser and may be paid by cancellation of any indebtedness of the purchaser
to the Company. The repurchase option shall lapse at a rate determined by the
Administrator.
The 1998 Stock Plan provides that each non-employee director shall
automatically be granted a nonstatutory stock option to purchase 60,000 shares
of Common Stock (the "First Option") on the date which such person first becomes
a non-employee director. In addition to the First Option, each non-employee
director shall automatically be granted an option to purchase 12,000 shares (a
"Subsequent Option") on the date of the Company's annual meeting of
stockholders, if on such date he or she shall have served on the Board for at
least six months. Each First Option and Subsequent Option shall have a term of
10 years. The shares subject to the First Option shall vest as to 20% of the
optioned stock one year from the date of grant, and 1/48th of the remaining
optioned stock shall vest each month thereafter, provided the person continues
to serve as a director on such dates. The shares subject to the Subsequent
Option shall vest as to 100% of the optioned stock on the anniversary of the
date of grant thereafter, provided the person continues to serve as a director
on such date. The exercise price of each First Option and each Subsequent Option
shall be 100% of the fair market value per share of the Common Stock.
Options and SPRs granted under the 1998 Plan are generally not transferable
by the optionee, and each option and SPR is exercisable during the lifetime of
the optionee only by such optionee. Options granted under the 1998 Plan must
generally be exercised within 30 days after the end of optionee's status as an
employee, director or consultant of the Company, or within one year after such
optionee's termination by disability or death, respectively, but in no event
later than the expiration of the option's term.
The 1998 Plan provides that in the event of a merger of the Company with or
into another corporation, or a sale of substantially all of the Company's
assets, each outstanding option and SPR shall be assumed or an equivalent option
substituted for by the successor corporation. If the outstanding options and
SPRs are not assumed or substituted for by the successor corporation, the
Administrator shall provide for the optionee to have the right to exercise the
option or SPR as to all of the optioned stock, including shares as to which it
would not otherwise be exercisable. If the Administrator makes an option or SPR
exercisable in full in the event of a merger or sale of assets, the
Administrator shall notify the optionee that the option or SPR shall be fully
exercisable for a period of 15 days from the date of such notice, and the option
or SPR will terminate upon the expiration of such period. In addition, in the
event of a change of control of the Company whereby the stockholders of the
Company immediately prior to the change of control event fail to hold at least
50% of the outstanding capital stock of the Company following the change of
control event or any sale of all or substantially all of the Company's assets,
then, immediately prior to any such change of control event, the vesting of
options under this plan will accelerate by one year.
53
1998 EMPLOYEE STOCK PURCHASE PLAN
The Company's 1998 Employee Stock Purchase Plan (the "1998 Purchase Plan")
was adopted by the Board of Directors in May 1998 and will be submitted for
approval by the stockholders in June 1998. A total of 300,000 shares of Common
Stock has been reserved for issuance under the 1998 Purchase Plan, plus annual
increases (beginning in 1999) equal to the lesser of (i) 2,000,000 shares, (ii)
1% of the outstanding shares or a lesser amount determined by the Board.
The 1998 Purchase Plan, which is intended to qualify under Section 423 of
the Internal Revenue Code of 1986, as amended, contains successive six month
offering periods. The offering periods generally start on the first trading day
on or after February 15 and August 15 of each year, except for the first such
offering period which commences on the first trading day on or after the
effective date of an initial public offering and ends on the last trading day on
or before February 14, 1999.
Employees are eligible to participate if they are customarily employed by
the Company or any participating subsidiary for at least 20 hours per week and
more than five months in any calendar year. However, any employee who (i)
immediately after grant owns stock possessing 5% or more of the total combined
voting power or value of all classes of the capital stock of the Company, or
(ii) whose rights to purchase stock under all employee stock purchase plans of
the Company accrues at a rate which exceeds $25,000 worth of stock for each
calendar year may be not be granted an option to purchase stock under the 1998
Purchase Plan. The 1998 Purchase Plan permits participants to purchase Common
Stock through payroll deductions of up to 15% of the participant's
"compensation". Compensation is defined as the participant's base straight time
gross earnings, commissions, overtime and bonuses but exclusive of any other
compensation. The maximum number of shares a participant may purchase during a
single offering period is 5,000 shares.
Amounts deducted and accumulated by the participant are used to purchase
shares of Common Stock at the end of each offering period. The price of stock
purchased under the 1998 Purchase Plan is 85% of the lower of the fair market
value of the Common Stock at the beginning or end of the offering period.
Participants may end their participation at any time during an offering period,
and they will be paid their payroll deductions to date. Participation ends
automatically upon termination of employment with the Company.
Rights granted under the 1998 Purchase Plan are not transferable by a
participant other than by will, the laws of descent and distribution, or as
otherwise provided under the 1998 Purchase Plan. The 1998 Purchase Plan provides
that, in the event of a merger of the Company with or into another corporation
or a sale of substantially all of the Company's assets, each outstanding option
may be assumed or substituted for by the successor corporation. If the successor
corporation refuses to assume or substitute for the outstanding options, the
offering period then in progress will be shortened and a new exercise date will
be set.
The Board of Directors has the authority to amend or terminate the 1998
Purchase Plan, except that no such action may adversely affect any outstanding
rights to purchase stock under the 1998 Purchase Plan, provided that the Board
of Directors may terminate an offering period on any exercise date if the Board
determines that the termination of the 1998 Purchase Plan is in the best
interests of the Company and its stockholders. The 1998 Purchase Plan will
become effective on the consummation of the offering and will terminate in 10
years from such date, unless sooner terminated by the Board of Directors.
401(K) PLAN
The Company maintains a retirement and deferred savings plan for its
employees (the "401(k) Plan") that is intended to qualify as a tax-qualified
plan under the Internal Revenue Code of 1986, as amended. The 401(k) Plan
provides that each participant may contribute up to 15% of his or her pre-tax
gross compensation (up to a statutory limit, which is $10,000 in calendar year
1998). Under the 401(k)
54
Plan, the Company may make discretionary matching contributions. The Company's
contribution to the 401(k) Plan in 1997 was $45,000 in the aggregate for all
employees. A matching contribution made by the Company vests at 25% per year
commencing on the first anniversary of a participant's date of employment with
the Company. All amounts contributed by participants and earnings on such
contributions are fully vested at all times.
LIMITATION OF LIABILITY AND INDEMNIFICATION MATTERS
The Company's Certificate of Incorporation limits the liability of directors
and executive officers to the maximum extent permitted by Delaware law. Delaware
law provides that directors of a corporation will not be personally liable for
monetary damages for breach of their fiduciary duties as directors, except
liability for (i) breach of their duty of loyalty to the corporation or its
stockholders, (ii) acts or omissions not in good faith or which involve
intentional misconduct or a knowing violation of law, (iii) unlawful payments of
dividends or unlawful stock repurchases or redemptions, or (iv) any transaction
from which the director derived an improper personal benefit. Such limitation of
liability does not apply to liabilities arising under the federal or state
securities laws and does not affect the availability of equitable remedies such
as injunctive relief or rescission.
The Company's bylaws provide that the Company shall indemnify its directors,
officers, employees and other agents to the fullest extent permitted by law. The
Company believes that indemnification under its Bylaws covers at least
negligence and gross negligence on the part of indemnified parties. The
Company's bylaws also permit it to secure insurance on behalf of any officer,
director, employee or other agent for any liability arising out of his or her
actions in such capacity, regardless of whether the bylaws permit such
indemnification.
The Company has entered into agreements to indemnify its directors and
executive officers, in addition to the indemnification provided for in the
Company's bylaws. These agreements, among other things, indemnify the Company's
directors and executive officers for certain expenses (including attorneys'
fees), judgments, fines and settlement amounts incurred by any such person in
any action or proceeding, including any action by or in the right of the Company
arising out of such person's services as a director, officer, employee, agent or
fiduciary of the Company, any subsidiary of the Company or any other company or
enterprise to which the person provides services at the request of the Company.
The Company believes that these provisions and agreements are necessary to
attract and retain qualified persons as directors and executive officers.
At present, there is no pending litigation or proceeding involving a
director or officer of the Company in which indemnification is required or
permitted, and the Company is not aware of any threatened litigation or
proceeding that may result in a claim for such indemnification.
55
CERTAIN TRANSACTIONS
In the third quarter of 1997, the Company was recapitalized in a transaction
(the "Recapitalization") involving (a) the borrowing of a $50,000,000 term loan
pursuant to a Credit Agreement with NationsBank of Texas, N.A., as
Administrative Agent, BankBoston, N.A. as Co-Agent and other financial
institutions, (b) the issuance of 485,184 shares of Class A Redeemable Preferred
Stock at an aggregate purchase price of $48,518,400, (c) the issuance of
45,806,874 shares of Class B Convertible Preferred Stock at an aggregate
purchase price of $48,518,400 and (d) the redemption of approximately 80% of the
Company's then-outstanding Common Stock at $7.646 per share for an aggregate
purchase price of approximately $156,217,600. The purchasers of Class A
Redeemable Preferred Stock and Class B Convertible Preferred Stock, and the
holders of Common Stock redeemed in the recapitalization included, among others,
the following directors, executive officers and holders of more than 5% of the
Company's Common Stock:
NUMBER OF NUMBER OF NUMBER OF
SHARES OF SHARES OF SHARES OF
CLASS A CLASS B COMMON
PREFERRED PREFERRED STOCK
STOCK STOCK REPURCHASED
----------- ------------- -------------
Henry Hamon........................................................... -- -- 1,013,334
Marc Hamon............................................................ -- -- 16,000,000
James Jordan.......................................................... -- -- 1,680,000
Richard Moley......................................................... 2,500 236,026 --
NationsBanc Capital Corp. (1)......................................... 80,000 7,552,908 --
Summit Ventures IV, L.P. (2).......................................... 236,856 22,361,872 --
TA Advent VIII........................................................ 65,511 6,184,996 --
- ------------------
(1) Robert Sheridan, an affiliate of NationsBanc Capital Corp. as well as
NationsBank of Texas, N.A., the Administrative Agent pursuant to the Credit
Agreement, is a director of the Company. Mr. Sheridan disclaims beneficial
ownership of the shares held by this entity except to the extent of his
proportionate partnership therein.
(2) Walter Kortschak, a General Partner of Summit Ventures IV, L.P., is a
director of the Company. Mr. Kortschak disclaims beneficial ownership of the
shares held by this entity except to the extent of his proportionate
partnership therein.
The purchasers of the Company's Class B Convertible Preferred Stock,
including the persons and entities described above, together with Marc Hamon, a
director of the Company, Henry Hamon, the Company's General Manager for Netcom
Systems Europe, James Jordan, the Company's Vice President, Sales, Barry Phelps,
the Company's President, Chief Executive Officer and director, Gene Zhang, the
Company's Vice President, Engineering, Stephane Johnson, the Company's Vice
President, International Sales and Richard Bass (collectively, the
"Recapitalization Parties") are parties to a Shareholders Agreement pursuant to
which they have agreed to vote their shares of stock to preserve the number of
authorized directors of the Company at six and to elect certain representatives
to serve as directors of the Company. Together, these persons and entities will
hold 48,513,538 shares, or 79.6% of the Company's outstanding Common Stock
following consummation of the Offerings (assuming no exercise of the
Underwriters' over-allotment options and assuming no exercise of options after
March 31, 1998). Accordingly, the parties to this Shareholders Agreement will be
empowered to control the election of directors of the Company. See
"Management--Directors and Executive Officers".
NationsBanc Montgomery Securities, LLC, a co-manager of the Offerings, as
well as certain of its affiliates & employees, including NationsBanc Capital
Corp., purchased shares of Class A Redeemable Preferred Stock and Class B
Convertible Preferred Stock in the Recapitalization. See "Underwriting".
56
In addition, the Recapitalization Parties are entitled to certain rights of
registration pursuant to a Registration Agreement between such persons and the
Company, including certain demand and piggyback registration rights. See
"Description of Capital Stock--Registration Rights of Certain Holders".
In September 1997, the Company purchased all of the outstanding shares of
Netcom Systems Europe, a company organized under the laws of the Republic of
France. In connection with such purchase, Henry Hamon, an executive officer of
the Company, received $150,000 in consideration for the sale of his shares in
Netcom Systems Europe to the Company.
In 1997, the Company loaned $670,000 to Marc Hamon, a director of the
Company and the former Chief Executive Officer of the Company, as an advance on
Mr. Hamon's salary. The loan was repaid in full on July 29, 1997. At that time,
interest charges of approximately $6,645 were paid by Mr. Hamon.
In the past, the Company has granted options to its executive officers and
directors. The Company intends to grant options to its officers and directors in
the future. See "Management--Option Grants During Year Ended December 31, 1997"
and "Management--Director Compensation".
The Company has entered into indemnification agreements with its officers
and directors containing provisions which may require the Company, among other
things, to indemnify its officers and directors against certain liabilities that
may arise by reason of their status or service as officers or directors (other
than liabilities arising from willful misconduct of a culpable nature) and to
advance their expenses incurred as a result of any proceeding against them as to
which they could be indemnified. The Company also intends to execute such
agreements with its future directors and executive officers. See
"Management--Limitation of Liability and Indemnification Matters".
The Company entered into a written employment agreement with James Jordan,
Vice President, Sales, in December 1994. The agreement, as amended over time,
sets forth Mr. Jordan's base salary, sales commissions and bonuses as well as
certain benefits to which Mr. Jordan is entitled. The agreement has a one year
renewable term. If not renewed by November 30 of any year, the agreement will
automatically terminate on December 1 of such year. Pursuant to such agreement,
Mr. Jordan agreed not to directly or indirectly compete with the Company in the
manufacture or sale of products which are identical or similar to those of the
Company for one year following termination of his employment.
By letter agreement in September 1996, the Company entered into a written
employment agreement with Barry Phelps, the President and Chief Executive
Officer of the Company. The letter agreement, as amended over time, provided for
certain bonuses and acceleration of options, each of which has been paid or
effected to date. In addition, the agreement with Mr. Phelps provides that
termination of Mr. Phelps' employment for convenience by the Company requires
three months' prior notice.
The Company entered into a written employment agreement with Stephane
Johnson, Vice President, International Sales, in September 1996. The agreement
sets forth Mr. Johnson's base salary, sales commissions and bonuses as well as
certain benefits to which Mr. Johnson is entitled. The agreement has a one year
renewable term. If not renewed by August 31 of any year, the agreement will
automatically terminate on September 1 of such year. The agreement with Mr.
Johnson provides for partial acceleration of certain options upon the
dissolution, liquidation merger or consolidation of the Company before September
1998. In addition, the agreement with Mr. Johnson provides that if Mr. Johnson
is involuntarily terminated without cause at any time after September 1, 1997,
the Company shall continue to pay Mr. Johnson's salary and car allowance and
shall continue to pay the premium cost of Mr. Johnson's group insurance for
three months following the effective date of such termination. Pursuant to such
agreement, Mr. Johnson agreed not to directly or indirectly compete with the
Company in the manufacture or sale of products which are identical or similar to
those of the Company for one year following termination of Mr. Johnson's
employment.
In June 1997, the Company entered into a written employment agreement with
Netcom Systems Europe and Netcom Systems Europe's General Manager, Henry Hamon.
The agreement with
57
Mr. Hamon sets forth his base salary, sales commissions and bonuses. The term of
employment covered by the agreement extends to February 1, 1999. After February
1, 1999, the Company may terminate the agreement for cause, as defined under
French law, subject to a three month notice period. Pursuant to such agreement,
Mr. Hamon agreed not to engage in any other employment, occupation, consulting
or other business activity directly related to the business of the Company for a
period of six months following termination.
In May 1998, the Company entered into Change-in-Control Agreements with each
of its executive officers. Such agreements provide that if the executive
officer's employment with the Company is involuntarily terminated at any time
within 24 months after a Change of Control other than for Cause (each as defined
therein), then the executive officer shall be entitled to (i) acceleration of
all options and (ii) a severance payment equal to one year of the executive
officer's base compensation for the Company's fiscal year then in effect plus
the executive officer's bonus calculated at one hundred percent of target for
the Company's fiscal year then in effect. Any severance payments are payable in
a lump sum on or prior to the termination date. In addition, for a period of 12
months following such termination, the executive officer shall continue to
participate in the Company's health and dental insurance benefit plans in
accordance with the rules established for individual participation in such
plans, as such rules may be amended from time to time.
Pursuant to such Change-in-Control Agreements, a "Change-in-Control" is
defined as (i) the acquisition by a third party of beneficial ownership of
securities of the Company representing 50% or more of the total voting power
represented by the Company's then outstanding voting securities; or (ii) a
change in the composition of the Board of Directors of the Company as a result
of which fewer than a majority of the directors are incumbent directors of the
Company or who are elected, or nominated for election, to the Board with the
affirmative votes of at least a majority of the incumbent directors at the time
of such election or nomination; or (iii) a merger or consolidation of the
Company with any other corporation, other than a merger or consolidation which
would result in the voting securities of the Company outstanding immediately
prior thereto continuing to represent at least 50% of the total voting power
represented by the voting securities of the Company or such surviving entity
outstanding immediately after such merger or consolidation; or (iv) the approval
by the stockholders of the Company of a plan of complete liquidation of the
Company or of an agreement for the sale or disposition by the Company of all or
substantially all the Company's assets.
The Company believes that all of the transactions described above were in
its best interests and on terms no less favorable to the Company than could have
been obtained from unaffiliated third parties. All of the Company's securities
referenced above were purchased or sold at prices equal to the fair market value
of such securities, as determined by the Company's Board of Directors, on the
date of redemption or issuance.
58
PRINCIPAL AND SELLING STOCKHOLDERS
The following table sets forth as of March 31, 1998, and as adjusted to
reflect the sale of the shares of Common Stock offered hereby, certain
information with respect to the beneficial ownership of the Common Stock as to
(i) each person known by the Company to own beneficially more than 5% of the
outstanding shares of Common Stock, (ii) each director of the Company, (iii)
each of the Executive Officers named in the Summary Compensation Table, (iv) all
directors and executive officers of the Company as a group and (v) all other
Selling Stockholders.
SHARES BENEFICIALLY OWNED SHARES BENEFICIALLY OWNED
PRIOR TO OFFERING(1)(2) AFTER OFFERING(1)(4)
-------------------------- SHARES ----------------------------
BENEFICIAL OWNER NUMBER PERCENT OFFERED NUMBER PERCENT(3)
- ---------------------------------------- ------------- ----------- ----------- ------------- -------------
Summit Partners (5)..................... 22,667,410 44.5% 1,664,372 21,003,038 34.5%
NationsBanc Capital Corp (6)............ 7,552,908 14.8 -- 7,552,908 12.4
TA Associates Group (7)................. 7,469,542 14.7 548,458 6,921,084 11.4
Marc Hamon (8).......................... 4,000,000 7.9 -- 4,000,000 6.6
Barry Phelps (9)........................ 66,666 * -- 168,888 *
James Jordan............................ 720,000 1.4 -- 720,000 1.2
Henry Hamon (10)........................ 288,888 * -- 376,888 *
Gene Zhang (11)......................... 106,666 * -- 226,666 *
Stephane Johnson (12)................... 13,334 * -- 101,334 *
Walter Kortschak (13)................... 22,667,410 44.5 1,664,372 21,003,038 34.5
Robert Sheridan III (14)................ 7,552,908 14.8 -- 7,552,908 12.4
Richard Moley........................... 236,026 * -- 236,026 *
Michael West............................ -- -- -- -- --
All officers and directors as a group
(13 persons) (15)..................... 35,661,498 69.8 1,664,372 34,536,014 56.0
Bain Securities, Inc. (16).............. 47,206 * 3,466 43,740 *
Chase Venture Capital Assoc., L.P.
(17).................................. 2,360,284 4.6 173,306 2,186,978 3.6
Peter Mooney, as Nominee for Broadview
Partners Group (18)................... 141,616 * 10,398 131,218 *
Delaware Charter Guarantee & Trust Co.
FBO M. Allen Chozen (19).............. 70,808 * -- 70,808 *
Spitfire Capital Partners, L.P. (20).... 1,416,170 2.8 -- 1,416,170 2.3
- ------------------
* Less than 1%
(1) Except pursuant to applicable community property laws or as indicated in the
footnotes to this table, to the Company's knowledge, each stockholder
identified in the table possesses sole voting and investment power with
respect to all shares of Common Stock shown as beneficially owned by such
stockholder.
(2) Applicable percentage ownership based on 50,929,218 shares of Common Stock
outstanding (assuming conversion of all shares of Class B Convertible
Preferred Stock) as of March 31, 1998, together with applicable options for
such stockholder. Beneficial ownership is determined in accordance with the
rules of the Commission, based on factors including voting and investment
power with respect to shares. Shares of Common Stock subject to options
currently exercisable, or exercisable within 60 days after March 31, 1998
are deemed not outstanding for computing the percentage ownership of any
other person.
59
(3) After giving effect to the issuance of 10,000,000 shares of Common Stock
offered hereby (assuming no exercise of the Underwriters' over-allotment
options).
(4) Based on vesting that occurs if the closing of the Offerings and certain
milestones are reached in 1998.
(5) The address of record for Summit Partners is 499 Hamilton Avenue, Suite 200,
Palo Alto, CA 94301. In the event of the exercise of the over-allotment
options by the Underwriters, Summit Partners has agreed to sell up to an
additional 602,368 shares.
(6) The address of record for NationsBanc Capital Corp. is 10th Floor, 100 North
Tryon, Charlotte, NC 28255. In the event of the exercise of the
overallotment options by the Underwriters, NationsBanc Capital Corp. has
agreed to sell up to 755,291 shares.
(7) The address of record for each member of the TA Associates Group is c/o TA
Associates, Inc., High Street Tower, Suite 2,500, 125 High Street, Boston,
MA 02110. Includes 6,184,996 shares of Common Stock held by and 454,138
shares of Common Stock offered by TA/Advent VIII, L.P., 1,160,846 shares of
Common Stock held by and 85,236 shares of Common Stock offered by Advent
Atlantic and Pacific III, L.P., and 123,740 shares of Common Stock held by
and 9,084 shares of Common Stock offered by TA Venture Investors, L.P.
TA/Advent VIII, L.P., Advent Atlantic & Pacific III, L.P., and TA Venture
Investors, L.P. are part of an affiliated group of investment partnerships
referred to, collectively, as the TA Associates Group. The general partner
of TA/Advent VIII, L.P., is TA Associates VIII, LLC and the general partner
of Advent Atlantic & Pacific III, L.P. is TA Associates AAP III Partners,
L.P. TA Associates, Inc. is the managing member of TA Associates VIII, LLC
and is the general partner of TA Associates AAP III Partners, L.P.
Individually, no stockholder, director or officer of TA Associates, Inc. is
deemed to have or share voting or investment power with respect to TA
Associates, Inc. Principals and employees of TA Associates, Inc. comprise
the general partners of TA Venture Investors, L.P. In the event of the
exercise of the over-allotment options by the Underwriters, TA Associates
Group has agreed to sell up to an additional 198,497 shares.
(8) Does not include 288,888 shares beneficially owned by Henry Hamon, Mr. Marc
Hamon's adult brother.
(9) Shares beneficially owned after the Offerings include 102,222 shares
issuable pursuant to options that become exercisable assuming the completion
of the Offerings and the attainment of certain milestones in 1998.
(10) Shares beneficially owned prior to the Offerings include an aggregate of
88,888 shares issuable pursuant to options exercisable within 60 days of
March 31, 1998. Shares beneficially owned after the Offerings include an
additional 88,000 shares issuable pursuant to options that become
exercisable assuming the completion of the Offerings and the attainment of
certain milestones in 1998. Does not include 4,000,000 shares beneficially
owned by Marc Hamon, Mr. Henry Hamon's adult brother.
(11) Shares beneficially owned prior to the Offerings include an aggregate of
66,666 shares issuable pursuant to options exercisable within 60 days of
March 31, 1998. Shares benefically owned after the Offerings include an
additional 120,000 shares issuable pursuant to options that become
exercisable assuming the completion of the Offerings and the attainment of
certain milestones in 1998.
(12) Shares beneficially owned prior to the Offerings consists of an aggregate
of 13,334 shares issuable pursuant to options exercisable within 60 days of
March 31, 1998. Shares beneficially owned after the Offerings include an
additional 88,000 shares issuable pursuant to options that become
exercisable assuming the completion of the Offerings and the attainment of
certain milestones in 1998.
60
(13) Consists of 22,667,410 shares held by Summit Partners prior to the
Offerings and 21,003,038 shares held by Summit Partners after the Offerings.
Walter Kortschak, a General Partner of Summit Ventures IV, L.P., is a
director of the Company. Mr. Kortschak disclaims beneficial ownership of the
shares held by this entity except to the extent of his proportionate
partnership therein.
(14) Consists of 7,552,908 shares held by Nationsbanc Capital Corp. Robert
Sheridan, a Senior Vice President of NationsBanc Capital Corp., is a
director of the Company. Mr. Sheridan disclaims beneficial ownership of the
shares held by this entity except to the extent of his proportionate
partnership therein.
(15) Shares beneficially owned prior to the Offerings include an aggregate of
178,488 shares issuable pursuant to options exercisable within 60 days of
March 31, 1998. Shares benefically owned after the Offerings includes an
additional 538,888 shares issuable pursuant to options that become
exercisable assuming the completion of the Offerings and the attainment of
certain milestones in 1998. Also includes 22,667,410 shares held by Summit
Partners (see footnote 12 above) and 7,552,908 shares held by NationsBanc
Capital Corp. (see footnote 11 above).
(16) The address of record for Bain Securities, Inc. is Bain & Company, Inc.,
Two Copley Place, Boston, MA 02116. In the event of the exercise of the
over-allotment options by the Underwriters, Bain Securities, Inc. has agreed
to sell up to an additional 1,254 shares.
(17) The address of record for Chase Venture Capital Assoc., L.P. is 380 Madison
Avenue, New York, NY 10017. In the event of the exercise of the
over-allotment options by the Underwriters, Chase Venture Capital Assoc.,
L.P. has agreed to sell up to an additional 62,723 shares.
(18) The address of record for Peter Mooney, as Nominee for Broadview Partners
Group ("Broadview"), is Broadview Associates, 950 Tower Lane, 18th Floor,
Foster City, CA 94404. In the event of the exercise of the over-allotment
options by the Underwriters, Broadview has agreed to sell up to an
additional 3,763 shares.
(19) The address of record for Delaware Charter Guarantee & Trust Co. FBO M.
Allen Chozen is 600 Montgomery Street, San Francisco, CA 94111. In the event
of the exercise of the over-allotment options by the Underwriters, Mr.
Chozen has agreed to sell up to 7,081 shares.
(20) The address of record for Spitfire Capital Partners, L.P. is 600 Montgomery
Street, San Francisco, CA 94111. In the event of the exercise of the
over-allotment options by the Underwriters, Spitfire Capital Partners, L.P.
has agreed to sell up to 140,000 shares.
61
DESCRIPTION OF CAPITAL STOCK
GENERAL
Upon completion of the Offerings, the total number of shares of all classes
of stock which the Company has authority to issue will be 200,000,000 shares of
Common Stock, $0.001 par value, and 10,000,000 shares of undesignated preferred
stock, $0.001 par value. As of March 31, 1998, there were 50,929,218 shares of
Common Stock outstanding (assuming conversion into Common Stock of all
outstanding shares of Class B Convertible Preferred Stock and assuming
redemption of all outstanding shares of Class A Redeemable Preferred Stock),
which were held of record by 86 stockholders, and no shares of undesignated
preferred stock outstanding. Upon completion of the Offerings and assuming no
exercise of options after March 31, 1998, the Company will have outstanding
60,929,218 shares of Common Stock, 61,018,241 shares if the Underwriters'
over-allotment options are exercised in full.
COMMON STOCK
The holders of Common Stock are entitled to one vote for each share held of
record on all matters submitted to a vote of stockholders. Holders of Common
Stock have no preemptive or subscription rights and there are no redemption
rights with respect to such shares. The outstanding shares of Common Stock are,
and the shares of Common Stock offered hereby will be, fully paid and
nonassessable.
PREFERRED STOCK
The Company's Board of Directors is authorized, without further stockholder
action, to issue preferred stock in one or more series and to fix the voting
rights, liquidation preferences, dividend rights, repurchase rights, conversion
rights, redemption rights and terms, including sinking fund provisions, and
certain other rights and preferences, of the preferred stock.
Although there is no current intention to do so, the Board of Directors of
the Company may, without stockholder approval, issue shares of a class or series
of preferred stock with voting and conversion rights which could adversely
affect the voting power or dividend rights of the holders of Common Stock and
may have the effect of delaying, deferring or preventing a change in control of
the Company.
OPTIONS
As of March 31, 1998, the Company had outstanding options to purchase a
total of 10,469,462 shares of Common Stock pursuant to the 1993 Stock Plan and
the 1997 Stock Plan and an additional 1,600,000 shares outside of the Company's
stock plans at a weighted average exercise price of $0.78 per share and had
issued no options pursuant to the 1998 Stock Plan. Recommendations for option
grants under the 1993 Stock Plan, the 1997 Stock Plan and the 1998 Stock Plan
(collectively, the "Stock Plans") or otherwise are made by the Compensation
Committee, subject to ratification by the full Board of Directors. The
Compensation Committee may issue options with varying vesting schedules, but all
options granted pursuant to the Stock Plans must be exercised within 10 years
from the date of grant.
REGISTRATION RIGHTS OF CERTAIN HOLDERS
The holders of approximately 50,913,538 shares of Common Stock issued prior
to the Offerings (the "Registrable Securities"), of which 45,806,874 shares are
"Investor Registrable Securities", or their transferees are entitled to certain
registration rights with respect to the registration of such shares under the
Securities Act of 1933, as amended (the "Securities Act"). These rights are
provided under the terms of the Registration Agreement between the Company and
the holders of the Registrable Securities. If, following the Offerings, the
Company registers any of its Common Stock either for its own account or for the
account of other security holders, the holders of Registrable Securities are
entitled to include their
62
shares of Common Stock in the registration. Certain of these shares will form a
part of the shares of Common Stock registered in the Offerings. A holder's right
to include shares in an underwritten registration statement is subject to the
ability of the underwriters to limit the number of shares included in the
offering. Beginning 180 days after the closing of this offering, the holder or
holders of at least 25% of the Investor Registrable Securities may also require
the Company to register all or a portion of the Registrable Securities on Form
S-2 or S-3 when use of such form becomes available to the Company, provided,
among other limitations, that the proposed aggregate selling price is at least
$1,000,000. In addition, beginning 180 days after the closing of this offering,
the holder or holders of at least two-thirds of the Investor Registrable
Securities may also require the Company to register all or a portion of the
Registrable Securities on Form S-1, provided, among other limitations, that the
proposed aggregate selling price is at least $3,000,000. All registration
expenses and all selling expenses relating to Registrable Securities must be
borne by the Company, except that the Company shall only be responsible for the
first four registrations on Form S-1 at the request of the holders of
Registrable Securities. If such holders, by exercising their registration
rights, cause a large number of securities to be registered and sold in the
public market, such sales could have an adverse effect on the market price for
the Company's Common Stock. If the Company were to initiate a registration and
include Registrable Securities pursuant to the exercise of piggyback
registration rights, the sale of such Registrable Securities may have an adverse
effect on the Company's ability to raise capital.
CERTAIN CHARTER AND BYLAWS PROVISIONS AND DELAWARE ANTI-TAKEOVER STATUTE
Certain provisions of the Restated Certificate of Incorporation and the
Company's bylaws may have the effect of making it more difficult for a third
party to acquire, or of discouraging a third party from attempting to acquire,
control of the Company. Such provisions could limit the price that certain
investors might be willing to pay in the future for shares of Common Stock.
Certain of these provisions allow the Company to issue preferred stock without
any vote or further action by the stockholders and eliminate the right of
stockholders to act by written consent without a meeting. These provisions may
make it more difficult for stockholders to take certain corporate actions and
could have the effect of delaying or preventing a change in control of the
Company. In addition, the Company is subject to Section 203 of the Delaware
General Corporation Law which, subject to certain exceptions, prohibits a
Delaware corporation from engaging in any business combination with any
interested stockholder for a period of three years following the date that such
stockholder became an interested stockholder, unless: (1) prior to such date,
the board of directors of the corporation approved either the business
combination or the transaction which resulted in the stockholder becoming an
interested stockholder, or (2) upon consummation of the transaction which
resulted in the stockholder becoming an interested stockholder, the interested
stockholder owned at least 85% of the voting stock of the corporation
outstanding at the time the transaction commenced, excluding for purposes of
determining the number of shares outstanding of those shares owned (i) by
persons who are directors and also officers and (ii) employee stock plans in
which employee participants do not have the right to determine confidentially
whether shares held subject to the plan will be tendered in a tender or exchange
offer, or (iii) on or subsequent to such time the business combination is
approved by the board of directors and authorized at an annual or special
meeting of stockholders, and not by written consent, by the affirmative vote of
at least 66 2/3 % of the outstanding voting stock which is not owned by the
interested stockholder.
TRANSFER AGENT AND REGISTRAR
The Transfer Agent and Registrar with respect to the Common Stock will be
Boston EquiServe, L.P. located at 150 Royall Street, Canton, Massachusetts, and
its telephone number is (781) 575-2000.
63
SHARES ELIGIBLE FOR FUTURE SALE
Upon completion of the Offerings and assuming no exercise of options after
March 31, 1998, the Company will have outstanding 60,929,218 shares of Common
Stock, 61,018,241 shares if the Underwriters' over-allotment options are
exercised in full. Of these shares, the 12,400,000 shares sold in the Offerings
will be freely tradable without restriction or further registration under the
Securities Act unless purchased by "affiliates" of the Company as that term is
defined in Rule 144 of the Securities Act ("Rule 144"). The remaining 48,529,218
shares outstanding upon completion of the Offerings will be "restricted
securities" as that term is defined under Rule 144 (the "Restricted Shares").
Each of the Company officers, directors and certain other stockholders have
agreed with the Underwriters not to sell or otherwise dispose of any shares of
Common Stock for a period of 180 days after the date of this Prospectus (the
"Lock-up Period") without the written consent of Goldman, Sachs & Co. Goldman,
Sachs & Co., in its sole discretion at any time and without notice, may release
any or all shares from the lock-up agreements and permit holders of the shares
to resell all or any portion of their shares at any time prior to the expiration
of the Lock-up Period. See "Underwriting". The number of shares of Common Stock
available for sale in the public market is further limited by restrictions under
the Securities Act.
Because of the restrictions noted above, on the date of this Prospectus, no
shares other than the 12,400,000 shares (14,260,000 shares if the Underwriters'
over-allotment options are exercised in full) offered hereby will be eligible
for sale. Beginning 180 days after the date of this Prospectus (or earlier with
the prior written consent of Goldman, Sachs & Co.), 52,880,198 shares, including
4,350,980 shares issuable upon exercise of currently outstanding vested options,
will be eligible for sale in the public market subject to Rule 144 and Rule 701
of the Securities Act.
In general, under Rule 144, as currently in effect, a person (or persons
whose shares are aggregated), including an affiliate, who has beneficially owned
Restricted Shares for at least one year from the later of the date such
Restricted Shares are acquired from the Company and (if applicable) the date
they were acquired from an affiliate, is entitled to sell, within any
three-month period, a number of shares that does not exceed the greater of 1% of
the then outstanding shares of Common Stock or the average weekly trading volume
in the Nasdaq National Market System during the four calendar weeks preceding
the filing of Form 144 with respect to such sale. Sales under Rule 144 are also
subject to certain requirements as to the manner and notice of sales and the
availability of public information concerning the Company. All shares, including
Restricted Shares, held by affiliates of the Company eligible for sale in the
public market under Rule 144 are subject to the foregoing volume limitations and
other restrictions. In addition, an individual that is not deemed to have been
an affiliate of the Company at any time during the 90 days preceding a sale, and
who has beneficially owned for at least two years the shares proposed to be
sold, would be entitled to sell such shares under Rule 144(k) without regard to
the requirements described above.
In general, Rule 701 permits resales of shares issued pursuant to certain
compensatory benefit plans and contracts commencing 90 days after the issuer
becomes subject to the reporting requirements of the Securities Exchange Act of
1934, as amended (the "Exchange Act"), in reliance upon Rule 144 but without
compliance with certain restrictions, including the holding period requirements,
contained in Rule 144. Prior to the expiration of the Lock-up Period, the
Company intends to register on a registration statement on Form S-8, (i) a total
of 300,000 shares of Common Stock reserved for issuance under the Purchase Plan
and (ii) assuming no exercise of options after March 31, 1998, 12,069,462 shares
of Common Stock subject to outstanding options under the Stock Plans and
5,860,000 shares reserved for future issuance pursuant to such Stock Plans. Such
registration will permit the resale of shares so registered by non-affiliates in
the public market without restriction under the Securities Act.
Prior to this offering, there has been no public market for the Common Stock
of the Company, and any sale of substantial amounts of Common Stock in the open
market may adversely affect the market price of the Common Stock offered hereby.
See "Risk Factors--Shares Eligible".
64
LEGAL MATTERS
The validity of the Common Stock offered hereby will be passed upon for the
Company by Wilson Sonsini Goodrich & Rosati, P.C. ("WSG&R"). Steven E. Bochner,
Esq., a member of WSG&R, and certain other attorneys of WSG&R beneficially own
an aggregate of 23,604 shares of Class B Convertible Preferred Stock and 250
shares of Class A Redeemable Preferred Stock of the Company. In addition, WS
Investment Company 97B, an investment fund for the benefit of certain attorneys
of WSG&R, owns an aggregate of 23,602 shares Class B Convertible Preferred Stock
and 250 shares of Class A Redeemable Preferred Stock. Certain legal matters in
connection with the offering will be passed upon for the Underwriters by Venture
Law Group, A Professional Corporation.
EXPERTS
The financial statements included in this Prospectus and elsewhere in the
Registration Statement have been audited by Arthur Andersen LLP, independent
public accountants, as indicated in their report with respect thereto, and are
included herein in reliance upon the authority of said firm as experts in giving
said report.
AVAILABLE INFORMATION
The Company has filed with the Commission a Registration Statement, of which
this Prospectus constitutes a part, under the Securities Act with respect to the
shares of Common Stock offered hereby. This Prospectus omits certain information
contained in the Registration Statement, and reference is made to the
Registration Statement and the exhibits thereto for further information with
respect to the Company and the Common Stock offered hereby. Statements contained
herein concerning the provisions of any documents are not necessarily an
exhaustive description of such documents, and reference is made to the copy of
each such document filed as an exhibit to the Registration Statement. Each such
statement is qualified in its entirety by such reference. The Registration
Statement, including exhibits filed therewith, may be inspected without charge
at the public reference facilities maintained by the Commission at Room 1024,
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549 and at the
regional offices of the Commission located at Seven World Trade Center, 13th
Floor, New York, New York 10048 and Citicorp Atrium Center, 500 West Madison
Street, Suite 1400, Chicago, Illinois 60661. Copies of such materials may be
obtained from the Public Reference Section of the Commission, Room 1034,
Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C. 20549, and its public
reference facilities in New York, New York and Chicago, Illinois, at prescribed
rates. In addition, the Commission maintains a World Wide Web site that contains
reports, proxy and information statements that are filed electronically with the
Commission. The address of the site is http://www.sec.gov.
65
GLOSSARY OF TERMS
ATM.......................................... Asynchronous transfer mode. A cell-based
multimedia protocol suitable for voice, video
and data traffic.
bridge....................................... Networking equipment for connecting users
within a LAN based workgroup.
Cable Modem.................................. Technology used to transmit data across
coaxial cables currently used to transmit
television.
cell......................................... A fixed sized capsule containing pieces of a
stream of data to be transmitted across a
network.
edge device.................................. A switch that allows LAN and WAN interfacing.
End User..................................... Corporate and government network end-users,
such as Fortune 1000 companies, financial
institutions, systems integrators and
government entities.
Ethernet..................................... A widely adopted network protocol operating
at 10 Mbps.
extranet..................................... A portion of an intranet that is accessible
from outside of the intranet.
Fast Ethernet................................ A 100 Mbps network protocol based on
Ethernet.
field programmable gate array................ A logic device that can be repeatedly
reprogrammed without factory intervention.
frame........................................ A variable sized packet of data used
primarily in Ethernet, Fast Ethernet, Gigabit
Ethernet and Frame Relay.
Frame Relay.................................. A frame-based protocol used primarily for
LAN-to-WAN data connections.
full duplex.................................. Feature of a device that allows an interface
card to both send and receive data.
Gbit......................................... Abbreviation for gigabit or one billion bits.
Gigabit Ethernet............................. A 1000 Mbps network protocol based on
Ethernet.
half duplex.................................. Feature of a device that allows an interface
card only to send data.
Internet Engineering Task Force.............. A networking standards setting body that
develops and specifies protocols and internet
standards.
Internet Protocol (IP)....................... A packet-based protocol used on the Internet.
intranet..................................... An enterprise's Internet based internal
network, which may extend across LANs and
WANs.
66
ISO.......................................... The International Standards Organization, a
standards body that defines networking
standards.
jitter....................................... A measurement of the variation of latency on
a network.
LAN.......................................... Local area network. Refers to a network in
which all components share physical
connections.
latency...................................... A measurement of the time required to process
data on a network.
layer........................................ Refers to a layer of the OSI Protocol Stack.
Mbit......................................... Abbreviation for megabit or one million bits.
Mbps......................................... Abbreviation for megabit or one million bits
per second.
NEM.......................................... Network equipment manufacturer.
OSI Protocol Stack........................... The Open Systems Interconnection, an
internationally accepted standard promulgated
by the ISO for communication among disparate
computer systems and networks. The OSI model
organizes the communications process into
seven separate categories or "layers" in
order of their proximity to the end user.
packet....................................... A variable sized capsule containing smaller
pieces of a stream of data to be transmitted
across a network.
packet loss.................................. A measurement of the loss or misplacement of
packets.
port......................................... An input/output connection through which data
transmissions travel. Each port enables one
connection to another piece of network gear.
protocol..................................... Technologies that govern access to the
network and communications between devices on
a network.
QoS.......................................... Quality of Service. A measurement of network
performance.
RFC.......................................... Request for comment. When finalized by the
IETF, a request for comment will define
industry standards such as network test
methodologies.
router....................................... A device that provides sophisticated data
forwarding capabilities between disparate
networks.
Service Provider............................. Service providers, such as telecommunications
carriers and internet service providers.
SmartBits.................................... Netcom Systems' flagship performance
measurement solution.
67
SmartCard.................................... A plug-in card that adds functionality to a
SmartBits chassis.
switch....................................... A network device that provides a dedicated
point-to-point connection between any two
devices on a network.
Token Ring................................... A network protocol operating at 4 and 16 Mbit
per second.
throughput................................... A measurement of the speed of a network.
VLAN......................................... Virtual LAN. Technology enabling dynamic
interconnection of disparate LANs.
WAN.......................................... Wide area network. Refers to a geographically
dispersed network. Typically uses
communication facilities operated by a
Service Provider.
wireline..................................... The speed at which data can be transmitted
across a wire.
xDSL......................................... A generic term for digital/analog converters
used for sending data across copper phone
lines. Includes ADSL.
68
INDEX TO FINANCIAL STATEMENTS
PAGE
-----
Report of Independent Public Accountants................................................................... F-2
Consolidated Balance Sheets as of December 31, 1996 and 1997 (audited), and as of March 31, 1998 and Pro
Forma March 31, 1998 (unaudited)......................................................................... F-3
Consolidated Statements of Income for each of the three years in the period ended December 31, 1997
(audited), and for the three months ended March 31, 1997 and 1998 (unaudited)............................ F-4
Consolidated Statements of Stockholders' Equity for each of the three years in the period ended December
31, 1997 (audited), and for the three months ended March 31, 1998 (unaudited)............................ F-5
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 1997
(audited), and for the three months ended March 31, 1997 and 1998 (unaudited)............................ F-6
Notes to Consolidated Financial Statements................................................................. F-7
F-1
To Netcom Systems, Inc.:
After the reincorporation and stock split discussed in Note 7 to Netcom
Systems, Inc.'s consolidated financial statements are effected, we expect to be
in a position to render the following audit report.
Los Angeles, California
May 12, 1998
"REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To Netcom Systems, Inc.:
We have audited the accompanying consolidated balance sheets of NETCOM
SYSTEMS, INC. (a California corporation) and subsidiaries as of December 31,
1996 and 1997, and the related consolidated statements of income, Class A
redeemable preferred stock and shareholders' equity (deficit) and cash flows for
each of the three years in the period 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 audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Netcom Systems, Inc. and
subsidiaries as of December 31, 1996 and 1997, and the results of their
operations and their cash flows for each of the three years in the period then
ended in conformity with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Los Angeles, California
May 12, 1998 (except with
respect to the matters in
Note 7 as to which the date
is June , 1998)"
F-2
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
DECEMBER 31, PRO FORMA
------------------------------ MARCH 31, MARCH 31,
1996 1997 1998 1998
------------- --------------- --------------- ---------------
(UNAUDITED) (UNAUDITED)
(NOTE 14)
ASSETS
CURRENT ASSETS:
Cash and cash equivalents..................................... $ 9,314,000 $ 17,708,000 $ 24,390,000 $ 24,390,000
Accounts receivable, net of allowances of $100,000 in 1996,
$350,000 in 1997 and $400,000 in 1998....................... 6,883,000 9,508,000 10,610,000 10,610,000
Inventories................................................... 551,000 2,885,000 3,468,000 3,468,000
Prepaid expenses and other.................................... 14,000 100,000 144,000 144,000
Income taxes receivable....................................... -- 455,000 -- --
Deferred income taxes......................................... 839,000 1,224,000 1,385,000 1,385,000
------------- --------------- --------------- ---------------
Total current assets........................................ 17,601,000 31,880,000 39,997,000 39,997,000
------------- --------------- --------------- ---------------
PROPERTY AND EQUIPMENT, at cost:
Machinery and equipment....................................... 463,000 1,318,000 1,751,000 1,751,000
Office equipment.............................................. 68,000 277,000 463,000 463,000
Software...................................................... 28,000 189,000 283,000 283,000
Leasehold improvements........................................ 17,000 305,000 310,000 310,000
------------- --------------- --------------- ---------------
576,000 2,089,000 2,807,000 2,807,000
Less--accumulated depreciation and amortization............. (85,000) (405,000) (550,000) (550,000)
------------- --------------- --------------- ---------------
491,000 1,684,000 2,257,000 2,257,000
------------- --------------- --------------- ---------------
OTHER ASSETS:
Deferred income taxes......................................... -- 247,000 247,000 247,000
Deferred financing costs...................................... -- 275,000 260,000 260,000
Deposits...................................................... 18,000 43,000 44,000 44,000
------------- --------------- --------------- ---------------
18,000 565,000 551,000 551,000
------------- --------------- --------------- ---------------
$ 18,110,000 $ 34,129,000 $ 42,805,000 $ 42,805,000
------------- --------------- --------------- ---------------
------------- --------------- --------------- ---------------
LIABILITIES, REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY
(DEFICIT)
CURRENT LIABILITIES:
Current portion of notes payable.............................. $ -- $ 2,500,000 $ 2,500,000 $ 2,500,000
Accounts payable.............................................. 698,000 2,916,000 1,330,000 1,330,000
Accrued expenses.............................................. 601,000 2,243,000 3,576,000 3,576,000
Deferred revenue.............................................. 205,000 454,000 426,000 426,000
Income taxes payable.......................................... 3,592,000 -- 3,329,000 3,329,000
------------- --------------- --------------- ---------------
Total current liabilities................................... 5,096,000 8,113,000 11,161,000 11,161,000
------------- --------------- --------------- ---------------
NOTES PAYABLE, net of current portion........................... -- 47,500,000 47,500,000 47,500,000
------------- --------------- --------------- ---------------
COMMITMENTS AND CONTINGENCIES (NOTE 10)
CLASS A REDEEMABLE PREFERRED STOCK, $0.001 par value:
Authorized-485,000 shares;
Issued and outstanding-no shares in 1996 and 485,000 shares in
1997 and 1998............................................... -- 49,520,000 50,255,000 50,255,000
------------- --------------- --------------- ---------------
SHAREHOLDERS' EQUITY (DEFICIT):
Class B convertible preferred stock, $0.001 par value:
Authorized-45,807,000 shares;
Issued and outstanding-no shares in 1996 and pro forma 1998
and 45,807,000 shares in 1997 and 1998.................... -- 48,518,000 48,518,000 --
Common stock, $0.001 par value:
Authorized-200,000,000 shares;
Issued and outstanding--21,920,000 shares in 1996, 5,056,000
in 1997, 5,122,000 in 1998 and 50,929,000 in pro forma
1998...................................................... 22,000 5,000 5,000 51,000
Additional paid-in capital.................................... 259,000 9,974,000 10,092,000 58,564,000
Deferred compensation......................................... -- -- (116,000) (116,000)
Note receivable for stock purchase............................ -- (120,000) (120,000) (120,000)
Retained earnings (deficit)................................... 12,733,000 (129,356,000) (124,443,000) (124,443,000)
Cumulative translation adjustments............................ -- (25,000) (47,000) (47,000)
------------- --------------- --------------- ---------------
13,014,000 (71,004,000) (66,111,000) (66,111,000)
------------- --------------- --------------- ---------------
$ 18,110,000 $ 34,129,000 $ 42,805,000 $ 42,805,000
------------- --------------- --------------- ---------------
------------- --------------- --------------- ---------------
The accompanying notes are an integral part of these consolidated balance
sheets.
F-3
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
THREE MONTHS ENDED
YEAR ENDED DECEMBER 31, MARCH 31,
------------------------------------- ------------------------
1995 1996 1997 1997 1998
----------- ----------- ----------- ----------- -----------
(UNAUDITED)
REVENUES......................................... $ 9,053,000 $27,454,000 $56,273,000 $10,115,000 $18,011,000
COST OF GOODS SOLD............................... 1,266,000 3,256,000 7,248,000 1,163,000 3,048,000
----------- ----------- ----------- ----------- -----------
Gross profit............................... 7,787,000 24,198,000 49,025,000 8,952,000 14,963,000
----------- ----------- ----------- ----------- -----------
OPERATING EXPENSES:
Research and development....................... 833,000 1,681,000 3,527,000 748,000 1,662,000
Sales and marketing............................ 844,000 1,466,000 3,713,000 540,000 2,271,000
General and administrative..................... 1,262,000 1,342,000 3,452,000 753,000 776,000
----------- ----------- ----------- ----------- -----------
2,939,000 4,489,000 10,692,000 2,041,000 4,709,000
----------- ----------- ----------- ----------- -----------
Income from operations..................... 4,848,000 19,709,000 38,333,000 6,911,000 10,254,000
OTHER INCOME (EXPENSE):
Interest income................................ 65,000 244,000 640,000 189,000 232,000
Interest expense............................... -- -- (1,233,000) -- (900,000)
Other expense.................................. -- -- (69,000) -- (14,000)
----------- ----------- ----------- ----------- -----------
65,000 244,000 (662,000) 189,000 (682,000)
----------- ----------- ----------- ----------- -----------
Income before provision for income taxes... 4,913,000 19,953,000 37,671,000 7,100,000 9,572,000
PROVISION FOR INCOME TAXES....................... 1,955,000 8,142,000 14,875,000 2,804,000 3,924,000
----------- ----------- ----------- ----------- -----------
NET INCOME....................................... $ 2,958,000 $11,811,000 $22,796,000 $ 4,296,000 $ 5,648,000
----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- -----------
NET INCOME PER COMMON SHARE:
Basic Net Income per Common Share.............. $ 0.14 $ 0.54 $ 1.35 $ 0.20 $ 0.96
----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- -----------
Weighted Average Number of Common Shares
Outstanding.................................. 21,255,000 21,880,000 16,149,000 21,931,000 5,119,000
----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- -----------
Diluted Net Income per Common and Common
Equivalent Share............................. $ 0.14 $ 0.49 $ 0.68 $ 0.17 $ 0.10
----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- -----------
Weighted Average Number of Common and Common
Equivalent Shares Outstanding................ 21,481,000 23,969,000 33,657,000 25,084,000 58,772,000
----------- ----------- ----------- ----------- -----------
----------- ----------- ----------- ----------- -----------
PRO FORMA NET INCOME PER COMMON SHARE:
Basic Net Income Per Common Share.............. $ 0.72 $ 0.11
----------- -----------
----------- -----------
Weighted Average Number of Common Shares
Outstanding.................................. 31,837,000 50,925,000
----------- -----------
----------- -----------
Diluted Net Income Per Common and Common
Equivalent Share............................. $ 0.68 $ 0.10
----------- -----------
----------- -----------
Weighted Average Number of Common and Common
Equivalent Shares Outstanding................ 33,657,000 58,772,000
----------- -----------
----------- -----------
The accompanying notes are an integral part of these consolidated statements.
F-4
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
STATEMENTS OF CLASS A REDEEMABLE PREFERRED STOCK AND SHAREHOLDERS' EQUITY
(DEFICIT)
-----------------------------------------------------------------------------
SHAREHOLDERS' EQUITY (DEFICIT)
-------------------------------------------------------
CLASS A CLASS B
REDEEMABLE CONVERTIBLE
PREFERRED STOCK PREFERRED STOCK COMMON STOCK
------------------------ --------------------------- --------------------------
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT
--------- ------------- ------------ ------------- ------------- -----------
BALANCE, December 31, 1994................. -- $ -- -- $ -- 20,341,000 $ 20,000
Issuance of common stock for services.... -- -- -- -- 1,500,000 2,000
Net income............................... -- -- -- -- -- --
--------- ------------- ------------ ------------- ------------- -----------
BALANCE, December 31, 1995................. -- -- -- -- 21,841,000 22,000
Cash distributions to shareholders....... -- -- -- -- -- --
Issuance of common stock for services.... -- -- -- -- 79,000 --
Net income............................... -- -- -- -- -- --
--------- ------------- ------------ ------------- ------------- -----------
BALANCE, December 31, 1996................. -- -- -- -- 21,920,000 22,000
Issuance of common stock................. -- -- -- -- 200,000 --
Exercise of employee stock options....... -- -- -- -- 2,735,000 3,000
Issuance of stock options as compensation
to non-employees....................... -- -- -- -- -- --
Tax benefit from non-qualified stock
options................................ -- -- -- -- -- --
--------- ------------- ------------ ------------- ------------- -----------
BALANCE, August 29, 1997, prior to
Recapitalization..................... -- -- -- -- 24,855,000 25,000
Recapitalization......................... 485,000 48,518,000 45,807,000 48,518,000 (20,431,000) (20,000)
Acquisition of Netcom Systems Europe..... -- -- -- -- -- --
Exercise of employee stock options....... -- -- -- -- 632,000 --
Accrued dividends on redeemable preferred
stock.................................. -- 1,002,000 -- -- -- --
Cumulative translation adjustments....... -- -- -- -- -- --
Net income............................... -- -- -- -- -- --
--------- ------------- ------------ ------------- ------------- -----------
BALANCE, December 31, 1997................. 485,000 49,520,000 45,807,000 48,518,000 5,056,000 5,000
Exercise of employee stock options
(unaudited)............................ -- -- -- -- 66,000 --
Accrued dividends on redeemable preferred
stock (unaudited)...................... -- 735,000 -- -- -- --
Deferred compensation relating to grants
of stock options (unaudited)........... -- -- -- -- -- --
Cumulative translation adjustments
(unaudited)............................ -- -- -- -- -- --
Net income (unaudited)................... -- -- -- -- -- --
--------- ------------- ------------ ------------- ------------- -----------
BALANCE, March 31, 1998 (unaudited)........ 485,000 $ 50,255,000 45,807,000 $ 48,518,000 5,122,000 $ 5,000
--------- ------------- ------------ ------------- ------------- -----------
--------- ------------- ------------ ------------- ------------- -----------
The accompanying notes are an integral part of these consolidated statements.
-------------------
ADDITIONAL RETAINED CUMULATIVE
PAID-IN DEFERRED NOTE EARNINGS TRANSLATION
CAPITAL COMPENSATION RECEIVABLE (DEFICIT) ADJUSTMENTS
------------- ---------------- ------------- --------------- --------------
BALANCE, December 31, 1994................. $ 93,000 $ -- $ -- $ 664,000 $ --
Issuance of common stock for services.... 117,000 -- -- -- --
Net income............................... -- -- -- 2,958,000 --
------------- ---------------- ------------- --------------- --------------
BALANCE, December 31, 1995................. 210,000 -- -- 3,622,000 --
Cash distributions to shareholders....... -- -- -- (2,700,000) --
Issuance of common stock for services.... 49,000 -- -- -- --
Net income............................... -- -- -- 11,811,000 --
------------- ---------------- ------------- --------------- --------------
BALANCE, December 31, 1996................. 259,000 -- -- 12,733,000 --
Issuance of common stock................. 600,000 -- (600,000) -- --
Exercise of employee stock options....... 1,894,000 -- -- -- --
Issuance of stock options as compensation
to non-employees....................... 15,000 -- -- -- --
Tax benefit from non-qualified stock
options................................ 6,916,000 -- -- -- --
------------- ---------------- ------------- --------------- --------------
BALANCE, August 29, 1997, prior to
Recapitalization..................... 9,684,000 -- (600,000) 12,733,000 --
Recapitalization......................... -- -- 480,000 (161,896,000) --
Acquisition of Netcom Systems Europe..... -- -- -- (1,987,000) --
Exercise of employee stock options....... 290,000 -- -- -- --
Accrued dividends on redeemable preferred
stock.................................. -- -- -- (1,002,000) --
Cumulative translation adjustments....... -- -- -- -- (25,000)
Net income............................... -- -- -- 22,796,000 --
------------- ---------------- ------------- --------------- --------------
BALANCE, December 31, 1997................. 9,974,000 -- (120,000) (129,356,000) (25,000)
Exercise of employee stock options
(unaudited)............................ 2,000 -- -- -- --
Accrued dividends on redeemable preferred
stock (unaudited)...................... -- -- -- (735,000) --
Deferred compensation relating to grants
of stock options (unaudited)........... 116,000 (116,000) -- -- --
Cumulative translation adjustments
(unaudited)............................ -- -- -- -- (22,000)
Net income (unaudited)................... -- -- -- 5,648,000 --
------------- ---------------- ------------- --------------- --------------
BALANCE, March 31, 1998 (unaudited)........ $ 10,092,000 $ (116,000) $ (120,000) $ (124,443,000) $ (47,000)
------------- ---------------- ------------- --------------- --------------
------------- ---------------- ------------- --------------- --------------
The accompanying no
-------------------
TOTAL
---------------
BALANCE, December 31, 1994................. $ 777,000
Issuance of common stock for services.... 119,000
Net income............................... 2,958,000
---------------
BALANCE, December 31, 1995................. 3,854,000
Cash distributions to shareholders....... (2,700,000)
Issuance of common stock for services.... 49,000
Net income............................... 11,811,000
---------------
BALANCE, December 31, 1996................. 13,014,000
Issuance of common stock................. --
Exercise of employee stock options....... 1,897,000
Issuance of stock options as compensation
to non-employees....................... 15,000
Tax benefit from non-qualified stock
options................................ 6,916,000
---------------
BALANCE, August 29, 1997, prior to
Recapitalization..................... 21,842,000
Recapitalization......................... (112,918,000)
Acquisition of Netcom Systems Europe..... (1,987,000)
Exercise of employee stock options....... 290,000
Accrued dividends on redeemable preferred
stock.................................. (1,002,000)
Cumulative translation adjustments....... (25,000)
Net income............................... 22,796,000
---------------
BALANCE, December 31, 1997................. (71,004,000)
Exercise of employee stock options
(unaudited)............................ 2,000
Accrued dividends on redeemable preferred
stock (unaudited)...................... (735,000)
Deferred compensation relating to grants
of stock options (unaudited)........... --
Cumulative translation adjustments
(unaudited)............................ (22,000)
Net income (unaudited)................... 5,648,000
---------------
BALANCE, March 31, 1998 (unaudited)........ $ (66,111,000)
---------------
---------------
The accompanying no
F-5
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
THREE MONTHS ENDED
YEAR ENDED DECEMBER 31, MARCH 31,
-------------------------------------- ------------------------
1995 1996 1997 1997 1998
---------- ----------- ------------- ----------- -----------
(UNAUDITED)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income................................................... $2,958,000 $11,811,000 $ 22,796,000 $ 4,296,000 $ 5,648,000
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization.............................. 10,000 25,000 319,000 64,000 145,000
Provision for doubtful accounts............................ 50,000 50,000 250,000 50,000 50,000
Interest expense relating to deferred financing costs...... -- -- 20,000 -- 15,000
Issuance of common stock or stock options for services..... 119,000 49,000 15,000 -- --
Change in operating assets and liabilities:
Accounts receivable...................................... (1,816,000) (4,803,000) (2,096,000) 644,000 (1,152,000)
Inventories.............................................. (47,000) (410,000) (2,334,000) (50,000) (583,000)
Prepaid expenses and other............................... (238,000) 224,000 (19,000) 14,000 (44,000)
Income taxes receivable.................................. -- -- (455,000) -- 455,000
Deferred income taxes.................................... (162,000) (669,000) (632,000) -- (161,000)
Deposits................................................. -- (15,000) (25,000) -- (1,000)
Accounts payable......................................... 266,000 377,000 1,994,000 (20,000) (1,586,000)
Accrued expenses......................................... 66,000 528,000 1,266,000 46,000 1,333,000
Deferred revenue......................................... -- 205,000 249,000 -- (28,000)
Income taxes payable..................................... 1,288,000 2,157,000 3,324,000 (630,000) 3,329,000
---------- ----------- ------------- ----------- -----------
Net cash provided by operating activities.............. 2,494,000 9,529,000 24,672,000 4,414,000 7,420,000
---------- ----------- ------------- ----------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of property and equipment.......................... (78,000) (400,000) (1,371,000) (119,000) (718,000)
Cash used in acquisition of Netcom Systems Europe, net of
cash acquired.............................................. -- -- (2,374,000) -- --
---------- ----------- ------------- ----------- -----------
Net cash used in investing activities.................. (78,000) (400,000) (3,745,000) (119,000) (718,000)
---------- ----------- ------------- ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Distributions to shareholders................................ -- (2,700,000) -- -- --
Borrowings under notes payable, net of deferred financing
costs...................................................... -- -- 49,705,000 -- --
Net proceeds from sale of preferred stock.................... -- -- 91,322,000 -- --
Exercise of stock options.................................... -- -- 2,187,000 -- 2,000
Repurchase of common stock................................... -- -- (155,722,000) -- --
---------- ----------- ------------- ----------- -----------
Net cash provided by (used in) financing activities.... -- (2,700,000) (12,508,000) -- 2,000
---------- ----------- ------------- ----------- -----------
EFFECT OF EXCHANGE RATE CHANGES ON CASH AND CASH EQUIVALENTS... -- -- (25,000) -- (22,000)
---------- ----------- ------------- ----------- -----------
NET INCREASE IN CASH AND CASH EQUIVALENTS...................... 2,416,000 6,429,000 8,394,000 4,295,000 6,682,000
CASH AND CASH EQUIVALENTS, beginning of period................. 469,000 2,885,000 9,314,000 9,314,000 17,708,000
---------- ----------- ------------- ----------- -----------
CASH AND CASH EQUIVALENTS, end of period....................... $2,885,000 $ 9,314,000 $ 17,708,000 $13,609,000 $24,390,000
---------- ----------- ------------- ----------- -----------
---------- ----------- ------------- ----------- -----------
The accompanying notes are an integral part of these consolidated statements.
F-6
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. LINE OF BUSINESS
Netcom Systems, Inc. and subsidiaries (the "Company"), is a leading provider
of network performance analysis and measurement systems for network equipment
manufacturers, service providers and end-users. The Company's flagship product,
SmartBits, generates flows of network traffic for testing network equipment and
enables users to identify the performance boundaries of networks and network
devices.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries Netcom Systems Europe S.A.R.L. and Netcom
(Barbados) Limited, a Foreign Sales Corporation. All significant intercompany
transactions and accounts have been eliminated.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents. The Company's cash and
cash equivalents balance, of which a significant portion exceeds federally
insured limits at December 31, 1997, was on deposit with two financial
institutions. This represents a concentration of credit risk as defined under
Statement of Financial Accounting Standards No. 105, "Disclosure of Information
about Financial Instruments with Off-Balance-Sheet Risk and Financial
Instruments with Concentrations of Credit Risk".
CONCENTRATION OF CREDIT RISK
During 1995, the Company had sales to two customers which represented 34
percent of sales. During 1996, the Company had sales to two customers which
represented 25 percent of sales. At December 31, 1996, one of these customers
accounted for 14 percent of accounts receivable. During 1997, the Company had
sales to the same two customers which represented 22 percent of sales. At
December 31, 1997, the two customers comprised 27 percent of accounts
receivable.
F-7
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
INVENTORIES
Inventories include costs of materials, labor and manufacturing overhead and
are stated at the lower of cost (first-in, first-out) or market. Inventories
consist of the following at December 31:
1996 1997
----------- -------------
Raw materials..................................................... $ 304,000 $ 708,000
Work-in-process................................................... 217,000 1,845,000
Finished goods.................................................... 30,000 332,000
----------- -------------
$ 551,000 $ 2,885,000
----------- -------------
----------- -------------
DEPRECIATION AND AMORTIZATION
Property and equipment are stated at cost, less accumulated depreciation and
amortization, which is computed on a straight-line basis over 1.5 to 7 years.
Ordinary repairs and maintenance are charged to operations as incurred.
Expenditures which extend the useful life of property and equipment are
capitalized. When assets are sold or otherwise disposed of, the cost and related
accumulated depreciation or amortization are removed from the accounts and any
resulting gain or loss is included in operations.
DEFERRED FINANCING COSTS
Deferred financing costs are amortized over the life of the related debt and
are presented net of accumulated amortization of $20,000 at December 31, 1997.
REVENUE RECOGNITION
The Company realizes revenues from the sale of hardware products, from the
licensing of related software and from maintenance contracts. Revenues on
product sales are recognized at the time of shipment, net of estimated
allowances for product returns. Revenues related to software licenses and
software maintenance is recognized in accordance with the American Institute of
Certified Public Accountants ("AICPA") Statement of Position No. 91-1, "Software
Revenue Recognition", and Financial Accounting Standards Board ("FASB")
Statement of Financial Accounting Standard ("SFAS") No. 48, "Revenue Recognition
When Right of Return Exists". Post-contract support obligations are
insignificant and are accrued for at the time of the sale. Maintenance revenues
for customer support and software updates are deferred and recognized ratably
over the term of the maintenance period (generally one year).
In October 1997, the AICPA issued Statement of Position 97-2, "Software
Revenue Recognition", which is effective for transactions entered into in fiscal
years beginning after December 15, 1997. The Statement of Position governs the
recognition of revenue by enterprises that license, sell, lease or otherwise
market software. Application of this Statement of Position in 1998 is not
expected to have a material impact on the Company's financial statements.
F-8
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
FOREIGN CURRENCY TRANSLATION
The functional currency of the Company's foreign subsidiaries is the local
foreign currency. The Company translates the assets and liabilities of its
foreign subsidiaries to U.S. dollars at the rates of exchange in effect at the
end of the year. Revenues and expenses are translated at the average rates of
exchange for the year. Translation adjustments, which are not significant, are
included in shareholders' deficit in the December 31, 1997 consolidated balance
sheet. Gains and losses resulting from foreign currency transactions denominated
in a currency other than the functional currency are included in "Other expense"
in the 1997 statement of income.
SOFTWARE DEVELOPMENT COSTS
In accordance with SFAS No. 86, "Accounting for the Costs of Computer
Software to be Sold, Leased, or Otherwise Marketed", development costs related
to software products are expensed as incurred until the technological
feasibility of the product has been established. Technological feasibility in
the Company's circumstances occurs when a working model is completed. After
technological feasibility is established, additional costs would be capitalized.
The Company believes its process for developing software is essentially
completed concurrent with the establishment of technological feasibility, and,
accordingly, no software development costs have been capitalized to date.
WARRANTY
The Company warrants its products against defects in materials and
workmanship for a period of one year. The Company provides for estimated
warranty costs when products are shipped.
SHAREHOLDERS' DISTRIBUTIONS
During 1996, the Company paid a total of $2,700,000 in shareholders'
distributions. No distributions were declared or paid in 1995 and 1997.
STATEMENTS OF CASH FLOWS
Cash paid for income taxes was $1,155,000, $4,998,000 and $12,315,000 in
1995, 1996 and 1997, respectively. Cash paid for interest was $977,000 in 1997.
There was no cash paid for interest in 1995 and 1996.
During 1997, the Company issued 200,000 shares of common stock in exchange
for a note receivable in the amount of $600,000. In addition, $480,000 of the
note receivable was reduced upon the repurchase of 160,000 shares of the common
stock by the Company (see Note 3). Also in 1997, the Company received a
$6,916,000 tax benefit from the exercise of non-qualified stock options and also
accrued $1,002,000 of dividends relating to the Company's Class A redeemable
preferred stock. These non-cash transactions are excluded from the 1997
statement of cash flows.
STOCK BASED COMPENSATION
The Company adopted SFAS No. 123, "Accounting for Stock Based Compensation"
("SFAS 123") in 1997. As allowed by SFAS 123, the Company has elected to
continue to measure compensation
F-9
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
expense under Accounting Principles Board Opinion No. 25, "Accounting for Stock
Issued to Employees" ("APB 25") and comply with the pro forma disclosure
requirements of the new standard (see Note 12).
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income". SFAS No. 130 applies to all companies and is effective for fiscal years
beginning after December 15, 1997. SFAS No. 130 establishes standards for the
reporting and display of comprehensive income in a set of financial statements.
Comprehensive income is defined as the change in net assets of a business
enterprise during a period from transactions generated from non-owner sources.
It includes all changes in equity during a period except those resulting from
investments by owners and distributions to owners. Management believes that the
adoption of SFAS No. 130 will not have a material impact on the Company's
financial statements.
In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information". SFAS No. 131 applies to all public
companies and is effective for fiscal years beginning after December 15, 1997.
SFAS No. 131 requires that business segment financial information be reported in
the financial statements utilizing the management approach. The management
approach is defined as the manner in which management organizes the segments
within the enterprise for making operating decisions and assessing performance.
Management believes the adoption of SFAS No. 131 will not have a material impact
on the Company's financial statements.
NET INCOME PER COMMON SHARE
The Company adopted SFAS No. 128, "Earnings Per Share " ("EPS") in 1997. The
statement requires presentation of basic EPS, which is computed by dividing
reported earnings available to common shareholders by the weighted average
shares outstanding. SFAS No. 128 also requires the calculation of diluted EPS,
which is similar to basic EPS except that the numerator is reduced by income
attributed to preferred shareholders and the denominator is increased for the
assumed conversion of common share equivalents.
F-10
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The following schedule summarizes the information used to compute historical
basic and diluted net income per common and common equivalent share for the
years ended December 31,1995,1996 and 1997, and for the unaudited three month
periods ended March 31,1997 and 1998 (in thousands, except per share data):
THREE MONTHS ENDED
------------------------
YEAR ENDED DECEMBER 31, MARCH 31,
--------------------------------------- ------------------------
1995 1996 1997 1997 1998
----------- ------------- ----------- ----------- -----------
(UNAUDITED)
Net income $ 2,958 $ 11,811 $ 22,796 $ 4,296 $ 5,648
Less: preferred stock dividends............... -- -- (1,002) -- (735)
----------- ------------- ----------- ----------- -----------
Net income applicable to common shares........ $ 2,958 $ 11,811 $ 21,794 $ 4,296 $ 4,913
----------- ------------- ----------- ----------- -----------
----------- ------------- ----------- ----------- -----------
Weighted averqage number of common shares used
to compute basic net income per common
share....................................... 21,255 21,880 16,149 21,931 5,119
Dilutive effect of stock options.............. 226 2,089 1,820 3,153 7,846
Dilutive effect of convertible preferred
stock....................................... -- -- 15,688 -- 45,807
----------- ------------- ----------- ----------- -----------
Weighted average number of common shares used
to compute diluted net income per common and
common equivalent share..................... 21,481 23,969 33,657 25,084 58,772
----------- ------------- ----------- ----------- -----------
----------- ------------- ----------- ----------- -----------
Basic net income per common share............. $ 0.14 $ 0.54 $ 1.35 $ 0.20 $ 0.96
----------- ------------- ----------- ----------- -----------
----------- ------------- ----------- ----------- -----------
Diluted net income per common and common
equivalent share............................ $ 0.14 $ 0.49 $ 0.68 $ 0.17 $ 0.10
----------- ------------- ----------- ----------- -----------
----------- ------------- ----------- ----------- -----------
3. RECAPITALIZATION
On August 29, 1997, the Company, its common shareholders (the "Sellers") and
certain investors (the "Purchasers") entered into a Recapitalization (the
"Recapitalization") pursuant to which the Company reconstituted its capital
structure through the sale of certain newly issued equity securities,
established senior debt obligations and repurchased certain of its outstanding
common shares. The Recapitalization resulted from three related transactions,
summarized as follows:
1. THE INVESTMENT. Subject to the terms and conditions of the
Recapitalization Agreement, the Purchasers invested an aggregate of
$97,037,000 in exchange for an aggregate of approximately 485,000 shares of
Class A redeemable preferred stock, $0.001 par value ("redeemable
preferred"), and an aggregate of approximately 45,807,000 shares of Class B
convertible preferred stock, $0.001 par value ("convertible preferred"). The
per share purchase prices of the redeemable preferred and convertible
preferred sold in the Recapitalization were $100.00 and $1.059,
respectively. Immediately following the closing of the Recapitalization, the
Purchasers held approximately
F-11
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. RECAPITALIZATION (CONTINUED)
78.9 percent of the voting equity securities of the Company on a fully
diluted basis (i.e. approximately 78.9 percent of the total number of
outstanding shares together with shares issuable upon exercise of
outstanding options). In connection with the Investment, the Company
incurred $5,715,000 of directly related costs, which have been recorded as a
charge to "Retained Deficit" in the accompanying December 31, 1997
consolidated financial statements. The total net proceeds from the sale of
the redeemable preferred and the convertible preferred were $91,322,000. See
Note 6 for details relating to the redeemable preferred and convertible
preferred.
2. THE SENIOR CREDIT FACILITY. Subject to the terms and conditions of
the Recapitalization Agreement, the Company entered into a credit agreement
with two banks pursuant to which the Company borrowed $50,000,000 through a
term loan facility and obtained a commitment for a $10,000,000 revolving
line of credit. See Note 5 for details relating to the credit facility.
3. THE REDEMPTION. Subject to the terms and conditions of the
Recapitalization Agreement, the Company purchased 80 percent of the
outstanding shares of common stock held by each shareholder of the Company
(including shares issued upon exercise of vested stock options) at the
approximate price of $7.65 per share. Immediately prior to the
Recapitalization, the Company had 22,120,000 shares of common stock
outstanding and approximately 3,419,000 shares relating to vested stock
options outstanding. The total aggregate number of common shares repurchased
by the Company (after the exercise of stock options) was approximately
20,431,000 and the total aggregate cash paid by the Company to the
shareholders was $155,722,000. As part of the redemption, the Company also
reduced the outstanding amount of a $600,000 note receivable due from a
shareholder by $480,000.
Following the closing of the Recapitalization, the Company's common
stock (through an independent appraisal approved by the Company's Board of
Directors) was valued at $0.75 per share.
4. ACQUISITION OF NETCOM SYSTEMS EUROPE S.A.R.L.
Effective September 15, 1997, the Company acquired all of the outstanding
common shares of Netcom Systems Europe S.A.R.L. ("NSE"), a research and
development, sales and distribution company located near Paris, France. On the
date of acquisition, NSE was owned by two brothers of the Company's founder,
majority shareholder and then president. The purchase price was $3,000,000, plus
$142,000 of directly related costs. The Company has accounted for the
acquisition using the purchase method, and the results of operations of the
acquired business are included in the Company's operations since acquisition.
Because the acquired company was a related entity, the Company has recorded the
premium paid in the transaction ($1,987,000) as an increase to retained deficit
in the accompanying 1997 financial statements.
F-12
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. ACQUISITION OF NETCOM SYSTEMS EUROPE S.A.R.L. (CONTINUED)
The following is a summary of the purchase price allocation:
Current assets and other tangible assets....................... $1,755,000
Current liabilities assumed.................................... (600,000)
----------
Net assets acquired............................................ 1,155,000
Purchase price................................................. 3,142,000
----------
Charge to retained deficit..................................... $1,987,000
----------
----------
5. CREDIT FACILITY
In August 1997, in connection with the Recapitalization, the Company entered
into a credit agreement with two banks pursuant to which the Company borrowed
$50,000,000 under a term loan facility and also received a commitment for a
$10,000,000 revolving line of credit. Both the term loan and the line of credit
are unsecured and mature in August 2002. The line of credit facility also
contains a $2,000,000 letter of credit subfacility.
Borrowings under both the term loan and the line of credit bear interest, at
the Company's election, at the "Base Rate" or the "LIBOR Rate". Interest is
payable quarterly. The Base Rate is the higher of (a) the prime rate or (b) the
federal funds overnight rate plus 0.5 percent per year. The LIBOR Rate is a per
annum rate of 30, 60, 90 or 180 days LIBOR, plus a margin based on the Company's
leverage ratio, ranging from 0.875 percent to 1.5 percent per year. Through
December 31, 1997, the Company selected the LIBOR Rate, and at December 31, 1997
the interest rate in effect was 7.185 percent.
The term loan is due and payable in quarterly installments beginning on
October 31, 1998. The amount of the installments will initially be $2,500,000
per quarter, rising to $5,000,000 per quarter on April 30, 2002. The credit
agreement contains certain financial and negative covenants, all of which the
Company was in compliance with at December 31, 1997.
At December 31, 1997, $50,000,000 was outstanding on the term loan and no
amounts were outstanding on the line of credit.
Future principal maturities under the term loan facility at December 31,
1997 are as follows:
1998.......................................................... $ 2,500,000
1999.......................................................... 10,000,000
2000.......................................................... 10,000,000
2001.......................................................... 10,000,000
2002.......................................................... 17,500,000
-----------
$50,000,000
-----------
-----------
F-13
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. PREFERRED STOCK
CLASS A REDEEMABLE PREFERRED STOCK
In August 1997, in connection with the Recapitalization, the Company sold
approximately 485,000 shares of redeemable preferred stock at the price of $100
per share. The redeemable preferred accrues a preferential dividend at the rate
of 6 percent per annum of the original purchase price and has a liquidation
value of $100 per share, plus all accrued but unpaid dividends. The Company is
required to redeem the stock in three equal, annual installments beginning
September 2002 at the liquidation value. In addition, all shares of redeemable
preferred will be redeemed by the Company in the event that a change in control
or certain events related to the Company's solvency occur. Further, the Company
must apply the cash proceeds of any public offering of the Company's securities
to the redemption of the redeemable preferred. The Company may voluntarily
redeem shares of the redeemable preferred at any time. The per share price for
any redemption of shares of redeemable preferred will be equal to the original
per share purchase price plus an amount equal to all accrued but unpaid
dividends thereon. Except for certain protective provisions and as otherwise
required by law, the shares of redeemable preferred will have no voting rights.
If the Company issues securities in a public offering registered with the
Securities and Exchange Commission and does not redeem all shares of redeemable
preferred with the proceeds thereof, the dividend rate on the redeemable
preferred will increase by an increment of 1.5 percent thirty days following
such issuance and will increase by an additional 1.5 percent at the end of each
successive 90 day period (up to a maximum of 12 percent) until the redeemable
preferred is redeemed in full. Although the redeemable preferred dividends will
accrue if not paid, the dividends of the redeemable preferred will be paid only
when and as declared by the Company's Board of Directors. No dividend on any
other class or series of stock may be paid until all accrued dividends on the
redeemable preferred have been paid.
As of December 31, 1997, $1,002,000 of dividends had been accrued on the
redeemable preferred, none of which have been declared by the Company's Board of
Directors.
CLASS B CONVERTIBLE PREFERRED STOCK
Also in August 1997 and in connection with the Recapitalization, the Company
sold approximately 45,807,000 shares of convertible preferred stock at the
approximate price of $1.06 per share.
Holders of convertible preferred will be entitled to dividends when and as
declared by the Company's Board of Directors. In addition, in the event the
Company declares a dividend on its common stock, holders of convertible
preferred will be entitled to a simultaneous dividend in an amount equal to the
dividend they would have received had they converted their convertible preferred
to common stock immediately prior to the record date for the dividend. Upon any
liquidation, dissolution or winding up of the Company, each holder of
convertible preferred will be entitled to be paid, before any payment is made on
any other class or series of capital stock (other than redeemable preferred), an
amount equal to the greater of (a) the original purchase price of the
convertible preferred plus all declared but unpaid dividends thereon or (b) the
amount which such holder would have received had all shares of convertible
preferred been converted to common stock immediately prior to such liquidation,
dissolution or winding up.
At the option of the holders of at least 66.7 percent of the outstanding
shares of convertible preferred following the occurrence of a change in control
of the Company or certain events related to the
F-14
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. PREFERRED STOCK (CONTINUED)
Company's solvency, the Company must redeem all shares of convertible preferred.
The per share price for any redemption of shares of convertible preferred will
be equal to the original per share purchase price plus an amount equal to all
declared but unpaid dividends thereon.
The convertible preferred may be converted into common stock at any time by
the holders thereof. In addition, each share of convertible preferred will
automatically be converted into common stock upon the election of the holders of
at least 66.7 percent of the outstanding shares of convertible preferred or upon
the closing of a firm commitment underwritten public offering of common stock
pursuant to an effective registration statement under the Securities Act of
1933, as amended (the "Securities Act"), in which (a) the aggregate price paid
by the public is at least $75,000,000, (b) the price per share paid by the
public for such shares is at least 300 percent of the original purchase price of
the convertible preferred (as adjusted for certain dilutive issuances,
subdivision or combination of the common stock, recapitalizations and the like)
and (c) all of the shares of the redeemable preferred are redeemed with the
proceeds of such offering. Each share of convertible preferred will initially be
convertible into one share of common stock, subject to adjustment for certain
dilutive issuances, subdivision or combination of the common stock,
recapitalizations and the like.
7. COMMON STOCK
In January 1997, the Company increased the authorized number of its common
shares to 60,000,000 and effected a two-for-one stock split of its common stock.
In September 1997, the Company amended its Articles of Incorporation to increase
the number of authorized shares of its common stock to 100,000,000. In May 1998,
the Company's Board of Directors approved an additional two-for-one stock split
of its common stock. All shares and per share prices of common stock and common
stock options included in these financial statements have been restated to give
retroactive effect to the stock splits for all periods presented. Also in May
1998, the Company's Board of Directors approved the Company's reincorporation in
the State of Delaware, and the subsequent amendment to the certificate of
incorporation, the effects of which have been reflected in these financial
statements, including the increase of authorized shares to 200,000,000.
In March 1997, the Company sold 200,000 shares of its common stock at a
price of $3.00 per share in exchange for a note receivable. The note is due June
1, 1998 and bears interest at an annual rate of eight percent. In connection
with the Recapitalization, $480,000 of the note receivable was reduced upon the
repurchase of 160,000 shares of the common stock by the Company. At December 31,
1997, $120,000 was outstanding on the note.
8. INCOME TAXES
The Company accounts for income taxes under the provisions of SFAS 109.
Under SFAS 109, deferred income tax assets or liabilities are computed based on
the temporary difference between the financial statement and income tax bases of
assets and liabilities using the current enacted marginal income tax rate.
Deferred income tax expenses or credits are based on the changes in the deferred
income tax assets or liabilities from period to period.
F-15
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. INCOME TAXES (CONTINUED)
The provision for income taxes for the years ended December 31, 1995, 1996
and 1997 is as follows:
1995 1996 1997
------------- ------------- --------------
Current:
Federal.......................................................... $ 1,699,000 $ 6,956,000 $ 12,175,000
State............................................................ 418,000 1,855,000 3,332,000
------------- ------------- --------------
2,117,000 8,811,000 15,507,000
------------- ------------- --------------
Deferred........................................................... (162,000) (669,000) (632,000)
------------- ------------- --------------
Provision for income taxes......................................... $ 1,955,000 $ 8,142,000 $ 14,875,000
------------- ------------- --------------
------------- ------------- --------------
Differences between the provision for income taxes and income taxes at the
statutory federal income tax rate for the years ended December 31, 1995, 1996
and 1997 are as follows (amounts in thousands):
1995 1996 1997
-------------------- -------------------- --------------------
Income tax at statutory federal rate......................... $ 1,670 34.0% $ 6,984 35.0% $ 13,185 35.0%
State income taxes, net of federal benefit................... 270 5.4 1,175 5.9 2,145 5.7
Research and development tax credits......................... (30) (0.6) (50) (0.3) (480) (1.3)
Other items, net............................................. 45 1.0 33 0.2 25 0.1
--------- --- --------- --- --------- ---
$ 1,955 39.8% $ 8,142 40.8% $ 14,875 39.5%
--------- --- --------- --- --------- ---
--------- --- --------- --- --------- ---
During the year ended December 31, 1997, the Company recorded pretax income
from U.S. operations in the amount of $37,866,000 and a pretax loss from foreign
operations in the amount of $80,000. Consequently, there was no income tax
liability relating to foreign operations as of December 31, 1997.
The Company does not provide federal income taxes on the undistributed
earnings of its foreign operations. The Company's policy is to leave the income
permanently invested in the country of origin. Such amounts will only be
distributed to the United States to the extent any federal income tax can be
fully offset by foreign tax credits.
F-16
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. INCOME TAXES (CONTINUED)
A detail of the Company's net deferred tax asset as of December 31, 1996 and
1997 is as follows:
1996 1997
----------- -------------
Accrued vacation.................................................. $ 38,000 $ 119,000
State taxes....................................................... 649,000 595,000
Depreciation...................................................... (16,000) (21,000)
Allowance for doubtful accounts................................... 41,000 144,000
Inventory reserve................................................. 33,000 139,000
Accrued warranty.................................................. 10,000 41,000
Deferred revenue.................................................. 84,000 186,000
Other............................................................. -- 21,000
----------- -------------
Total current deferred asset.................................. 839,000 1,224,000
Net operating loss carryforward................................... -- 247,000
----------- -------------
$ 839,000 $ 1,471,000
----------- -------------
----------- -------------
At December 31, 1997, the Company had a federal net operating loss
carryforward (NOL) of approximately $700,000, which was primarily due to the
timing of the Company's changing of its year-end from July 31 to December 31
(which was effective in December 1997) and the significant tax benefit of
$6,916,000 it received from the exercise of stock options during the period from
July 31, 1997 to December 31, 1997. Due to the income tax laws relating to the
changing of year-ends, the Company can only realize the NOL over a six year
period.
Under SFAS 109, deferred tax assets may be recognized for temporary
differences that will result in deductible amounts in future periods and for
loss carryforwards. A valuation allowance is recognized if, based on the weight
of available evidence, it is more likely than not that some portion or all of
the deferred tax asset will not be realized. The Company has not recorded a
valuation allowance as of December 31, 1996 or 1997.
9. GEOGRAPHIC INFORMATION
The Company markets and sells its products from its operations in the United
States and France. Direct sales in Europe are primarily to customers in France
and the United Kingdom. Information regarding operations in different geographic
regions for the three month period ended March 31, 1998 is as follows:
1995 1996 1997
------------- -------------- --------------
Revenues:
United States................................................... $ 7,436,000 $ 22,863,000 $ 41,596,000
Europe.......................................................... 750,000 953,000 3,998,000
Pacific Rim..................................................... 505,000 2,045,000 6,744,000
Middle East..................................................... 180,000 1,383,000 1,605,000
Canada.......................................................... 182,000 210,000 2,330,000
------------- -------------- --------------
Total......................................................... $ 9,053,000 $ 27,454,000 $ 56,273,000
------------- -------------- --------------
------------- -------------- --------------
F-17
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. GEOGRAPHIC INFORMATION (CONTINUED)
1995 1996 1997
------------- -------------- --------------
Income from operations:
United States................................................... $ 3,961,000 $ 16,408,000 $ 28,338,000
Europe.......................................................... 412,000 685,000 2,722,000
Pacific Rim..................................................... 277,000 1,470,000 4,593,000
Middle East..................................................... 98,000 995,000 1,093,000
Canada.......................................................... 100,000 151,000 1,587,000
------------- -------------- --------------
Total......................................................... $ 4,848,000 $ 19,709,000 $ 38,333,000
------------- -------------- --------------
------------- -------------- --------------
Identifiable assets:
United States................................................... $ 5,683,000 $ 18,110,000 $ 32,287,000
Europe.......................................................... -- -- 1,842,000
------------- -------------- --------------
Total......................................................... $ 5,683,000 $ 18,110,000 $ 34,129,000
------------- -------------- --------------
------------- -------------- --------------
10. COMMITMENTS AND CONTINGENCIES
LEASE COMMITMENTS
The Company leases its primary facility and sales and distribution offices
under noncancellable leases accounted for as operating leases expiring at
various dates through August 2002. The Company leases its primary facility from
a shareholder of its common stock (see Note 11). Total rental expense under all
operating leases was $41,000, $155,000 and $405,000 in 1995, 1996 and 1997,
respectively.
Minimum commitments under existing operating leases are as follows:
YEARS ENDING DECEMBER 31,
- -------------------------------------------------------------------------------
1998........................................................................... $ 484,000
1999........................................................................... 481,000
2000........................................................................... 487,000
2001........................................................................... 486,000
2002........................................................................... 324,000
-------------
$ 2,262,000
-------------
-------------
EMPLOYMENT AGREEMENTS
The Company has employment agreements with four of its employees. One of the
agreements provides for a three year term which expires in 1999, while the other
three agreements are on a year-to-year basis. Each agreement provides for a base
salary, a bonus and/or commission and the granting of non-qualified stock
options. All option grant commitments under the employment agreements were
fulfilled as of January 8, 1998.
F-18
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. COMMITMENTS AND CONTINGENCIES (CONTINUED)
CHANGE-IN-CONTROL AGREEMENTS
In May 1998, the Company entered into Change-in-Control Agreements with each
of its executive officers. Such agreements provide that if the executive
officer's employment with the Company is involuntarily terminated at any time
within 24 months after a change in control other than for cause (each as defined
therein), then the executive officer shall be entitled to receive a severance
payment equal to one year of the executive officer's base compensation for the
Company's fiscal year then in effect plus the executive officer's bonus
calculated at 100 percent of target for the Company's fiscal year then in
effect.
11. RELATED PARTY TRANSACTIONS
During 1996 and 1997 (through the acquisition date of NSE), the Company had
sales of $953,000 and $3,109,000 to NSE. At December 31, 1996, accounts
receivable from NSE totaled $425,000. There were no sales to NSE in 1995.
On March 27, 1997, the Company sold shares of its common stock to the lessor
of its primary facility. In August 1997, the Company entered into a new five
year lease agreement with the lessor. The initial monthly base rent under the
agreement is $37,440, with provisions for increasing monthly payments at various
stages during the lease term. Rent under the lease agreements from March 27,
1997 through December 31, 1997 was approximately $342,000.
F-19
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. STOCK BASED COMPENSATION PLANS
STOCK OPTION PLANS
The Company has three stock option plans (the 1993 Stock Plan, the amended
and restated 1997 Stock Plan and the 1998 Stock Plan) under which the Company is
authorized to issue incentive and non-qualified stock options and stock purchase
rights to its directors, officers, employees and consultants totaling up to
approximately 19,763,000 shares of common stock. Options are generally granted
at exercise prices not less than the fair market value ("FMV") on the date of
grant and expire ten years after the date of grant. Options granted under these
plans generally vest over a five year period.
Following the Recapitalization, all options with exercise prices above $0.75
per share (options representing 4,470,000 shares) were cancelled and regranted
at the exercise price of $0.75 per share (the newly established FMV of the
Company's common stock).
The following summarizes option activity for 1995, 1996 and 1997 (in
thousands, except exercise price data):
1995 1996 1997
------------------------ ------------------------ ---------
WTD. AVG. WTD. AVG.
FIXED OPTIONS SHARES EX. PRICE SHARES EX. PRICE SHARES
- ------------------------------------------------------------ ----------- ----------- ----------- ----------- ---------
Outstanding at beginning of year............................ -- $ -- 4,200 $ 0.76 7,844
Granted..................................................... 4,200 0.76 3,644 1.44 9,406
Exercised................................................... -- -- -- -- (3,367)
Cancelled................................................... -- -- -- -- (4,495)
----- ----- ----- ----- ---------
Outstanding at end of year.................................. 4,200 $ 0.76 7,844 $ 1.08 9,388
----- ----- ----- ----- ---------
----- ----- ----- ----- ---------
Options exercisable at end of year.......................... -- $ -- 820 $ 0.19 206
----- ----- ----- ----- ---------
----- ----- ----- ----- ---------
Weighted average fair value of options granted during the
year...................................................... $ 0.01 $ 0.08
----- -----
----- -----
WTD. AVG.
FIXED OPTIONS EX. PRICE
- ------------------------------------------------------------ -----------
Outstanding at beginning of year............................ $ 1.08
Granted..................................................... 1.02
Exercised................................................... 0.64
Cancelled................................................... 1.95
-----
Outstanding at end of year.................................. $ 0.71
-----
-----
Options exercisable at end of year.......................... $ 0.71
-----
-----
Weighted average fair value of options granted during the
year...................................................... $ 0.28
-----
-----
The following table summarizes information about the options outstanding at
December 31, 1997:
NUMBER OF SHARES WEIGHTED AVERAGE NUMBER OF SHARES
RANGE OF OUTSTANDING AT REMAINING EXERCISABLE AT
EXERCISE PRICES DECEMBER 31, 1997 CONTRACTUAL LIFE DECEMBER 31, 1997
- --------------- ------------------ --------------------------- ------------------
$ 0.03-0.05 200,000 7.3 --
0.19-0.25 174,000 7.3 --
0.63 958,000 8.2 76,000
0.75 8,056,000 9.7 130,000
---------- --------
9,388,000 206,000
---------- --------
---------- --------
As permitted by SFAS 123, the Company continues to apply the accounting
rules of APB 25 governing the recognition of compensation expense from its Stock
Option Plans. Such accounting rules measure compensation expense on the first
date at which both the number of shares and the exercise price are known. Under
the Company's plans, this would typically be the grant date. To the extent that
the exercise price equals or exceeds the market value of the stock on the grant
date, no
F-19
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. STOCK BASED COMPENSATION PLANS (CONTINUED)
expense is recognized. As options are generally granted at exercise prices not
less than the fair market value on the date of grant, no compensation expense is
recognized under this accounting treatment in the accompanying statements of
income. However, under the provisions of SFAS 123, options (and other equity
instruments) granted to non-employees are excluded from the pro forma disclosure
requirements and must be recorded as compensation expense at fair value in the
accompanying statements of income. During the year ended December 31, 1997, the
fair value of options granted to non-employees, which was charged to
compensation expense in the accompanying statements of income, was $15,000. Had
the Company applied the fair value based method of accounting, which is not
required, to all grants of options, under SFAS 123, the Company's net income
would have been decreased by the following pro forma amounts:
1995 1996 1997
------------- -------------- --------------
Net income--as reported........................................... $ 3,077,000 $ 11,860,000 $ 22,796,000
Net income--pro forma............................................. 3,066,000 11,786,000 22,139,000
These pro forma amounts were determined by estimating the fair value of each
option on its grant date using the Black-Scholes option-pricing model.
Assumptions of 5.8 percent to 6.6 percent for risk free interest rate, five
years for expected life and no expected dividends or volatility were applied to
all grants for each year presented.
EMPLOYEE STOCK PURCHASE PLAN
The Company's 1998 Employee Stock Purchase Plan (the "1998 Purchase Plan")
was approved by the Board of Directors in May 1998. A total of 300,000 shares of
common stock has been reserved for issuance under the 1998 Purchase Plan, plus
annual increases (beginning in 1999) equal to the lessor of (i) 1,000,000 shares
(ii) 1 percent of the outstanding shares or a lesser amount determined by the
Board.
The 1998 Purchase Plan, which is intended to qualify under Section 423 of
the Internal Revenue Code of 1986, as amended, contains successive six-month
offering periods. The offering periods generally start on the first trading day
on or after February 15 and August 15 of each year, except for the first such
offering period which commences on the first trading day on or after the
effective date of an offering and ends on the last trading day on or before
February 14, 1999.
13. EMPLOYEE SAVINGS PLAN
In 1997, the Company established an employee 401(k) savings plan covering
all eligible employees. The Company's contributions to the plan for 1997 were
$45,000.
14. UNAUDITED INFORMATION
INTERIM FINANCIAL STATEMENTS
The unaudited financial statements have been prepared pursuant to the rules
and regulations of the Securities and Exchange Commission. Certain information
and note disclosures normally included in annual financial statements prepared
in accordance with generally accepted accounting principles have been omitted
pursuant to those rules and regulations, although the Company believes that the
disclosures made are adequate to make the information presented not misleading.
These unaudited financial statements reflect, in the opinion of management, all
adjustments (which include only normal recurring
F-20
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. UNAUDITED INFORMATION (CONTINUED)
adjustments) necessary to fairly present the results of operations, changes in
cash flows and financial position as of and for the periods presented. These
unaudited financial statements should be read in conjunction with the audited
financial statements and related notes, thereto, appearing elsewhere herein. The
results for the interim periods presented are not necessarily indicative of
results to be expected for a full year.
PRO FORMA BALANCE SHEET PRESENTATION
Under the terms of the Company's agreements with the holders of the Class B
convertible preferred stock (see Note 6), all of such preferred stock will be
converted automatically into shares of common stock upon the closing of an
initial public offering of the Company's common stock, meeting specified
requirements. The unaudited pro forma information at March 31, 1998 reflects the
conversion of the Class B convertible preferred stock into approximately
45,807,000 shares of common stock as if the conversion occurred on March 31,
1998.
PRO FORMA NET INCOME PER COMMON SHARE
Unaudited pro forma net income per common and common equivalent share for
the year ended December 31, 1997 and for the three month period ended March 31,
1998, was based on the weighted average number of common and common equivalent
shares outstanding during the period. The unaudited pro forma weighted average
number of common shares used to compute basic net income per common share
assumes that all of the Class B convertible preferred stock had been converted
to common stock as of the original issuance date (August 29, 1997). The
unaudited pro forma weighted average number of common shares used to compute
diluted net income per common share also includes shares issuable upon the
assumed exercise of stock options, computed in accordance with the treasury
stock method.
The following schedule summarizes the information used to compute pro forma
basic and diluted net income per common and common equivalent share for the year
ended December 31, 1997 and the three month period ended March 31, 1998:
1997 1998
-------------- --------------
Net income applicable to common shares....................... $ 22,796,000 $ 5,648,000
-------------- --------------
-------------- --------------
Pro forma weighted average number of common shares used to
compute basic net income per common share.................. 31,837,000 50,925,000
Dilutive effect of stock options............................. 1,820,000 7,847,000
-------------- --------------
Pro forma weighted average number of common shares used to
compute diluted net income per common share................ 33,657,000 58,772,000
-------------- --------------
-------------- --------------
Basic net income per common share............................ $ 0.72 $ 0.11
-------------- --------------
-------------- --------------
Diluted net income per common share.......................... $ 0.68 $ 0.10
-------------- --------------
-------------- --------------
F-21
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. UNAUDITED INFORMATION (CONTINUED)
STOCK BASED COMPENSATION PLANS
The following summarizes option activity for the three month period ended
March 31, 1998:
WTD. AVG.
FIXED OPTIONS SHARES EX. PRICE
- ------------------------------------------------------------------- ------------- -----------
Outstanding at beginning of period................................. 9,388,000 $ 0.71
Granted.......................................................... 2,778,000 1.13
Exercised........................................................ (67,000) 0.03
Canceled......................................................... (30,000) 1.00
------------- -----
Outstanding at end of period....................................... 12,069,000 $ 0.78
------------- -----
------------- -----
Options exercisable at end of period............................... 206,000 $ 0.71
------------- -----
------------- -----
Weighted average fair value of options granted during the period... $ 0.31
-----
-----
During the three month period ended March 31, 1998, the Company continued to
apply the accounting rules of APB 25. Had the Company applied the fair value
based method of accounting to all grants of option, under SFAS 123, the
Company's net income would have been decreased by the following pro forma
amount:
Net income--as reported........................................ $5,648,000
Net income--pro forma.......................................... 5,474,000
The pro forma amount was determined by estimating the fair value of each
option on its grant date using the Black-Scholes option-pricing model.
Assumptions of 6.5 percent for risk free interest rate, five years for expected
life and no expected dividends or volatility were applied to all grants for the
period presented.
DEFERRED COMPENSATION
During the three month period ended March 31, 1998, the Company recorded
deferred compensation in the amount of $116,000, which related to the granting
of employee stock options below fair market value. The deferred compensation
will be amortized over five years (the vesting period of the options).
COMPREHENSIVE INCOME
During the three month period ended March 31, 1998, "Other Comprehensive
Income" related solely to foreign currency translation adjustments. During the
period, translation losses, net of tax, were $22,000. Comprehensive income was
$5,626,000 during the period. "Accumulated Other Comprehensive Loss" as of March
31, 1998 was $47,000.
F-22
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. UNAUDITED INFORMATION (CONTINUED)
INVENTORIES
Inventories at March 31, 1998 consisted of the following:
Raw materials.................................................. $1,541,000
Work-in-process................................................ 1,705,000
Finished goods................................................. 222,000
----------
$3,468,000
----------
----------
SUPPLEMENTAL CASH FLOW INFORMATION
There was no cash paid for income taxes during the three month period ended
March 31, 1998. Cash paid for income taxes was $3,877,000 during the three month
period ended March 31, 1997. Cash paid for interest during the three month
period ended March 31, 1998 was $773,000. There was no cash paid for interest
during the three month period ended March 31, 1997.
In March 1997, the Company issued 200,000 shares of common stock in exchange
for a note receivable in the amount of $600,000. This non-cash transaction is
excluded from the March 31, 1997 statement of cash flows.
INCOME TAXES
Differences between the provision for income taxes and income taxes at the
statutory federal income tax rate for the three month periods ended March 31,
1997 and 1998 are as follows (amounts in thousands):
1997 1998
-------------------- --------------------
Income tax at statutory federal rate........................................ $ 2,485 35.0% $ 3,350 35.0%
State income taxes, net of federal benefit.................................. 405 5.7 584 6.1
Foreign Sales Corporation tax benefit....................................... -- -- (130) (1.4)
Research and development tax credits........................................ (92) (1.3) (55) (0.5)
Foreign taxes............................................................... -- -- 98 1.0
Other items, net............................................................ 6 0.1 77 0.8
--------- --- --------- ---
$ 2,804 39.5% $ 3,924 41.0%
--------- --- --------- ---
--------- --- --------- ---
F-23
NETCOM SYSTEMS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. UNAUDITED INFORMATION (CONTINUED)
GEOGRAPHIC INFORMATION
Information regarding operations in different geographic regions for the
three month period ended March 31, 1998 is as follows:
Revenues:
United States............................................... $13,280,000
Europe...................................................... 1,785,000
Pacific Rim................................................. 2,373,000
Middle East................................................. 282,000
Canada...................................................... 291,000
-----------
Total..................................................... $18,011,000
-----------
-----------
Income from operations:
United States............................................... $ 7,560,000
Europe...................................................... 1,016,000
Pacific Rim................................................. 1,351,000
Middle East................................................. 161,000
Canada...................................................... 166,000
-----------
Total..................................................... $10,254,000
-----------
-----------
Identifiable assets:
United States............................................... $40,224,000
Europe...................................................... 2,581,000
-----------
Total..................................................... $42,805,000
-----------
-----------
F-24
UNDERWRITING
Subject to the terms and conditions set forth in the Underwriting Agreement,
the Company and the Selling Stockholders have agreed to sell to each of the U.S.
Underwriters named below (the "Underwriters"), and each U.S. Underwriter for
whom Goldman, Sachs & Co., NationsBanc Montgomery Securities LLC and BT Alex.
Brown Incorporated are acting as representatives (the "Representatives"), has
severally agreed to purchase from the Company and the Selling Stockholders, the
respective number of shares of Common Stock set forth opposite its name below:
NUMBER OF
SHARES OF
COMMON
UNDERWRITER STOCK
- ------------------------------------------------------------------------------- -------------
Goldman, Sachs & Co............................................................
NationsBanc Montgomery Securities LLC..........................................
BT Alex. Brown Incorporated....................................................
-------------
Total........................................................................ 12,400,000
-------------
-------------
Under the terms and conditions of the Underwriting Agreement the U.S.
Underwriters are committed to take and pay for all of the shares offered hereby,
if any are taken.
The U.S. Underwriters propose to offer the shares of Common Stock in part
directly to the public at the initial public offering price set forth on the
cover page of this Prospectus and in part to certain securities dealers at such
prices less a concession of $ per share. The U.S. Underwriters may
allow, and such dealers may reallow, a concession not in excess of $ per
share to certain brokers and dealers. After the shares of Common Stock are
released for sale to the public, the offering price and other selling terms may
from time to time be varied by the representatives.
The Company has entered into an underwriting agreement (the "International
Underwriting Agreement") with the underwriters of the international offering
(the "International Underwriters") providing for the concurrent offer and sale
of 2,480,000 shares of Common Stock in the International Offering outside the
United States. The initial offering price and aggregate underwriting discounts
and commissions per share for the Offerings will be identical. The closing of
the U.S. Offering made hereby is a condition to the closing of the International
Offering, and vice versa. The representatives of the International Underwriters
are Goldman Sachs International, NationsBanc Montgomery LLC and BT Alex. Brown
International.
Pursuant to an Agreement between the U.S. and International Underwriting
Syndicates (the "Agreement Between") relating to the Offerings, each of the U.S.
Underwriters named herein has agreed that, as a part of the distribution of the
shares offered hereby and subject to certain exceptions, it will offer, sell or
deliver the shares of Common Stock, directly or indirectly, only in the United
States of America (including the States and the District of Columbia), its
territories, its possessions and other areas subject to its jurisdiction (the
"United States") and to U.S. persons, which term shall mean, for purposes of
this paragraph: (a) any individual who is a resident of the United States or (b)
any corporation, partnership or other entity organized in or under the laws of
the United States or any political subdivision thereof and whose office most
directly involved with the purchase is located in the United States. Each of the
International Underwriters has agreed pursuant to the Agreement Between that, as
part of the distribution of the shares offered as a part of the International
Offering, and subject to certain exceptions, it will (i) not, directly or
indirectly, offer, sell or deliver shares of Common Stock (a) in the United
States or to any U.S. persons or (b) to any person whom it believes intends to
reoffer, resell or deliver the shares in the United States or to any U.S.
persons, and (ii) cause any dealer to whom it may sell such shares at any
concession to agree to observe a similar restriction.
Pursuant to the Agreement Between, sales may be made between the U.S.
Underwriters and the International Underwriters of such number of shares of
Common Stock as may be mutually agreed. The
U-1
price of any shares so sold shall be the initial public offering price, less an
amount not greater than the selling concession.
The Company and the Selling Stockholders have granted the U.S. Underwriters
an option exercisable for 30 days after the date of this Prospectus to purchase
up to an aggregate of 71,218 and 1,416,782 additional shares of Common Stock,
respectively, to cover over-allotments, if any. If the U.S. Underwriters
exercise their over-allotment option, the Underwriters have severally agreed,
subject to certain conditions, to purchase approximately the same percentage
thereof that the number of shares to be purchased by each of them, as shown in
the foregoing table, bears to the total number of shares of Common Stock offered
in the U.S. Offering. The Company and certain Selling Stockholders have granted
the International Underwriters a similar option to purchase up to an aggregate
of 372,000 additional shares of Common Stock.
The representatives of the Underwriters have informed the Company that they
do not expect sales to accounts over which they exercise discretionary authority
to exceed five percent of the total number of shares of Common Stock offered by
them.
The Company and the Selling Stockholders have agreed that, during the period
from the date of this Prospectus and continuing to and including the date 180
days after the date of this Prospectus, they will not offer, sell, contract to
sell or otherwise dispose of any securities of the Company (other than pursuant
to employee stock option plans existing, or on the conversion or exchange of
convertible or exchangeable securities outstanding, on the date of this
Prospectus) which are substantially similar to the shares of Common Stock or
which are convertible into or exchangeable for securities which are
substantially similar to the shares of Common Stock without the prior written
consent of the representatives, except for the shares of Common Stock offered in
connection with the Offerings.
The Company and the Selling Stockholders have agreed to indemnify the
several Underwriters against certain liabilities, including liabilities under
the Securities Act of 1933.
In the Recapitalization, NationsBanc Capital Corp., Spitfire Capital
Partners L.P. and certain other persons related to or affiliated with Montgomery
Securities acquired an aggregate of 12,839,022 shares of the Company's Class B
Convertible Preferred Stock at a purchase price per share of $1.0592 and an
aggregate of 135,975 shares of Class A Redeemable Preferred Stock at a purchase
price of $100 per share. The shares owned by the foregoing entities represent
25.2% of the outstanding capital stock of the Company before the Offerings. All
of such shares were acquired from the Company as part of the Recapitalization on
the same terms pursuant to which all other participants in the Recapitalization
purchased their shares. See "Certain Transactions" and "Principal and Selling
Stockholders".
In connection with the Offerings, the Underwriters may purchase and sell
shares of the Company's Common Stock in the open market. These transactions may
include over-allotment and stabilizing transactions, and purchases to cover
syndicate short positions created in connection with the offering. Stabilizing
transactions consist of certain bids or purchases for the purpose of preventing
or retarding a decline in the market price of the Common Stock; and syndicate
short positions involve the sale by the Underwriters of a greater number of
shares of Common Stock than they are required to purchase from the Company and
the Selling Stockholders in the offering. The Underwriters also may impose a
penalty bid, whereby selling concessions allowed to syndicate members or other
broker-dealers in respect of the securities sold in the offering for their
account may be reclaimed by the syndicate if such shares of Common Stock are
repurchased by the syndicate in stabilizing or covering transactions. These
activities may stabilize, maintain or otherwise affect the market price of the
Common Stock, which may be higher than the price that might otherwise prevail in
the open market; and these activities, if commenced, may be discontinued at any
time. These transactions may be effected on the Nasdaq National Market in the
over-the-counter market or otherwise.
U-2
Prior to the Offerings, there has been no public market for the shares. The
initial public offering price will be negotiated among the Company, the Selling
Stockholders and the representatives. Among the factors to be considered in
determining the initial public offering price of the Common Stock, in addition
to prevailing market conditions, will be the Company's historical performance,
estimates of the business potential and earnings prospects of the Company, an
assessment of the Company's management and the consideration of the above
factors in relation to market valuation of companies in related businesses.
Under Rule 2720 of the National Association of Securities Dealers, Inc. (the
"NASD"), the Company may be deemed to be an affiliate of NationsBanc Montgomery
Securities. For a description of certain relationships between NationsBanc
Montgomery Securities and its affiliates and the Company, see "Certain
Transactions" and "Principal and Selling Stockholders". The offering is being
conducted in accordance with Rule 2720, which provides that, among other things,
when an NASD member participates in the underwriting of an affiliate's equity
securities, the initial public offering price can be no higher than that
recommended by a "qualified independent underwriter" meeting certain standards.
In accordance with this requirement, Goldman, Sachs & Co. will serve in such
role and will recommend a price in compliance with the requirements of Rule
2720. Goldman, Sachs & Co. will receive compensation from the Company in the
amount of $10,000 for serving in such role. In connection with the offering,
Goldman, Sachs & Co. in its role as qualified independent underwriter has
performed due diligence investigations and reviewed and participated in the
preparation of this Prospectus and the Registration Statement of which this
Prospectus forms a part. In addition, the Underwriters may not confirm sales to
any discretionary account without the prior approval of the customer.
U-3
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS IN CONNECTION WITH THIS OFFERING OTHER THAN THOSE CONTAINED IN
THIS PROSPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATIONS MUST
NOT BE RELIED UPON AS HAVING BEEN AUTHORIZED. THIS PROSPECTUS DOES NOT
CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY ANY SECURITIES
OTHER THAN THE REGISTERED SECURITIES TO WHICH IT RELATES. THIS PROSPECTUS DOES
NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF AN OFFER TO BUY SUCH
SECURITIES IN ANY CIRCUMSTANCES IN WHICH SUCH OFFER OR SOLICITATION IS UNLAWFUL.
NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER
ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE
AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF OR THAT THE INFORMATION CONTAINED
HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO ITS DATE.
------------------
TABLE OF CONTENTS
PAGE
-----
Prospectus Summary................................. 3
Risk Factors....................................... 6
Use of Proceeds.................................... 16
Dividend Policy.................................... 16
Capitalization..................................... 17
Dilution........................................... 18
Selected Consolidated Financial Data............... 19
Management's Discussion and Analysis of Financial
Condition and Results of Operations............... 20
Business........................................... 29
Management......................................... 43
Certain Transactions............................... 56
Principal and Selling Stockholders................. 59
Description of Capital Stock....................... 62
Shares Eligible for Future Sale.................... 64
Legal Matters...................................... 65
Experts............................................ 65
Available Information.............................. 65
Glossary of Terms.................................. 66
Financial Statements............................... F-1
Underwriting....................................... U-1
------------------
UNTIL , 1998 (THE 25TH DAY AFTER THE DATE OF THIS PROSPECTUS),
ALL DEALERS EFFECTING TRANSACTIONS IN THE REGISTERED SECURITIES, WHETHER OR NOT
PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS.
THIS IS IN ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS WHEN
ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR
SUBSCRIPTIONS.
12,400,000 SHARES
NETCOM SYSTEMS, INC.
COMMON STOCK
(PAR VALUE $0.001 PER SHARE)
-------------
[LOGO]
-------------
GOLDMAN, SACHS & CO.
NATIONSBANC MONTGOMERY
SECURITIES LLC
BT ALEX( BROWN
REPRESENTATIVES OF THE UNDERWRITERS
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
ITEM 13. OTHER EXPENSES OF ISSUANCE AND DISTRIBUTION
The following table sets forth the costs and expenses, other than
underwriting discounts and commissions, payable by the Company in connection
with the sale of Common Stock being registered. All amounts are estimates except
the registration fee, the NASD filing fee and the Nasdaq National Market System
listing fee.
AMOUNT
TO BE PAID
-----------
Registration Fee................................................................. $ 54,688
NASD Filing Fee.................................................................. 19,038
The Nasdaq National Market System Listing Fee.................................... 90,000
Printing......................................................................... 125,000
Legal Fees and Expenses.......................................................... 250,000
Accounting Fees and Expenses..................................................... 150,000
Registrar and Transfer Agent Fees................................................ 10,000
Miscellaneous.................................................................... 151,274
-----------
Total.................................................................... $ 850,000
-----------
-----------
ITEM 14. INDEMNIFICATION OF DIRECTORS AND OFFICERS
Section 145 of the Delaware General Corporation Law permits a corporation to
include in its charter documents, and in agreements between the corporation and
its directors and officers, provisions expanding the scope of indemnification
beyond that specifically provided by the current law.
Article VII of the Registrant's Certificate of Incorporation provides for
the indemnification of directors to the fullest extent permissible under
Delaware law.
Article VII of the Registrant's Bylaws provides for the indemnification of
officers, directors and third parties acting on behalf of the corporation if
such person acted in good faith and in a manner reasonably believed to be in and
not opposed to the best interest of the corporation, and, with respect to any
criminal action or proceeding, the indemnified party had no reason to believe
his conduct was unlawful.
The Registrant has entered into indemnification agreements with its
directors and executive officers, in addition to indemnification provided for in
the Registrant's Bylaws, and intends to enter into indemnification agreements
with any new directors and executive officers in the future.
ITEM 15. RECENT SALES OF UNREGISTERED SECURITIES
(a) From August 7, 1989 through March 31, 1998, the Registrant has issued
and sold the following unregistered securities:
(1) On April 16, 1993, the Registrant sold 20,240,000 shares of Common
Stock to three investors in consideration of services rendered.
(2) On May 31, 1994, the Registrant sold 101,000 shares of Common Stock
to one investor in consideration of services rendered.
(3) On March 15, 1995, the Registrant sold 1,000,000 shares of Common
Stock to one investor in consideration of services rendered.
II-1
(4) On October 7, 1995, the Registrant sold 500,000 shares of Common
Stock to two investors in consideration of services rendered.
(5) On July 10, 1996, the Registrant sold 79,000 shares of Common Stock
to one investor in consideration of services rendered.
(6) On January 16, 1997, the Registrant effected a 2-for-1 stock split
of its Common Stock for no consideration.
(7) On March 26, 1997, the Registrant sold 200,000 shares of Common
Stock to one investor at a per share purchase price of $3.00.
(8) On August 27, 1997, the Registrant sold 2,735,292 shares upon the
exercise of options at prices ranging from $0.025 per share to $0.75 per
share.
(9) On August 29, 1997, the Registrant sold 482,684 shares of Class A
Redeemable Preferred Stock, which will be redeemed upon the closing of this
offering, to 12 investors at a price of $100.00 per share, payable in cash.
(10) On August 29, 1997, the Registrant sold 45,570,848 shares of Class
B Convertible Preferred Stock, which will automatically convert to Common
Stock upon the closing of this offering, to 12 investors at an as-converted
price of $1.0592 per share, payable in cash.
(11) On September 10, 1997, the Registrant sold 2,500 shares of Class A
Redeemable Preferred Stock, which will be redeemed upon the closing of this
offering, to one investor at a price of $100.00 per share, payable in cash.
(12) On September 10, 1997, the Registrant sold 236,026 shares of Class
B Convertible Preferred Stock, which will automatically convert to Common
Stock upon the closing of this offering, to one investors at an as-converted
price of $1.0592 per share, payable in cash.
(13) On October 13, 1997, the Registrant sold 66,666 shares upon the
exercise of options at prices ranging from $0.625 to $0.75 per share.
(14) On October 16, 1997, the Registrant sold 1,068 shares upon the
exercise of options at a price of $0.625 per share.
(15) On October 17, 1997, the Registrant sold 42,134 shares upon the
exercise of options at prices ranging from $0.025 to $0.75 per share.
(16) On October 20, 1997, the Registrant sold 69,570 shares upon the
exercise of options at prices ranging from $0.05 to $0.75 per share.
(17) On October 21, 1997, the Registrant sold 48,694 shares upon the
exercise of options at prices ranging from $0.025 to $0.75.
(18) On October 22, 1997, the Registrant sold 1,600 shares upon the
exercise of options at a price of $0.75 per share.
(19) On October 23, 1997, the Registrant sold 40,000 shares upon the
exercise of options at a price of $0.625 per share.
(20) On October 27, 1997, the Registrant sold 343,280 shares upon the
exercise of options at a price of $0.75 per share.
(21) On October 28, 1997, the Registrant sold 12,000 shares upon the
exercise of options at a price of $0.25 per share.
(22) On November 17, 1997, the Registrant sold 4,000 shares upon the
exercise of options at a price of $0.75 per share.
(23) On November 20, 1997, the Registrant sold 2,668 shares upon the
exercise of options at a price of $0.625 per share.
II-2
(24) On January 7, 1998, the Registrant sold 66,666 shares upon the
exercise of options at a price of $0.1875 per share.
(25) On May 5, 1998, the Registrant sold 300,000 shares upon the
exercise of options at a price of $0.75 per share.
(26) On May 11, 1998, the Registrant sold 133,332 shares upon the
exercise of options at a price of $0.1875 per share.
(b) There were no underwriters, brokers or finders employed in connection
with any of the transactions set forth above.
(c) The sales of the above securities were deemed to be exempt from
registration under the Securities Act in reliance on Section 4(2) of the
Securities Act, or Regulation D or Regulation S promulgated thereunder, or Rule
701 promulgated under Section 3(b) of the Securities Act as transactions by an
issuer not involving a public offering or transactions pursuant to compensatory
benefit plans and contracts relating to compensation as provided under such Rule
701. The recipients of securities in each such transaction represented their
intentions to acquire the securities for investment only and not with a view to
or for sale in connection with any distribution thereof and appropriate legends
were affixed to the instruments representing such securities issued in such
transactions. All recipients had adequate access, through their relationships
with the Company, to information about the Registrant.
ITEM 16. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(A) EXHIBITS
1.1* Form of Underwriting Agreement.
3.1 Certificate of Incorporation of Registrant, as currently in effect.
3.2 Form of Certificate of Amendment of Certificate of Incorporation of
Registrant, to be filed immediately following the closing of the offering
made under this Registration Statement.
3.3 Bylaws of the Company.
4.1* Specimen Common Stock Certificate.
5.1 Form of Opinion of Wilson Sonsini Goodrich & Rosati, Professional
Corporation.
10.1 Amended and Restated 1993 Non-Statutory Stock Option Plan, as amended, and
form of Stock Option Agreement thereunder.
10.2 Second Amended and Restated 1997 Stock Plan, as amended, and form of Stock
Option Agreement thereunder.
10.3 1998 Stock Plan and form of Stock Option Agreement thereunder.
10.4 1998 Employee Stock Purchase Plan.
10.5 Recapitalization Agreement, dated August 29, 1997, between Registrant and
certain shareholders.
10.6 Credit Agreement, dated August 29, 1997, between Registrant, the lenders
named therein, BankBoston, N.A., as co-agent, and NationsBank of Texas, N.A.,
as administrative agent.
10.7 Registration Agreement, dated August 29, 1997, as amended, between Registrant
and certain shareholders.
10.8 Shareholders Agreement, dated August 29, 1997, as amended, between Registrant
and certain shareholders.
10.9 Standard Industrial/Commercial Single-Tenant-Lease-Net, dated March 28, 1996,
as amended, between Registrant and Nordhoff Industrial Complex.
II-3
10.10 Form of Indemnification Agreement between Registrant and each director and
executive officer.
10.11 Form of Change-in-Control Agreement between Registrant and certain executive
officers.
10.12* 401(k) Plan.
11.1 Calculation of earnings per share (contained in Notes 2 and 14 of the Notes
to Financial Statements).
21.1 List of Subsidiaries of Registrant.
23.1 Consent of Arthur Andersen LLP, Independent Public Accountants.
23.2 Consent of Counsel (included in Exhibit 5.1).
24.1 Power of Attorney (see page II-5).
27.1 Financial Data Schedule (Fiscal 1997)
27.2 Financial Data Schedule (First Quarter 1998)
- ------------------
+ Confidential treatment requested for portions of these agreements.
* To be filed by amendment.
(B) FINANCIAL STATEMENT SCHEDULES
Schedules have been omitted because the information required to be set forth
therein is not applicable or is shown in the financial statements or notes
thereto.
ITEM 17. UNDERTAKINGS
Insofar as indemnification for liabilities arising under the Securities Act
of 1933 may be permitted to directors, officers and controlling persons of the
registrant pursuant to the provisions described in Item 14, or otherwise, the
registrant has been advised that in the opinion of the Securities and Exchange
Commission such indemnification is against public policy as expressed in the
Securities Act and is, therefore, unenforceable. In the event that a claim for
indemnification against such liabilities (other than the payment by the
registrant of expenses incurred or paid by a director, officer or controlling
person of the registrant in the successful defense of any action, suit or
proceeding) is asserted by such director, officer or controlling person in
connection with the securities being registered, the registrant will, unless in
the opinion of its counsel the matter has been settled by controlling precedent,
submit to a court of appropriate jurisdiction the question whether such
indemnification by it is against public policy as expressed in the Securities
Act and will be governed by the final adjudication of such issue.
The undersigned registrant hereby undertakes to provide to the Underwriter
at the closing specified in the underwriting agreement certificates in such
denominations and registered in such names as required by the Underwriter to
permit prompt delivery to each purchaser.
The undersigned registrant hereby undertakes that:
(1) For purposes of determining any liability under the Securities Act
of 1933, the information omitted from the form of prospectus filed as part
of this registration statement in reliance upon Rule 430A and contained in
the form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or
(4) or 497 (h) under the Securities Act shall be deemed to be part of this
registration statement as of the time it was declared effective.
(2) For the purpose of determining any liability under the Securities
Act of 1933, each post-effective amendment that contains a form of
prospectus shall be deemed to be a new registration statement relating to
the securities offered therein, and the offering of such securities at that
time shall be deemed to be the initial bona fide offering thereof.
II-4
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as amended, the
Registrant has duly caused this Registration Statement to be signed on its
behalf by the undersigned, thereunto duly authorized, in the City of Sunnyvale,
State of California, on the 10th day of June, 1998.
NETCOM SYSTEMS, INC.
By: /s/ BARRY PHELPS
------------------------------------------
Barry Phelps
PRESIDENT AND CHIEF EXECUTIVE OFFICER
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below hereby constitutes and appoints, jointly and severally, Barry Phelps and
Gil Cabral, each of them acting individually, as his or her attorney-in-fact,
each with full power of substitution, for him or her any and all capacities, to
sign any and all amendments (including, without limitation, post-effective
Amendments and any amendments or abbreviated registration statements increasing
the amount of securities for which registration is being sought) to this
Registration Statement, with all exhibits and any and all documents required to
be filed with respect thereto, with the Securities and Exchange Commission or
any regulatory authority, granting unto such attorneys-in-fact and agents, and
each of them, full power and authority to do and perform each and every act and
thing requisite and necessary to be done in order to effectuate the same as
fully to all intents and purposes as he or she might or could do if personally
present, hereby ratifying and confirming all that such attorneys-in-fact and
agents, or any of them, or their substitute or substitutes, may lawfully do or
cause to be done.
PURSUANT TO THE REQUIREMENTS OF THE SECURITIES ACT OF 1933, AS AMENDED, THIS
REGISTRATION STATEMENT HAS BEEN SIGNED BY THE FOLLOWING PERSONS IN THE
CAPACITIES AND ON THE DATES INDICATED.
SIGNATURE TITLE DATE
- ------------------------------ --------------------------- -------------------
/s/ BARRY PHELPS President, Chief Executive
- ------------------------------ Officer and Director June 10, 1998
Barry Phelps
/s/ GIL CABRAL Vice President, Finance,
- ------------------------------ Chief Financial Officer June 10, 1998
Gil Cabral and Secretary
/s/ MARC HAMON Director
- ------------------------------ June 10, 1998
Marc Hamon
/s/ WALTER G. KORTSCHAK Director
- ------------------------------ June 10, 1998
Walter G. Kortschak
/s/ RICHARD MOLEY Director
- ------------------------------ June 10, 1998
Richard Moley
/s/ ROBERT H. SHERIDAN III Director
- ------------------------------ June 10, 1998
Robert H. Sheridan III
/s/ MICHAEL WEST Director
- ------------------------------ June 10, 1998
Michael West
II-5
EXHIBIT INDEX
EXHIBIT NO.
1.1* Form of Underwriting Agreement.
3.1 Certificate of Incorporation of Registrant, as currently in effect.
3.2 Form of Certificate of Amendment of Certificate of Incorporation of Registrant, to be filed
immediately following the closing of the offering made under this Registration Statement.
3.3 Bylaws of the Company.
4.1* Specimen Common Stock Certificate.
5.1 Form of Opinion of Wilson Sonsini Goodrich & Rosati, Professional Corporation.
10.1 Amended and Restated 1993 Non-Statutory Stock Option Plan, as amended, and form of Stock Option
Agreement thereunder.
10.2 Second Amended and Restated 1997 Stock Plan, as amended, and form of Stock Option Agreement
thereunder.
10.3 1998 Stock Plan and form of Stock Option Agreement thereunder.
10.4 1998 Employee Stock Purchase Plan.
10.5 Recapitalization Agreement, dated August 29, 1997, between Registrant and certain shareholders.
10.6 Credit Agreement, dated August 29, 1997, between Registrant, the lenders named therein,
BankBoston, N.A., as co-agent, and NationsBank of Texas, N.A., as administrative agent.
10.7 Registration Agreement, dated August 29, 1997, as amended, between Registrant and certain
shareholders.
10.8 Shareholders Agreement, dated August 29, 1997, as amended, between Registrant and certain
shareholders.
10.9 Standard Industrial/Commercial Single-Tenant-Lease-Net, dated March 28, 1996, as amended, between
Registrant and Nordhoff Industrial Complex.
10.10 Form of Indemnification Agreement between Registrant and each director and executive officer.
10.11 Form of Change-in-Control Agreement between Registrant and certain executive officers.
10.12* 401(k) Plan.
11.1 Calculation of earnings per share (contained in Notes 2 and 14 of the Notes to Financial
Statements).
21.1 List of Subsidiaries of Registrant.
23.1 Consent of Arthur Andersen LLP, Independent Public Accountants.
23.2 Consent of Counsel (included in Exhibit 5.1).
24.1 Power of Attorney (see page II-5).
27.1 Financial Data Schedule (Fiscal 1997)
27.2 Financial Data Schedule (First Quarter 1998)
- ------------------
+ Confidential treatment requested for portions of these agreements.
* To be filed by amendment.