FORM 10 - Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 26, 1998 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period_________ to __________. Commission File Number 0-19175 OpenROUTE Networks, Inc. (Formerly Proteon, Inc.) (Exact name of Registrant as specified in its charter) Massachusetts 04-2531856 (State or other jurisdiction of incorporation) (IRS Employer Identification Number) Nine Technology Drive, Westborough, MA 01581 (Address of principal executive offices) Registrant's telephone number (508) 898-2800 Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding twelve months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past ninety days. YES [X] NO [ ] Indicate number of shares outstanding of each of the Issuer's classes of common stock as of September 26, 1998. Common Stock, $0.01 par value 15,332,870 ----------------------------- ---------- (Title of each class) (Number of shares) OpenROUTE Networks, Inc. Form 10-Q Quarterly Report September 26, 1998 Table of Contents Part I. Financial Information Item 1. Financial Statements Consolidated Balance Sheets as of September 26, 1998 and December 31, 1997. Consolidated Statements of Operations for the three and nine months ended September 26, 1998 and September 27, 1997. Consolidated Statements of Cash Flows for the nine months ended September 26, 1998 and September 27, 1997. Notes to the Consolidated Financial Statements. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. Item 3. Quantitative and Qualitative Disclosures about Market Risk. Part II. Other Information Item 1. Legal Proceedings. Item 2. Changes in Securities. Item 3. Defaults upon Senior Securities. Item 4. Submission of Matters to a Vote of Security Holders. Item 5. Other Information. Item 6. Exhibits and Reports on Form 8-K. Part I. Financial Information Item 1. Financial Statements OpenROUTE Networks, Inc. Consolidated Balance Sheets (in thousands) Assets September 26, December 31, 1998 1997 (unaudited) -------------- ------------ Current assets: Cash and cash equivalents $ 2,295 $ 5,317 Marketable securities 6,013 12,443 Accounts receivable, net 2,243 6,224 Inventories 8,505 5,710 Deposits and other assets 431 437 -------- -------- Total current assets 19,487 30,131 Property and equipment, net 2,993 3,272 -------- -------- Total assets $ 22,480 $ 33,403 -------- -------- -------- -------- Liabilities and Stockholders' Equity Current liabilities: Accounts payable $ 1,296 $ 2,292 Accrued compensation 169 765 Accrued expenses 3,316 2,779 Accrued warranty 676 675 -------- -------- Total current liabilities 5,457 6,511 Stockholders' equity: -------- -------- Common stock 157 157 Capital in excess of par value 49,417 49,347 Accumulated deficit (31,628) (21,666) Accumulated translation adjustments 133 110 Less treasury stock, at cost (1,056) (1,056) -------- -------- Total stockholders' equity 17,023 26,892 -------- -------- Total liabilities and stockholders' equity $ 22,480 $ 33,403 -------- -------- -------- -------- The accompanying notes are an integral part of the consolidated financial statements. OpenROUTE Networks, Inc. Consolidated Statements of Operations (in thousands, except per share data) (unaudited) Three months ended Nine months ended ----------------------------- ----------------------------- September 26, September 27, September 26, September 27, 1998 1997 1998 1997 ------------- ------------- ------------- ------------- Sales: Product $ 1,714 $ 4,195 $ 7,733 $ 18,229 Software licensing -- -- 1,663 756 Service and other 454 811 1,785 2,894 -------- -------- -------- -------- Net sales 2,168 5,006 11,181 21,879 Cost of sales: Product 1,017 2,577 5,281 10,273 Service and other 411 675 1,452 1,848 -------- -------- -------- -------- Cost of sales 1,428 3,252 6,733 12,121 Gross profit 740 1,754 4,448 9,758 Operating expenses: Research and development 1,142 1,555 3,532 4,601 Selling and marketing 1,714 2,524 6,653 7,992 General and administrative 1,598 1,074 4,561 2,452 Restructure Costs -- (241) -- (241) -------- -------- -------- -------- Total operating expenses 4,454 4,912 14,746 14,804 -------- -------- -------- -------- Loss from operations (3,714) (3,158) (10,298) (5,046) Interest income, net 145 271 498 790 -------- -------- -------- -------- Loss before income taxes (3,569) (2,887) (9,800) (4,256) Provision for income taxes 4 7 162 84 -------- -------- -------- -------- Net loss ($ 3,573) ($ 2,894) ($ 9,962) ($ 4,340) -------- -------- -------- -------- -------- -------- -------- -------- Per share data: Basic and diluted loss per share ($ 0.23) ($ 0.19) ($ 0.65) ($ 0.28) -------- -------- -------- -------- -------- -------- -------- -------- Basic and diluted weighted average number of common shares outstanding 15,323 15,276 15,302 15,312 The accompanying notes are an integral part of the consolidated financial statements. OpenROUTE Networks, Inc. Consolidated Statements of Cash Flows for the nine months ended (in thousands) (unaudited) September 26, September 27, 1998 1997 ------------- ------------- Cash flows provided by operating activities: Net loss ($ 9,962) ($ 4,340) Adjustments to reconcile net loss to cash flows provided (used) by operating activities: Bad debt provision 470 Depreciation and amortization 890 1,145 Loss (gain) on disposition of fixed assets 4 (60) Changes in assets and liabilities: Decrease in accounts receivable 3,511 133 (Increase) decrease in inventories (2,795) 3,631 (Increase) decrease in deposits and other assets 6 225 Decrease in accounts payable and accrued expenses (1,054) (4,108) ------ ------ Net cash provided (used) by operating activities (8,930) (3,374) ------ ------ ------ ------ Cash flows generated (used) by investing activities: Proceeds from the sale of fixed assets 1 48 Capital expenditures (616) (248) Marketable securities sales and maturities 14,070 8,734 Marketable securities purchases (7,640) (13,193) ------ ------- Net cash generated (used) by investing activities 5,815 (4,659) ------ ------ Cash flows provided (used) by financing activities: Proceeds from the issuance of common stock 70 55 Purchase of treasury stock -- (422) ------ ------ Net cash provided (used) by financing activities 70 (367) Effect of exchange rate changes on cash 23 (64) ------ ------ Net decrease in cash and cash equivalents (3,022) (8,464) Cash and cash equivalents at beginning of period 5,317 16,612 ------ ------ Cash and cash equivalents at end of period 2,295 8,148 ------ ------ ------ ------ The accompanying notes are an integral part of the consolidated financial statements. OpenROUTE Networks, Inc. Notes to Consolidated Financial Statements, unaudited Basis of Presentation The accompanying condensed consolidated financial statements are unaudited and have been prepared by the Company in accordance with generally accepted accounting principles. Certain information and footnote disclosures normally included in the Company's annual financial statements have been condensed or omitted. The interim financial statements, in the opinion of management, reflect all adjustments (including normal recurring accruals) necessary for a fair statement of the results for the interim periods ended September 26, 1998 and September 27, 1997. These interim financial statements should be read in conjunction with the audited financial statements for the year ended December 31, 1997, which are contained in the Company's 1997 Annual Report to its shareholders and in its Form 10-K filed with the Securities and Exchange Commission. The Articles of Organization of the Company were amended on June 10, 1998 to change the Company's name to OpenROUTE Networks, Inc. from its former name of Proteon, Inc. Inventories Inventories are stated at the lower of cost or market, with cost determined under the first-in, first-out method. (in thousands) September 26, 1998 December 31, 1997 - -------------- ------------------ ----------------- Raw materials $1,733 $1,043 Work in process 447 373 Finished goods 6,325 4,294 ------ ------ Total inventories $8,505 $5,710 ------ ------ Net Loss Per Common and Common Equivalent Share Basic EPS excludes the effect of any dilutive options, warrants or convertible securities and is computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Diluted EPS is computed by dividing income available to common stockholders by the sum of the weighted average number of common shares and common share equivalents computed using the average market price for the period under the treasury stock method. Outstanding options of 2,078,263 with an average exercise price of $1.72 as of September 26, 1998 and outstanding options of 1,526,417 with an average exercise price of $2.95 as of September 27, 1997 were not included in the diluted EPS computation because their effect would be antidilutive. All earnings per share amounts have been restated to conform to the requirements of SFAS No. 128, "Earnings Per Share". Comprehensive Income The Company has adopted SFAS No. 130, "Reporting Comprehensive Income", which requires that all components of comprehensive income and total comprehensive income be reported and that changes be shown in a financial statement displayed with the same prominence as other financial statements. The Company has elected to disclose this information in its statement of stockholders' equity. For the quarters ended September 26, 1998 and September 27, 1997 total comprehensive loss was $3,593,000 and $2,878,000 respectively. Total comprehensive loss for the quarter ended September 26, 1998 was comprised of net loss of $ 3,573,000 and foreign currency translation adjustments of $ 20,000. Total comprehensive loss for the quarter ended September 27, 1997 was comprised of net loss of $2,894,000 and foreign currency translation adjustments of $16,000. For the nine months ended September 26, 1998 and September 27, 1997 total comprehensive loss was $9,985,000 and $4,277,000 respectively. Total comprehensive loss for the nine months ended September 26, 1998 was comprised of net loss of $9,962,000 and foreign currency translation adjustments of $23,000. Total comprehensive loss for the nine months ended September 26, 1997 was comprised of net loss of $4,340,000 and foreign currency translation adjustments of $63,000. Newly Issued Accounting Standards The FASB issued Statement No. 131 ("SFAS 131"), "Disclosures about Segments of an Enterprise and Related Information". This Statement, which supersedes Statement No. 14 "Financial Reporting for Segments of a Business Enterprise," changes the way public companies report information about segments. The Statement, which is based on the management approach to segment reporting, includes requirements to report segment information quarterly and entity-wide disclosures about products and services, major customers, and the material countries in which the entity holds assets and reports revenues. The Statement is effective for periods beginning after December 15, 1997. Restatement for earlier years is required for comparative purposes unless impracticable. In addition, SFAS 131 need not be applied to interim periods in the initial year, however, in subsequent years, interim period information must be presented on a comparative basis. The Company is currently evaluating this Statement and its effect on financial statement disclosures. Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Results of Operations Net Sales Net sales for the quarter ended September 26, 1998 were $2,168,000 as compared with $5,006,000 for the quarter ended September 27, 1997, a decrease of $2,838,000 or 56.7%. For the first nine months of 1998, net sales were $11,181,000 as compared with $21,879,000 for the same period in 1997, a decrease of $10,698,000 or 48.9%. Product sales for the quarter ended September 26, 1998 were $1,714,000 as compared with $4,195,000 for the quarter ended September 27,1997, a decrease of $2,481,000, or 59.1%. For the first nine months of 1998, product sales were $7,733,000 as compared with $18,229,000 for the same period in 1997, a decrease of $10,496,000 or 57.6%. Product sales results reflect the Company's ongoing product transition from LAN to Internet Access products. Overall product revenue for the quarter and for the nine months ended September 26, 1998 is down when compared to the same period of a year ago. This is due to anticipated decreases in the LAN and Enterprise router product categories as well as from a decline in product unit sales and the average selling prices of certain GlobeTrotter products. It is also reflective of a change in the Company's selling strategy to focus more of its efforts on the internet service provider and telephone company marketplace, which has resulted in lower sales to traditional customers not yet offset by increased sales into these markets. There was no software licensing revenue for the quarter ended September 26, 1998 and September 27, 1997. For the first nine months of 1998, software licensing revenue was $1,663,000 as compared with $756,000 for the same period in 1997, an increase of $907,000. The increase in software licensing revenue is primarily the result of a software licensing agreement signed with a multinational foreign corporation. The software licensing agreement will not provide recurring software licensing revenue but could provide future royalty revenues based on the multinational foreign corporation's unit sales of products containing the licensed software. The Company expects that it will continue to have software licensing revenue in the future, however at varying and uncertain levels. Software licensing revenue is an ancillary component of the Company's core revenue stream but strategic in its promotion of the OpenROUTE routing technology in its markets. For the quarter ended September 26, 1998 service and other revenues decreased by $357,000 or 44.0%, to $454,000, as compared to $811,000 for the quarter ended September 27, 1997. For the first nine months of 1998, service and other revenues were $1,785,000 as compared with $2,894,000 for the same period in 1997, a decrease of $1,109,000 or 38.3%. This decrease was primarily due to the reduction in service contracts worldwide resulting from the Company's decision to focus on Internet Access products, which require fewer support services. Gross Profit Total gross profit decreased as a percentage of net sales to 34.1% for the quarter ended September 26, 1998 from 35.0% for the quarter ended September 27, 1997. Total gross profit decreased as a percentage of net sales to 39.8% for the first nine months of 1998 from 44.6% for the nine months ended September 27, 1997. These decreases were primarily the result of a decline in overall product unit sales as well as a reduction in the GlobeTrotter average selling price. The Company's product gross profit for the quarter ended September 26, 1998 was 40.7%, an increase from 38.6% for the same period in 1997. Product gross profit for the nine month period decreased to 31.7% from 43.6% for the same period in 1997. The decreases in the nine month period are primarily due to the impact of certain fixed overheads on cost of sales as a result of lower product volumes and an inventory write down during the second quarter. Research and Development Research and development expenses were $1,142,000 or 52.7% of net sales for the quarter ended September 26, 1998 compared to $1,555,000 or 31.1% of net sales for the same period in the prior year. The decrease in expenses of $413,000 or 26.6% was primarily due to concentrating the Company's development efforts on the Internet Access products as well as lower personnel and personnel-related costs. For the first nine months of 1998, research and development costs were $3,532,000 or 31.6% of net sales compared to $4,601,000 or 21.0% of net sales for the first nine months of 1997. The decrease of $1,069,000 or 23.2% was due primarily to the same factors stated above. The Company considers investments in research and development to be critical to future revenues and intends to focus these expenditures on Internet Access products. Selling and Marketing Selling and marketing expenses were $1,714,000 or 79.1% of net sales for the quarter ended September 26, 1998 compared to $2,524,000 or 50.4% of net sales for the quarter ended September 27, 1997, a decrease of $810,000, or 32.1%. This decrease was mainly due to reduced commissions as a result of the lower level of revenue and to reduced, refocused marketing programs associated with the Company's new selling strategy. For the first nine months of 1998, selling and marketing expenses were $6,653,000 or 59.5% of net sales, as compared to $7,992,000 or 36.5% of net sales for the same period in the prior year. This decrease in expenses of $1,339,000 or 16.8% was due primarily to the same factors stated above. General and Administrative General and administrative expenses were $1,598,000, or 73.7% of net sales for the quarter ended September 26, 1998, compared to $1,074,000 or 21.5% of net sales for the quarter September 27, 1997, an increase of $524,000 or 48.8%. This increase was principally due to provisions recorded in the third quarter of 1998 pertaining to office closure costs and severance provisions. For the first nine months of 1998, general and administrative expenses were $4,561,000 or 40.8% of net sales compared to $2,452,000 or 11.2% of net sales. The increase of $2,109,000 or 86.0% was due primarily to the same factors stated above as well as provisions recorded in the first quarter of 1998 pertaining to potential international bad debts and additional professional service costs, and provisions recorded in the second quarter of 1998 for office and severance costs. Provision for Income Taxes For the quarter ended September 26, 1998, the Company booked an income tax provision of $4,000 bringing the 1998 year to date provision to $162,000. This is a result of foreign taxes withheld from software licensing fees received from a foreign corporation in the second quarter, as well as state income taxes and tax liabilities in its foreign subsidiaries. Liquidity and Capital Resources During the first nine months of 1998, the Company consumed $8,917,000 of cash from operating activities. This was due primarily to the net operating loss of $9,962,000 and an increase in inventory of $2,795,000. This was offset by depreciation of $890,000, a decrease in accounts receivable of $3,511,000 and a decrease in accounts payable and accrued expenses of $1,054,000. Investing activities for the nine months ended September 26, 1998, generated net proceeds of $5,815,000 principally from the sales of marketable securities. The Company's management believes that if it achieves its twelve month operating plan, then current levels of cash, cash equivalents and marketable securities will satisfy its expected working capital and capital expenditure requirements through the next twelve months. If the operating plan is not achieved, it is likely that it will be necessary to secure alternative forms of financing and there is no assurance that the financing would be available when needed. Safe Harbor for Forward Looking Statements This Form 10-Q filing contains forward-looking statements within the meaning of the "safe harbor" provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are based on management's current expectations and involve a number of risks and uncertainties. The Company's future results remain difficult to predict and may be affected by the factors described below. Risk Factors Technological Change, New Products and Industry Standards The data communications industry continues to undergo a fundamental shift away from hierarchical single vendor systems to open, peer-to-peer communications networks and information management tools that provide users with greater computing power and access to information. This evolution has fostered the growth of two dynamic markets: workstations and networking. Workstations deliver increasingly powerful, personal productivity tools, and data communications networks provide the "highways" that distribute and share this processing power throughout an organization, enabling users to more fully leverage and manage information resources. As the deployment of networks matures, four recent trends continue to develop: networking of remote sites to the headquarters office via remote access routers; reduction of network congestion with the implementation of local area networks (LANs); segmentation using various switching technologies; and the push by businesses of all sizes and individuals to connect their systems and networks to the Internet. OpenROUTE Networks is positioning itself as a company focused on the network access market. OpenROUTE Networks views the network access market as having two segments: Internet access and local access. Its current strategy is based upon concentration on the Internet access market segment. Rapidly changing technology, new product introductions and a multiplicity of current and evolving industry standards characterize the market for the Company's products. Accordingly, the Company believes that its future success will depend on its continuing ability to enhance and expand its existing products and to develop or private label other manufacturer's technology and introduce in a timely fashion new products which incorporate new technologies, conform to standards and achieve market acceptance. There can be no assurance that the Company's strategy is the correct one under the circumstances; that the Company has correctly assessed trends in the marketplace; that the Company will be able to develop, market or support, or secure external supplies of, such products successfully; or that the Company will be able to respond effectively to technological changes, new product announcements by others or new industry standards. Manufacturing and Supply; Dependence on Suppliers The Company's manufacturing operations primarily consist of assembly, testing and quality control of materials, components, subassemblies, and systems. U.S. Assemblies, a major subcontract manufacturer with access to cost effective, high volume manufacturing, distribution, and repair capability worldwide, and others manufacture the majority of OpenROUTE Networks' board assemblies for its router, hub, and adapter card product lines. The Token Ring chipsets used in the Company's 4/16 Mbps and 4 Mbps adapters are currently manufactured for external sale solely by Texas Instruments. The Company has an agreement with Texas Instruments under which it believes it will be able to obtain adequate supplies of these chipsets in a timely manner to meet customer demand. Certain logic semiconductors, signal processors, and subassembly components used in the Company's products are also available only from limited sources. The Company has not experienced any significant problems in obtaining required supplies of such limited source components and believes that alternative sources could be developed quickly, if necessary. OpenROUTE Networks continues to have OEM arrangements with manufacturers for some of its Ethernet product offerings. In most cases, if supplies from one vendor were interrupted or reduced, the Company could find a comparable source for the affected product with limited delays in shipment. The inability to obtain sufficient sole or limited source components as required, or to develop alternative sources if and as required in the future, could result in delays or reductions in product shipments which would adversely affect the Company's operating results. There can be no assurance that, in the event of interruptions in contract manufacturing, supplies of components from sole or limited sources or supplies of units from OEM vendors or similar occurrences, the Company could find and engage suitable alternatives in a timely manner. Such interruptions or the inability of OpenROUTE Networks to counteract them successfully could have an adverse effect on the Company's business, operations and finances. Intellectual Property Currently, OpenROUTE Networks relies principally upon a combination of contractual rights, trade secrets, and copyright laws to establish and protect proprietary aspects of its products. The Company believes that, because of the rapid pace of technological change in the data communications and computer industries, legal protection for its products is a less significant factor in the Company's success than the knowledge, ability, and experience of the Company's employees, the frequency of product enhancements and the timeliness and quality of support services provided by the Company. However, should a successful challenge be mounted against the rights of OpenROUTE Networks in and to its intellectual property, by allegations of infringement on the rights of others or for any other reason, the Company's business, operations and finances could be adversely affected. Certain technology used in the Company's products is licensed by the Company from third parties. The termination of certain of these licenses would have a material adverse effect on the Company's operations. Product Compatibility and Competition Network Interface Card Products IBM dominates the market for Token Ring network interface card products. While Token Ring networking is an industry standard, OpenROUTE Networks believes that its ability to address successfully the market for Token Ring network products is dependent upon the compatibility and interoperability of the Company's products with products offered by IBM and upon maintaining compatibility with the Token Ring standard as it continues to evolve. Internet Access (Routers) OpenROUTE Networks expects to participate significantly in the market segment of Internet access routing specifically addressing the needs of users to connect to the Internet or build corporate intranets. The Company has enhanced its Internet access capabilities with the introduction of new products and expanded its presence in the Integrated Services Digital Networks (ISDN) marketplace. LAN Access The Company continues to sell: Token Ring Switches; intelligent hubs that provide connectivity and management of different network cabling schemes and LAN topologies; Ethernet hubs, the ProNET/E series, for the workgroup market segment; Token Ring hubs, the Series 75 Stackable Hub family for building networked and extended workgroups; Token Ring adapters for physical connectivity and Token Ring signaling between a PC or workstation and LAN cabling; a multiport Token Ring PCI network adapter card; and a line of Ethernet network adapter cards intended to provide a full range of solutions for the client/server marketplace. The Company also seeks opportunities to leverage technology through licensing arrangements. Internetworking Software OpenROUTE-TM-, OpenROUTE Networks' internetworking software suite, is the foundation of the Company's high performance Internet access and internetworking products. All of OpenROUTE Networks' internetworking products ship with this software technology installed. Also, OpenROUTE Networks licenses this software to other providers of internetworking products. As routing technology progresses, the Company may be required to modify its routing and bridging software to maintain compatibility of its products with various standards and interoperability with other manufacturers' router products. Failure by the Company to maintain such compatibility, interoperability, and technical competencies could adversely affect the Company's business, operations and finances. Competition The data communications, networking and computer industries are highly competitive and characterized by rapidly changing technology and evolving industry standards. These advances result in frequent new product introductions, increased capabilities and improvements in the relative price/performance of networking products. As a competitor in the networking industry, OpenROUTE Networks believes one of the keys to success will be making networks more accessible to a broader base of customers. OpenROUTE Networks is committed to open, standards based products, innovative solutions to customer requirements for reliable and high performance networks, a favorable price/performance ratio, ease of installation and ease of use. The Company competes with several companies having greater research and development, marketing and financial resources, manufacturing capability, customer support organizations, and name recognition than those of the Company. There can be no assurance that the Company will be able to compete successfully in the future or competitive pressures will not adversely affect the Company's business. Research and Product Development Management believes the Company's future success depends in large part upon timely enhancement of existing products and the development of new products that not only maintain technological excellence, but also improve the capabilities, efficiency, and cost effectiveness of the end users' data communications networks. The Company is developing new products to improve price/performance ratios, enhance its network management capabilities, simplify ease of use, and ensure interoperability with other vendors' standards based products. Variability of Quarterly Operating Results The Company's quarterly operating results may vary significantly depending upon factors such as the timing of new product announcements and releases by the Company and its competitors, the timing of significant orders, the mix of products sold and the mix of distribution channels through which the products are sold. In addition, substantially all of the Company's sales in each quarter result from orders booked in that quarter. Consequently, if sales do not close in any quarter as anticipated the Company's results of operations for that quarter would be adversely affected. Further, the Company's expense levels are based, in part, on its expectations as to future sales. If sales levels are below expectations, operating results may be adversely affected. Also, quarterly results can be materially affected by timing of software licensing revenues, if any. Method of Distribution The Company sells its products to end users worldwide primarily through an indirect sales channel comprised of Internet Service Providers ("ISPs"), Original Equipment Manufacturers ("OEMs"), Value Added Resellers ("VARs") and distributors. These resellers also represent other lines of products which are, in some cases, identical or complementary to, or which compete with, those of the Company. While the Company attempts to encourage these resellers to focus on its products through marketing and support programs, there is a risk that these resellers may give higher priority to products of other suppliers, thereby reducing their efforts devoted to selling the Company's products. One reseller accounted for approximately 11%, 11% and 12%, of the Company's sales in 1997, 1996 and 1995, respectively, and a second reseller accounted for approximately 8%, 14% and 10% of the Company's sales in 1997, 1996 and 1995, respectively. There can be no assurance that the Company has selected appropriate channels of distribution for its products or that existing resellers will dedicate adequate resources to sales of the Company's products. Failure to do so could result in an adverse impact on the Company's business, operations and finances. Marketing, Sales and Customers End users of OpenROUTE Networks' products have typically been organizations with critical applications requiring connectivity integrating their headquarters and wide area computing environments. OpenROUTE Networks' marketing and distribution strategy is to reach these end users primarily through an indirect sales channel comprised of ISPs, OEMs, VARs, and distributors with experience in network integration and reputation for excellent service. In addition, the Company's strategy includes increased presence of OpenROUTE Networks' sales force in end user sites. There can be no assurance that the Company has correctly formulated its end user profile or selected appropriate methods of marketing and selling its products. Failure to do so could result in an adverse impact on the Company's business, operations and finances. Liquidity Failure of the Company to create and maintain adequate working capital and liquidity, by sales of equity, obtaining lines of credit or otherwise, could adversely impact the Company's business, operations and finances. International Sales, Regulatory Standards and Currency Exchange International sales accounted for 35.4%, 38.3% and 35.7% in 1997, 1996 and 1995, respectively, of the Company's net sales and the Company expects that international sales will continue to be a significant portion of the Company's business. Foreign regulatory bodies continue to establish standards different from those in the United States, and the Company's products are designed generally to meet those standards. The inability of the Company to design products in compliance with such foreign standards could have an adverse effect on the Company's operating results. The Company's international business may be affected by changes in demand resulting from fluctuation in currency exchange rates and tariffs and difficulties in obtaining export licenses. Shares Eligible for Future Sale Approximately 15,332,870 outstanding shares of Common Stock as of September 26, 1998 are now freely tradable or eligible for sale on the open market. In addition, options to acquire an aggregate of 610,388 shares of Common Stock were vested as of September 26, 1998, and the shares issuable upon exercise of any such option will be freely tradable or eligible for sale in the public market. Additional shares will become eligible for resale in the public market at subsequent dates. Sales of substantial numbers of such shares in the public market could adversely affect the market price of the Common Stock. Possible Volatility of Stock Price The Company believes factors such as announcements of new products by the Company or its competitors and quarterly variations in financial results could cause the market price of the Common Stock to fluctuate substantially. In addition, the stock market has experienced volatility which has particularly affected the market prices for many high technology companies' stock and which often has been unrelated to the operating performance of such companies. These market fluctuations may adversely affect the price of the Company's Common Stock. Certain Charter and By Law Provisions The Company's Amended and Restated Articles of Organization and By Laws contain certain provisions that could 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 such provisions allow the Company to issue preferred stock with rights senior to those of the Common Stock and impose various procedural and other requirements which could make it more difficult for stockholders to effect certain corporate actions. Year 2000 The "Year 2000 Issue" is the result of computer programs that were written using two digits rather than four to define the applicable year. If computer programs with date sensitive functions are not Year 2000 compliant, they may recognize a date using "00" as the Year 1900 rather than the Year 2000. This could result in a system failure or miscalculations causing disruptions of operations, including, among other things, a temporary inability to process transactions or engage in similar normal business activities. The Company has initiated a program to review the Year 2000 readiness of its internal systems, the Company's product line, and of third party suppliers and vendors. The program consists of: (i) inventory of products and suppliers to determine systems which may encounter date processing problems; (ii) assessment of the Year 2000 issues presented; (iii) remediation, if necessary, of products owned or manufactured by the Company; (iv) testing of systems; and (v) contingency plans. The program's implementation varies depending upon the problems or issues encountered, and their resolution. PRODUCTS MANUFACTURED BY THE COMPANY. The Company's main business since its formation has consisted primarily of the manufacture and sale of: (i) Remote Access Routers used to access the Internet; (ii) Local Area Network (LAN) equipment used to link together computers and peripheral devices; and (iii) Network Interface Cards (NIC), which connect computer workstations to a network. The Company has installed its own proprietary software in all of its manufactured Remote Access Routers and LANs, and at times has licensed this software to third parties. The Company's installed proprietary software and the products manufactured and sold by the Company, now and in the past, do not track or report dates, are not date dependent, and are Year 2000 compliant. The Company's manufactured NIC cards do not contain any date-dependent functions, and thus also are Year 2000 compliant. Therefore, the Company does not expect that Year 2000 processing problems will occur in products sold by the Company, or that Year 2000 product problems would have a material effect on the Company's business, financial condition, or the results of operations. INTERNAL BUSINESS SOFTWARE AND SYSTEMS. The Company in 1998 conducted an inventory of its internal business systems, to determine whether any Year 2000 processing problems existed in critical equipment or systems. As a result, and as part of a corporate program intended to reduce cycle time and improve efficiency, the Company purchased new business operations systems which operate the Company's financial, administrative, business, manufacturing, and customer service functions. The software vendor has indicated these systems are Year 2000 compliant. The Company is installing this system, and expects installation to be complete by January 1, 1999. The Company has a one year limited warranty on these systems commencing from the date of delivery, which warranty would expire before January 1, 2000. Testing of this new operations system for Year 2000 issues is expected to occur in the first quarter of 1999. The Company also has installed a new telephone system under a long-term lease which it understands is Year 2000 compliant. However, if testing demonstrates unexpected Year 2000 problems in these new systems, there would be no assurance that the Year 2000 problems would not have a material impact on the Company's internal operations and would not materially impact the Company's business, financial conditions, or results of operations. The Company expended $240,000 in Year 2000 system costs in the first nine months of 1998. Some of these costs have been capitalized under generally accepted accounting practices. The Company expects to incur additional expenditures of $140,000 in 1999 related to Year 2000 equipment purchases and leases, including consulting fees, license agreements, and lease payments. READINESS OF THIRD PARTY SUPPLIERS AND VENDORS. The Company relies on third party suppliers, service providers, and contractors for critical services, including utility power and telephone, parts and supplies. In addition, the Company sells its products to customers, including Internet service providers and others, which are highly dependent on computers, and which could be adversely affected by their own or their suppliers' lack of Year 2000 readiness. The Company is conducting an inventory of its critical suppliers, service providers, and contractors to determine the extent to which the Company's operations could be affected by those third parties' failure to remedy their own Year 2000 issues. The Company expects to have this inventory complete by the end of 1998 or January 1999. Following completion of its inventory and assessment of third party readiness, the Company will determine whether testing, verification, or contingency plan procedures are necessary. The most reasonably likely worst case scenario if suppliers or customers were not Year 2000 compliant would be interruption in the Company's ability to manufacture or deliver its products through loss of power, supply shortages, or disruption of delivery systems, or a material decrease in the sale of products if customers lose substantial business or divert substantial resources to uncorrected Internet Year 2000 problems. The Year 2000 readiness of outside suppliers or customers is outside the Company's control. There can be no assurance that the failure of third party suppliers or the Company's customers to effectively remedy Year 2000 defects would not have a material adverse impact on the Company's business, results of operations, or financial condition. The above description contains "forward-looking" statements addressing uncertainties and future events relating to the Company's Year 2000 issues. These statements are based on assumptions and predictions which are difficult to verify and may change over time. The Company expects that future events and information, if known by the Company, may affect assessment of the Year 2000 issues potentially affecting the Company. Item 3. Quantitative and Qualitative Disclosures about Market Risk Not Applicable Part II - Other Information Item 1. Legal Proceedings: Not applicable. Item 2. Changes in Securities: Not applicable. Item 3. Defaults upon senior Securities: Not applicable. Item 4. Submission of Matters to a Vote of Security Holders: At the Company's Annual Meeting of Shareholders held on June 10, 1998, The following matters were voted upon: The following persons were elected as Directors: Daniel J. Capone, Jr. with 13,980,882 shares voting for election and votes of 606,912 shares withheld; Howard C. Salwen with 13,988,931 shares voting for election and votes of 598,863 shares withheld; Dr. David Clark with 14,004,111 shares voting for election and votes of 583,683 shares withheld; and Dr. Robert M. Glorioso with 13,995,511 shares voting for election and votes of 592,283 shares withheld. The Company's 1991 Restated Stock Option Plan increased by 500,000 the number of shares reserved for issuance upon exercise of options granted under the Plan with 13,164,160 shares voting for the increase, 1,283,238 shares voting against the increase and 140,396 shares abstaining. The Company's Restated Articles of Organization were amended to change the name of the Company from Proteon, Inc. to OpenROUTE Networks, Inc. with 13,238,841 shares voting for the name change, 1,231,870 shares voting against the name change and 117,083 shares abstaining. Item 5. Other Information: To be considered for inclusion in the proxy statement relating to the Annual Meeting of stockholders to be held in 1999, stockholder proposals must be received no later than December 18, 1998. To be considered for presentation at the Annual Meeting, although not included in the proxy statement, proposals must be received no later than April 12, 1999. All stockholder proposals should be marked for the attention of Mr. Steven T. Shedd, Vice President, Finance, Chief Financial Officer, Treasurer and Clerk, OpenROUTE Networks, Inc., Nine Technology Drive, Westborough, Massachusetts 01581. Item 6. Exhibits and Reports on Form 8 - K: (a) Exhibits: See Exhibits Index (b) Reports on Form 8 - K: The Company filed a Form 8 - K with the Securities and Exchange Commission on each of June 16, 1998 and July 10, 1998 reporting under Item 5. other events in connection with the amendment of the Company's Restated Articles of Organization to change the name of the Registrant from Proteon, Inc. to OpenROUTE Networks, Inc, and the announcement of the appointment of Bryan R. Holley as Chief Executive Officer and as a member of the Board of Directors of the Company. Signatures In accordance with the requirements of the Exchange Act, the Registrant has caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. OpenROUTE Networks, Inc. November 9, 1998 By: /s/ Bryan R. Holley ------------------- Bryan R. Holley President & Chief Executive Officer (principal executive officer) By: /s/ Steven T. Shedd ------------------- Steven T. Shedd Chief Financial Officer, Vice President Treasurer and Clerk (principal financial officer) By: /s/ Sally Teo ------------- Sally Teo Corporate Controller (principal accounting officer) Exhibit Index Exhibit Number Description - ------- (3.1) Restated Articles of Organization as Amended * ( a ) (filed as Exhibit 3.1) (3.3) By-Laws, as amended and restated, of the Registrant * ( b ) (filed as Exhibit 3.3) (4.1) Article 4 of the Restated Article of Organization, (See 3.1 above) (4.2) Form of Common Stock Certificate * ( c ) (filed as Exhibit 4.2) (27) Financial Data Schedule All exhibit descriptions followed by an asterisk and a letter in parentheses were previously filed with the Securities and Exchange Commission as Exhibits to, and are hereby incorporated by reference from, the document to which the letter in parentheses corresponds, as set forth below: ( a ) Registrant's Annual Report on Form 10-K for the fiscal year ended December 31, 1991. ( b ) Registrant's Registration Statement on Form S-1 Registration No. 33-40073. ( c ) Amendment No. 1 on Form 8 to the Registrant's Registration Statement on Form 8-A, File No. 0-19175. Where documents are incorporated by reference from previous filings, the Exhibit number of the document in that previous filing is indicated in parentheses after the incorporation by reference code.