SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 1998.
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from ______ to ______
Commission File Number: 0-26392
LEVEL 8 SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
NEW YORK 11-2920559
(STATE OF INCORPORATION) (I.R.S. EMPLOYER
IDENTIFICATION NO.)
8000 REGENCY PARKWAY, CARY, NORTH CAROLINA 27511
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES, INCLUDING ZIP CODE)
(919) 380-5000
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
--------------------
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $.01 PAR VALUE
----------------------------
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Aggregate market value of the voting stock held by non-affiliates of the
Registrant as of March 26, 1999 was approximately $28,131,936. There were
8,720,994 shares of Common Stock outstanding as of March 26, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement for the 1999 Annual Meeting of
Shareholders are incorporated by reference in Part III hereof.
Exhibit Index appears on Page E-1.
LEVEL 8 SYSTEMS, INC.
ANNUAL REPORT ON FORM 10-K
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
TABLE OF CONTENTS
Item Page
Number Number
- ------ ------
PART I
1. Business........................................................... 1
2. Properties......................................................... 11
3. Legal Proceedings.................................................. 11
4. Submission of Matters to a Vote of Security Holders................ 12
PART II
5. Market for Registrant's Common Stock and Related Shareholder
Matters........................................................... 13
6. Selected Financial Data............................................ 13
7. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................. 14
7A. Quantitative and Qualitative Disclosures About Market Risk......... 23
8. Financial Statements and Supplementary Data........................ 23
9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure............................................. 23
PART III
10. Directors and Executive Officers of the Registrant................. 23
11. Executive Compensation............................................. 23
12. Security Ownership of Certain Beneficial Owners and Management..... 24
13. Certain Relationships and Related Transactions..................... 24
PART IV
14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K... 24
SIGNATURES............................................................... 29
INDEX TO FINANCIAL STATEMENTS............................................ F-1
INDEX TO EXHIBITS........................................................ E-1
PART I
ITEM 1. BUSINESS.
OVERVIEW
Level 8 Systems, Inc. (the "Company" or "Level 8") is a leading provider
of scaleable enterprise application integration solutions. As new computer
technologies have proliferated in enterprise computing environments, the
integration and management of the applications which rely on them has grown in
complexity. Enterprise application integration (or "EAI") solutions address the
emerging need for information systems to deliver enterprise-wide views of a
company's business information and processes. The Company's products and
services are designed to enable organizations to address information systems
integration and management problems in a simple and cost effective way. The
Company provides customers with solutions to link their critical business
applications internally across the enterprise and externally with strategic
business partners. The Company's products and services also enable organizations
to engage in electronic commerce. Electronic commerce or "E-commerce" refers to
business conducted over the Internet. Currently, Level 8's products and services
are sold worldwide through a network of regional sales offices. To date, the
Company's products and services have been utilized by companies in a wide
variety of industries including banking and financial services, insurance,
retail, manufacturing, data processing, public utilities, and transportation.
Specifically, Level 8's customer base includes major corporations around the
world such as ABN AMRO, Information Technology Services Company, Charles Schwab
& Company, Inc., Credit Suisse First Boston, Italia Telecom, Prudential
Insurance Company of America, Sikorsky Aircraft, TeleDenmark A/S, Telenor A/S
and Montgomery Ward & Co., Incorporated.
From inception in 1988 through 1997, the Company provided systems
integration consulting services, primarily to manufacturing businesses in the
State of California. In October 1994, the Company acquired ProfitKey
International, Inc. ("ProfitKey") and Bizware Computer Systems (Canada) Inc.
and, in April 1995, the Company acquired Level 8 Technologies, Inc. ("Level 8
Technologies"). The Company decided to focus on the middleware business of
Level 8 Technologies and sold substantially all the assets of Bizware for
$230,000 on September 9, 1996, and subsequently changed the Company's name to
Level 8 Systems, Inc. In early 1998, the Company sold its ProfitKey
subsidiary and completed the acquisition of Momentum Software Corporation
("Momentum"). See "Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations -General Information and Recent
Developments."
On November 23, 1998, the Company entered into an agreement with Welsh,
Carson, Anderson & Stowe VI L.P. ("WCAS") and certain other parties affiliated
or associated with WCAS pursuant to which the Company agreed to acquire
approximately 69% of the outstanding voting stock of Seer Technologies, Inc., a
Delaware corporation ("Seer"), from WCAS and its affiliates in exchange for
1,000,000 shares of common stock of the Company and warrants to purchase an
additional 250,000 shares of common stock of the Company at an exercise price of
$12 per share. Pursuant to its agreement with WCAS, the Company acquired 69% of
the voting stock of Seer on December 31, 1998 and has commenced a tender offer
to acquire all of the remaining shares of Seer for $0.35 per share in cash. The
Company has also agreed to acquire any remaining shares of Seer following
completion of the tender offer through a merger at the same $0.35 cash price per
share. The Company expects to complete its acquisition of the entire equity
interest in Seer in the second quarter of 1999.
The Company was incorporated under New York law in 1988 under the name
Advanced Systems U.S.A. (LSU) Inc., and was initially a wholly owned
subsidiary of Liraz Systems Ltd. ("Liraz"), an Israeli public company in the
systems integration business. The Company's principal executive offices are
located at 8000 Regency Parkway, Cary, North Carolina 27511, telephone number
(919) 380-5000.
INDUSTRY BACKGROUND
A significant challenge facing global 5000-sized companies today is the
integration of critical business applications which run on disparate computer
systems. Business and competitive pressures are driving the demand for
information systems that offer enterprise-wide views of a company's business
information. Further, information systems departments of global 5000-sized
companies are compelled by both economic necessity and internal mandates to find
ways to leverage their existing investment in information technology.
EAI solutions, including those developed by the Company, are designed to
provide these capabilities through an open, enterprise-wide infrastructure
that can accomplish the complete integration of a Company's entire
1
computing systems environment, including technologies enabling E-commerce. In
addition, EAI encompasses extending the productive life cycle of existing
systems by adding new functionality and by cost-effectively managing all aspects
of the development, deployment, and continued enhancement of existing systems.
Indeed, the Company believes that lines between "new" development and what has
in the past been considered "maintenance" are blurring. More and more of the
"new" development going forward is going to be in the area of enhancing the
functionality of existing systems in an enterprise's computing infrastructure.
Key factors driving the current need for EAI solutions include:
- The current computer systems of many companies were developed in
an era when systems tended to be self-contained. The ability of
the systems to communicate with other systems was not considered
important. As a result, many current systems were not designed to
accommodate communications with different systems.
- Many global 5000-sized companies addressed computer system
development problems by adopting new technologies as they have
emerged. This approach has resulted in increasingly diverse
computing environments that mix a variety of hardware platforms,
operating systems and programming languages.
- Many global 5000-sized companies have made significant recent
investments in ensuring that their existing systems will be able
to function properly in the year 2000 and beyond. The size of the
investment made by these companies addressing year 2000 problems
is forcing information systems departments to find ways to
leverage such investments by extending the life of current
systems.
- Global 5000-sized companies have dramatically increased their use
of the Internet and intranets both to expedite internal
communication and to support business-to-business and
business-to-consumer transactions. This has created strong demand
for an entirely new class of enterprise-wide computer
applications. Meeting this demand in a cost efficient manner
requires modernizing existing systems to enable them to operate
intranet and E-commerce applications, as well as developing new
applications.
- As a result of mergers and acquisitions, the computer systems of
many companies have become considerably more complex at an
enterprise-wide level. The increased complexity results from the
fact that the newly-acquired computer systems are rarely
compatible with the existing computer systems. Furthermore, there
are often redundancies between the respective systems that make
integration more difficult.
PRODUCTS AND SERVICES
The Company's goal is to be a recognized leader in the growing market for
EAI solutions. The Company's solutions combine software products and consulting
services to help enterprises meet their application development, integration and
management needs. FalconMQ, first introduced in early 1998, replicates Microsoft
Corporation's Message Queue Server ("MSMQ") capability on non-Microsoft systems,
thereby enabling non-Microsoft systems to communicate freely with Windows NT
systems using MSMQ. The new Geneva Integration Server, scheduled for official
launch in April 1999 and expected to become one of the Company's leading
products, is designed to provide comprehensive, secure and reliable
interoperability between applications running on disparate and otherwise
incompatible computer systems. As a result of the Seer acquisition, the Company
also offers the Seer*HPS product, which is a set of application development
tools that assists customers in developing and adapting enterprise-wide computer
applications for client/server networks. In addition to its products, the
Company offers a broad range of consulting services in the EAI solutions area.
The Company's consulting staff is highly experienced in large-scale,
enterprise-wide applications and the complex networked computing environments in
which they run. To position the Company as a leading global provider of EAI
solutions, the Company has developed a plan for staged product development and
integration as well as service enhancements which management believes will
enable the Company to effectively accomplish its objectives.
FALCONMQ
In client/server networks, messages that contain information and/or
processing instructions are passed from one system to one or more other systems
for processing. A completion message is returned to the originating system
-2-
when all of the steps in the transaction are completed. In the synchronous
communication model traditionally used within client/server networks, the system
sending the message must wait until it receives a return message that the
transaction was completed before sending the next message to start a new
transaction. This results in a significant amount of wasted system capacity,
since both the client and server systems must sit idle waiting for a response
before moving on to the next task.
Message queuing technology, such as that found in Microsoft's MSMQ
product and IBM's MQ Series, was developed to eliminate the wasted capacity
problem associated with synchronous communication by enabling more sophisticated
asynchronous communication. In asynchronous communication, a client or server
performs a function and then dispatches that function in the form of a "message"
to its opposite member and immediately moves on to perform the next function.
Once the dispatched function has been processed by the opposite member, the
result is then "messaged" back to the client or server for further processing.
In addition, message queuing is used by developers to guarantee reliable data
delivery in applications, even if the network goes down.
FalconMQ is message-oriented middleware technology intended to provide
the asynchronous communication capability of MSMQ on non-Microsoft systems, such
as UNIX systems, MVS operating systems for IBM mainframe computers, IBM AS/400
systems, Sun Microsystems' SOLARUS systems and LINUX systems. FalconMQ is
designed for developers to leverage the power and flexibility of message queuing
on the systems mentioned above. Accordingly, FalconMQ permits the free exchange
of messages over a network between any MSMQ application and any FalconMQ client
applications.
The current version of the FalconMQ product requires that the message
queues themselves reside on a Microsoft Windows NT system. The Company is
developing version 2.0 of FalconMQ, currently targeted for release in early
2000, that will allow message queues to reside on all non-Microsoft systems
supported by FalconMQ. This additional capability of FalconMQ version 2.0 is
designed to enable seamless interconnectivity between applications running on a
broad spectrum of systems on an enterprise-wide basis.
GENEVA INTEGRATION SERVER
The Company's new Geneva Integration Server, scheduled for official
launch in April 1999, has been deployed at a limited number of customer sites
since early 1998 in connection with the implementation of fully integrated
enterprise application systems. The Geneva Integration Server is designed to
provide comprehensive, secure and reliable interoperability between applications
running on disparate and otherwise incompatible computer systems. Because
different computer systems and the applications developed for them vary widely
in the ways in which they send, receive, view and process information,
information can not generally be exchanged between diverse applications running
on different systems. The Geneva Integration Server, which runs on Windows NT
server systems, will enable the sharing of information between disparate systems
by automatically transforming the data from one system into formats and
representations that can be used by other systems. In this way, Geneva
Integration Server can enable timely access to enterprise-wide critical business
information without the need for complex and costly ongoing software program
modifications. Geneva Integration Server's extensive message transformation
capabilities allow Geneva Integration Server to collect messages from existing
systems and transform them into forms that can be exchanged via the Internet and
vice versa, which makes it well-suited to enable existing applications for
E-commerce.
The Company believes that Geneva Integration Server provides the
following advantages to corporate information services departments:
- Improved customer service and reduced time to market by promoting
reuse of the knowledge base embodied in existing applications.
- Reduced time to market in delivering scalable, cost-effective
E-commerce applications.
- Enhanced agility and flexibility of information technology assets
in addressing changing business conditions.
- Improved utilization and the ability to leverage the skills of the
rapidly growing number of developers with Windows NT expertise,
reducing the need for more costly and specialized expertise.
-3-
Geneva Integration Server embodies a core set of translation services,
together with "adapter" modules that allow it to link to many popular systems,
to middleware such as Microsoft's MSMQ and IBM's MQ Series, and to Internet
interfaces such as HTTP, HTML, XML and others. The combination of the
translation services and adapters allows Geneva Integration Server to act as a
liaison with respect to three fundamental elements of inter-system communication
that vary widely between disparate systems: the technical protocols required for
the delivery of messages, the message formats that set forth the manner in which
data will appear in a communication, and the actual content of the message
itself, which often must be transformed in order to permit communication between
incompatible systems.
Geneva Integration Server enhances the ability of information systems
departments to monitor and manage the flow of transactions and tasks across
various applications by providing and tracking information about the nature and
character of data, or "metadata," in a secure medium separate from the data
message itself. This supports system and workflow management to optimize system
performance. For example, metadata may tell a computer that the first four
digits of a particular communication represent the identification code for loan
recipients. If a bank using a traditional system switched from 4-digit to
6-digit identification codes, a labor-intensive search and recoding of the
bank's software programs would be required to process 6-digit codes accurately.
Geneva Integration Server's use of metadata allows a user simply to modify the
definition of that particular type of communication to tell it about 6-digit
codes and Geneva Integration Server automatically ensures that all affected
applications will accurately process the new 6-digit codes.
Geneva Integration Server also has the ability to contain system workflow
procedures in a medium that is separate from the tasks that need to be performed
in order to complete an application requirement. "System workflow procedures"
refers to information regarding the order in which a series of tasks must be
completed in order to complete a given application. For example, when a customer
orders a product the complete transaction may entail a series of interdependent
steps. Geneva Integration Server's workflow management capability tracks the
dependencies between the serial steps in the transaction process. If any of the
serial steps are not completed successfully, Geneva Integration Server would
automatically reset to the beginning before any applications or databases are
updated.
The Company believes that the Geneva Integration Server product is
currently the most comprehensive product of its kind to provide enterprise
application integration capabilities for Microsoft NT server-based environments.
SEER*HPS
Seer*HPS is a set of application development tools that assists customers
in developing, adapting and managing enterprise-wide computer applications for
client/server networks. The product enables users to define in a high level,
simplified language the tasks and operations the users would like an application
to perform. Users can then simply "push a button" and Seer*HPS automatically
generates the necessary software programming to perform the tasks and operations
defined. This significantly speeds the development and deployment of highly
complex, large-scale, custom enterprise applications and greatly enhances the
productivity of programming resources.
Unlike its primary competitors, Seer*HPS includes its own embedded
middleware, enabling communications among Seer*HPS developed application
components across various systems throughout a client/server network. Seer*HPS
enables users to specify which applications or portions of an application are to
be executed on a given system within the computing environment. This enables
workload balancing among systems, which allows customers to utilize available
resources in their respective computing environments more efficiently and
improve system performance.
Seer*HPS stores all of the information pertaining to each
Seer*HPS-developed application in its own centrally located repository. Use of
repository facilitates the efficient enhancement of the functionality of
Seer*HPS applications. Since the repository contains all relevant system data,
Seer*HPS is able to assess automatically the potential impact of any such
proposed changes in functionality. As a result, not only are initial development
time and costs reduced, but on-going system maintenance and enhancement efforts
are simplified as well.
FUTURE INTEGRATION AND DEVELOPMENT OF COMPANY PRODUCTS
FALCONMQ. Currently, FalconMQ requires that all message queues reside on
a Microsoft Windows NT system. FalconMQ Version 2.0, scheduled for release in
early 2000, will permit the message queues to reside on all systems supported by
FalconMQ. The Company also intends to ensure continued compatibility between
FalconMQ
-4-
and Microsoft's MSMQ. As a result, companies can safely build and link
applications using FalconMQ with confidence that their systems will continue to
operate without disruption, with no need for manual programming updates as new
versions of MSMQ are released by Microsoft.
GENEVA INTEGRATION SERVER. The Company intends to enhance Geneva
Integration Server to meet marketplace needs as they evolve. Enhancements
planned through the second quarter of 2000 include strengthening Geneva
Integration Server's ability to support and interact with the MVS operating
system for IBM mainframe computers and the UNIX operating system as well as
applications components based on the Java language, which is typically used for
web-based applications. In the longer term, the Company plans to incorporate the
repository capability found in Seer*HPS into Geneva Integration Server. Among
other things, expanding Geneva Integration Server repository capabilities will
allow information regarding system workflow procedures to be stored in a
comprehensive, enterprise-wide repository and retrieved as needed by the Geneva
Integration Server product. The Company also plans to introduce a new graphical
user interface that will facilitate a customer's reconfiguration of its system.
This interface will represent a customer's system as a schematic diagram, and
reconfiguration of the system will be accomplished by a customer changing the
way the different elements of its system are linked through the schematic
diagram.
SEER*HPS. The Company is currently adapting Seer*HPS to support common
industry standards in order to interact with applications and components that
are not part of a Seer*HPS system. The first step, scheduled for mid-1999, will
be the development of an adapter to link the Seer*HPS middleware layer with
Geneva Integration Server. This link will make available all of the capabilities
of Geneva Integration Server to Seer*HPS customers. Other planned extensions
include providing support for the Java language and "Java Beans" architecture
plus support for other middleware products, such as CORBA and the FalconMQ and
MQ Series products. Longer term product development plans include the creation
of an Information Systems Warehouse based on leading industry standard "core
repository" technologies. The Information Systems Warehouse will manage the
development and interaction of applications across the entire enterprise. The
repository for the current version of Seer*HPS manages the development and
interaction of applications only for Seer*HPS-generated applications.
OTHER PRODUCTS
The XIPC product is an advanced software toolset that greatly simplifies
the development, deployment and management of distributed applications in
complex client/server networks. XIPC manages the different forms of network
communication while showing the developer only a single, simple unified view or
model of the communications taking place. This means that XIPC effectively
shields developers from the complexity of diverse computing environments while
letting them take advantage of all of the capabilities and functionality that
these environments can provide in developing efficient and sophisticated
applications.
In addition, the Company offers other products which it intends to
continue to support and further enhance, but which management does not believe
are material to the Company's business.
SERVICES
The Company provides a full spectrum of consulting services as part of
its commitment to providing its customers industry-leading EAI solutions. The
Company's worldwide consulting team has in-depth experience in developing
successful enterprise-class solutions as well as valuable insight into the
business information needs of customers in global 5000-size companies. The
Company offers consulting services in project management, applications and
platform integration, application design and development, application renewal
and web- and E-commerce enablement, along with expertise in a wide variety of
development environments and programming languages.
In addition, the Company's training organization offers a full curriculum
of courses and labs designed to help customers become proficient in the use of
the Company's products and related technology as well as enabling customers to
take full advantage of the Company's field-tested best practices methodologies.
-5-
SALES AND MARKETING
SALES
The Company derives revenue primarily from software licenses, consulting
services and software maintenance. Presently, almost all of the Company's
revenue is derived from sales of Seer*HPS and related maintenance and consulting
services. Management believes this mix will change significantly over time to
reflect an increasing proportion of revenue resulting from sales of FalconMQ and
Geneva Integration Server.
Seer*HPS and Geneva Integration Server are designed for use primarily in
large-scale, complex computing environments. A customer's decision to use such
products involves a substantial commitment of financial and personnel resources.
Accordingly, a decision to purchase these products typically involves a lengthy
internal review process, often involving a customer's senior management. As a
result, the sales cycle for these products is relatively lengthy, averaging nine
to twelve months. The Company's sales strategy for such products will continue
to involve a complete evaluation of the customer's business, followed by the
identification and sale of solutions incorporating software and related
services. These products and their related services also provide customers the
flexibility to scale up or down and integrate new component products, whether
created by the Company or a third party.
The FalconMQ and XIPC products are by design more project-oriented in
scope. As a result, they are typically sold in smaller configurations than
Seer*HPS or Geneva Integration Server. FalconMQ is typically sold through the
Internet and by telephone and the sales cycle has averaged two to six months.
The Company is evaluating alternative sales strategies for FalconMQ, including a
mix of outsourced telephone sales and indirect channels such as sales through
strategic partners and independent software vendors (known as "ISV's") who could
bundle FalconMQ with applications they develop and sell.
The Company's direct sales staff has substantial knowledge of the
Company's products and service offerings as well as general experience in the
software industry. The Company's direct field sales force is headed by two
general managers -- one for the Americas and one for all other territories that
are the focus of active sales efforts. These currently include the United
Kingdom, France, Spain, Italy, Greece, the Benelux countries, Germany, Austria,
Switzerland, the Scandinavian and eastern bloc countries, Australia and
Asia-Pacific Rim countries. The general managers' respective operations include
sales and consulting services for new and existing customers. On a pro forma
basis, taking into account the business combination between Seer and Level 8,
$26 million (39%) of the Company's 1998 revenue was generated from the Americas
and $41 million (61%) was generated outside the Americas. Since substantially
all of the Company's 1998 revenues were derived from sales of Seer*HPS and
related services, the geographic distribution of the Company's revenues may
change as the Company's revenue mix changes.
MARKETING
The target market for the Company's products and services is global
5000-sized companies. Around the world, global 5000-sized companies are making
substantial expenditures in renovating existing applications for year 2000
compliance. In addition, the rapid development of the Internet and intranet
technology is driving companies to find ways to take advantage of these new
technologies out of competitive necessity. As a result, information systems
departments are compelled by both economic necessity and internal mandates to
find ways to leverage their investment in information technology.
In addition, the lines between "new" development and what has in the past
been considered "maintenance" are blurring. The Company believes more and more
of the "new" development going forward will be in the area of enhancing the
functionality of existing operational systems in an enterprise's current
computing infrastructure, resulting in the identification of new and emerging
markets for EAI solutions.
The Company's marketing staff has an in-depth understanding of the global
software marketplace and the needs of customers in that marketplace. The staff
also has broad knowledge of the Company's products and services and how they can
meet these customer needs, as well as experience in all of the key marketing
disciplines. Marketing is headed by a vice president of worldwide marketing who
manages an international staff, with corporate marketing and core functions
performed by the majority of the staff which is based at corporate headquarters.
Regional marketing programs are supported by corporate staff as well as locally
by staff located in the various regions. The Company also has a vice president
of alliances who identifies potential strategic alliance partners and develops
and manages the Company's relationships with these alliance partners.
-6-
The Company utilizes a wide variety of marketing programs which are
intended to attract potential customers and to promote the Company and its brand
names. The Company uses a mix of market research, analyst updates, seminars,
telemarketing, direct mail, tradeshows, speaking engagements, public relations,
and website marketing in order to achieve these goals. The marketing department
also produces collateral material for distribution to prospects including
demonstrations, presentation materials, white papers, case studies, articles,
brochures, fact sheets, and materials that are specific to the area of interest.
The Company is also implementing an alliance program to support its channel
partners with a variety of programs, incentives, and support plans.
The Company has a key strategic relationship with Microsoft. Microsoft
has licensed from the Company software originally developed by the Company that
enables its Windows NT server platforms to integrate with IBM's MQ Series
message-oriented middleware ("MOM"), which currently represents a significant
share of the worldwide MOM market. Microsoft intends to ship this software as
part of its Windows 2000 operating system and to make it available to its
Windows NT server platform customers through its website. Microsoft recommends
FalconMQ as its preferred implementation of the MSMQ functionality on operating
systems other than Microsoft Windows. The Company is actively exploring
opportunities to continue and expand its relationship with Microsoft in EAI
related areas.
The Company is also actively seeking alliances with other third parties
who provide complementary products and services. In particular, the Company is
targeting the hundreds of companies active in Microsoft's Solution Providers
partner program as potential partners with complementary products and services.
In addition, the Company's Seer subsidiary has an important historical
relationship with IBM in Europe, which in the past has been a major marketer and
distributor of Seer*HPS in Europe.
COMPETITION
The Company competes in markets that are intensely competitive and
characterized by rapidly changing technology and evolving standards. The rapid
growth and long-term potential of the market for EAI solutions make it
attractive to new competition. Many of the Company's competitors have greater
name recognition, a longer installed customer base and significantly greater
financial, technical, marketing, and other resources than the Company. The
Company believes it offers a broader range of EAI solutions than its
competitors, and therefore generally competes on a product-by-product basis.
FALCONMQ
The competition in the message-oriented middleware market is primarily
between Microsoft's MSMQ and IBM's MQ Series. However, since FalconMQ is
designed to link MSMQ-based applications, FalconMQ indirectly competes with
middleware technology designed for IBM's MQ Series message queues product,
including middleware marketed by IBM itself.
GENEVA INTEGRATION SERVER
Geneva Integration Server competes most directly with the MQIntegrator
product from New Era of Networks (known as "NEON"), which enables the
integration of both existing and packaged enterprise resource planning (known as
"ERP") applications through IBM's MQ Series middleware. IBM and NEON recently
announced an agreement whereby NEON's MQIntegrator product will be sold through
IBM's distribution and reseller network. Geneva Integration Server also competes
against a number of other early entrants in the EAI solutions market, such as
the Mercator product line from TSI International Software, Ltd.; TIB
ActiveEnterprise from TIBCO Software, Inc.; and BusinessWare from Vitria
Technology, Inc.
The majority of these competitors focus on the integration of a
customer's existing applications to large ERP packaged applications such as
those provided by SAP, PeopleSoft, Baan and JD Edwards. The most successful of
these competitors have focused their products primarily on mainframe and UNIX
systems. Because Geneva Integration Server takes advantage of advanced features
of Windows NT such as superior security for E-commerce, the Company believes
Geneva Integration Server has a competitive advantage in the current
marketplace.
SEER*HPS
Historically, the primary competitor to Seer*HPS has been Sterling
Software with its Cool:GEN product lines. As the Company repositions Seer*HPS as
one of its EAI solution offerings, it will face new and different
-7-
competitors such as Viasoft and Platinum, who offer repository technologies and
consulting services that they promote as addressing the application renewal and
life cycle management aspects of EAI.
SERVICES
In the system integration and consulting services market, the Company
competes with providers of systems integration services, such as Andersen
Consulting and Logica PLC, and with numerous local and regional providers of
consulting and integration services. In this area, the Company also competes
with providers of software packages for particular markets, such as Fourth Shift
Corporation and Symix Systems, Inc. Some of the Company's competitors,
particularly systems integrators, generally have substantially larger
operations, broader product lines with greater name recognition and market
acceptance and significantly greater resources than the Company. However, the
Company's consulting staff's expertise is focused primarily on supporting and
accelerating the productivity of purchasers of the Company's software products.
The Company believes this offers the Company a competitive advantage in selling
services to new and existing customers of the Company's software products.
CUSTOMERS
The Company's products and services are currently used by thousands of
software developers. Hundreds of enterprise-wide applications built and
integrated through the Company's products are used daily by over a million end
users worldwide. The Company's customer base includes major corporations around
the world such as ABN AMRO, Information Technology Services Company, Charles
Schwab & Company, Inc., Credit Suisse First Boston, Italia Telecom, Prudential
Insurance Company of America, Sikorsky Aircraft, TeleDenmark A/S, Telenor A/S
and Montgomery Ward & Co., Incorporated. Industries that are significantly
represented in the Company's customer base include banking and financial
services, insurance, retail, manufacturing, data processing, public utilities,
and transportation. ABN AMRO was the Company's only customer accounting for 10%
or more of 1998 historical operating revenue. On a pro forma basis, after giving
effect to the acquisition of Seer, no one customer accounted for more than 10%
of operating revenues in 1998.
The Company seeks to form strong partnering relationships with customers
in order to gain an in-depth understanding of the business and technology
challenges they face. Notably, the Company maintains a customer advisory board
for Seer*HPS customers that meets regularly. The volunteer members of the
customer advisory board represent the Company's global customer base and act as
a sounding board for new ideas and initiatives, as well as providing a means for
information flow and feedback regarding the Company's products and services. In
conjunction with the customer advisory board, the Company supports several
internet-based special interest groups providing discussion forums focused on
specific areas of technology. The Company also intends to provide customers of
its other products the opportunity to participate in a customer advisory board.
In addition, the Company holds periodic international customer
conferences to present new information, address customer questions and concerns
and provide constructive open forums for customer interaction. In many areas
around the world, local customers hold periodic regional user group meetings
that are supported and encouraged by the Company. The Company also receives a
great deal of feedback through its consulting services and technical support
organization regarding the effectiveness of the Company's products in meeting
customer needs.
RESEARCH AND PRODUCT DEVELOPMENT
The Company has made substantial investments in research and development.
The Company conducts research and development to enhance its existing products
and to develop new products. The Company intends to focus its research and
development efforts on integrating and evolving its Geneva Integration Server,
FalconMQ and Seer*HPS product lines in such a manner that all of these products
can interact with each other to provide customers a comprehensive EAI solution.
Research and development expense increased 100% from 1997 to 1998 and 99% from
1996 to 1997. The increase in 1998 is partially attributable to the acquisition
of Momentum and the personnel added in this area of the Company. The trend in
increasing research and development expenses is a result of the Company's
investment in new products, primarily Geneva Integration Server and Version 2.0
of FalconMQ. This trend is expected to continue with the purchase of Seer, the
Company's continuing attempts to strengthen its messaging products and
completion of the transition into the EAI marketplace.
-8-
The markets for the Company's products are characterized by rapidly
changing technologies, evolving industry standards, frequent new product
introductions and short product life cycles. The Company's future 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 and evolving
industry standards. The Company budgets for research and development based on
planned product introductions and enhancements. Actual expenditures, however,
may significantly differ from budgeted expenditures. Inherent in the product
development process are a number of risks. The development of new,
technologically advanced software products is a complex and uncertain process
requiring high levels of innovation, as well as the accurate anticipation of
technological and market trends. The introduction of new or enhanced products
also requires the Company to manage the transition from older products in order
to minimize disruption in customer ordering patterns, as well as ensure that
adequate supplies of new products can be delivered to meet customer demand.
There can be no assurance that the Company will successfully develop, introduce
or manage the transition to new products. The Company has in the past, and may
in the future, experience delays in the introduction of its products, due to
factors internal and external to the Company. Any 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 could adversely affect the Company's results of operations,
particularly on a quarterly basis.
For additional information, see "Item 7. Management's Discussion and
Analysis of Financial Condition and Results of Operations - Years Ended December
31, 1998, 1997 and 1996 - Research and Development."
INTELLECTUAL PROPERTY
The Company's success is dependent upon developing, protecting and
maintaining its intellectual property assets. The Company relies upon
combinations of copyright, trademark and trade secrecy protections, along
with contractual provisions, to protect its intellectual property rights in
software, documentation, data models, methodologies, data processing systems,
and related written materials in the international marketplace. In addition,
the Company has patents with respect to certain of Seer's products. The
effectiveness of these various types of protection can be limited, however,
by variations in laws and enforcement procedures from country to country.
There can be no assurance that the steps taken by the Company will prevent
misappropriation of its technology, and such protections do not preclude
competitors from developing products with functionality or features similar
to the Company's products. Furthermore, there can be no assurance that third
parties will not independently develop competing technologies that are
substantially equivalent or superior to the Company's technologies. Any
failure by or inability of the Company to protect its proprietary technology
could have a material adverse effect on the Company's business, operating
results and financial condition.
Copyright protection is generally available under United States laws
and international treaties for the Company's software and printed materials.
Seer has obtained patents in the United States and Australia with regard to
the basic application development and deployment technology in the Seer*HPS
product line, and has related patents pending in various countries. Seer has
registered the trademarks "SEER", "Archetype", "CASIM", "Freeway", "NewArc
2000", "Seer*HPS", and "TurboCycler" in the United States, and has active
programs to register the "SEER" mark in other countries where it does
business. The Company has registered the trademark "Level 8 Systems," and
uses the trademarks "Monitor MQ", "Monitor XIPC", "Level 8", "XIPC",
"FalconMQ", "Geneva", "Geneva Integration Server", "NetEssential",
"SeerTalk", "SmartPak" and "The Seer*Method". The Company intends to seek
registration of some of the trademarks including "FalconMQ", "Geneva", and
"Geneva Integration Server."
Although the Company does not believe its products infringe the
proprietary rights of any third parties, there can be no assurance that
infringement claims will not be asserted against the Company or its customers in
the future. In addition, the Company may be required to indemnify its
distribution partners and end users for similar claims made against them.
Furthermore, the Company may initiate claims or litigation against third parties
for infringement of the Company's proprietary rights or to establish the
validity of the Company's proprietary rights. Litigation, either as a plaintiff
or defendant, would cause the Company to incur substantial costs and divert
management resources from productive tasks whether or not such litigation is
resolved in the Company's favor, which could have a material adverse effect on
the Company's business, operating results and financial condition. Parties
making claims against the Company could secure substantial damages, as well as
injunctive or other equitable relief which could effectively block the Company's
ability to license its products in the United States or abroad. Such a judgment
could have a material adverse effect on the Company's business, operating
results and financial condition. If it appears necessary or desirable, the
Company may seek licenses to intellectual property that
-9-
it is allegedly infringing. There can be no assurance, however, that licenses
could be obtained on commercially reasonable terms, if at all, or that the terms
of any offered license would be acceptable to the Company. The failure to obtain
the necessary licenses or other rights could have a material adverse effect on
the Company's business, operating results and financial condition. As the number
of software products in the industry increases and the functionality of these
products further overlaps, the Company believes that software developers may
become increasingly subject to infringement claims. Any such claims, with or
without merit, can be time consuming and expensive to defend and could adversely
affect the Company's business, operating results and financial condition. The
Company is not aware of any currently pending claims that the Company's
products, trademarks or other proprietary rights infringe upon the proprietary
rights of third parties.
EMPLOYEES
As of March 15, 1999, the Company had a total of 366 employees. Of these
employees, 35 were engaged in software sales and marketing, and technical
support; 50 in administration; 102 in research, development, and technical
support; and 179 in consulting and training. The Company's continued success is
dependent on its ability to attract and retain qualified employees. During 1998,
Seer experienced difficulties in recruiting and retaining qualified employees
due, in part, to the uncertainty of its financial position. Seer also reduced
its headcount as part of its revision of its business plan. The Company also
experienced difficulty in recruiting and retaining consultants and research and
development employees during fiscal 1998 due to the intense competition for such
personnel in the software industry. The Company believes that to fully implement
its business plan it will be required to enhance its marketing functions by
adding additional marketing personnel. In addition, the Company believes
additional sales associates will be required to support the Company's sales
operations following the acquisition of Seer. Although the Company believes it
will be successful in attracting and retaining qualified employees to fill these
positions, no assurance can be given that the Company will be successful in
attracting and retaining these employees now or in the future. The Company's
employees are not represented by a union or a collective bargaining agreement.
-10-
FORWARD LOOKING AND CAUTIONARY STATEMENTS:
Certain statements contained in this Annual Report may constitute
"forward looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995 ("Reform Act"). The Company may also make forward
looking statements in other reports filed with the Securities and Exchange
Commission, in materials delivered to shareholders, in press releases and in
other public statements. In addition, the Company's representatives may from
time to time make oral forward looking statements. Forward looking statements
provide current expectations of future events based on certain assumptions and
include any statement that does not directly relate to any historical or current
fact. Words such as "anticipates," "believes," "expects," "estimates,"
"intends," "plans," "projects," and similar expressions, may identify such
forward looking statements. In accordance with the Reform Act, set forth below
are cautionary statements that accompany those forward looking statements.
Readers should carefully review these cautionary statements as they identify
certain important factors that could cause actual results to differ materially
from those in the forward looking statements and from historical trends. The
following cautionary statements are not exclusive and are in addition to other
factors discussed elsewhere in the Company's filings with the Securities and
Exchange Commission and in materials incorporated therein by reference: the
Company's future success depends on the market acceptance of the new Geneva
Integration Server; an unexpected revenue shortfall may adversely affect the
Company's business because its expenses are largely fixed; the Company's
quarterly operating results may vary significantly because the Company cannot
accurately predict the amount and timing of individual sales and this may
adversely impact the Company's stock price; trends in sales of the Company's
products and general economic conditions may affect investors' expectations
regarding the Company's financial performance and may adversely affect the
Company's stock price; because a substantial amount of the Company's revenues
have historically been derived from Seer*HPS, decreased demand for services
relating to this product could adversely affect the Company's business; the
Company's future results may depend upon the continued growth and business use
of the Internet; the Company may lose market share and be required to reduce
prices as a result of competition from its existing competitors, other vendors
and information systems departments of customers; the Company may not have the
resources to successfully manage the integration of Seer; the Company's future
results may depend upon the successful integration of acquisitions; the Company
may not have the resources to successfully manage additional growth; rapid
technological change could render the Company's products obsolete; if the
Company's relationship with Microsoft weakens, it could adversely affect the
Company's business; the loss of any one of the Company's major customers could
adversely affect the Company's business; the Company's business is subject to a
number of risks associated with doing business abroad including the effect of
foreign currency exchange fluctuations on the Company's results of operations;
the Company's products may contain undetected software errors, which could
adversely affect its business; because the Company's technology is complex, the
Company may be exposed to liability claims; year 2000 issues may cause problems
with the Company's systems and expose the Company to liability; the failure of
the Company to meet product delivery dates could adversely affect its business;
the Company may be unable to enforce or defend its ownership and use of
proprietary technology; because the Company is a technology company, its Common
Stock may be subject to erratic price fluctuations; and the Company may not have
sufficient liquidity and capital resources to meet changing business conditions.
ITEM 2. PROPERTIES.
The Company maintains its principal executive offices in approximately
54,000 square feet of leased space in Cary, North Carolina. The Company also
maintains executive offices in approximately 13,500 square feet of leased space
in New York, New York. As of December 31, 1998, the Company also leased 14
additional offices to provide consulting services to its clients and to
facilitate the development, sale and distribution of its products. The Company
leases office space abroad in Canberra, Melbourne and Sydney, Australia;
Toronto, Canada; Copenhagen, Denmark; London, England; Paris, France; Frankfurt,
Germany; Rome, Italy; Milan, Italy; Madrid, Spain; and Nieuwegein, The
Netherlands. The Company also maintains an office in Limerick, Ireland on a set
fee arrangement.
ITEM 3. LEGAL PROCEEDINGS.
Seer, the Company's 69% subsidiary acquired December 31, 1998, filed a
lawsuit against Saadi Abbas and Cambridge Business Solutions (UK) Limited
("CBS") in December 1997 alleging that Mr. Abbas and CBS had injured Seer by
interfering with Seer's ability to market and sublicense the LightSpeed
Financial Model. Seer obtained a preliminary injunction against Mr. Abbas and
CBS halting their actions. Mr. Abbas and CBS filed counterclaims against Seer
claiming wrongful dismissal of Abbas and breach of the license agreement. Due to
the erosion of the market for the LightSpeed Financial Model, Seer voluntarily
dismissed its claims against Mr. Abbas and CBS in the summer of 1998. Mr. Abbas
and CBS are continuing to pursue their claims against Seer. At the present point
in the litigation, it is impossible to calculate the chances of success in this
litigation. However, Seer
-11-
intends to continue to vigorously defend against the counterclaim. Seer has made
provisions for its estimated costs to resolve this matter. Management does not
believe at this point in the litigation that any additional amounts required to
ultimately resolve this matter will have a material effect on the financial
position, cash flows, or results of operations of Seer or the Company.
From time to time, the Company is a party to routine litigation
incidental to its business. As of the date of this Report, the Company was not
engaged in any legal proceedings that are expected, individually or in the
aggregate, to have a material adverse effect on the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
-12-
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON STOCK AND RELATED SHAREHOLDER MATTERS.
During fiscal years 1997 and 1998, the Common Stock of the Company was
traded on the Nasdaq Stock Market under the symbol "LVEL." The Company has never
declared or paid any cash dividends on its Common Stock. The Company anticipates
that all of its earnings will be retained for the operation and expansion of the
Company's business and does not anticipate paying any cash dividends in the
foreseeable future. The Company's credit agreements require the Company to
obtain approval from its lenders prior to declaration or payment of any cash
dividends on its Common Stock. The chart below sets forth the high and low stock
prices for the quarters of the fiscal years ended December 31, 1997 and 1998.
1997 1998
---------------------- -----------------------
Quarter High Low High Low
------- --------- --------- --------- ----------
First $ 18.2500 $ 10.2500 $ 16.3125 $ 10.3750
Second $ 18.5000 $ 10.6250 $ 14.0000 $ 8.3750
Third $ 25.8750 $ 15.8750 $ 11.0000 $ 6.5625
Fourth $ 23.8750 $ 11.5000 $ 9.8750 $ 5.0000
The closing price of the Common Stock on December 31, 1998 was $9.6875 per
share. As of March 26, 1999, the Company had 122 registered shareholders of
record.
ITEM 6. SELECTED FINANCIAL DATA.
The following selected financial data is derived from the consolidated
financial statements of the Company. The data should be read in conjunction with
the consolidated financial statements, related notes, and other financial
information included herein.
For 1998, the following data includes the Company, ASU, Level 8
Technologies and Momentum since its acquisition on March 26, 1998. For 1997,
the following data includes the Company, ASU, and Level 8 Technologies. For
1996, the following data includes the Company, ASU, and Level 8 Technologies.
For 1995, the following data includes the Company for the full year and Level
8 Technologies since its acquisition on April 1, 1995. For 1994, the
following data includes the Company and ASU.
YEAR ENDED DECEMBER 31,
(IN THOUSANDS, EXCEPT PER SHARE DATA)
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
SELECTED STATEMENT OF OPERATIONS DATA
Revenue $ 1,660 $ 3,012 $ 7,272 $ 14,680 $ 10,685
Net income (loss) from continuing operations 26 (429) (845) 1,036 (23,688)
Net income (loss) from continuing operations
per common and common
equivalent share - basic .01 (.10) (.14) .16 (3.15)
Net income (loss) from continuing operations
per common and common equivalent share - diluted .01 (.10) (.14) .14 (3.15)
Weighted average common and common equivalent
shares outstanding - basic 3,839 4,314 6,076 6,992 7,552
Weighted average common and common equivalent
shares outstanding - diluted 3,839 4,403 6,076 7,561 7,552
-13-
AT DECEMBER 31,
1994 1995 1996 1997 1998
---- ---- ---- ---- ----
SELECTED BALANCE SHEET DATA
Working capital (deficiency) $(1,679) $ 4,103 $ 11,007 $ 15,826 $(19,774)
Total assets 5,848 15,059 20,787 23,482 70,770
Long-term debt, net of current maturities 19 43 23 16 1,541
Loans from related companies, net 2,015 454 331 202 12,519
Shareholders' equity 489 11,499 18,300 20,371 8,892
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
GENERAL INFORMATION AND RECENT DEVELOPMENTS
The Company is a leading provider of scaleable enterprise application
integration solutions. As new computer technologies have proliferated in
enterprise computing environments, the integration and management of the
applications which rely on them has grown in complexity. Enterprise application
integration (or "EAI") solutions address the emerging need for information
systems to deliver enterprise-wide views of a company's business information and
processes. The Company's products and services are designed to enable
organizations to address information systems integration and management problems
in a simple and cost effective way. The Company provides customers with
solutions to link their critical business applications internally across the
enterprise and externally with strategic business partners. The Company's
products and services also enable organizations to engage in electronic
commerce. Currently, Level 8's products and services are sold worldwide through
a network of regional sales offices. To date, the Company's products and
services have been utilized by companies in a wide variety of industries
including banking and financial services, insurance, retail, manufacturing, data
processing, public utilities, and transportation.
As part of the Company's strategic shift to the EAI market in the
first quarter of 1998, the Company decided to sell its wholly owned
subsidiary, ProfitKey International Inc. (which sale was completed on April
6, 1998). See Note 3 to Consolidated Financial Statements.
The Company thereupon, on March 26, 1998, acquired Momentum Software
Corporation ("Momentum") in return for 594,866 shares of the Company's common
stock and warrants to purchase 200,000 common shares at an exercise price of
$13.11 per share, subject to additional consideration based on the market value
of the Company's stock on December 1, 1998. In December 1998, the Company issued
notes totaling $3 million in payment of such additional consideration. Momentum
was purchased primarily for its technology, some of which has been integrated
into Level 8's Falcon product set.
The Company's most significant step to date into the EAI marketplace was
the acquisition of a controlling interest in Seer Technologies, Inc. ("Seer") on
December 31, 1998. Seer is one of the software industry's earliest pioneers and
a long-time leader in software application development tools. During 1998, Seer
redirected its focus on emerging market demand for extending the life cycle of
enterprise applications through enterprise application renewal. On November 23,
1998, the Company entered into an agreement with Welsh, Carson, Anderson & Stowe
VI L.P. ("WCAS") and certain other parties affiliated or associated with WCAS
pursuant to which the Company agreed to acquire approximately 69% of the
outstanding voting stock of Seer from WCAS and its affiliates in exchange for
1,000,000 shares of common stock of the Company and warrants to purchase an
additional 250,000 shares of common stock of the Company at an exercise price of
$12 per share. Pursuant to its agreement with WCAS, the Company acquired 69% of
the voting stock of Seer on December 31, 1998 and has commenced a tender offer
to acquire all of the remaining shares of Seer for $0.35 per share in cash. The
Company has also agreed to acquire any remaining shares of Seer following
completion of the tender offer through a merger at the same $0.35 cash price per
share. The Company expects to complete its acquisition of the entire equity
interest in Seer in the second quarter of 1999.
As a result of (i) the purchase of Momentum at the end of the first
quarter of 1999, (ii) the purchase of 69% of the voting stock of Seer on
December 31, 1998, (iii) the pending completion of the purchase of the remaining
31% of the voting stock of Seer, and (iv) the disposition of ProfitKey, the
information within this report is not necessarily indicative of future operating
results. Also, these changes make it difficult to compare the results for the
years presented as the direction of the business has evolved throughout the
period. Unless otherwise specifically indicated, the information in this report
is stated as of December 31, 1998 and does not give effect to the remaining
portion of the pending acquisition of the remaining 31% of Seer. The Company
expects that its results of
-14-
operations will significantly change with its acquisition of Seer and through
the development of its other technologies as it continues to attempt to
strengthen its position in the EAI marketplace.
This report contains forward-looking statements relating to such matters
as anticipated financial performance, business prospects, technological
developments, new products, research and development activities, the pending
transaction with Seer, liquidity and capital resources, Year 2000 issues and
similar matters. The Private Securities Litigation Reform Act of 1995 provides a
safe harbor for forward-looking statements. In order to comply with the terms of
the safe harbor, the Company notes that a variety of factors could cause its
actual results to differ materially from the anticipated results or other
expectations expressed in the Company's forward-looking statements. See "Item 1.
Business - Forward Looking and Cautionary Statements."
[remainder of page intentionally left blank]
-15-
RESULTS OF OPERATIONS
The Company's 1998 results of operations include the operations of the
Company and its subsidiaries. Operations for the subsidiaries acquired during
1998 are included from the date of acquisition. Accordingly, the 1998 results of
operations include the operations of Momentum since March 26, 1998. The 1998
results of operations do not reflect any of Seer's operations since the
Company's 69% interest in Seer was not acquired until December 31, 1998. The
shareholders of the remaining 31% of the outstanding voting stock were
considered to have shared in the losses of Seer only for their proportionate
share of Seer's net assets. No minority interest for Seer is reflected in the
Company's consolidated balance sheet at December 31, 1998 because Seer had net
liabilities of $25 million at December 31, 1998. The Company has only recorded
69% of the value of the Company's intangible assets, including the value of
in-process technology which has been written off. Subsequent to December 31,
1998, the Company commenced a tender offer for the remaining 31% of Seer. Until
the tender offer is completed, the Company will report only 69% of any net
earnings and 100% of any net losses of Seer. The Company anticipates completing
the tender offer and acquiring the remaining minority interest in Seer during
the second quarter of 1999. Following the acquisition of the minority interest
in Seer, the Company's operations will include all of Seer's operations and the
Company will record the remaining intangible assets of Seer, including an
additional write-off for in-process technology.
The following table sets forth, for the years indicated, the Company's
results of continuing operations expressed as a percentage of revenue.
Years Ended December 31,
1998 1997 1996
----- ----- -----
Revenue:
Software products 14.5% 29.7% 20.4%
Services 85.5% 69.3% 75.9%
Other -- 1.0% 3.7%
----- ----- -----
Total 100.0% 100.0% 100.0%
Cost of revenue:
Software products 19.3% 17.4% 19.6%
Services 55.9% 34.0% 42.0%
Other -- 0.3% 0.5%
----- ----- -----
Total 75.2% 51.7% 62.1%
----- ----- -----
Gross profit 24.8% 48.3% 37.9%
Operating expenses:
Research and product development 19.8% 7.2% 7.3%
Selling, general and administrative 91.5% 30.5% 40.8%
Amortization of goodwill and 18.1% 2.9% 5.8%
intangibles
Write-off of in-process research and 55.1% -- --
development
Write-off of goodwill 43.1% -- --
Restructuring charges 14.4%
----- ----- -----
Total 242.0% 40.5% 53.9%
Other income (expense), net (0.7)% 3.0% 2.0%
----- ----- -----
Income (loss) before taxes (217.9)% 10.8% (14.0%)
Income tax provision (benefit) 3.8% 3.8% (2.4)%
----- ----- -----
Net income (loss) from continuing operations (221.7)% 7.0% (11.6)%
----- ----- -----
----- ----- -----
-16-
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
REVENUE AND GROSS MARGIN. The Company has two categories of
revenue: software products and services. Software products revenue is comprised
primarily of fees from licensing the Company's proprietary software products
and, to a lesser extent, from product development contracts. Services revenue is
comprised of fees for maintaining, supporting, providing periodic upgrades and
consulting and training services related to the Company's software products.
The Company's revenues vary from quarter to quarter, with the largest
portion of revenue typically recognized in the last month of each quarter. The
Company believes that these patterns are partly attributable to the Company's
sales commission policies, which compensate sales personnel for meeting or
exceeding quarterly quotas, and to the budgeting and purchasing cycles of
customers. The Company typically does not have any material backlog of unfilled
software orders, and product revenue in any quarter is substantially dependent
upon orders received in that quarter. Because the Company's operating expenses
are based on anticipated revenue levels and are relatively fixed over the short
term, variations in the timing of recognition revenue can cause significant
variations in operating results from quarter to quarter. Fluctuations in
operating results may result in volatility in the price of the Company's common
stock.
Effective January 1, 1998, the Company adopted Statement of Position
97-2, "Software Revenue Recognition" ("SOP 97-2"), as amended by Statement of
Position 98-4 "Deferral of the Effective Date of Certain Provisions of SOP
97-2." SOP 97-2 requires each element of a software sale arrangement to be
separately identified and accounted for based on the relative fair value of such
element. Revenue cannot be recognized on any element of the sale arrangement if
undelivered elements are essential to the functionality of the delivered
elements.
Adoption of SOP 97-2 resulted in the deferral of license revenue of
approximately $262. In addition, the unique nature of a significant contract
resulted in the deferral of $3,700 of software revenue as of December 31,
1998. At least a portion of the license revenue for these contracts may have
been recognized under SOP 91-1 "Software Revenue Recognition", which was
effective in previous years.
Statement of Position 98-9, "Modification of SOP 97-2, 'Software Revenue
Recognition,' with Respect to Certain Transactions" ("SOP 98-9") will be
effective for the Company's fiscal year beginning January 1, 1999. Retroactive
application is prohibited. SOP 98-9 amends SOP 97-2 to require that an entity
recognize revenue for multiple element arrangements by means of the "residual
method" when (1) there is vendor-specific objective evidence ("VSOE") of the
fair values of all of the undelivered elements that are not accounted for by
means of long-term contract accounting, (2) VSOE of fair value does not exist
for one or more of the delivered elements, and (3) all revenue recognition
criteria of SOP 97-2 (other than the requirement for VSOE of the fair value of
each delivered element) are satisfied. The provisions of SOP 98-9 that extend
the deferral of certain passages of SOP 97-2 became effective December 15, 1998.
The Company is evaluating the future requirements of SOP 98-9 and the effects,
if any, on the Company's current revenue recognition policies.
Total revenues decreased 27% from 1997 to 1998 and increased 102% from
1996 to 1997. The decrease from 1997 to 1998 was primarily attributable to a
decrease in software products revenue, along with a reduction in services
revenue. The increase from 1996 to 1997 was a result of significant increases in
both software products and services. The gross margins were 25%, 48%, and 38%
for 1998, 1997, and 1996, respectively.
Results for 1998 do not reflect any revenue from an agreement the
Company entered into with Microsoft in August, 1998. Under the agreement, the
Company has agreed to license to Microsoft the source and object codes for
certain software products that enable interoperability between Microsoft's
Message Queue Server running on Microsoft's Windows NT operating systems and
IBM Corporation's MQ Series message software running on a variety of
operating systems. Microsoft accepted the English version of the product in
September and the Japanese version in November. The Company received cash
equal to the $3.7 million total contract value from Microsoft in 1998. Due to
certain limitations with respect to available "vendor specific objective
evidence," all other associated contract revenue has been deferred and will
be recognized beginning in 1999 ratably over the contract's period.
SOFTWARE PRODUCTS. Software products revenue decreased 64% in 1998 in
comparison to 1997 and increased 193% from 1996 to 1997. The gross margins on
software products was (33%), 41%, and 4% for the 1998, 1997, and 1996 fiscal
periods, respectively. Cost of software is composed of production and
distribution costs, amortization of capitalized software and royalties to third
parties.
-17-
The decrease in software revenue from 1997 to 1998 is the result of
the Company's shift in strategic direction primarily relating to the
Company's dispositions and acquisitions in 1998, as well as reduced emphasis
on resales of IBM's MQ Series licenses in favor of the Company's FalconMQ
Products developed by the Company. The decrease in gross margins between 1997
and 1998 is the effect of increased amortization costs, lower software
product revenues, $.38 million of royalties to Liraz under the joint
development agreement described under "-Research and Development." and a
write-off of approximately $.3 million of capitalized technology costs.
Software revenue increased from 1996 to 1997 from sales of products
introduced in 1997 and the resale of IBM's MQ Series. The increase in gross
margins is primarily a result of the increased software revenue, somewhat offset
by increased amortization expense related to products becoming generally
available in 1997.
SERVICES. Services revenue decreased by 10% from 1997 to 1998 and
increased by 84% from 1996 to 1997. Services gross margins were 35%, 51%, and
45% for 1998, 1997, and 1996 respectively. Cost of services primarily includes
personnel and travel costs related to the delivery of services.
The services revenue decline from 1997 to 1998 was primarily
attributable to the decline in software products revenue and the resultant
decline in utilization of billable services. The decline in software
products revenue impacts services revenue as there are fewer new customers
than in the prior year, reducing the base of the customers utilizing the
Company's consulting and training services as part of an overall technology
solution purchase. Gross margins decreased in 1998 in relation to 1997 due to
lower than normal billable utilization of consultants caused by project
delays.
The significant increase in services revenues increase from 1996 to 1997
was a result of the addition of a combination of new consulting and training
services and increases in maintenance services in correlation with the
introduction of new products that created increased market demand. Gross profits
increased in 1997 due to the Company's ability to obtain higher billing rates
than previously earned and high utilization of staff during this growth period.
RESEARCH AND DEVELOPMENT. Research and development expenses primarily
include personnel costs for product authors, product developers and product
documentation personnel. Research and development expense increased 100% from
1997 to 1998 and 99% from 1996 to 1997. The increase in 1998 is partially
attributable to the acquisition of Momentum and the personnel added in this area
of the Company. The trend in increasing research and development expenses is a
result of the Company's investment in new products, primarily Geneva Integration
Server, which is scheduled to be released in the second quarter of 1999 and
Version 2.0 of FalconMQ which is expected to be released in early 2000. This
trend is expected to continue with the purchase of Seer, the Company's
continuing attempts to strengthen its messaging products and completion of the
transition into the EAI marketplace.
The Company and Liraz previously had an agreement for the joint
development of certain software for a Microsoft contract. Under the
agreement, Liraz and the Company were each to pay 50% of the total project
development costs. In exchange for providing 50% of such costs, Liraz was
previously entitled to receive royalties of 30% of the first $2 million in
contract revenue, 20% of the next $1 million, and 8% thereafter. On April 1,
1998, the agreement was amended to provide that the Company would reimburse
Liraz's costs of development of $1.5 million and would pay Liraz royalties of
3% of program revenues generated from January 1, 1998 until December 31,
2000. The $1.5 million reimbursement is being amortized over the term of the
revised royalty agreement and was paid to Liraz by the delivery of an 8% note
payable in three installments in 1998, 1999 and 2000. Additional royalties of
$.13 million are payable to Liraz for 1998 sales.
SELLING, GENERAL, AND ADMINISTRATIVE. Selling expenses consist of sales
and marketing expenses for personnel, travel, trade show participation, and
other promotional expenses. General and administrative expenses consist of
personnel costs for the executive, legal, financial, human resources, and
administrative staff and all overhead expenses. Overhead expenses primarily
include office rent, depreciation and lease costs on machinery and equipment,
communications expenses, insurance, allowances for bad debts and other expenses
of operating the Company and its facilities.
Selling, general, and administrative expenses increased 51% in 1997 in
comparison to 1996 and 119% in 1998 in relation to 1997. The increases are
primarily related to additional sales and marketing expenses for new products,
the additional general and administrative support necessary following the
purchase of Momentum, and continued efforts to build a supporting infrastructure
for further acquisitions, such as Seer.
-18-
AMORTIZATION OF GOODWILL AND OTHER INTANGIBLE ASSETS. Amortization of
goodwill and other intangible assets was $1.9 million in 1998 and $.4 million in
each of 1997 and 1996. The amortization of goodwill in 1997 and 1996 was related
to the purchase of Level 8 Technologies. In 1998, the amortization of goodwill
and other intangible assets related to the purchase of Momentum as well as Level
8 Technologies.
OTHER ITEMS. As a result of the acquisitions of Momentum and Seer, the
Company recorded several nonrecurring charges in 1998. Based on the results
of third-party appraisals, the Company recorded charges totaling $5.9 million
to expense purchased in-process research and development costs, consisting of
$1.2 million and $4.7 million related to the acquisition of Momentum and
Seer, respectively. In the opinion of management and the appraiser, the
acquired in-process research and development had not yet reached
technological feasibility and had no alternative future uses. The value of
the in-process projects was adjusted to reflect the relative value and
contribution of the acquired research and development. In doing so,
management gave consideration to the stage of completion, the complexity of
the work completed to date, the difficulty of completing the remaining
development costs already incurred, and the projected cost to complete the
projects. The value assigned to purchased in-process technology was based on
key assumptions, including revenue growth rates for each technology
considering, among other things, current and expected industry trends,
acceptance of the technologies and historical growth rates for similar
industry products. As a consequence of the Company's transition to an
enterprise application integration solutions provider, the Company abandoned
certain planned development efforts for products acquired in the Momentum
transaction and reassessed the remaining undiscounted projected cash flows
related to the identifiable and unidentifiable intangible assets acquired
from Momentum. It was concluded that, with the principal exception of the
Momentum technology utilized in the Level 8's Falcon product set and the XIPC
products, the goodwill and intangible acquired in the Momentum transaction
should be written off. Accordingly, during the fourth quarter of 1998, the
Company adjusted the carrying value of its identifiable and unidentifiable
assets to their fair value of $32,217, resulting in a non-cash impairment
loss of $4,601.
During the fourth quarter of 1998, the Company reorganized its
existing operations due to its acquisition of Seer. The restructuring
included a staff reduction of 20% (15 employees), the abandonment of certain
leased facilities, and the write-down to fair value of certain capitalized
software costs for product lines which were being discontinued. The Company
recorded a restructuring charge of approximately $1.5 million, which
consisted of approximately $.7 million in personnel-related charges,
approximately $.3 million in costs associated with carrying vacated space
until the lease expiration date, approximately $.2 million of property and
equipment related charges, approximately $.2 million in write-down of
capitalized software costs, and approximately $.1 million in professional
fees related to the restructuring. To date, the Company has paid
approximately $.1 million in cash related to the restructuring. The Company
believes the accrued restructuring cost of $1.0 million at December 31, 1998
represents its remaining cash obligations.
PROVISION FOR INCOME TAXES. The Company accounts for income taxes in
accordance with Statement of Financial Accounting Standards No. 109, "Accounting
for Income Taxes." The effective income tax rate for continuing operations
decreased from 35% for 1997 to (2%) for 1998 primarily because an income tax
benefit was not recorded for the net loss incurred in 1998. The Company provided
a full valuation allowance on the total amount of its deferred tax assets at
December 31, 1998 since management does not believe that it is more likely than
not that these assets will be realized.
DISCONTINUED OPERATIONS. The loss on disposal of ProfitKey was
approximately $1.2 million. The loss on discontinued operations related to
ProfitKey was $.14 million for 1998.
IMPACT OF INFLATION. Inflation has not had a significant effect on the
Company's operating results during the periods presented.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents increased $.7 million in 1996 to $3.3 million
at year end. During 1996, the Company completed a second public offering of
common stock for net proceeds of $9.1 million. Net cash outflow of $1.1 million
used in operating activities in 1996 was partially funded through the 1996
public offering. The net cash used by operations in 1996 consisted of increases
in operating expenses to support headcount growth, principally for sales and
marketing in new functions and regions. Net cash used in investing activities
was $7.2 million, primarily as a result of a net $4.5 million investment in
marketable securities. The Company also invested $1.5 million in property and
capitalized software costs, and $1.2 million was used by the Company's
discontinued operations.
During 1997, cash and cash equivalents increased $3.7 million to $7.0
million at year end. The increase was due primarily to the Company's investment
activities in marketable securities offset by a $1.7 million
-19-
investment for capitalized software development costs and equipment, and
a $1 million use of cash by the Company's discontinued operations. The Company
funded its operations in 1997 with cash remaining from the 1996 offering.
During 1998, cash and cash equivalents decreased by $1 million to $6
million at year end. The decrease in cash is due to the purchase of $.9 million
in equipment, spending of $1.2 million for capitalized software development
costs, and debt service of $1.5 million. This decrease was offset by $1.7
million of cash provided by operations, $.5 million from the sale of ProfitKey,
and $.4 million of net cash acquired from acquisitions. Additionally, the
Company borrowed $12 million from Liraz which was used to pay down Seer's bank
debt on December 31, 1998.
As of December 31, 1998, the Company did not have any material
commitments for capital expenditures. Future maturities on the Company's
outstanding debt at December 31, 1998 include $13.7 million in 1999, $13.3
million in 2000 and $.7 million in 2001. Of such amounts, $.6 million in 1999
and $12.5 million in 2000 are due to Liraz, the Company's controlling
shareholder.
The Company has agreed to acquire the remaining equity of Seer and
expects to complete the acquisition of the remaining Seer shares in the second
quarter of 1999 for approximately $1.7 million. In connection with the
acquisition of Seer, the Company committed to fund Seer's operations through
January 15, 2000, if necessary.
During the fourth quarter of 1998, the Company issued $3 million in
notes to the sellers of Momentum as additional consideration, as provided for
in the purchase agreement. These notes bear interest at 10% per year
retroactive to the Momentum acquisition date of March 26, 1998, payable in
four equal installments plus interest on December 1, 1998, November 26, 1999,
November 20, 2000, and November 15, 2001. There are no financial covenants in
these notes.
In connection with the acquisition of 69% of Seer on December 31, 1998,
the Company issued a $12 million note payable to Liraz and applied the proceeds
to pay off Seer's bank debt. In connection therewith, the Company and Liraz
agreed that the Company would effect a pro rata offering to its shareholders of
shares of preferred stock intended to have an aggregate liquidation preference
initially equal to the principal and accrued interest under the note and to be
convertible into an aggregate number of common stock determined by dividing the
aggregate liquidation preference (which will accrete at the rate of 12% a year,
compounded quarterly) by the conversion price. The conversion price would be an
amount equal to the greater of $5.00 and two-third of the average closing price
of a share of the Company's common stock during the 20 trading days ending on
the fifth trading day before the rights offering. Each share of preferred stock
would be entitled to two votes for each share of common stock into which it is
convertible. The preferred stock would be redeemable at the Company's option at
any time after June 30, 2000, upon at least 30 days' notice, at a redemption
price equal to the preferred stock's accreted liquidation preference. The
purchase price for each share of preferred stock to be offered to the Company's
shareholders would equal its initial liquidation preference. Liraz would be
permitted to pay the purchase price for any preferred stock it purchases in the
offering with cash or by reducing the amount payable to it under the $12 million
note. If the rights offering is consummated before June 30, 1999, the Company is
required to use the net proceeds of the rights offering to prepay the unpaid
balance under the $12 million note. In the context of reviewing other financing
alternatives, the Company and Liraz are currently reevaluating the proposed
rights offering and may determine not to proceed with the rights offering.
As of December 31, 1998, Seer had outstanding borrowings of $12.3 million
under its credit facility with a commercial bank (the "Credit Facility") at an
interest rate of 7.75%. Subsequent to December 31, 1998, the Credit Facility was
amended to include the Company as a borrower. As amended, the Credit Facility
provides for borrowings up to the lesser of $25 million or the sum of (i)
eligible receivables, (ii) a $7 million term loan payable in monthly
installments over two years, commencing on January 1, 2000, and (iii) a $2.5
million equipment loan payable over two and one-half years, commencing on April
1, 1999. There are no other financial covenants. The Credit Facility will bear
interest at Prime Rate through June 30, 1999, Prime Rate plus 1% per annum
through June 30, 2000, and Prime Rate plus 2% per annum thereafter. The Credit
Facility as amended is due on demand and terminates on December 31, 1999;
however, it is automatically renewed for successive additional terms of one year
each, unless terminated by either party. The Credit Facility is collateralized
by the Company's accounts receivable, equipment and intangibles, including
intellectual property. The $12 million note and other debt payable to Liraz is
subordinate in right of payment to the Credit Facility.
In early 1999, management began both to effect the various restructuring
actions discussed previously and to implement other cost control and cost
reduction efforts. Management's planned actions also include the sale of
-20-
certain technologies that are not closely related to the Company's current
strategic direction and positioning the Company for the proposed rights offering
or an alternative financing transaction.
The Company incurred a net loss of $26.2 million and has negative
working capital of $20.3 million and an accumulated deficit of $26.4 million
at December 31, 1998. Additionally, Seer, in which the Company acquired a 69%
interest on December 31, 1998, reported a loss of $62.4 million for its most
recent fiscal year. The Company's ability to generate positive cash flow is
dependent upon the Company achieving and sustaining certain cost reductions
and generating sufficient revenues for the year. The Company already
implemented certain steps to, among other things, reduce headcount,
restructure operations and eliminate various costs from the business. As
discussed above, the Company has also renegotiated the Credit Facility to
increase borrowing capacity. Liraz has committed to provide the Company up to
$7.5 million of working capital on an as needed basis, upon thirty days
notice. Advances, if any, made under the commitment would become due and
payable upon the earlier of March 31, 2000 or the successful completion of an
equity financing which provides more than $7.5 million in proceeds to the
Company. The advancement of funds under the commitment is subject to the
Company's acceptance of certain terms including possible conversion of the
outstanding balance, if any, to common stock of the Company and the execution
of appropriate documentation. Management's plans also include the possibility
of raising additional equity financing. The Company believes that existing
cash on hand, cash provided by future operations and additional borrowings
under the Credit Facility and Liraz commitment will be sufficient to finance
its operations and expected working capital and capital expenditure
requirements for at least the next twelve months so long as the Company
continues to perform to its operating plan. However, there can be no
assurance that the Company will be able to continue to meet its cash
requirements through operations or, if needed, obtain additional financing on
acceptable terms, and the failure to do so may have an adverse impact on the
Company's business and operations.
YEAR 2000
The Company is aware of the issues associated with the programming code
in existing computer systems as the millennium (Year 2000) approaches. The "Year
2000 Problem" is pervasive and complex as virtually every computer operation
will be affected in some way by the rollover of the two digit year value to 00.
The issue is whether computer systems will properly recognize date sensitive
information when the year changes to 2000. Systems that do not properly
recognize such information could generate erroneous data or cause a system to
fail.
SOFTWARE SOLD TO CONSUMERS. The Company believes that it has
substantially identified potential Year 2000 Problems with the software products
that it develops and markets. See "Item 1. Business - Products and Services,"
for a further discussion of the Company's products. The Company's Seer*HPS
toolset products are designed to allow developers to develop applications that
are Year 2000 compliant, through the use of four-digit year fields which can
accept and accurately represent dates both before and after the Year 2000. Once
a four-digit year is properly input, applications built with the Seer*HPS
toolset can properly process the dates.
Dates may be input into these applications either by entering a
four-digit year or, as a shortcut, by entering the last two digits of the year.
In the latter case, the application assigns a century to the date and "feeds
back" a four-digit year to the user by displaying it on the screen. For all
versions of Seer*HPS above 5.2.3K, the century is assigned according to a moving
100-year window. The Company has made available documentation to its customers
that explains how this moving 100-year window can be adjusted, both on the
workstation platform and on the host. For version 5.2.3K, the century is
assigned a default value of "19". In either case, the user can either accept the
proposed four-digit date or correct it, if the application has assigned the
wrong century in a particular case.
The foregoing description related to Seer*HPS versions 5.2.4S and higher
(for the workstation) and 5.2.3K and higher (for the host), which were released
in December 1995. The Company believes that if operated properly, applications
constructed with these versions in accordance with the product documentation
should not manifest Year 2000-related errors traceable to the Seer*HPS product.
The Company does not believe any of its customers are using earlier versions of
the software.
The Company cannot, however, eliminate the possibility of input errors,
where input is in the form of two-digit years. Among other potential errors, it
is possible to introduce incorrect dates into applications using the shortcut
mentioned above if the operator is inattentive to the feedback, or if the
operator or batch data inputs dates represented as two-digit years, without any
way for the operator to determine which century a given year falls in. The
Company has attempted to identify the possible errors by making documentation
available to its customers.
With respect to the Company's Seer*HPS development environment itself,
the Company is not aware of any Year 2000 issues except the following. The tools
store certain information with respect to objects created using the tools (such
as the dates the object was created or last modified) as two-digit dates.
Because of the way the tools use these dates, the Company does not believe this
will cause any Year 2000-related problems except in the limited instance of
migrations spanning the century boundary. The Company has made available to its
customers documentation calling their attention to this issue and a workaround.
Accordingly, the Company believes that it has fulfilled its obligations
to its customers with respect to Year 2000 functionality. However, the law in
this area is still evolving and lawsuits are being filed against software
companies on an ongoing basis, many of them asserting novel theories of damage
and liability. Accordingly, no assurance can be given that claims will not be
made against the Company relating to date-processing issues or that the effect
of such claims on the Company will not be material.
INTERNAL INFRASTRUCTURE. The Company is currently identifying
substantially all of the major computers, software applications, and related
equipment used in connection with its internal operations that must be modified,
upgraded, or replaced to minimize the possibility of a material disruption to
its business and has commenced the process of modifying, upgrading, and
replacing major systems that have been identified as adversely affected, and
expects to complete this process by the middle of 1999.
-21-
SYSTEMS OTHER THAN INFORMATION TECHNOLOGY SYSTEMS. In addition to
computers and related systems, the operation of office and facilities equipment,
such as fax machines, photocopiers, telephone switches, security systems,
elevators, and other common devices may be affected by the Year 2000 Problem.
The Company is currently assessing the potential effect of, and costs of
remediating, the Year 2000 Problem on its office and facilities equipment.
The Company's assessment of its internal systems is approximately 80%
complete. Based on its current assessment, the Company does not believe the
total cost to the Company of completing any required modifications, upgrades, or
replacements of these internal systems will have a material adverse effect on
the Company's financial condition, cash flows, or results of operations.
SUPPLIERS. The Company has reviewed information from third party
suppliers of the major computers, software, and other equipment used, operated,
or maintained by the Company to identify and, to the extent possible, to resolve
issues involving the Year 2000 Problem. However, the Company has limited or no
control over the actions of these third party suppliers. Thus, there can be no
assurance that these suppliers will resolve any or all Year 2000 Problems with
these systems before the occurrence of a material disruption to the business of
the Company or any of its customers. Any failure of these third parties to
resolve Year 2000 problems with their systems in a timely manner could have a
material adverse effect on the Company's business, financial condition, and
results of operation.
MOST LIKELY CONSEQUENCES OF YEAR 2000 PROBLEMS. The Company does not
believe that the Year 2000 Problem will have a material adverse effect on the
Company's business or results of operations. However, management believes that
it is not possible to determine with complete certainty that all Year 2000
Problems affecting the Company have been identified or corrected. The number of
devices that could be affected and the interactions among these devices are
simply too numerous. In addition, one cannot accurately predict how many Year
2000 Problem-related failures will occur or the severity, duration, or financial
consequences of these perhaps inevitable failures. As a result, management
expects that the Company could suffer the following consequences:
1. a significant number of operational inconveniences and
inefficiencies for the Company and its clients that may divert
management's time and attention and financial and human resources from
its ordinary business activities; and
2. a lesser number of serious system failures that may require
significant efforts by the Company or its clients to prevent or alleviate
material business disruptions.
CONTINGENCY PLANS. The Company is currently developing contingency plans
to be implemented as part of its efforts to identify and correct Year 2000
Problems affecting its internal systems. The Company expects to complete its
contingency plans by the middle of 1999. Depending on the systems affected,
these plans could include accelerated replacement of affected equipment or
software, short to medium-term use of backup equipment and software, increased
work hours for Company personnel or use of contract personnel to correct on an
accelerated schedule any Year 2000 Problems that arise or to provide manual
workarounds for information systems, and similar approaches. If the Company is
required to implement any of these contingency plans, it could have a material
adverse effect on the Company's financial condition and results of operations.
DISCLAIMER. The discussion of the Company's efforts, and management's
expectations, relating to Year 2000 compliance are forward-looking statements.
The Company's ability to achieve Year 2000 compliance and the level of
incremental costs associated therewith, could be adversely impacted by, among
other things, the availability and cost of programming and testing resources,
vendors' ability to modify proprietary software, and unanticipated problems
identified in the ongoing compliance review.
-22-
EURO CONVERSION
Several European countries will adopt a Single European Currency (the
"Euro") as of January 1, 1999 with a transition period continuing through
January 1, 2002. The Company is reviewing the anticipated impact the Euro may
have on its internal systems and on its competitive environment. The Company
believes its internal systems will be Euro capable without material modification
cost. Further, the Company does not presently expect the introduction of the
Euro currency to have an adverse material impact on the Company's financial
condition, cash flows, or results of operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Prior to the acquisition of Seer, the Company was not exposed to
significant risks of foreign currency fluctuation. Following the acquisition of
Seer, the Company's US-based operations now have significant receivables
denominated in foreign currency and are subject to transactions gains and
losses, which are recorded as a component in determining net income.
Additionally, the assets and liabilities of the Company's non-U. S. operations
are translated into U.S. dollars at exchange rates in effect as of the
applicable balance sheet dates, and revenue and expense accounts of these
operations are translated at average exchange rates during the month the
transactions occur. Unrealized translation gains and losses will be included as
an adjustment to shareholders' equity. Based upon the foregoing, the Company
intends to begin hedging transactions in an effort to reduce its exposure to
currency exchange rates. However, as a matter of procedure, the Company will not
invest in speculative financial instruments as a means of hedging against such
risk
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required by this item appears beginning on page F-1 of
this report. See Items 14(a)(1) and (2).
ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL DISCLOSURE.
On January 21, 1999, the Company engaged PricewaterhouseCoopers LLP to
replace Grant Thornton LLP as its independent auditors. For further information
regarding this change, reference is made to the Company's Forms 8-K filed with
the Securities and Exchange Commission (the "Commission") on December 22, 1998
and January 21, 1999 and the Form 8-K/A filed with the Commission on January 11,
1999. Reference is also made to the Letter to the Commission from Grant Thornton
LLP dated January 11, 1999 and filed as Exhibit 99.2 to the Form 8-K/A on
January 11, 1999. On January 28, 1998, the Company engaged Grant Thornton LLP to
replace Lurie, Besikof, Lapidus & Co., LLP. For further information regarding
this change, reference is made to the Company's Forms 8-K filed with the
Securities and Exchange Commission on January 30, 1998.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required by this item is incorporated by reference to
information to be included under the captions "Election of Directors,"
"Executive Officers" and "Compliance with Section 16(a) of the Securities
Exchange Act of 1934" in the Company's Proxy Statement for the 1999 Annual
Meeting of Shareholders.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by this item is incorporated by reference to
information to be included under the captions "Election of Directors - Director
Compensation" and "- Compensation Committee Interlocks and Insider
Participation," "Executive Compensation," "Compensation Committee Report on
Executive Compensation" and "Stock Performance Graph" in the Company's Proxy
Statement for the 1999 Annual Meeting of Shareholders.
-23-
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by this item is incorporated by reference to
information to be included under the caption "Beneficial Ownership of Common
Stock" in the Company's Proxy Statement for the 1999 Annual Meeting of
Shareholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required by this item is incorporated by reference to
information to be included under the caption, "Certain Relationships and Related
Party Transactions" and "Election of Directors - Compensation Committee
Interlocks and Insider Participation" in the Company's Proxy Statement for the
1999 Annual Meeting of Shareholders.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a) The following documents are filed as part of this Report:
1. Financial Statements:
The following financial statements of the Company and the
related report of independent accountants thereon are set
forth immediately following the Index of Financial
Statements which appears on page F-1 of this report:
Reports of Independent Certified Public Accountants
Consolidated Balance Sheets as of December 31, 1998 and
1997
Consolidated Statements of Operations for the years ended
December 31, 1998, 1997 and 1996
Consolidated Statements of Changes in Shareholders' Equity
for the years ended December 31, 1998, 1997 and 1996
Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996
Notes to Consolidated Financial Statements
2. Financial Statement Schedules:
All other schedules for which provision is made in the
applicable accounting regulations of the Securities and
Exchange Commission are not required under the related
instructions or are inapplicable and therefore have been
omitted.
3. (a) Exhibits: The following exhibits are filed as part
of this Report. Parenthetical references indicate
incorporation by reference to documents previously
filed by the Company with the Securities and
Exchange Commission.
-24-
2.1 Agreement dated November 23, 1998 among the Company
and Welsh, Carson, Anderson & Stowe VI L.P. ("WCAS")
and related parties (the "WCAS Parties") named
therein relating to the acquisition of capital stock
of Seer Technologies, Inc. by the Company (filed as
exhibit 2.1 to the Seer Technologies, Inc. Form 10-K
for the fiscal year ended September 30, 1998, No.
0-26194, and incorporated herein by reference.)
2.2 Amendment No. 1 to the Agreement dated
November 23, 1998 among the Company and WCAS
and the WCAS Parties relating to the
acquisition of capital stock of Seer (filed
as Exhibit (c)(2) to the Company' s Schedule
13e-3 filed on March 29, 1999 and
incorporated herein by reference).
3.1 Restated Certificate of Incorporation of the
Company (filed as exhibit 3.1 to Registration
Statement No. 33-92230 on Form S-1 and
incorporated herein by reference.)
3.2 By-Laws of the Company (filed as exhibit 3.2
to Registration Statement No. 33-92230 on
Form S-1 and incorporated herein by
reference).
4.1 Form of Warrant(s) representing the 250,000
Level 8 warrants issued to the WCAS Parties
(filed as exhibit 8.2(A) to Seer's Annual
Report on Form 10-K for the year ended
September 30, 1998, No. 0-26194, and
incorporated herein by reference).
10.1 The Company's February 2, 1995 Non-Qualified
Option Plan (filed as exhibit 10.1 to
Registration Statement No. 33-92230 on Form
S-1 and incorporated herein by reference).*
10.2 Amended and Restated Employment Agreement,
effective November 8, 1996, between Level 8
Technologies, Inc. ("Level 8 Technologies")
and Samuel Somech (filed as exhibit 10.12 to
Registration Statement No. 33-92230 on Form
S-1/A and incorporated herein by reference).*
10.2A Amendment dated February 26, 1999 to the
Employment Agreement between the Company and
Samuel Somech dated November 8, 1996 (filed
herewith).*
10.3 Consulting Agreement, effective April 1,
1995, between the Company and Theodore Fine
(filed as exhibit 10.13 to Registration
Statement No. 33-92230 on Form S-1 and
incorporated herein by reference).*
10.4 Form of Amendment, dated June, 1995, among
the Company, Registrant and Theodore Fine
(filed as exhibit 10.13A to Registration
Statement No. 33-92230 on Form S-1 and
incorporated herein by reference).*
10.5 Employment Agreement, dated May 1, 1995,
between the Company and Arie Kilman (filed as
exhibit 10.14 to Registration Statement No.
33-92230 on Form S-1 and incorporated herein
by reference).
10.5A Amendment to Employment Agreement, dated as
of September 18, 1996 between the Company and
Arie Kilman (filed as exhibit 10.14A to
Registration Statement No. 33-9230 on Form
S-1 and incorporated herein by reference).*
10.5B Amendment to Employment Agreement, dated
December 16, 1996, between the Company and
Arie Kilman (filed as exhibit 10.14B to
Registration Statement No. 33-92230 on Form
S-1/A and incorporated herein by reference).*
10.6 Employment Agreement between the Company and
Joseph Schwartz dated June 1, 1998 (filed
herewith).*
10.6A Employment Agreement between the Company and
Gonen Ziv dated
-25-
April 2, 1998 (filed herewith).*
10.7 Agreement, dated June 13, 1995, between the
Company and Liraz (filed as exhibit 10.23 to
Registration Statement No. 33-92230 on Form
S-1 and incorporated herein by reference).
10.8 Registration Rights Agreement, dated June 13,
1995, between the Company and Liraz (filed as
exhibit 10.24 to Registration Statement No.
33-92230 on Form S-1 and incorporated herein
by reference).
10.9 Form of Warrant Agreement, between the
Company and Hampshire Securities Corporation
for 135,000 shares of common stock (filed as
exhibit 10.27 to Registration Statement No.
33-92230 on Form S-1 and incorporated herein
by reference).
10.10 Form of Loan Agreement, dated June, 1995,
between the Company and Liraz regarding
Registrant's agreement to repay the principal
amount of $1,228,172 (filed as exhibit 10.28
to Registration Statement No. 33-92230 on
Form S-1 and incorporated herein by
reference).
10.11 Form of Loan Agreement, dated June, 1995,
between the Company and Liraz regarding
Registrant's agreement to repay the principal
amount of $628,172 (filed as exhibit 10.29 to
Registration Statement No. 33-92230 on Form
S-1 and incorporated herein by reference).
10.12 Development Agreement dated July 17, 1995
between Microsoft Corporation and the Company
(filed as exhibit 10.38 to Registration
Statement No. 33-92230 on Form S-1 and
incorporated herein by reference).
10.13 Letter Agreement dated June 1, 1995 from Visa
International Service Association to the
Company (filed as exhibit 10.39 to
Registration Statement No. 33-92230 on Form
S-1 and incorporated herein by reference).
10.14 Development Agreement dated December 19, 1995
between Liraz and the Company (filed as
exhibit 10.38 to Registration Statement No.
33-92230 on Form S-1 and incorporated herein
by reference).
10.14A Amendment No. 1 to the Development Agreement
dated December 15, 1995 between Liraz and the
Company (filed herewith).
10.15 Agreement and Plan of Reorganization by and
among the Company, Middleware Acquisition
Corporation, Momentum Software Corporation,
and Robert Brill, Bruns Grayson and Hubertus
Vandervoort, as Trustees of the Momentum
Liquidating Trust, on Behalf of the
Securityholders of Momentum Software
Corporation dated February 27, 1998 (filed as
exhibit 10.42 to the Company's Annual Report
on Form 10-K for the fiscal year ended
December 31, 1998 and incorporated herein by
reference).
10.16 Form of Employee's Non Competition,
Confidentiality and Invention Assignment
Agreement (filed as exhibit 10.6 to Seer's
Registration Statement No. 33-92050 on Form
S-1 and incorporated herein by reference).
10.17 Form of Consultant's Non Competition,
Confidentiality and Invention Assignment
(filed as exhibit 10-7 to Seer's Registration
Statement No. 33-92050 on Form S-1 and
incorporated herein by reference).
10.18 Lease Agreement, dated December 25, 1992,
between Seer Technologies, Inc. and Capital &
Counties (London, England) (filed as exhibit
10.22 to Seer' Registration Statement No.
33-92050 on Form S-1 and incorporated herein
by reference).
10.19 Employment Agreement between Steven
Dmiszewicki and the
-26-
Company dated December 4, 1998 (filed
herewith)*
10.20 Credit Agreement between Seer and Greyrock
Business Credit, dated March 26, 1997 (filed
as exhibit 10.46 to Seer's Quarterly Report
on Form 10-Q for the period ended March 31,
1997, No. 0-26194, and incorporated herein by
reference), as amended by the Amendment
thereto dated May 5, 1998 (filed as exhibit
10.53 and incorporated herein by reference).
10.21 Lease Amendment for Seer's Cary Office, dated
March 31, 1997, between Seer and Regency Park
Corporation (Cary, NC) (filed as exhibit
10.47 to Seer's Quarterly Report on Form 10-Q
for the period ended March 31, 1997, No.
0-26194, and incorporated herein by
reference), as amended by Addendum #1 thereto
added July 6, 1998 (filed as exhibit 10.58
and incorporated herein by reference).
10.21A Lease Amendment for Seer's Cary Office, dated
January 21, 1999, between Seer and Regency
Park Corporation (Cary, NC) (filed herewith).
10.22 Amendment to Credit Agreement between Seer
and Greyrock Business Credit, dated May 5,
1998 (filed as exhibit 10.53 to Seer's
Quarterly Report on Form 10-Q for the period
ended March 31, 1998, No. 0-26194, and
incorporated herein by reference; original
agreement is exhibit 10.46 to Seer's
Quarterly Report on Form 10-Q for the period
ended March 31, 1997, No. 0-26194, and
incorporated herein by reference).
10.23 Addendum #1 to the Lease Agreement between
Seer and Regency Park Corporation (Cary, NC),
dated July 6, 1998 (filed as exhibit 10.58 to
Seer's Quarterly Report on Form 10-Q for the
period ended June 30, 1998, No. 0-26194, and
incorporated herein by reference; original
agreement is exhibit 10.47 to Seer's
Quarterly Report on Form 10-Q for the period
ended March 31, 1997, No. 0-26194, and
incorporated herein by reference).
10.24 Amendment dated December 31, 1998 between
Greyrock Capital, a division of NationsCredit
Corporation (formerly Greyrock Business
Credit) and Seer to the Loan and Security
Agreement between Greyrock Business Credit
and Seer dated March 26, 1997, as amended
(filed as exhibit 10.60 to Seer's Annual
Report on Form 10-K for the year ended
September 30, 1998, No. 0-26194, and
incorporated herein by reference).
10.25 Level 8 Guaranty Agreement dated December 31,
1998 (filed as exhibit 10.1 to the Company's
Form 8-K filed as of January 15, 1999, No.
0-26392, and incorporated herein by
reference).
10.26 Level 8 Promissory Note dated December 31,
1998, in favor of Liraz Systems Ltd. in the
principal amount of $12,000,000 (filed as
exhibit 10.2 to the Company's Form 8-K filed
as of January 15, 1999, No. 0-26392, and
incorporated herein by reference).
10.27 Seer Promissory Note dated December 31, 1998,
in favor of Level 8 in the principal amount
of $12,000,000 (filed as exhibit 10.3 to the
Company's Form 8-K filed as of January 15,
1999, No. 0-26392, and incorporated herein by
reference).
10.28 Liraz Agreement dated December 31, 1998
(filed as exhibit 10.4 to the Company's Form
8-K filed as of January 15, 1999, No.
0-26392, and incorporated herein by
reference).
10.29 Amended and Restated Loan and Security
Agreement among Seer, the Company and
Greyrock Capital, a division of NationsCredit
Commercial Corporation, dated March 30, 1999
(filed herewith).
-27-
11.1 Statement Regarding Computation of Per Share
Earnings (filed herewith).
16.1 Letter from Lurie, Besikof, Lapidus and Co.,
LLP regarding change in certifying accountant
(filed as exhibit 1 to the Company's Form 8-K
filed as of January 28, 1998, No. 0-26392,
and incorporated herein by reference).
16.2 Letter from Grant Thornton LLP regarding
change in certifying accountant, dated
December 22, 1998 (filed as exhibit 16 to the
Company's Form 8-K filed as of December 22,
1998, No. 0-26392, and incorporated herein by
reference).
16.3 Letter from Grant Thornton LLP regarding
change in certifying accountant, dated
January 11, 1999 (filed as exhibit 99.2 to
the Company's Form 8-K/A filed as of January
11, 1999, No. 0-26392, and incorporated
herein by reference).
21.1 List of subsidiaries of the Company (filed
herewith).
23.1 Consent of PricewaterhouseCoopers LLP (filed
herewith).
27.1 Financial Data Schedule for Company (filed
herewith).
* Management contract or compensatory agreement.
(b) Reports on Form 8-K
On October 13, 1998, the Company filed a Form 8-K to announce that the
Company had entered into a license agreement with Microsoft Corporation. On
December 22, 1998, the Company filed a Form 8-K, and on January 11, 1999, the
Company filed a Form 8-K/A, to record the dismissal of its independent auditors,
Grant Thornton LLP. On January 15, 1999, the Company filed a Form 8-K to
announce the acquisition of 69% of the outstanding and issuable common stock of
Seer Technologies, Inc., and on January 21, 1999, the Company filed a Form 8-K
to announce the engagement of PricewaterhouseCoopers LLP as its independent
auditors.
-28-
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized.
LEVEL 8 SYSTEMS, INC.
By: /S/ ARIE KILMAN
---------------------------------------------
Arie Kilman
Chairman of the Board and Chief Executive Officer
Date: March 31, 1999
--------------------------------------------
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Date: March 31, 1999 /S/ ARIE KILMAN
------------------ -------------------------------------------------
Arie Kilman
Chairman of the Board and Chief Executive Officer
(Principal Executive Officer)
Date: March 31, 1999 /S/ STEVEN DMISZEWICKI
------------------ -------------------------------------------------
Chief Operating Officer (Principal Financial and
Accounting Officer)
Date: March 31, 1999 /S/ SAMUEL SOMECH
------------------ -------------------------------------------------
Samuel Somech
President and Director
Date: March 31, 1999 /S/ ROBERT M. BRILL
------------------ -------------------------------------------------
Robert M. Brill
Director
Date: March 31, 1999 /S/ MICHEL BERTY
------------------ -------------------------------------------------
Michel Berty
Director
Date: March 31, 1999 /S/ THEODORE FINE
------------------ -------------------------------------------------
Theodore Fine
Director
Date: March 31, 1999 /S/ LENNY RECANATI
------------------ -------------------------------------------------
Lenny Recanati
Director
Date: March 31, 1999 /S/ FRANK J. KLEIN
------------------ -------------------------------------------------
Frank J. Klein
Director
-29-
LEVEL 8 SYSTEMS, INC.
INDEX TO FINANCIAL STATEMENTS
Page No.
--------
Reports of Independent Accountants...................................... F-2
FINANCIAL STATEMENTS
Consolidated Balance Sheets............................................. F-5
Consolidated Statements of Operations................................... F-6
Consolidated Statements of Changes in Shareholders' Equity.............. F-7
Consolidated Statements of Cash Flows................................... F-8
Notes to Consolidated Financial Statements.............................. F-10
F-1
Report of Independent Accountants
-----------------
To the Shareholders of Level 8 Systems, Inc.
In our opinion, the accompanying consolidated balance sheet as of
December 31, 1998 and the related consolidated statements of operations,
changes in shareholders' equity and cash flows present fairly, in all
material respects, the financial position of Level 8 Systems, Inc. (the
"Company") and its subsidiaries at December 31, 1998 and the results of their
operations and their cash flows for the year then ended, in conformity with
generally accepted accounting principles. These financial statements are the
responsibility of the Company's management; our responsibility is to express
an opinion on these financial statements based on our audit. We conducted our
audit of these statements in accordance with generally accepted auditing
standards which 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, assessing
the accounting principles used and significant estimates made by management,
and evaluating the overall financial statement presentation. We believe that
our audit provides a reasonable basis for the opinion expressed above. The
financial statements of the Company as of December 31, 1997 and for the year
then ended and for the year ended December 31, 1996 were each audited by
other independent accountants whose reports, dated February 23, 1998 and
January 31, 1997, respectively, expressed unqualified opinions on those
statements.
As explained in Note 14, the Company has entered into certain agreements with
its primary shareholder, Liraz Systems, Ltd.
/s/ PricewaterhouseCoopers LLP
Washington, D.C.
March 31, 1999
F-2
Report of Independent Accountants
-----------------
Board of Directors
Level 8 Systems, Inc. and subsidiaries
We have audited the consolidated balance sheet of Level 8 Systems, Inc. and
subsidiaries as of December 31, 1997, and the related consolidated statements of
operations, shareholders' equity and cash flows for the year then ended. These
financial statements are the responsibility of the company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the 1997 financial statements referred to above present fairly,
in all material respects, the consolidated financial position of Level 8
Systems, Inc. and subsidiaries as of December 31, 1997, and the consolidated
results of their operations and their consolidated cash flows for the year then
ended, in conformity with generally accepted accounting principles.
/s/ Grant Thornton LLP
New York, New York
February 23, 1998 (except for Note 2, as to which the date is February 27, 1998
and Note 3, as to which the date is April 6, 1998)
F-3
Independent Auditor's Report
-----------------
Shareholders and Board of Directors
Level 8 Systems, Inc.
We have audited the accompanying consolidated statements of operations, changes
in shareholders' equity, and cash flows of Level 8 Systems, Inc. for the year
ended December 31, 1996. These financial statements are the responsibility of
the company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatements. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated results of their operations and their
cash flows of Level 8 Systems, Inc. for the year ended December 31, 1996, in
conformity with generally accepted accounting principles.
/s/ Lurie, Besikof, Lapidus & Co., LLP
Minneapolis, Minnesota
January 31, 1997, (except for Note 3, as to which the date is April 6, 1998)
F-4
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
December 31, December 31,
1998 1997
-------- --------
ASSETS
Cash and cash equivalents $ 6,078 $ 7,062
Trade accounts receivable, less allowance for doubtful accounts 16,992 6,455
Note receivable for sale of subsidiary 2,000 --
Due from related party 271 --
Income taxes receivable -- 406
Inventory -- 336
Prepaid expenses and other current assets 2,606 421
Net assets from discontinued operations -- 3,577
-------- --------
Total current assets 27,947 18,257
Property and equipment, net 2,682 974
Goodwill and other intangibles, net 32,217 1,793
Capitalized software costs, net 6,753 2,168
Other assets 1,171 290
-------- --------
Total assets $ 70,770 $ 23,482
-------- --------
-------- --------
LIABILITIES AND SHAREHOLDERS' EQUITY
Notes payable, due on demand $ 12,275 $ --
Current maturities of loan from related party 628 128
Current maturities of long-term debt 799 7
Accounts payable 3,691 1,936
Accrued expenses:
Compensation 318 82
Commissions 1,021 17
Restructuring 973 --
Merger - related 4,803 --
Other 8,275 125
Due to related party 82 --
Customer deposits and deferred revenue 13,075 42
Deferred taxes -- 94
Income taxes payable 1,781 --
-------- --------
Total current liabilities 47,721 2,431
Deferred revenue 97 --
Long-term debt, net of current maturities 1,541 16
Loan from related party, net of current maturities 12,519 202
Deferred income taxes -- 462
-------- --------
Total liabilities 61,878 3,111
-------- --------
Commitments and contingencies (Notes 16 and 17)
Shareholders' equity:
Preferred stock, $0.01 par value, 1,000,000 shares authorized;
no shares issued or outstanding at December 31, 1998 and 1997 -- --
Common stock, $0.01 par value, 15,000,000 shares authorized;
8,708,231 and 7,044,634 shares issued and outstanding at
December 31, 1998 and 1997, respectively 87 70
Additional paid-in-capital 34,045 20,603
Accumulated deficit (25,240) (184)
Accumulated other comprehensive income -- (118)
-------- --------
Total shareholders' equity 8,892 20,371
-------- --------
Total liabilities and shareholders' equity $ 70,770 $ 23,482
-------- --------
-------- --------
The accompanying notes are an integral part of the consolidated
financial statements.
F-5
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
For the Years Ended
December 31,
1998 1997 1996
-------- -------- --------
Operating revenue:
Software products $ 1,552 $ 4,354 $ 1,485
Services 9,133 10,171 5,521
Other -- 155 266
-------- -------- --------
Total operating revenue 10,685 14,680 7,272
Cost of revenue:
Software products 2,060 2,554 1,422
Services 5,973 4,995 3,056
Other -- 40 39
-------- -------- --------
Total cost of revenue 8,033 7,589 4,517
Gross profit 2,652 7,091 2,755
Operating expenses:
Research and product development 2,111 1,057 531
Selling, general and administrative 9,777 4,473 2,966
Amortization of goodwill and other intangibles 1,933 422 422
Purchased in-process research and development 5,892 -- --
Write-off of goodwill and other intangibles 4,601 -- --
Restructuring charge 1,540 -- --
-------- -------- --------
Total operating expenses 25,854 5,952 3,919
-------- -------- --------
Income (loss) from operations (23,202) 1,139 (1,164)
Other income (expense):
Interest income 283 410 170
Gain on sale of ASU -- 60 --
Interest expense (364) (20) (25)
-------- -------- --------
Other income (expense), net (81) 450 145
-------- -------- --------
Income (loss) from continuing operations before provision
for income taxes (23,283) 1,589 (1,019)
Income tax provision (benefit) 405 553 (174)
-------- -------- --------
Income (loss) from continuing operations (23,688) 1,036 (845)
Income (loss) from discontinued operations, net of tax (135) 53 (40)
Gain (loss) on disposal of discontinued operations, net of tax (1,233) -- (1,484)
-------- -------- --------
Net income (loss) $(25,056) $ 1,089 $ (2,369)
-------- -------- --------
-------- -------- --------
Income (loss) per share from continuing operations - basic $ (3.14) $ 0.15 $ (0.14)
Income (loss) per share from discontinued operations - basic $ (0.18) $ 0.01 $ (0.25)
-------- -------- --------
Total income (loss) per common share - basic $ (3.32) $ 0.16 $ (0.39)
-------- -------- --------
-------- -------- --------
Income (loss) per share from continuing operations - diluted $ (3.14) $ 0.13 $ (0.14)
Income (loss) per share from discontinued operations - diluted $ (0.18) $ 0.01 $ (0.25)
-------- -------- --------
Total income (loss) per common share - diluted $ (3.32) $ 0.14 $ (0.39)
-------- -------- --------
-------- -------- --------
Weighted average common shares outstanding - basic 7,552 6,992 6,076
Weighted average common shares outstanding - diluted 7,552 7,561 6,076
The accompanying notes are an integral part of the consolidated
financial statements.
F-6
LEVEL 8 SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
(in thousands)
Additional Retained
Common Stock Paid-In Earnings
Shares Amount Capital (Deficit)
------------ ------------ ------------ -----------
Balance as of 12/31/95 5,922 $ 59 $ 10,371 $ 1,096
Common Stock
Private investor 247 2 2,607
Public offering 705 7 6,470
Stock option exercises 81 1 58
Cumulative translation adjustment
Adjustment of unearned compensation
Net loss (2,369)
----- -------- -------- --------
Balance as of 12/31/96 6,955 69 19,506 (1,273)
Stock option and warrant exercises 90 1 507
Additional public offering costs (137)
Net income 464
Unearned compensation related to
issuance of non-employee stock options 263
Adjustment of unearned compensation
Net income 1,089
----- -------- -------- --------
Balance as of 12/31/97 7,045 70 20,603 (184)
Shares issued for Momentum 595 6 6,480
Shares issued for Seer 1,000 10 6,088
Warrants issued for Momentum 654
Warrants issued for Seer 280
Stock option and warrant exercises 68 1 58
Adjustment of unearned compensation (118)
Net loss (25,056)
----- -------- -------- --------
Balance as of 12/31/98 8,708 $ 87 $ 34,045 $(25,240)
----- -------- -------- --------
----- -------- -------- --------
Accumulated
Other
Comprehensive
Income Total
------------ --------
Balance as of 12/31/95 $ (28) $ 11,498
Common Stock
Private investor 2,609
Public offering 6,477
Stock option exercises 59
Cumulative translation adjustment (5) (5)
Adjustment of unearned compensation 30 30
Net loss (2,369)
-------- --------
Balance as of 12/31/96 (3) 18,299
Stock option and warrant exercises 508
Additional public offering costs (137)
Net income 464
Unearned compensation related to
issuance of non-employee stock options (263) --
Adjustment of unearned compensation 148 148
Net income 1,089
-------- --------
Balance as of 12/31/97 (118) 20,371
Shares issued for Momentum 6,486
Shares issued for Seer 6,098
Warrants issued for Momentum 654
Warrants issued for Seer 280
Stock option and warrant exercises 59
Adjustment of unearned compensation 118 --
Net loss (25,056)
-------- --------
Balance as of 12/31/98 $ -- $ 8,892
-------- --------
-------- --------
The accompanying notes are an integral part of the consolidated
financial statements.
F-7
LEVEL 8 SYSTEMS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
For the Years Ended
December 31,
1998 1997 1996
-------- -------- --------
Cash flows from operating activities:
Net income (loss) $(25,056) $ 1,089 $ (2,369)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities, net of assets
and liabilities acquired:
(Income) loss from discontinued operations 135 (53) 40
(Gain) loss on sale of businesses 1,233 (60) 1,484
Depreciation and amortization 3,175 788 458
Deferred income taxes (129) 281 90
Provision for uncollectible accounts 838 332 165
Loss on disposal of property 407 -- --
Purchased in-process research and development 5,892 -- --
Write-off of goodwill and other intangibles 4,601 -- --
Write-down of capitalized software costs 723 -- --
Other -- 120 --
Changes in assets and liabilities:
Trade accounts receivable 3,255 (4,376) (1,969)
Prepaid expenses and other assets (755) (156) (616)
Net assets of discontinued operations -- 507 726
Accounts payable, accrued expenses,
and income taxes payable 2,450 969 930
Customer deposits and deferred revenue 4,888 42 --
-------- -------- --------
Net cash provided by (used in) operating 1,657 (517) (1,061)
activities
Cash flows from investing activities:
Cash received from acquisitions 916 -- --
Cash expenditures for acquisitions (484) -- --
Proceeds from sales of subsidiaries 464 65 157
Change in net assets of discontinued operations -- (888) (1,191)
Purchase of marketable securities -- (1,998) (6,525)
Redemption of marketable securities -- 8,523 2,045
Employee advances (repayments) -- -- (102)
Purchases of property and equipment (941) (516) (413)
Capitalization of software development costs (1,177) (1,156) (1,182)
-------- -------- --------
Net cash provided by (used in) investing (1,222) 4,030 (7,211)
activities
Cash flows from financing activities:
Issuance of common shares 59 507 10,529
Costs of issuance of common shares -- (137) (1,383)
Change in net assets of discontinued operations -- (7) (39)
Payments under capital lease obligations (45) -- --
Borrowings from related party 12,000 -- --
Payments on loans to related party (683) (123) (118)
Paydown of line of credit (12,000) -- --
Payment on other long-term debt (750) (9) (10)
-------- -------- --------
Net cash provided by (used in) financing activities (1,419) 231 8,979
Net increase (decrease) in cash and cash equivalents (984) 3,744 707
Cash and cash equivalents:
Beginning of period 7,062 3,318 2,611
-------- -------- --------
End of period $ 6,078 $ 7,062 $ 3,318
-------- -------- --------
Supplemental disclosures of cash flow information:
Cash paid during the period for:
Income taxes $ -- $ 11 $ 92
-------- -------- --------
-------- -------- --------
Interest $ 293 $ 20 $ 25
-------- -------- --------
-------- -------- --------
Noncash Investing and Financing Activities
The accompanying notes are an integral part of the consolidated
financial statements.
F-8
CONSOLIDATED STATEMENTS OF CASH FLOW
(continued)
(in thousands, except share and per share data)
During 1998, the Company acquired all of the common stock of Momentum Software
Corporation ("Momentum") for approximately $10,717. In connection with the
acquisition, the Company issued 594,866 shares of common stock, warrants to
purchase an additional 200,000 shares of common stock, and a $3,000 note. See
Note 2.
A reconciliation of the cost of the acquisition to the net cash received from
the acquisition is as follows:
Fair value of :
Assets received $ 11,703
Liabilities assumed (986)
Additional direct costs (503)
Stock issued (6,485)
Warrants issued (654)
Note payable issued (3,000)
--------
Cash paid 75
Cash acquired 437
--------
Net cash received
from acquisition $ 362
--------
--------
During 1998, the Company acquired 69% of the voting stock of Seer Technologies,
Inc. ("Seer") for approximately $7,754. In connection with the acquisition, the
Company issued 1,000,000 shares of common stock and warrants to purchase an
additional 250,000 shares of common stock. See Note 2.
A reconciliation of the cost of the acquisition to the net cash received from
the acquisition is as follows:
Fair value of :
Assets received $ 55,081
Liabilities assumed (47,327)
Additional direct costs (966)
Stock issued (6,099)
Warrants issued (280)
--------
Cash paid 409
Cash acquired 479
--------
Net cash received
from acquisition $ 70
--------
--------
During 1998, the Company renegotiated a royalty arrangement with its majority
shareholder. The arrangement was financed through a $1,500 note. See Note 14.
During 1998, the Company sold its subsidiary ProfitKey International, Inc. in
exchange for $464 in cash at closing and a $2,000 note receivable. See Note 3.
During 1997, the Company acquired certain computer equipment through the
issuance of capital leases totaling $60.
During 1997, the Company recognized deferred unearned compensation expense
related to the issuance of nonemployee stock options totaling $25.
During 1997, the Company sold its ASU consulting division for $65, resulting
in a gain of $60. See note 3.
During 1996, the Company sold its subsidiary Bizware in exchange for $120 in
cash at closing and a $110 note receivable. See Note 3.
The accompanying notes are an integral part of the consolidated
financial statements.
F-9
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
NOTE 1. SUMMARY OF OPERATIONS, SIGNIFICANT ACCOUNTING POLICIES, AND RECENT
ACCOUNTING PRONOUNCEMENTS OPERATIONS
Level 8 Systems, Inc. ("Level 8" or the "Company") is a premier provider of
scaleable enterprise application integration solutions through a combination of
technologies and services that enable organizations to meet their information
systems integration and management needs.
Liraz Systems, Ltd. and its wholly-owned subsidiaries own approximately 57% of
Level 8's outstanding common stock at December 31, 1998.
PRINCIPLES OF CONSOLIDATION
The accompanying consolidated financial statements include the accounts of the
Company and its subsidiaries. See Notes 2 and 3 regarding the acquisitions and
sales of subsidiaries. All of the Company's subsidiaries are wholly-owned except
for Seer Technologies, Inc. ("Seer"). The Company acquired a 69% interest in
Seer on December 31, 1998. Seer had net liabilities of $24,535 at the
acquisition date. The shareholders of the remaining 31% of the outstanding
voting stock were deemed to have shared in the losses of Seer only for their
proportionate share of Seer's net assets. Accordingly, there is no minority
interest for the Seer subsidiary reflected in the consolidated balance sheet at
December 31, 1998. Because the acquisition occurred on December 31, 1998, the
consolidated statement of operations does not include Seer's operations for
1998.
All significant intercompany accounts and transactions are eliminated in
consolidation.
FOREIGN CURRENCY TRANSLATION
The assets and liabilities of foreign subsidiaries of Seer are translated to
U.S. dollars at the current exchange rate as of the balance sheet date.
Statements of operations items are translated at average rates of exchange
during each reporting period.
REVENUE RECOGNITION
Effective January 1, 1998, the Company adopted Statement of Position 97-2,
"Software Revenue Recognition" ("SOP 97-2"),as amended by Statement of
Position 98-4 "Deferral of the Effective Date of Certain Provisions of SOP
97-2." SOP 97-2 requires each element of a software sale arrangement to be
separately identified and accounted for based on the relative fair value of
such element. Revenue cannot be recognized on any element of the sale
arrangement if undelivered elements are essential to the functionality of the
delivered elements.
Adoption of SOP 97-2 resulted in the deferral of license revenue of
approximately $262. In addition, the unique nature of a significant contract
resulted in the deferral of $3,700 of software revenue as of December 31, 1998.
At least a portion of the license revenue for these contracts may have been
recognized under SOP 91-1 "Software Revenue Recognition" which was effective
in previous years.
Statement of Position 98-9, "Modification of SOP 97-2, 'Software Revenue
Recognition,' with Respect to Certain Transactions" ("SOP 98-9") will be
effective for the Company's fiscal year beginning January 1, 1999. Retroactive
application is prohibited. SOP 98-9 amends SOP 97-2 to require that an entity
recognize revenue for multiple element arrangements by means of the "residual
method" when (1) there is vendor-specific objective evidence ("VSOE") of the
fair values of all of the undelivered elements that are not accounted for by
means of long-term contract accounting, (2) VSOE of fair value does not exist
for one or more of the delivered elements, and (3) all revenue recognition
criteria of SOP 97-2 (other than the requirement for VSOE of the fair value of
each delivered element) are satisfied. The provisions of SOP 98-9 that extend
the deferral of certain passages of SOP 97-2 became effective December 15, 1998.
The Company is evaluating the future requirements of SOP 98-9 and the effects,
if any, on the Company's current revenue recognition policies.
Revenue from recurring maintenance contracts is recognized ratably over the
maintenance contract period, which is typically twelve months. Maintenance
revenue that is not yet earned is included in deferred revenue.
Revenue from consulting and training services is recognized as services are
performed. Any unearned receipts from service contracts result in deferred
revenue.
F-10
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
COST OF REVENUE
The primary components of the Company's cost of revenue for its software
products are packaging and distribution costs, software amortization and
royalties. The primary component of the Company's cost of revenue for services
is compensation expense.
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include all cash balances and highly liquid
investments with a maturity of three months or less from the date of purchase.
For these instruments, the carrying amount is considered to be a reasonable
estimate of fair value. The Company places substantially all cash and cash
equivalents with various financial institutions in both the United States and
several foreign countries. At times, such cash and cash equivalents may be in
excess of FDIC insurance limits.
INVENTORY
Inventory is valued at the lower of cost (first-in, first-out) or market and
consists of software held for resale.
NET ASSETS OF DISCONTINUED OPERATIONS
As of December 31, 1997, net assets of discontinued operations of ProfitKey
International, Inc. ("ProfitKey") consist primarily of service contracts
acquired, software development costs, and accounts receivable. On April 6, 1998,
the Company sold substantially all assets and operations of ProfitKey. See Note
3.
DEFERRED COSTS
At December 31, 1997, the Company had deferred costs of $178 relating to the
acquisition of Momentum. The deferred acquisition costs were recorded as part of
the purchase price of the acquisition during 1998.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost and depreciated using the straight-line
method over the estimated useful lives of the related assets as follows:
Leasehold improvements The lesser of the lease term
or estimated useful life
Furniture and fixtures 3 to 5 years
Office equipment 3 to 5 years
Computer equipment 3 to 5 years
Expenditures for repairs and maintenance are charged to expense as incurred. The
cost and related accumulated depreciation of property and equipment are removed
from the accounts upon retirement or other disposition and any resulting gain or
loss is reflected in operations.
F-11
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
SOFTWARE DEVELOPMENT COSTS
The Company capitalizes certain software costs after technological feasibility
of the product has been established. The establishment of technological
feasibility and the ongoing assessment of recoverability of capitalized software
development costs requires considerable judgment by management with respect to
certain external factors, including, but not limited to, technological
feasibility, anticipated future gross revenue, estimated economic life and
changes in software and hardware technologies.
Capitalized software costs are amortized over related sales on a
product-by-product basis at the greater of the amount computed using (a) the
ratio of current gross revenues for a product to the total of current and
anticipated future gross revenues or (b) the straight-line method over the
remaining estimated economic life of the product. Generally, an original
estimated economic life of three years is assigned to capitalized software
costs, once the product is available for general release to customers. Costs
incurred prior to the establishment of technological feasibility are charged to
research and development expense. Each quarter, the Company evaluates the value
of its capitalized software costs based on the estimated discounted future cash
flows. See Note 6.
EXCESS OF COST OVER NET ASSETS OF BUSINESS ACQUIRED
Excess of Cost over Net Assets of Business Acquired consists of both
identifiable and unidentifiable assets (goodwill) and is amortized on a
straight-line basis over periods from three to seven years. The Company
periodically assesses the recoverability of intangible assets by determining
whether the amortization of the balance over its remaining life can be recovered
through undiscounted future operating cash flows of the related operations. See
Note 7.
COMPREHENSIVE INCOME
During 1998 the Company adopted SFAS No. 130 "Reporting Comprehensive
Income." SFAS No. 130 requires additional disclosures with respect to certain
changes in assets and liabilities that previously were not required to be
reported as results of operations for the period. All prior periods have been
presented to conform with the provisions of the statement. Other components
of comprehensive income are included in the consolidated statement of
shareholders' equity and consist of foreign currency translation adjustments
and unearned compensation related to option grants to non-employees.
ADVERTISING EXPENSES
The Company expenses advertising costs as incurred. Sales brochures and
materials are carried as prepaid expenses until they are consumed or determined
to be obsolete. Advertising expenses were approximately $770, $358, and $154,
for the years ended December 31, 1998, 1997 and 1996, respectively.
RESEARCH AND PRODUCT DEVELOPMENT
Research and product development costs are expensed as incurred.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT
The fair value of acquired in-process research and development ("IPR&D")
projects acquired in business combinations is expensed immediately. The amount
of purchase price allocated to IPR&D is determined based on independent
appraisals obtained by the Company using appropriate valuation techniques,
including percentage-of-completion which utilizes the key milestones to estimate
the stage of development of each project at the date of acquisition, estimating
cash flows resulting from the expected revenue generated from such projects, and
discounting the net cash flows back to their present value. The discount rate
includes a factor that takes into account the uncertainty surrounding the
successful development of the purchased in-process technology. At the respective
dates of acquisition, the IPR&D projects had not yet reached technological
feasibility and did not have alternative future uses. As discussed in Note 2,
material risks existed with each IPR&D project, however, management expects that
such projects will be completed.
INCOME TAXES
The Company uses Statement of Financial Accounting Standards ("SFAS") No.
109, "Accounting for Income Taxes" to account for income taxes. This
statement requires an asset and liability approach that recognizes deferred
tax assets and liabilities for the expected future tax consequences of events
that have been recognized in the Company's financial statements or tax
returns. In estimating future tax consequences, all expected future events
other than enactments of changes in the tax law or rates are generally
considered. A valuation allowance is recorded when it is "more probable than
not" that recorded deferred tax assets will not be realized.
F-12
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
any potentially dilutive securities. Potentially dilutive securities outstanding
during 1998, 1997 and 1996 include stock options and warrants to purchase common
stock of the Company.
STOCK-BASED COMPENSATION
The Company has adopted the disclosure provisions of SFAS 123 and has applied
Accounting Principles Board Opinion No. 25 and related Interpretations in
accounting for its stock-based compensation plans. Accordingly, no compensation
cost has been recognized in the Consolidated Statement of Operations for its
stock option plans.
See Note 10.
ACCOUNTING 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 amounts could differ from these estimates.
RECLASSIFICATIONS
Certain prior year amounts in the accompanying financial statements have been
reclassified to conform to the 1998 presentation. Such reclassifications had no
effect on previously reported net income or shareholders' equity.
NOTE 2. ACQUISITIONS AND PRO FORMA FINANCIAL STATEMENTS
ACQUISITION OF MOMENTUM
On March 26, 1998, the Company acquired Momentum Software Corporation
("Momentum"). Under the agreement, Level 8 issued 594,866 shares of common stock
and warrants to purchase 200,000 common shares at an exercise price of $13.108
per share. During the fourth quarter of 1998, the Company issued a $3,000 note
as additional consideration as provided in the purchase agreement. The total
cost of the acquisition was approximately $10,717. The acquisition was recorded
utilizing purchase accounting. As a result of the acquisition of Momentum, the
Company incurred a one-time charge to earnings of approximately $1,200 related
to the estimated value of the purchase of in-process research and development
costs. The remaining amount was allocated to other intangibles, goodwill and
software development costs. The results of operations of Momentum are included
in the financial statements since the date of acquisition.
The purchase price was allocated to the assets acquired and liabilities
assumed based on the Company's estimates of fair value at the acquisition
date. The fair value assigned to intangible assets acquired was based on a
valuation prepared by an independent third-party appraisal company of the
purchased in-process research and development, developed technology, and
assembled workforce of Momentum. The purchase price exceeded the amounts
allocated to tangible and intangible assets acquired less liabilities assumed
by approximately $8,615. This excess of the purchase price over the fair
values of assets acquired less liabilities assumed was allocated to goodwill.
The cost of the acquisition was allocated as follows:
Cash $ 437
Accounts receivable 125
Prepaid expenses and other current assets 52
Property and equipment 174
In-process research and development 1,200
Developed technology 1,100
Goodwill 8,615
Accounts payable (507)
Deferred revenue (367)
Long-term debt (112)
--------
Cost of net assets acquired $ 10,717
--------
--------
Approximately $1,200 of the purchase price represents purchased in-process
research and development that had not yet reached technological feasibility
and had no alternative future use. Accordingly, this amount was immediately
expensed in the Consolidated Statement of Operations upon consummation of the
acquisition. The value assigned to in-process research and development, based
on a valuation prepared by an independent third-party appraisal company, was
determined by identifying research projects, all of which related to either
add-ons or enhancements of Momentum's
F-13
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
existing XIPC product, in areas for which technological feasibility had not
been established. The value of the in-process projects was adjusted to
reflect the relative value and contributions of the required research and
development. In doing so, consideration was given to the stage of completion,
the complexity of the work completed to date, the difficulty of completing
the remaining development costs already incurred, and the projected cost to
complete the projects. The discount rate included a factor that takes into
account the uncertainty surrounding successful development of the purchased
in-process research and development.
ACQUISITION OF SEER TECHNOLOGIES, INC.
On December 31, 1998, the Company, as the first step in its pending
acquisition of the entire equity interest in Seer, acquired beneficial
ownership of approximately 69% of the outstanding voting stock of Seer, which
was held by Welsh, Carson, Anderson and Stowe VI L.P. ("WCAS") and certain
other parties affiliated or associated with WCAS ("WCAS Parties") in exchange
for 1,000,000 shares of the Company common stock and warrants to purchase an
additional 250,000 shares of the Company common stock at an exercise price of
$12.00 per share. The total cost of the acquisition was $7,754 and has been
accounted for by the purchase method of accounting. Because the net book
value of Seer's liabilities exceeded its assets on the acquisition date, no
minority interest in Seer was recorded. Because the acquisition occurred on
December 31, 1998, there are no operations of Seer included in the Company's
consolidated results of operations for the periods presented. The purchase
price was allocated to the assets acquired and liabilities assumed based on
the Company's estimates of fair value at the acquisition date. The fair value
assigned to intangible assets acquired was based on a valuation prepared by
an independent third-party appraisal company of the purchased in-process
research and development, developed technology, installed customer base,
assembled workforce, and trademarks of Seer. The purchase price exceeded the
amounts allocated to tangible and intangible assets acquired less liabilities
assumed by approximately $18,684. This excess of the purchase price over the
fair values of assets acquired less liabilities assumed was allocated to
goodwill.
The cost of the acquisition was allocated as follows:
Cash $ 479
Accounts receivable 14,505
Prepaid expenses and other current assets 1,418
Property and equipment 1,614
Capitalized software and developed technology 3,659
In-process research and development 4,692
Goodwill and other intangibles 28,344
Other assets 370
Accounts payable (1,949)
Accrued expenses and other liabilities (13,228)
Deferred revenue (7,875)
Notes payable, due on demand (12,275)
Long-term debt (12,000)
--------
Cost of net assets acquired $ 7,754
--------
--------
Approximately $4,692 of the purchase price represents purchased in-process
research and development that had not yet reached technological feasibility
and had no alternative future use. Accordingly, this amount was immediately
expensed in the Consolidated Statement of Operations upon consummation of the
acquisition. The value assigned to in-process research and development, based
on a valuation prepared by an independent third-party appraisal company, was
determined by identifying research projects in areas for which technological
feasibility had not been established, including Java based projects ($3,105)
and application warehousing projects ($1,587). The value of the in-process
projects was adjusted to reflect the relative value and contributions of the
required research and development. In doing so, consideration was given to
the stage of completion, the complexity of the work completed to date, the
difficulty of completing the remaining development costs already incurred,
and the projected cost to complete the projects. The discount rate included a
factor that takes into account the uncertainty surrounding successful
development of the purchased in-process research and development.
In connection with the Company's purchase of Seer's capital stock from the WCAS
Parties, WCAS contributed approximately $17 million to Seer and the Company
provided a $12 million subordinated loan to Seer to pay down Seer's bank debt.
The funds used by the Company to make the subordinated loan to Seer were
obtained from Liraz Systems Ltd. ("Liraz"), a principal shareholder of the
Company. See Note 8. The Company also has agreed to use its best efforts to
acquire all the remaining shares of Seer's outstanding common stock and has
commenced a tender offer. See Note 19.
In connection with the acquisition of 69% of Seer on December 31, 1998, the
Company and Liraz agreed that the Company would effect a pro rata offering to
its shareholders of shares of preferred stock intended to have an aggregate
liquidation preference initially equal to the principal and accrued interest
under the note and to be convertible into an aggregate number of common stock
determined utilizing an agreed-upon pricing formula. The preferred stock would
be redeemable at the Company's option at any time after June 30, 2000, upon at
least 30 days' notice, at a redemption price equal to the preferred stock's
accreted liquidation preference. The purchase price for each share of preferred
stock to be offered to the Company's shareholders would equal its initial
liquidation preference. Liraz would be permitted to pay the purchase price for
any preferred stock it purchases in the offering with cash or by reducing the
amount payable to it under
F-14
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
the $12 million note. If the rights offering is consummated before June 30,
1999, the Company is required to use the net proceeds of the rights offering to
prepay the unpaid balance under the $12 million note. In the context or
reviewing other financing alternatives, the Company and Liraz are currently
reevaluating the proposed rights offering and may determine not to proceed with
the rights offering.
Under the agreement between Company and the WCAS Parties, the WCAS Parties
agreed that, prior to January 1, 2001, at any meeting of shareholders of the
Company, WCAS Parties shall grant a proxy to one or more individuals named by
the Company to vote all of the WCAS Parties' shares of common stock acquired by
the WCAS Parties in connection with the transaction. Also, subject to limited
exceptions, prior to January 1, 2001, the WCAS Parties may not sell, exchange or
otherwise assign any of its shares of the Company without the prior written
consent of the Company.
The following unaudited pro forma results of continuing operations assume the
transactions described above occurred as of January 1, 1997 after giving effect
to certain adjustments, including amortization of the excess of cost over
underlying net assets.
1998 1997
--------- ---------
Net sales $ 67,473 $ 118,146
Net loss from continuing operations before income
taxes and extraordinary items (58,994) (14,844)
Net loss (81,145) (15,770)
Loss per share - basic and diluted (9.34) (1.84)
Weighted average shares outstanding - basic and diluted 8,688 8,587
The pro forma financial information does not purport to be indicative of the
results of operations which would have actually resulted had the transactions
taken place at the beginning of the periods presented or of future results of
operations.
NOTE 3. DISCONTINUED OPERATIONS
In recent years, the Company has disposed of several wholly-owned subsidiaries.
From October 3, 1994 through the first quarter of 1998, the Company's operations
included the operations of ProfitKey International, Inc. ("ProfitKey").
ProfitKey offered turnkey manufacturing resource planning and scheduling
software packages, and related installation, training and support services for
use by manufacturing businesses. From October 28, 1994 through September 9,
1996, the Company's operations included the operations of Bizware Computer
Systems (Canada) Inc. ("Bizware"). Bizware sold software packages that provided
cost information used by the petroleum and retail industries to manage and
control individual retail outlets and groups of outlets.
Income from discontinued operations consists of the following items for the
years ended December 31:
1998 1997 1996
------- ------- -------
Net income (loss) of ProfitKey $ (135) $ 53 $ 132
Net loss of Bizware -- -- (172)
Loss on disposal of ProfitKey, net of tax (1,233) -- --
Loss on disposal of Bizware, net of tax -- (1,484)
------- ------- -------
Total $(1,368) $ 53 $(1,524)
------- ------- -------
------- ------- -------
SALE OF PROFITKEY
On April 6, 1998, the Company sold substantially all assets and operations of
ProfitKey for $464 at closing and a note receivable from the purchaser of
$2,000. The note is due on April 6, 2000 and bears interest at 9%. According to
the terms of the ProfitKey sale agreement, the purchase price is subject to
adjustment to reflect any variance in working capital from a specified amount.
The purchaser has notified the Company that it believes there are adjustments
totaling $1,466 which would require a reduction in the purchase price. The
Company intends to vigorously contest this claim and has made provision for its
estimate of the purchase price adjustment and the costs to resolve this matter
as part of discontinued operations. Management believes at this time that any
additional provisions required to ultimately resolve
F-15
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
this matter will not have a material effect on the financial position, cash
flows, or results of operations of the Company. The Company recorded a net loss
from the sale of ProfitKey of $1,233.
The disposition of ProfitKey was accounted for as a discontinued operation and,
accordingly, prior periods have been restated. Results of the discontinued
operations of ProfitKey consisted of the following for the years ended December
31:
1998 1997 1996
------- ------- -------
Net sales $ 1,156 $ 5,545 $ 5,441
Income (loss) from operations before tax (225) 191 345
Income tax expense (benefit) (90) 138 213
Income (loss) from discontinued operations $ (135) $ 53 $ 132
For 1998, discontinued operations of ProfitKey includes ProfitKey's results of
operations through the date of sale.
SALE OF BIZWARE
On September 9, 1996, the Company sold substantially all the assets and
operations of Bizware for $120 at closing and a note receivable from the
purchaser for $110. The note receivable was due in six equal monthly
installments and has been fully collected by December 31, 1998. The Company
recorded a loss from the sale of Bizware of $1,484, net of taxes of $0.
The disposition of Bizware was accounted for as a discontinued operation.
Results of the discontinued operations of Bizware consisted of the following for
the year ended December 31:
1996
-----
Net sales $ 363
Loss from operations before tax (358)
Income tax benefit (186)
Loss from discontinued operations $(172)
For 1996, discontinued operations of Bizware includes Bizware's results of
operations through the date of sale.
SALE OF ASU
Effective December 31, 1997, the Company sold the business and related assets of
the ASU Consulting division for $65, resulting in a gain of $60 for the year
ended December 31, 1997. The sale of the ASU Consulting division was not
accounted for as a discontinued operation.
NOTE 4. ACCOUNTS RECEIVABLE
Trade accounts receivable consists of the following at December 31:
1998 1997
-------- --------
Current trade accounts receivable $ 20,244 $ 6,889
Less: Allowance for doubtful accounts (3,252) (434)
-------- --------
$ 16,992 $ 6,455
-------- --------
-------- --------
Approximately $4,165 and $1,050 of current trade receivables were unbilled at
December 31, 1998 and 1997, respectively. There were no receivables with payment
terms in excess of one year recorded during the fiscal year ended December 31,
1998.
During 1998, the Company acquired certain trade receivables, net of allowances
for doubtful accounts, in conjunction with its acquisition of Momentum and Seer.
See Note 2.
F-16
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
The provision for uncollectible amounts was $838, $332 and $165 for the years
ended December 31, 1998, 1997, and 1996, respectively. Write-offs of accounts
receivable were $736, $95, and $43 for the years ended December 31, 1998, 1997,
and 1996, respectively.
NOTE 5. PROPERTY AND EQUIPMENT
Property and equipment consists of the following at December 31:
1998 1997
------- -------
Computer equipment $ 1,922 $ 957
Furniture and fixtures 286 239
Office equipment 312 174
Leasehold improvements 544 51
------- -------
Subtotal 3,064 1,421
Less accumulated depreciation and amortization (382) (447)
------- -------
Total $ 2,682 $ 974
------- -------
Depreciation and amortization expense was $426, $228, and $36 for the fiscal
years ended December 31, 1998, 1997, and 1996, respectively.
During the fourth quarter of fiscal year 1998, property and equipment was
written down for obsolescence and retirement of assets based in part on the
Company's restructured operations. The write-down totaled $595, of which $188 is
included in the restructuring charges in the Consolidated Statement of
Operations. See Note 15.
NOTE 6. CAPITALIZED SOFTWARE COSTS
For the fiscal years ended December 31, 1998, 1997 and 1996, the Company
capitalized $1,177, $1,156, and $1,182, respectively, of internal costs related
to developing software for sale. The Company also acquired $1,100 and $3,659 in
capitalized software costs through its acquisitions of Momentum and Seer,
respectively. During the fiscal years ended December 31, 1998, 1997 and 1996,
the Company recognized $816, $137, and $0, respectively, of expense related to
the amortization of these costs, which is recorded as cost of software in the
Consolidated Statements of Operations. During the first and fourth quarters of
fiscal year 1998, capitalized software cost was written down to its fair value
based upon an evaluation of its net realizable value. The write downs totaled
$535, of which $241 is included in the restructuring charges in the Consolidated
Statement of Operations. Accumulated amortization of capitalized software costs
is $606 and $121 at December 31, 1998 and 1997, respectively.
NOTE 7. IDENTIFIABLE AND UNIDENTIFIABLE INTANGIBLE ASSETS
Identifiable and unidentifiable intangible assets primarily include goodwill,
existing customer base, assembled workforce and trademarks recorded in
connection with the acquisition of Seer Technologies on December 31, 1998. This
goodwill is being amortized using the straight-line method over seven years.
Also included are goodwill amounts acquired in the purchase of Momentum Software
on March 26, 1998 and Level 8 Technologies on April 1, 1995. These assets are
being amortized over three years and seven years, respectively. At December 31,
1998 and 1997, identifiable and unidentifiable intangible assets consist of the
following:
F-17
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
1998 1997
-------- --------
Goodwill, Level 8 Technologies $ 2,954 $ 2,954
Goodwill, Momentum 4,014 --
Goodwill, Seer Technologies 18,684 --
Assembled workforce, Seer Technologies 4,278 --
Customer base, Seer Technologies 4,761 --
Trademark, Seer Technologies 623 --
-------- --------
Subtotal 35,314 2,954
Less accumulated amortization (3,097) (1,161)
-------- --------
Total $ 32,217 $ 1,793
-------- --------
-------- --------
Amortization expense was $1,933, $422, and $422 for the fiscal years ended
December 31, 1998, 1997, and 1996, respectively.
The Company assesses whether its identifiable and unidentifiable intangible
assets are impaired as required by SFAS No. 121, Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed Of,
based on an evaluation of undiscounted projected cash flows through the
remaining amortization period. If an impairment exists, the amount of such
impairment is calculated based on the estimated fair value of the asset
determined based upon anticipated cash flows discounted at a rate
commensurate with the risk involved. As a consequence of the Company's
transition to an enterprise application integration solutions provider, the
Company abandoned certain planned development efforts for products acquired
in the Momentum transaction and reassessed the remaining undiscounted
projected cash flows related to the identifiable and unidentifiable
intangible assets acquired from Momentum. It was concluded that, with the
principal exception of the Momentum technology utilized in the Level 8's
Falcon product set and the XIPC products, the goodwill and intangible assets
acquired in the Momentum transaction should be written off. Accordingly,
during the fourth quarter of 1998, the Company adjusted the carrying value of
its identifiable and unidentifiable assets to their fair value of $32,217,
resulting in a non-cash impairment loss of $4,601.
F-18
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
NOTE 8. LONG-TERM DEBT AND CREDIT FACILITIES
Notes payable, long-term debt, and notes payable to a related party consist of
the following at December 31:
1998 1997
-------- --------
Credit facility $ 12,275 $ --
Notes payable - Momentum 2,250 --
Capital leases 90 23
-------- --------
14,615 23
Less current maturities (13,074) (7)
-------- --------
$ 1,541 $ 16
-------- --------
-------- --------
Notes payable to a related party 13,147 330
Less current maturities (628) (128)
-------- --------
$ 12,519 $ 202
-------- --------
-------- --------
At December 31, 1998, one of the Company's subsidiaries, Seer, maintained a
credit facility (the "Revolving Facility") which provides for borrowing for
working capital purposes based on the Company's eligible accounts receivable, as
defined in the loan agreement. The Revolving Facility allows for borrowings of
up to $25,000, bears interest at the prime rate and is collateralized by Seer's
accounts receivable, equipment, and intangibles. There are no financial
covenants for this credit facility. The Company has guaranteed, as of December
31, 1998, Seer's revolving credit facility (i) exceeding $20,000 through
December 31, 1999, (ii) exceeding $10,000 from January 1, 2000 through December
31, 2000, and (iii) without limit thereafter. As of December 31, 1998, the
interest rate on borrowings under the Revolving Facility was 7.75%.
Subsequent to December 31, 1998, the Company amended its Revolving Facility (the
"Amended Facility") to involve the Company as a borrower. The terms of the
Amended Facility allow the Company to maintain outstanding borrowings not to
exceed the lesser of $25,000 or the sum of (a) eligible receivables, as defined
in the Amended Facility, (b) a $7,000 term loan, and (c) a $2,500 equipment
loan. The Amended Facility bears interest at the prime rate until June 30, 1999.
The Amended Facility bears interest at 1% above the prime rate from July 1, 1999
through June 30, 2000. The Amended Facility bears interest at 2% above the prime
rate subsequent to July 1, 2000. The $7,000 term loan is to be repaid in 24
equal monthly installments beginning on January 1, 2000. The $2,500 equipment
loan is to be repaid in 30 equal monthly installments beginning on April 1,
1999.
On December 1, 1998 in connection with the acquisition of Momentum Software
Corporation as described in Note 2, the Company issued notes totaling $3,000
payable over three years. The notes bear interest at 10% per year, retroactive
to the Momentum acquisition date of March 26, 1998, and are due in four equal
installments plus interest on December 1, 1998, November 26, 1999, November 20,
2000, and November 15, 2001. There are no financial covenants in this note.
The Company is obligated under various capital leases for certain computer and
office equipment providing for aggregate payment, excluding interest, of $49
during 1999 and $41 during 2000.
On December 31, 1998 in connection with the acquisition of Seer Technologies,
Inc. as described in Note 2, the Company issued a note payable to a related
party in the amount of $12,000. The note bears interest at 12% per year, payable
at maturity, and is due on June 30, 2000. In addition, if the Company
consummates the rights offering as described in Note 10 before June 30, 1999,
the Company shall pay to the holder of the note the amount of the net proceeds
of the rights offering, to the extent the note shall not have been cancelled in
payment of the subscription price for shares purchased in the rights offering.
On April 1, 1998 in connection with an amendment to a custom computer
programming agreement, the Company issued a note payable to a related party
in the amount of $1,500. The note bears interest at 8% per year and is
payable in three annual installments. The first installment, including
accrued interest, was paid during 1998. The second installment of $450 plus
accrued interest is due on April 1, 1999 and the third installment of $450
plus interest is due on April 1, 2000.
On September 1, 1995, the Company issued a note payable to a related party in
the amount of $628. The note bears interest at 4% per year and is payable in
equal quarterly installments of $35, including interest. As of December 31,
1998, the principal amount outstanding on the note payable is $202.
F-19
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
Principal amounts of notes payable and long-term debt and notes payable to a
related party maturing in each of the next five years ending December 31 are as
follows:
Notes Payable Notes Payable
and to a
Long-term Debt Related Party
-------------- -------------
1999 $13,074 $ 628
2000 791 12,519
2001 750 --
------- -------
Total $14,615 $13,147
------- -------
------- -------
NOTE 9. INCOME TAXES
Income tax expense (benefit) consists of the following as of December 31:
1998 1997 1996
----- ----- -----
Federal - current $ -- $ 239 $(247)
State and local - current
-- 42 (43)
----- ----- -----
-- 281 (290)
Federal - deferred 344 231 99
State and local - deferred 61 41 17
----- ----- -----
405 272 116
----- ----- -----
Total income tax expense (benefit) $ 405 $ 553 $(174)
----- ----- -----
----- ----- -----
A reconciliation of expected income tax at the statutory Federal rate with the
actual income tax expense (benefit) is as follows for the fiscal years ended
December 31:
1998 1997 1996
------- ------- -------
Expected income tax benefit at
statutory rate (34%) $(7,916) $ 540 $ (347)
Loss on sale of discontinued operations (331) -- (468)
Discontinued operations (77) 65 (41)
State taxes, net of federal tax benefit (1,082) 97 --
Effect of foreign tax rates and credits -- -- 8
Effect of change in valuation allowance 6,246 (304) 381
Rate Differences -- -- 15
Amortization and write-off of non-deductible
goodwill 2,787 197 182
In-process research and development - Momentum 408 -- --
Write-off of income tax receivable 406 -- --
Non-deductible expenses 12 34 14
Non-deductible loss on sale of foreign
Subsidiary -- -- 106
Other 121 61 3
------- ------- -------
Total $ 574 $ 690 $ (147)
------- ------- -------
------- ------- -------
Allocated as follows:
Continuing operations 405 553 (174)
Sale of discontinued operations 259 -- --
Discontinued operations (90) 137 27
Approximately $2,070 of the current year change in the valuation allowance is
due to a valuation allowance offsetting certain deferred tax assets acquired
from Momentum as recorded at the purchase date.
F-20
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
Significant components of the net deferred tax asset (liability) are as follows:
1998 1998 1997 1997
Current Long-Term Current Long-Term
------- ------- ------- -------
Deferred tax assets
Allowance for uncollectible accounts $ 240 $ -- $ 175 $ --
receivable
Accrued expenses non-tax deductible 660 -- 12 --
Deferred revenue 1,621 -- 8 --
Loss carryforwards -- 5,539 35 399
Unearned compensation -- -- -- 73
Depreciation and amortization -- 577 -- --
------- ------- ------- -------
2,521 6,116 230 472
------- ------- ------- -------
Deferred tax liabilities
Depreciation and amortization -- -- -- (931)
Change from cash to accrual basis -- -- (3) (3)
------- ------- ------- -------
-- -- (3) (934)
------- ------- ------- -------
Deferred tax asset valuation allowance (2,521) (6,116) (321) --
------- ------- ------- -------
Net deferred tax (liability) $ -- $ -- $ (94) $ (462)
------- ------- ------- -------
------- ------- ------- -------
At December 31, 1998, the Company also has approximate net operating loss
carryforwards of $13,500, which may be applied against future taxable income.
These carryforwards will expire at various times between 2005 and 2019 with over
$6,500 not expiring until 2019. A substantial portion of these carryforwards is
restricted to future taxable income of certain of the Company's subsidiaries or
limited by Internal Revenue Code Section 382. Thus, the utilization of these
carryforwards cannot be assured. Approximately $2,070 of the valuation allowance
relates to deferred tax assets for which any subsequently recognized tax
benefits will be allocated directly to reduce goodwill or other noncurrent
intangible assets of Momentum.
The Company provided a full valuation allowance on the total amount of its
deferred tax assets at December 31, 1998 since management does not believe that
it is more likely than not that these assets will be realized.
NOTE 10. STOCK OPTIONS, WARRANTS AND RIGHTS
STOCK OPTIONS
The Company has 1995 and 1997 Stock Incentive Plans, which permit the issuance
of incentive and nonstatutory stock options, stock appreciation rights,
performance shares, and restricted and unrestricted stock to employees,
officers, directors, consultants, and advisors. The Plans reserve a combined
total of 2,300,000 shares of common stock for issuance upon the exercise of
awards and provide that the term of each award be determined by the Board of
Directors.
Under the terms of the Plans, the exercise price of the incentive stock
options may not be less than the fair market value of the stock on the date
of the award and the options are exercisable for a period not to exceed five
years from date of grant. Stock appreciation rights entitle the recipients to
receive the excess of the fair market value of the Company's stock on the
exercise date, as determined by the Board of Directors, over the fair market
value on the date of grant. Performance shares entitle recipients to acquire
Company stock upon the attainment of specific performance goals set by the
Board of Directors. Restricted stock entitle recipients to acquire Company
stock subject to the right of the Company to repurchase the shares in the
event conditions specified by the Board are not satisfied prior to the end of
the restriction period. The Board may also grant unrestricted stock to
participants at a cost not less than 85% of fair market value on the date of
sale. Options granted vest at varying periods up to five years and expire in
ten years.
F-21
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
Activity for stock options issued under these plans for the fiscal years ending
December 31, 1998, 1997 and 1996 is as follows:
Weighted
Average
Plan Option Price Exercise
Activity Per Share Price
--------- ----------- --------
Balance at December 31, 1995 489,678 $ .69-5.75 $ 4.23
Granted 496,620 5.75-10.25 9.74
Exercised (80,156) .69-11.00 .73
Forfeited (122,987) .69-11.00 9.10
---------
Balance at December 31, 1996 783,155 .69-11.00 7.31
Granted 444,500 10.69-16.62 8.14
Exercised (91,646) .69-16.62 7.01
Forfeited (45,705) .69-16.62 11.38
---------
Balance at December 31, 1997 1,090,304 .69-16.62 7.51
Granted 1,293,000 7.25-12.75 8.56
Exercised (38,175) .69-11.76 9.13
Forfeited (433,035) .69-16.62 10.88
---------
Balance at December 31, 1998 1,912,094 .69-16.62 8.85
---------
The weighted average grant date fair value of options issued during the years
ended December 31, 1998, 1997 and 1996 was equal to $4.37, $9.35 and $6.85 per
share, respectively. The fair value of options granted during the fiscal years
ended December 31, 1998, 1997 and 1996 was equal to $5,652, $4,156 and $3,402,
respectively. There were no option grants issued below fair market value during
1998 or 1997. During 1996, the Company granted 187,420 options at exercise
prices below fair market value. The fair value of options granted below fair
market value was $1,192.
The fair value of the Company's stock-based awards to employees was estimated as
of the date of the grant using the Black-Scholes option-pricing model, using the
following weighted-average assumptions:
1998 1997 1996
---- ---- ----
Expected life (in years) 5 years 5 years 5 years
Expected volatility 52% 77% 75%
Risk free interest rate 5.0% 6.05% 6.44%
Expected dividend yield 0% 0% 0%
For disclosure purposes, the adjusted estimated fair value of the Company's
stock-based awards to employees is amortized over the vesting period. Had
compensation cost for the Company's stock-based compensation plans been
determined based on the fair value at the grant dates as calculated in
accordance with SFAS 123, the Company's net loss and loss per share for the
fiscal years December 31, 1998, 1997, and 1996 would have been increased to the
pro forma amounts indicated below. The Company's adjusted information follows
(in thousands, except for per share information):
1998 1997 1996
---- ---- ----
Net income (loss), as reported $ (25,056) $ 1,088 $ (2,369)
Net income (loss), as adjusted (27,697) (821) (3,525)
Net income (loss) per share, as reported - basic (3.32) 16 (.39)
Pro forma net income (loss) per share, as adjusted - basic (3.67) (.12) (.58)
Net income (loss) per share, as reported - diluted (3.32) 14 (.39)
Pro forma net income (loss) per share, as adjusted - diluted (3.67) (.11) (.58)
F-22
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
At December 31, 1998 and 1997, options to purchase approximately 908,638 and
539,980 shares of common stock were exercisable, respectively, pursuant to the
plans at prices ranging from $.69 to $16.62. The following table summarizes
information about stock options outstanding at December 31, 1998:
Remaining
Contractual Life
Number for Options Number
Exercise Price Outstanding Outstanding Exercisable
-------------- ----------- ----------- -----------
1.37 695 6.25 695
5.00 116,707 6.33 116,707
5.50 105,600 6.58 104,200
5.75 64,250 6.83 57,469
7.25 200,000 10.00 50,000
7.88 395,000 10.00 98,750
8.29 18,000 7.58 16,500
8.50 20,625 9.58 5,156
8.82 9,875 7.42 4,938
9.00 453,125 9.50 108,906
9.56 12,325 7.83 8,713
10.25 250,000 7.92 183,333
10.69 31,750 8.17 15,875
11.76 38,267 8.92 25,511
12.75 30,875 9.25 12,719
14.00 10,000 10.00 2,500
14.73 126,000 8.67 84,000
16.03 15,000 8.50 3,333
16.62 14,000 8.58 9,333
--------- -------
1,912,094 908,638
--------- -------
--------- -------
As of December 31, 1998, Seer also had a Stock Option and Restricted Stock
Purchase Plan and a Stock Option Plan for Non-Employee Directors, pursuant to
which certain employees, officers, and non-employee directors of Seer had been
granted options to acquire up to 2,720,000 of Seer's common stock. In connection
with the acquisition of Seer by the Company, all of Seer's stock option plans
are being terminated.
Subsequent to December 31, 1998, the Company has adopted a Stock Option Plan for
Non-Employee Directors, pursuant to which non-employee directors can be granted
options to acquire up to 12,000 shares of the Company's common stock, upon being
elected to the Board of Directors. The options vest in one-third increments, on
each of the first through third anniversaries of the grant date.
STOCK WARRANTS
In connection with the acquisition of Momentum during 1998, the Company issued
warrants to purchase 200,000 shares of the Company's common stock. The warrants
have an exercise price of $13.108 per share and expire on March 26, 2003. The
warrants were valued at $654 or $3.27 per share. See Note 2.
In connection with the acquisition of Seer during 1998, the Company issued
warrants to purchase 250,000 shares of the Company's common stock. The warrants
have an exercise price of $12 per share and expire on December 31, 2002. The
warrants were valued at $280 or $1.12 per share. See Note 2.
In connection with the initial and secondary public offerings, the Company
issued 140,000 and 110,000 warrants, respectively, to the underwriter. The
warrants are exercisable for four years, commencing one year from the effective
dates of the public offerings at exercise prices of $7.43 and $14.85 per share,
respectively, and have grant date fair values of $3.82 and $6.85 per share,
respectively.
Warrants totaling 1,200 and 18,168 were exercised at an exercise price of $7.43
during the years ended December 31, 1998 and 1997, respectively.
F-23
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
STOCK RIGHTS
In connection with the issuance of a $12 million note payable to Liraz, the
Company and Liraz agreed that the Company would effect a pro rata offering to
its shareholders of shares of preferred stock intended to have an aggregate
liquidation preference initially equal to the principal and accrued interest
under the note and to be convertible into an aggregate number of common stock
determined by dividing the aggregate liquidation preference (which will
accrete at the rate of 12% a year, compounded quarterly) by the conversion
price. The conversion price would be an amount equal to the greater of $5.00
and two-third of the average closing price of a share of the Company's common
stock during the 20 trading days ending on the fifth trading day before the
rights offering. Each share of preferred stock would be entitled to two votes
for each share of common stock into which it is convertible. The preferred
stock would be redeemable at the Company's option at any time after June 30,
2000, upon at least 30 days' notice, at a redemption price equal to the
preferred stock's accreted liquidation preference. The purchase price for
each share of preferred stock to be offered to the Company's shareholders
would equal its initial liquidation preference. Liraz would be permitted to
pay the purchase price for any preferred stock it purchases in the offering
with cash or by reducing the amount payable to it under the $12 million note.
If the rights offering is consummated before June 30, 1999, the Company is
required to use the net proceeds of the rights offering to prepay the unpaid
balance under the $12 million note.
NOTE 11. EMPLOYEE BENEFIT PLANS
The Company has a 401(k) plan for all qualified Momentum employees (the
"Momentum Plan"). Matching contributions to the Momentum Plan are made at the
discretion of the Board of Directors. For the year ended December 31, 1998, the
Board of Directors did not authorize any contributions to the Momentum Plan.
The Company has a 401(k) plan for all qualified U.S. employees of Seer (the
"Seer Plan"). The Seer Plan provides for a matching contribution of 25% for an
employee's contribution up to 4% of an employee's salary. Because Seer was
acquired on December 31, 1998, the Company did not make any contributions to the
Seer Plan for the year ended December 31, 1998.
The Company has a 401(k) plan for all other qualified employees (the "Level 8
Plan"). Matching contributions to the Level 8 Plan are made at the discretion of
the Board of Directors. For the year ended December 31, 1998, 1997, and 1996,
the Board of Directors did not authorize any contributions to the Level 8 Plan.
Effective January 27, 1999, the Company merged the Momentum Plan and the Level 8
Plan into the Seer Plan and changed the name of the Seer Plan to the Level 8
Systems 401(k) and Profit Sharing Plan (the "Plan"). Participants in the
Momentum Plan and the Level 8 Plan are allowed to roll over the balance of their
accounts in the Momentum Plan and the Level 8 Plan into the Plan. Also effective
January 27, 1999, the Company amended the new Level 8 Plan to provide a 50%
matching contribution for an employee's contribution up to 4% of an employee's
salary and a discretionary match of up to $0.50 on the dollar up to 2% of the
employees salary based on the Company's performance and board of directors
discretion. Participants must be employed at December 31 of each calendar year
to be eligible for employer matching contributions.
In connection with the acquisition of Seer, the Company also has employee
benefit plans for each of its foreign subsidiaries, as mandated by each
country's laws and regulations. There was no expense recognized under these
plans for the years ended December 31, 1998, 1997, and 1996.
Effective January 27, 1999, the Company adopted an Employee Stock Purchase
Plan (U.S.) (the "U.S. Stock Purchase Plan") and the International Stock
Purchase Plan (the "Stock Purchase Plan - International") for its employees.
The Stock Purchase Plan (U.S. and International) allow employees to purchase
shares of the Company's common stock for 85% of fair market value. The
Company is responsible for the differential in market value, as well as
administrative costs of the plans.
NOTE 12. SIGNIFICANT CUSTOMERS, CONCENTRATION OF CREDIT RISK, AND FOREIGN
CURRENCIES
One customer accounted for more than 10% of operating revenue for the fiscal
years ended December 31, 1998, 1997, and 1996.
Due to the acquisition of Seer, the Company has entered into several marketing
and distribution agreements with IBM, primarily in the European market. The
percentage of outstanding receivables from IBM-related transactions as of
December 31, 1998, is approximately 24.8%.
As of December 31, 1998, the Company had significant balances outstanding from
individual customers due to the nature of its operations. It is the policy of
the Company to closely monitor all accounts receivable and to record a provision
for uncollectible accounts as they become estimable. Generally, no collateral is
required.
F-24
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
At December 31, 1998, the Company had approximately $219 and $8,527 U.S. dollar
equivalent cash and trade receivable balances, respectively, denominated in
foreign currencies.
The more significant trade accounts receivable denominated in foreign currencies
as a percentage of total trade accounts receivable were as follows:
1998
----
Danish Krona 8.73%
Pound Sterling 8.53%
Italian Lira 8.33%
NOTE 13. SEGMENT INFORMATION AND GEOGRAPHIC INFORMATION
In 1998, the Company adopted SFAS 131, "Enterprise and Related Information."
SFAS 131 supercedes SFAS 14, "Financial Reporting for Segments of a Business
Enterprise," replacing the "industry segment" approach with the "management
approach". The management approach designates the internal organization that is
used by management for making operating decisions and assessing performance as
the source of the Company's reporting segment. For the periods presented,
management reviewed the continuing operations as one segment. Due to the
acquisition of Seer, management is reevaluating the "management approach" to
reviewing its operations.
Due to the acquisition of Seer, the Company now operates in a variety of
geographic regions. The following table represents a summary of long-lived
assets by geographic region as of December 31:
1998 1997 1996
------- ------- -------
United States $41,136 $ 4,935 $ 4,051
United Kingdom 416 -- --
Other 100 -- --
------- ------- -------
Total assets $41,652 $ 4,935 $ 4,051
------- ------- -------
------- ------- -------
The Company's foreign operations are reimbursed by the Company for their costs
plus an appropriate mark-up for profit. Intercompany profits and losses are
eliminated in consolidation.
NOTE 14. RELATED PARTY INFORMATION
During 1995, the Company and Liraz entered into a custom computer programming
agreement for the joint development of certain software. Liraz and the
Company were each to pay 50% of the total project development costs. In
exchange for providing 50% of the project development costs, Liraz was to
receive royalties of 30% of the first $2,000 in contract revenue from the
sale of products developed under this agreement, 20% of the next $1,000, and
8% thereafter.
Due to a change in the Company's development plans for this product, during
the first quarter of 1998, the Company and Liraz entered into an amendment to
the original custom computer programming agreement, whereby the original
royalty payment provisions were repealed. Under the new agreement, the
Company agreed to reimburse Liraz's costs of development of $1,500 and to pay
Liraz royalties of 3% of program revenues, as defined in the agreement,
generated from January 1, 1998 until December 31, 2000. The Company issued a
note to Liraz for $1,500 for cost reimbursement pursuant to this agreement
and is amortizing the cost of reimbursement over the term of the agreement.
See Note 8. The amortization of the cost reimbursement is included as a
component of cost of software in the consolidated statement of operations
In addition, the Company and Liraz were awarded an Israel - U.S. Binational
Industrial Research and Development Foundation ("BIRD") grant totaling $432. The
BIRD grant provided for reimbursement of up to 50% of the development costs of
the above project. At the point at which the products developed under this grant
are available for sale, BIRD will be paid a royalty of 2.5% of related sales in
the first year and 5% in subsequent years until BIRD recovers 110% to 150%
(depending on the elapsed time) of its reimbursement of development costs. The
Company capitalized the software
F-25
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
development costs associated with Level 8's project development costs and
reduced the capitalized costs by any grant funds received from BIRD. At December
31, 1998, the Company had capitalized approximately $1,249, after reimbursement
of BIRD funds totaling approximately $400.
The Company sold software licenses to Liraz for $15 and $160 in 1998 and 1997,
respectively, for resale to unrelated third parties.
Liraz also pays the salaries and expenses of certain company employees and is
reimbursed by the Company. Salaries and expense paid by Liraz amounted to $568
and $14 during 1998 and 1997, respectively.
At December 31, 1998 and 1997, the Company had accounts receivable of $271 and
$160 and accounts payable of $82 and $14 from and to Liraz, respectively.
See Note 8 regarding notes payable to Liraz.
In connection with the acquisition of Seer, the Company committed to fund
Seer's operations through January 15, 2000, if necessary.
NOTE 15. RESTRUCTURING CHARGES
During the fourth quarter of 1998, the Company reorganized its existing
operations due to its acquisition of Seer. The restructuring included a staff
reduction in its development and administrative areas of 20% (15 employees),
the abandonment of certain leased facilities, and the write-down to fair
value of certain capitalized software costs for product lines which were
being discontinued. The Company recorded a restructuring charge of
approximately $1,540, which consisted of approximately $706 in
personnel-related charges, approximately $292 in costs associated with
carrying vacated space until the lease expiration date, approximately $188 of
property and equipment related charges, approximately $241 in write-down of
capitalized software costs, approximately $100 in professional fees related
to the restructuring, and approximately $13 for other charges. Through
December 31, 1998, the Company has paid approximately $113 in cash related to
the restructuring. The Company believes the accrued restructuring cost of
$973 at December 31, 1998 represents its remaining cash obligations.
NOTE 16. LEASE COMMITMENTS
The Company leases certain facilities and equipment under various operating
leases. Future minimum lease commitments on operating leases that have initial
or remaining non-cancelable lease terms in excess of one year as of December 31,
1998 are as follows:
1999 $ 3,310
2000 2,579
2001 2,030
2002 1,741
2003 1,543
Thereafter 2,570
--------
$13,773
Rent expense for the fiscal years ended December 31, 1998, 1997 and 1996 was
$790, $378, and $279, respectively.
NOTE 17. CONTINGENCIES
Litigation. Various lawsuits and claims have been brought against the Company
in the normal course of business. Management is of the opinion that the
liability, if any, resulting from these claims would not have a material
effect on the financial position or results of operations of the Company.
In December 1997, Seer filed a lawsuit against Saadi Abbas and Cambridge
Business Solutions (UK) Limited ("CBS") alleging that Mr. Abbas and CBS had
injured Seer by interfering with Seer's ability to market and sublicense the
LightSpeed Financial Model. Seer obtained a preliminary injunction against Mr.
Abbas and CBS halting their actions. Mr. Abbas and CBS filed counterclaims
against Seer claiming wrongful dismissal of Abbas and breach of the license
agreement. Due to the erosion of the market for the LightSpeed Financial Model,
Seer voluntarily dismissed its claims against Mr. Abbas and CBS in the summer of
1998. Mr. Abbas and CBS are continuing to pursue their claims against Seer. At
the present point in the litigation, it is impossible to calculate the chances
of success in this litigation. However, Seer intends to continue to vigorously
defend against the counterclaim. Seer has made provision for its estimated costs
to resolve this matter. Management does not believe at this point in the
litigation that any additional amounts required to ultimately resolve this
matter will have a material effect on the financial position, cash flows, or
results of operations of Seer.
Liquidity. As reflected in the accompanying financial statements, the Company
incurred a net loss of $26.2 million and has negative working capital of
$20.3 million and an accumulated deficit of $26.4 million at December 31,
1998. Additionally, Seer Technologies, Inc. in which the Company acquired a
69% interest on December 31, 1998, reported a loss of $62.4 million for its
most recent fiscal year. The Company's ability to generate positive cash flow
is dependent upon the Company achieving and sustaining certain cost
reductions and generating sufficient revenues for the year. Management has
already implemented certain steps to, among other things, reduce headcount,
restructure operations and eliminate various costs from the business. They
have also re-negotiated the Company's line of credit, to secure increased
borrowing capacity, see Note 8. Management's plans also include the
possibility of raising additional equity financing. Liraz has committed to
provide up to $7.5 million of funding to the company on an as-needed basis
through the earlier of March 31, 2000 or the completion of an equity
financing which provides more than $7.5 million in proceeds to the Company.
The Company believes that existing cash on hand, cash provided by future
operations and additional borrowings under the credit facility and Liraz
commitment will be sufficient to finance its operations and expected working
capital and capital expenditure requirements for at least the next twelve
months so long as the Company continues to perform to its operating plan.
However, there can be no assurance that the Company will be able to continue
to meet its cash requirements through operations of, if needed, obtain
additional financing on acceptable terms, and the failure to do so may have
an adverse impact on the Company's business and operations.
F-26
LEVEL 8 SYSTEMS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(dollars in thousands, except share and per share data)
NOTE 18. SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
First Second Third Fourth
(In thousands, except per share data) Quarter Quarter Quarter Quarter
------- ------- ------- -------
1998:
Net revenues $3,093 $3,155 $2,349 $2,088
Gross profit 1,079 1,580 608 (615)
Net loss (2,484) (2,026) (2,918) (17,628)
Net loss per share - basic and diluted ($0.35) ($0.26) ($0.38) ($2.29)
1997:
Net revenues $2,853 $2,767 $2,937 $6,123
Gross profit 1,200 1,502 2,094 2,295
Net income 150 222 323 394
Net income per share - basic $0.02 $0.03 $0.05 $0.06
Net income per share - diluted $0.02 $0.03 $0.04 $0.05
During the fourth quarter of 1998, the Company recorded significant nonrecurring
adjustments totaling $14,025. These adjustments related primarily to the
acquisition of Seer, the impairment of the note receivable from the sale of a
subsidiary, the impairment of goodwill recorded in connection with the
acquisition of Momentum, and the restructuring charges. See Notes 2, 3, 7, and
15.
During the fourth quarter of 1997, the Company increased its allowance for
doubtful accounts by $275 and recorded compensation expense of approximately
$120 for options issued to a consultant.
The foregoing unaudited selected quarterly financial data differ from the
Company's previously reported quarterly financial data included in its Quarterly
Reports on Form 10-Q for 1998 as a result of a change in the valuation of the
in-process technology of Momentum and certain other adjustments identified in
connection with the audit of the 1998 financial statements. Accordingly, the
Company intends to amend its previously filed Quarterly Reports on Form 10-Q
promptly.
NOTE 19. SUBSEQUENT EVENTS
On February 1, 1999, Level 8 commenced a tender offer for all the remaining
outstanding shares of the common stock of Seer for $0.35 per share, net to the
seller in cash, upon the terms and conditions set forth in the offer to purchase
and the letter of transmittal. The tender offer is expected to be completed in
the second quarter of 1999 for an estimated cost of $1.7 million, plus
expenses. Upon the completion the tender offer and related merger, Seer will
become a wholly-owned subsidiary of the Company.
F-27