FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
/x/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2001
-------------------
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
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Commission File Number 0-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0216135
(State of Incorporation) (I.R.S. Employer Identification No.)
125 Baylis Road 11747
Melville, New York (Zip code)
(Address of principal executive offices)
Registrant's telephone number, including area code: 631-777-5188
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
The number of shares of Common Stock issued and outstanding as of November 8,
2001 was 44,758,145, which includes redeemable common shares.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
FORM 10-Q
INDEX
Page
PART I. Financial Information 3
Item 1. Consolidated Financial Statements 3
Consolidated Balance Sheets at September 30, 2001
(unaudited) and December 31, 2000 3
Unaudited Consolidated Statements of Operations for the
three and nine months ended September 30, 2001, the three
months ended September 30, 2000 and the period from
inception (February 10, 2000) through September 30, 2000 4
Unaudited Consolidated Statements of Cash Flows for the
nine months ended September 30, 2001 and the
period from inception (February 10, 2000) through
September 30, 2000 5
Notes to the Unaudited Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 10
Item 3. Qualitative and Quantitative Disclosures about Market Risk 18
PART II. Other Information 19
Item 1. Legal Proceedings 19
Item 4. Submission of Matters to a Vote of Security Holders 19
Item 6. Exhibits and Reports on Form 8-K 19
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PART I. FINANCIAL INFORMATION
ITEM 1. Consolidated Financial Statements
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
September 30, 2001 December 31, 2000
------------------ -----------------
Assets (Unaudited)
Current assets:
Cash and cash equivalents ............................................... $ 54,218,677 $ 7,727,182
Marketable securities ................................................... 18,780,824 --
Accounts receivable, net ................................................ 928,744 15,814
Prepaid expenses and other current assets ............................... 571,748 47,995
------------ ------------
Total current assets ........................................... 74,499,993 7,790,991
Property and equipment, net ................................................ 1,416,969 583,201
Other assets ............................................................... 2,602,464 220,099
------------ ------------
Total assets ................................................... $ 78,519,426 $ 8,594,291
============ ============
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable ........................................................ $ 1,393,942 $ 137,365
Accrued expenses ........................................................ 1,568,820 266,949
Deferred revenue ........................................................ 425,441 133,000
Net liabilities of discontinued operations .............................. 6,006,750 --
------------ ------------
Total current liabilities ...................................... 9,394,953 537,314
------------ ------------
Long-term liabilities of discontinued operations ....................... 3,324,653 --
------------ ------------
Commitments
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 and 10,000,000
shares authorized, respectively
Series A, -0- and 3,000,000 shares issued and outstanding, respectively -- 3,000
Series B, -0- and 4,900,000 shares issued and outstanding, respectively -- 4,900
Series C, -0- shares issued and outstanding ........................... -- --
Common stock - $.001 par value, 100,000,000 shares authorized, .........
44,752,961 and 10,900,016 shares issued and outstanding, respectively 44,753 10,900
Additional paid-in capital ............................................. 77,788,420 10,625,252
Deferred compensation .................................................. (1,153,805) (469,351)
Accumulated deficit .................................................... (10,899,968) (2,095,719)
Accumulated other comprehensive income (loss) .......................... 20,420 (22,005)
------------ ------------
Total stockholders' equity ..................................... 65,799,820 8,056,977
------------ ------------
Total liabilities and stockholders' equity ..................... $ 78,519,426 $ 8,594,291
============ ============
See accompanying notes to unaudited consolidated financial statements .
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Period from
Nine Months Inception
Three Months Ended Ended (February 10,
September 30, September 30, 2001 2000) through
2001 2000 September 30, 2000
Revenues ....................................... $ 2,521,887 $ 68,350 $ 2,565,287 $ 68,350
Operating expenses:
Cost of revenues ............................ 519,887 32,622 1,075,061 32,622
Software development costs .................. 1,417,473 498,104 3,702,894 683,735
Selling and marketing ....................... 1,850,936 15,768 5,301,639 19,185
General and administrative .................. 619,238 87,315 2,114,727 131,971
------------ ------------ ------------ ------------
4,407,534 633,809 12,194,321 867,513
------------ ------------ ------------ ------------
Operating loss ...................... (1,885,647) (565,459) (9,629,034) (799,163)
------------ ------------ ------------ ------------
Interest and other income ...................... 441,990 76,071 826,097 102,557
------------ ------------ ------------ ------------
Loss before income taxes .............. (1,443,657) (489,388) (8,802,937) (696,606)
Provision for income taxes ..................... -- -- 1,312 --
------------ ------------ ------------ ------------
Net loss .............................. $ (1,443,657) $ (489,388) $ (8,804,249) $ (696,606)
------------ ------------ ------------ ------------
Beneficial conversion feature attributable
to convertible preferred stock............... -- -- 3,896,287 --
------------ ------------ ------------ ------------
Net loss attributable to common
shareholders ................................ $ (1,443,657) $ (489,388) $(12,700,536) $ (696,606)
============ ============ ============ ============
Basic and diluted net loss per share ........... $ (0.04) $ (0.02) $ (0.40) $ (0.04)
============ ============ ============ ============
Weighted average basic and diluted shares
outstanding ................................. 37,004,055 21,655,701 32,076,681 19,835,499
============ ============ ============ ============
See accompanying notes to unaudited consolidated financial statements.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
Period from
Inception (February
Nine Months 10, 2000) through
Ended September 30, September
2001 30, 2000
------------------- --------------------
Cash flows from operating activities:
Net loss ..................................................................... $ (8,804,249) $ (696,606)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization .......................................... 312,916 25,616
Non-cash professional services expenses ................................ 429,671 --
Equity-based compensation earned ....................................... 344,186 --
Changes in operating assets and liabilities:
Accounts receivable, net ............................................... (820,930) (68,350)
Prepaid expenses and other current assets .............................. (523,753) --
Accounts payable ....................................................... 1,256,577 255,001
Accrued expenses ....................................................... 1,301,871 --
Deferred revenue ....................................................... 292,441 --
------------ ------------
Net cash used in operating activities ............................... (6,211,270) (484,339)
------------ ------------
Cash flows from investing activities:
Purchase of property and equipment ........................................... (1,034,462) (314,376)
Purchase of software licenses ................................................ (2,240,000) --
Net cash acquired from acquisition of NPI .................................... 48,208,649 --
Security deposits ............................................................ (204,587) (241,054)
------------ ------------
Net cash provided by (used in) investing activities ....................... 44,729,600 (555,430)
------------ ------------
2,403,603
Cash flows from financing activities:
Net proceeds from issuance of preferred stock ................................ 7,932,335 9,030,000
Proceeds from exercise of stock options ...................................... 72,125 --
------------ ------------
Net cash provided by financing activities ................................. 8,004,460 9,030,000
------------ ------------
Effect of exchange rate changes on cash ......................................... (31,295) (4,918)
------------ ------------
Net increase in cash and cash equivalents ....................................... 46,491,495 7,985,313
Cash and cash equivalents, beginning of period .................................. 7,727,182 --
------------ ------------
Cash and cash equivalents, end of period ........................................ $ 54,218,677 $ 7,985,313
============ ============
Supplemental disclosures of cash flow information
The assets acquired and liabilities assumed in the acquisition of NPI
(note 2), which was accounted for as a recapitalization of
FalconStor, Inc. are as follows:
Cash acquired .............................................................. 57,091,647
Marketable securities acquired ............................................. 18,707,104
Merger related costs ....................................................... (8,882,998)
Fair value of other tangible assets acquired ............................... 142,000
Liabilities of discontinued operations assumed ............................. (9,331,403)
------------
Increase in additional paid in capital ..................................... $ 57,726,350
============
See accompanying notes to unaudited consolidated financial statements.
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FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
(1) Summary of Significant Accounting Policies
(a) The Company and Nature of Operations
FalconStor Software, Inc., a Delaware Corporation (the "Company"), develops,
manufactures and sells storage networking infrastructure software. The Company
also provides network consulting services.
(b) Principles of Consolidation
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiaries from their respective dates of acquisition. All
significant intercompany balances and transactions have been eliminated in
consolidation.
(c) Unaudited Interim Financial Information
The unaudited interim consolidated financial statements of the Company as of and
for the three and nine months ended September 30, 2001, for the three months
ended September 30, 2000 and the period from inception (February 10, 2000)
through September 30, 2000, included herein have been prepared, without audit,
pursuant to the rules and regulations of the SEC. Certain information and note
disclosures normally included in financial statements prepared in accordance
with accounting principles generally accepted in the United States of America
have been condensed or omitted pursuant to such rules and regulations relating
to interim financial statements.
In the opinion of management, the accompanying unaudited interim financial
statements reflect all adjustments, consisting only of normal recurring
adjustments, necessary to present fairly the financial position of the Company
at September 30, 2001, the results of its operations for the three months ended
September 30, 2001 and 2000, and the results of its operations and cash flows
for the nine months ended September 30, 2001 and the period from inception
(February 10, 2000) through September 30, 2000.
(d) Cash Equivalents
The Company considers all highly liquid investments with a maturity of three
months or less when purchased to be cash equivalents. Cash equivalents,
consisting of money market funds and commercial paper, amounted to approximately
$53.7 million at September 30, 2001. Marketable securities at September 30, 2001
consist of corporate bonds and government securities. Cash, cash equivalents and
marketable securities amounted to approximately $63.7 million at September 30,
2001, after deducting liabilities of discontinued operations.
(e) Revenue Recognition
The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, Software Revenue Recognition. Accordingly,
revenue for non-customized software is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable and the software is
delivered, provided no significant obligations remain and collection of the
resulting receivable is deemed probable. Software delivered to a customer on a
trial basis is not recognized as revenue until a permanent key is delivered to
the customer. When a customer licenses software together with the purchase of
maintenance, the Company allocates a portion of the fee to maintenance for its
fair value based on the contractual maintenance renewal rate. Software
maintenance fees are deferred and recognized as revenue ratably over the term of
the contract. The cost of providing technical support is included in cost of
revenues.
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Network consulting fees, which are billed on a time and material basis, are
recognized as revenue when the services are performed. These services have not
been provided to our end user software license customers and, thus, are not a
component of multi-element arrangements. Costs of providing these services are
included in cost of revenues.
The Company has entered into various distribution, licensing and joint promotion
agreements with OEM's, whereby the Company has provided the OEM a non-exclusive
software license to install the Company's software on certain hardware in
exchange for royalty payments based on the number of products distributed by the
OEM. Nonrefundable advances received by the Company from an OEM for software
engineering services are recorded as deferred revenue and recognized as revenue
when the services are complete and the software product master is delivered and
accepted. Deferred revenue related to such arrangements amounted to $425,441 at
September 30, 2001.
(f) Earnings Per Share (EPS)
Basic EPS is computed based on the weighted average number of shares of common
stock outstanding. Diluted EPS is computed based on the weighted average number
of common shares outstanding increased by dilutive common stock equivalents. Due
to a net loss, all common stock equivalents were excluded from diluted net loss
per share.
(g) Comprehensive Income (Loss)
Comprehensive loss amounted to $8,783,829 and $701,524 for the nine months ended
September 30, 2001 and for the period from inception (February 10, 2000) through
September 30, 2000, respectively and includes the Company's net loss, foreign
currency translation adjustments, and unrealized gains on marketable securities.
(h) Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
effect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
(i) New Accounting Pronouncements
In June 2001, the FASB issued SFAS No. 142 "Goodwill And Other Intangible
Assets" ("SFAS No. 142"), which is effective for fiscal years beginning after
June 15, 2001. SFAS No. 142 establishes accounting and reporting standards for
goodwill and other intangible assets. In accordance with SFAS No. 142, an entity
can no longer amortize goodwill over its estimated useful life. Rather goodwill
will be subject to assessments for impairment by applying a fair-value-based
test. Intangible assets must be separately recognized and amortized over their
useful life. FalconStor expects the adoption of SFAS No. 142 on January 1, 2002
will not have a material impact on its consolidated results of operations or
financial position.
The FASB also recently issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," that is applicable to financial statements
issued for fiscal years beginning after December 15, 2001. The FASB's new rules
on asset impairment supersede FASB Statement 121, "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and portions
of APB Opinion 30, "Reporting the Results of Operations." This Standard provides
a single accounting model for long-lived assets to be disposed of and
significantly changes the criteria that would have to be met to classify an
asset as held-for-sale. Classification as held-for-sale is an important
distinction since such assets are not depreciated and are stated at the lower of
fair value and carrying amount. This Standard also requires expected future
operating losses from discontinued operations to be displayed in the period(s)
in which the losses are incurred, rather than as of the measurement date as
presently required. FalconStor expects the adoption of SFAS No. 144 will not
have a material impact on its consolidated results of operations or financial
position.
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(2) Merger with Network Peripherals Inc.
Effective August 22, 2001, pursuant to the Agreement and Plan of Merger and
Reorganization, dated as of May 4, 2001, (the "Merger Agreement"), among
FalconStor, Inc. ("FalconStor"), Network Peripherals Inc. ("NPI") and Empire
Acquisition Corp., a wholly-owned subsidiary of NPI ("MergerSub"), MergerSub
merged with and into FalconStor, with FalconStor as the surviving corporation.
Under the terms of the Merger Agreement, all of FalconStor's preferred shares
were converted into common shares and the stockholders of FalconStor received
0.721858 shares of NPI common stock for each share of FalconStor common stock
that they held. Although NPI acquired FalconStor as a result of the transaction,
FalconStor stockholders held a majority of the voting interests in the combined
enterprise. Accordingly, for accounting purposes, the acquisition was a "reverse
acquisition" and FalconStor was the "accounting acquiror." Further, as a result
of NPI's decision on June 1, 2001 to discontinue its NuWave and legacy business,
NPI is a non-operating public shell with no continuing operations, and no
intangible assets associated with NPI were purchased by FalconStor. Accordingly,
the transaction was accounted for as a recapitalization of FalconStor and
recorded based on the fair value of NPI's net tangible assets acquired by
FalconStor, with no goodwill or other intangible assets being recognized. Costs
incurred by FalconStor directly related to the transaction, amounting to
$8,882,998, were charged to additional paid-in capital. The conversion of all of
FalconStor's preferred stock into common stock resulted in an additional
20,207,460 shares of common stock outstanding and, for accounting purposes, the
merger resulted in the issuance of 13,419,884 common shares to NPI's pre-merger
shareholders. In connection with the merger, the name of NPI was changed to
FalconStor Software, Inc.
The following unaudited pro forma consolidated financial information reflects
NPI as a discontinued operation and gives effect to the above described merger
as if the merger had occurred at the beginning of the respective periods by
consolidating the continuing results of operations of the Company and NPI for
the nine months ended September 30, 2001 and the period from inception (February
10, 2000) through September 30, 2000.
Period from Inception
Nine months Ended (February 10, 2000) through
September 30, 2001 September 30, 2000
Revenues $ 2,340,287 $ 68,350
---------------------------------------------------------------------------------------------------
Net Loss from continuing operations (9,029,249) (696,606)
---------------------------------------------------------------------------------------------------
Basic and diluted net
loss from continuing operations per share $ (0.21) $ (0.02)
---------------------------------------------------------------------------------------------------
Weighted average basic and
diluted shares outstanding 43,518,342 33,184,104
---------------------------------------------------------------------------------------------------
The pro forma statements are provided for illustrative purposes only and do not
represent what the actual consolidated results of operations would have been had
the merger occurred on the dates assumed, nor are they necessarily indicative of
future results of operations.
(3) Stock Option Plans
In June 2001, the Company's shareholders approved an increase in the number of
shares available for issuance upon exercise of options under the FalconStor
Software, Inc. 2000 Stock Option Plan from 8,000,000 to 12,000,000. In
connection with the merger with NPI, the number of shares available for issuance
under this plan was converted from 12,000,000 to 8,662,296 based upon the common
stock conversion factor of .721858 in the merger agreement.
As of September 30, 2001, there were outstanding options to purchase 1,474,079
shares under several of the former NPI stock option plans. All of these
outstanding options expire within one year and the Company does not intend to
grant any additional options under these plans except for the 1994 Outside
Directors Stock Option Plan which has 150,000 shares
-8-
authorized for issuance upon the exercise of options of which options to
purchase 135,416 shares are outstanding as of September 30, 2001. The Company
will seek stockholder approval to increase the number of shares issuable upon
the exercise of options under this plan from 150,000 to 500,000.
(4) Software Licenses
In 2001, the Company purchased two software licenses for $2,240,000. The Company
is further developing the acquired software, which is included in other assets
and is being amortized over three years.
(5) Liabilities of Discontinued Operations
As of October 31, 2001, the Company consummated the wind down of NPI's
discontinued operations, including the termination of all of NPI's former
employees. Liabilities of NPI's discontinued operations at September 30, 2001
consisted of $3.7 million in future lease obligations, $1.0 million in warranty
related liabilities, $0.9 million in severance related payments, $0.4 million in
professional fees and $3.3 million in other related liabilities.
(6) Beneficial Conversion Feature
On May 4, 2001, the Company issued 3,193,678 shares of its Series C preferred
stock at $2.55 per share for net proceeds of $7,932,335. Each share of Series C
preferred stock was convertible into one share of common stock, was not
redeemable at the option of the holder and has other terms similar to the
previous issuance of Series C shares. The issuance of the Series C preferred
stock resulted in a beneficial conversion feature, which was recorded as a
preferred stock dividend in the second quarter of 2001, since the Series C
preferred stock was convertible at issuance. The beneficial conversion feature
of $3,896,287 was calculated on the date of issuance, based on the difference
between the fair value of the Company's common stock which would be issued upon
conversion of the preferred stock and the amount paid for the preferred stock.
(7) Subsequent Events
Investment in Network-1 Security Solutions
On October 5, 2001, the Company invested $2.3 million in Network-1 Security
Solutions, Inc., ("Network-1"), a publicly traded corporation that develops next
generation distributed firewalls and other network security software products.
As part of a private placement, the Company acquired Network-1's preferred
stock, which if converted into common stock, would represent an approximate
16.5% ownership of Network-1. This investment will be accounted for under the
cost method.
Simultaneously with this financing, the Company entered into a multi-year
Technology License Agreement with Network-1, in which the Company will have the
right to distribute Network-1's product offerings in its indirect and OEM
channels.
Stock Repurchase Program
On October 25, 2001, the Company announced that its Board of Directors
authorized the repurchase of up to two million shares of the Company's
outstanding common stock. The repurchases will be made from time to time in open
market transactions in such amounts as determined at the discretion of the
Company's management. The terms of the stock repurchases will be determined by
management based on market conditions.
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ITEM 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations contains "forward-looking statements" within the meaning
of Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. These forward-looking statements can be identified by the
use of predictive, future-tense or forward-looking terminology, such as
"believes," "anticipates," "expects," "estimates," "plans," "may," "intends,"
"will," or similar terms. Investors are cautioned that any forward-looking
statements are not guarantees of future performance and involve significant
risks and uncertainties, and that actual results may differ materially from
those projected in the forward-looking statements. The following discussion
should be read together with the condensed consolidated financial statements and
notes to those statements included elsewhere in this report.
OVERVIEW
FalconStor was incorporated in Delaware for the purpose of developing,
manufacturing and selling storage networking infrastructure software. Our unique
open software approach to storage networking enables companies to better capture
and manipulate the expanding volume of enterprise data than existing storage
solutions, without rendering those solutions obsolete. By moving the
intelligence of storage management from hardware to software, we allow companies
to adopt the state-of-the-art Fibre Channel technology while at the same time,
leverage their prior investments in Ethernet information technology (IT)
infrastructure, taking full advantage of the ubiquitous connectivity of the
industry-standard Internet Protocol (IP). Our software technology can rapidly
embrace various input/output (I/O) interface, communications standards and
innovative storage services as they are introduced. Our unique architecture has
been recognized and licensed by partners in Gigabit Ethernet Switch,
SCSI-to-Fibre Channel Router, Disk-Subsystem and Appliances spaces. Our flagship
IPStor(TM) product, which began shipping in May, 2001, is currently the only
available all-software solution that combines industry-standard connectivity
with next-generation network storage services, offering large, distributed
enterprises a complete storage management solution that includes all four of the
key service categories: universal connectivity supporting both Fibre Channel and
IP/iSCSI-based storage provisioning; virtualization; storage services such as
fail-over, mirroring, replication and snapshot; and unified SAN (storage area
network) and NAS (network-attached storage).
From March 2000 through May 2001, we received net proceeds of approximately
$18.2 million from the sale of our preferred stock which converted into
approximately 20.2 million shares of our common stock. Our operations since
inception through the second quarter of 2001 were mainly comprised of the
development of our core storage networking infrastructure software product.
During 2000 and the first two quarters of 2001, we were in the development stage
of operations, as a result there were no significant revenues generated from our
planned principal operations. During the second quarter of 2001, we completed
the development of our principal product and released our software. We began to
earn our first significant revenues from software licenses in the third quarter
of 2001.
On August 22, 2001, we merged with Network Peripherals Inc. ("NPI"), a publicly
traded company. For more information relating to the merger with NPI, including
the accounting treatment, see note 2 to the unaudited condensed consolidated
financial statements.
RESULTS OF OPERATIONS - FOR THE QUARTER ENDED SEPTEMBER 30, 2001
Revenues
Revenues for the quarter ended September 30, 2001 were approximately $2.5
million, a $2.5 million increase from the prior year's comparable quarter. The
increase is due to the release of our principal product at the end of the second
quarter of 2001. We entered into various distribution, licensing and joint
promotion agreements with OEMs, whereby we provide the OEM a non-exclusive
software license to install our software on certain hardware in exchange for
royalty payments based on the number of products sold by the OEM. Nonrefundable
advances that we receive for software engineering services are
- 10 -
recorded as deferred revenue and recognized as revenue when the services are
complete and the software product master is delivered and accepted.
Additionally, we recognized approximately $50,000 during the quarter ended
September 30, 2001 from network consulting fees, which were billed on a time and
materials basis and recognized as revenue when the services were performed.
During the quarter ended September 30, 2000, we did not generate any revenues
from software licenses since our software was still in the development process
and had not yet been released. All revenues during the quarter ended September
30, 2000, were related to network consulting services. Future revenues are
expected to be derived substantially from software licenses and maintenance fees
related to our software.
Cost of Revenues
Cost of revenues for the quarter ended September 30, 2001 were approximately
$0.5 million compared to $33,000 for the quarter ended September 30, 2000. Cost
of revenues consist primarily of salaries and related expenses for storage
architects, training personnel, technical support personnel, production costs
and shipping costs. The increase in cost of revenues from the prior year is
mainly due an increase in the number of employees. As a result of the release of
our software in the second quarter of 2001, we hired additional employees to
help implement and support our software. We expect cost of revenues to increase
in absolute dollars, as additional staffing will be required to support our
anticipated revenue growth.
Gross profit for the quarter ended September 30, 2001 was $2.0 million or 79%
compared to $36,000 or 52% for the quarter ended September 30, 2000. The
increase in gross margin was due to the increase in software license revenues
which have a higher gross margin than network consulting fees.
Software Development Costs
Software development costs were approximately $1.4 million for the quarter ended
September 30, 2001 compared to approximately $0.5 million in the prior year's
comparable quarter. Included in software development costs are the salaries and
related expenses of our research and development personnel, and other
development related expenses. The $0.9 million increase from the prior year is
mainly due to an increase in employees. The increase in employees was needed to
develop our core storage networking infrastructure software product, as well as,
to develop new innovative features and options. Software development costs are
expected to increase in the future as we continue to modify and enhance our
product.
Selling and Marketing
Selling and marketing expenses increased from approximately $16,000 in the
quarter ended September 30, 2000 to approximately $1.9 million in the quarter
ended September 30, 2001. Selling and marketing expenses were mainly comprised
of salary and related costs of our sales and marketing staff, travel and
entertainment, public relations expense, collaterals, promotions, commissions,
trade shows expenses and costs associated with our sales offices in Taiwan,
Japan, France and Australia. This increase in selling and marketing expenses was
due to our product being released during the end of the second quarter of 2001.
As a result of this release, we expanded our sales force to accommodate our
revenue growth and we initiated our marketing efforts to promote our product and
create brand awareness.
Selling and marketing expenses were limited in the third quarter of 2000 since
our product had not yet been released. Selling and marketing expenses are
expected to increase in the future due to increased staffing costs necessary to
support our anticipated growth and continued branding and marketing efforts.
General and Administrative
General and administrative expenses were approximately $0.6 million for the
quarter ended September 30, 2001, an increase of approximately $0.5 million from
the prior year's comparable period. General and administrative expenses consist
primarily of salaries and related personnel costs for general corporate
functions, legal and professional fees and general corporate overhead costs. The
increase in general and administrative expenses was due to increased salaries
associated with building our corporate infrastructure. Additionally, as a public
company, we now incur additional legal and
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professional fees and corporate directors and officers insurance expense.
General and administrative expenses are expected to increase in absolute dollars
in the future to support our overall growth.
Interest and Other Income
Interest and other income was approximately $0.4 million for the quarter ended
September 30, 2001 compared to $76,000 for the quarter ended September 30, 2000.
The increase in interest income was due to a higher average cash, cash
equivalent and marketable securities balance as a result of the merger with NPI,
as well as, the cash we raised from the issuance of Series C convertible
preferred stock.
Income Taxes
We did not record a tax benefit associated with the pre-tax loss incurred from
the period from inception (February 10, 2000) through September 30, 2001, as we
deemed that it was more likely than not that the deferred tax assets will not be
realized based on our development and now early stage operations and,
accordingly, we provided a full valuation allowance against the deferred tax
asset.
RESULTS OF OPERATIONS - FOR THE NINE MONTHS ENDED SEPTEMBER 30, 2001 COMPARED TO
THE PERIOD FROM INCEPTION (FEBRUARY 10, 2000) THROUGH SEPTEMBER 30, 2000.
Revenues
Revenues for the nine months ended September 30, 2001 were approximately $2.6
million compared to approximately $68,000 for the period from inception
(February 10, 2000) through September 30, 2000. The increase of approximately
$2.5 million is due to the release of our principal product at the end of the
second quarter of 2001. As a result of the release of our product, we recognized
approximately $2.5 million in revenue from software licenses. Additionally, for
the nine months ended September 30, 2001 we recognized $70,000 from network
consulting fees. For the period from inception (February 10, 2000) through
September 30, 2000, we did not generate any revenues from software licenses
since our software was still in the development process and had not yet been
released. All revenues in 2000 were related to network consulting services.
Future revenues are expected to be derived substantially from software licenses
and maintenance fees related to our software.
Cost of Revenues
Cost of revenues for the nine months ended September 30, 2001 were approximately
$1.1 million compared to $33,000 for the period from inception (February 10,
2000) through September 30, 2000. The increase in cost of revenues from the
prior year is mainly due an increase in employees. As a result of the release of
our software in the second quarter of 2001, we hired additional employees to
help implement and support our software.
Gross profit for the nine months ended September 30, 2001 was $1.5 million or
58% compared to $36,000 or 52% for the period from inception (February 10, 2000)
through September 30, 2000. The increase in gross margin was due to the increase
in software license revenues, which have a higher gross margin than network
consulting fees.
Software Development Costs
Software development costs were approximately $3.7 million for the nine months
ended September 30, 2001 compared to approximately $0.7 million for the period
from inception (February 10, 2000) through September 30, 2000. The $3.0 million
increase from the prior year is mainly due to an increase in employees. The
increase in employees was needed to develop our core storage networking
infrastructure software product, as well as, to develop new innovative features
and options.
- 12 -
Selling and Marketing
Selling and marketing expenses increased from approximately $19,000 for the
period from inception (February 10, 2000) through September 30, 2000 to
approximately $5.3 million for the nine months ended September 30, 2001. This
increase in selling and marketing expenses was due to our product being released
during the end of the second quarter of 2001. As a result of this release, we
expanded our sales force to accommodate our revenue growth and we initiated our
marketing efforts to promote our product and create brand awareness. Selling and
marketing expenses were limited in 2000 since our product had not yet been
released.
General and Administrative
General and administrative expenses were approximately $2.1 million for the nine
months ended September 30, 2001, an increase of approximately $2 million from
the period from inception (February 10, 2000) through September 30, 2000. The
increase in general and administrative expenses was due to increased salaries
associated with building our basic corporate infrastructure. Additionally, as a
public company, we now incur additional legal and professional fees and
corporate directors and officers insurance expense.
Interest and Other Income
Interest and other income was approximately $0.8 million for the nine months
ended September 30, 2001 compared to $0.1 million for the period from inception
(February 10, 2000) through September 30, 2000. The $0.7 million increase in
interest income was due to higher average cash, cash equivalent and marketable
securities balances as a result of the merger with NPI, as well as the cash we
raised from the issuance of Series C convertible preferred stock.
Income Taxes
We did not record a tax benefit associated with the pre-tax loss incurred from
the period from inception (February 10, 2000) through September 30, 2001, as we
deemed that it was more likely than not that the deferred tax assets will not be
realized based on our development and now early stage operations and,
accordingly, we provided a full valuation allowance against the deferred tax
asset.
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 2001, we had approximately $54.2 million in cash and cash
equivalents and $18.8 million in marketable securities. Net cash used in
operating activities for the nine months ended September 30, 2001 was $6.2
million compared to approximately $0.5 million for period from inception
(February 10, 2000) through September 30, 2000. The increase in net cash used
was mainly attributable to the increase in net loss of $8.1 million partially
offset by non-cash expenses of approximately $1.1 million and increases in
accounts payable, accrued expenses and deferred revenue of approximately $2.9
million. The increase in net cash used was also attributable to increases in
accounts receivable and prepaid expenses and other current assets totaling
approximately $1.3 million.
Net cash provided by investing activities for the nine months ended September
30, 2001 was approximately $44.7 million compared to cash used of approximately
$0.6 million for period from inception (February 10, 2000) through September 30,
2000. The increase in cash provided by investing activities is mainly due to the
$48.2 million net cash acquired from the merger with NPI. This amount was
partially offset by $1.0 million in purchases of property and equipment, $2.2
million related to the purchase of software licenses and $0.2 million paid in
security deposits. For the period from inception (February 10, 2000) through
September 30, 2000 the net cash used was attributable to purchases of property
and equipment of $0.3 million and approximately $0.2 million in security
deposits.
- 13 -
Net cash provided by financing activities was approximately $8.0 million for the
nine months ended September 30, 2001. The $8.0 million was comprised of $7.9
million raised from our Series C financing and approximately $0.1 million from
the exercise of stock options. For the period from inception (February 10, 2000)
through September 30, 2000 cash provided by financing activities was
approximately $9.0 million from the issuance of Series A and B preferred stock.
As of September 30, 2001, we had $9.3 million of liabilities related to the
discontinued operations of NPI. Subsequent to September 30, 2001, we announced
that our Board of Directors authorized the repurchase of up to two million
shares of our outstanding stock. We also invested $2.3 million in Network-1. Our
principal sources of liquidity are cash, cash equivalents and marketable
securities, which are expected to be used for general corporate purposes,
including expansion of operations and capital expenditures.
We believe that our current balance of cash, cash equivalents and marketable
securities and expected cash flows from operations will be sufficient to meet
our cash requirements for at least the next twelve months.
Impact of Recently Issued Accounting Pronouncements
In June 2001, the FASB issued SFAS No. 142 "Goodwill And Other Intangible
Assets" ("SFAS No. 142"), which is effective for fiscal years beginning after
June 15, 2001. SFAS No. 142 establishes accounting and reporting standards for
goodwill and other intangible assets. In accordance with SFAS No. 142, an entity
can no longer amortize goodwill over its estimated useful life. Rather goodwill
will be subject to assessments for impairment by applying a fair-value-based
test. Intangible assets must be separately recognized and amortized over the
useful life. FalconStor expects the adoption of SFAS No. 142 on January 1, 2002
will not have a material impact on its consolidated results of operations or
financial position.
The FASB also recently issued SFAS No. 144, "Accounting for the Impairment or
Disposal of Long-Lived Assets," that is applicable to financial statements
issued for fiscal years beginning after December 15, 2001. The FASB's new rules
on asset impairment supersede FASB Statement 121, "Accounting for the Impairment
of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of," and portions
of APB Opinion 30, "Reporting the Results of Operations." This Standard provides
a single accounting model for long-lived assets to be disposed of and
significantly changes the criteria that would have to be met to classify an
asset as held-for-sale. Classification as held-for-sale is an important
distinction since such assets are not depreciated and are stated at the lower of
fair value and carrying amount. This Standard also requires expected future
operating losses from discontinued operations to be displayed in the period(s)
in which the losses are incurred, rather than as of the measurement date as
presently required. FalconStor expects the adoption of SFAS No. 144 will not
have a material impact on its consolidated results of operations or financial
position.
RISK FACTORS
Failure of our merger with Network Peripherals Inc to achieve potential benefits
could harm our business and operating results.
We expect that our merger will result in potential benefits for us. Achieving
these potential benefits will depend on a number of factors, some of which
include:
o retention of key management, marketing and technical personnel after
the merger;
o our ability to increase our customer base and to increase the sales of
our products; and
o competitive conditions in the storage networking infrastructure
software market.
- 14 -
We cannot assure you that the anticipated benefits will be achieved. The failure
to achieve anticipated benefits could harm our business, financial condition and
operating results.
We have had limited revenues and a history of losses, and we may not achieve or
maintain profitability.
Due to the early stage of our product, we have had limited revenues and a
history of losses. For the period from inception (February 10, 2000) through
September 30, 2001, we had net losses of $10,899,968. We currently have signed
contracts with resellers and original equipment manufacturers, or OEMs, to ship
our products and expect that as a result of these contracts, our revenues will
increase in the future. Our business model depends upon signing agreements with
additional OEM customers, developing a reseller sales channel, and expanding our
direct sales force. Any difficulty in obtaining these OEM and reseller customers
or in attracting qualified sales personnel will negatively impact our financial
performance.
Network Peripherals Inc. has liabilities and ongoing obligations to certain
customers and suppliers as a result of the winding down of its business.
Network Peripherals Inc. had existing agreements with certain suppliers and
customers. NPI may have liabilities to certain existing customers and suppliers
as a result of the termination of these agreements. While we are taking steps to
minimize any such potential liability, we cannot be sure that our efforts to
remove all such liability will be successful.
The market for IP-based storage solutions is new and uncertain, and our business
will suffer if it does not develop as we expect.
The rapid adoption of Internet protocol (IP)-based storage solutions is critical
to our future success. The market for IP-based solutions is still unproven,
making it difficult to predict its potential size or future growth rate, and
there are currently only a handful of companies with IP-based storage products
that are commercially available. Most potential customers have made substantial
investments in their current storage networking infrastructure, and they may
elect to remain with current network architectures or to adopt new architecture,
in limited stages or over extended periods of time. We will need to convince
these potential customers of the benefits of our IP-based storage products for
future storage network infrastructure upgrades or expansions. We cannot be
certain that a viable market for our products will develop or be sustainable. If
this market does not develop, or develops more slowly than we expect, our
business, financial condition and results of operations would be seriously
harmed.
If we are unable to develop and manufacture new products that address additional
storage networking infrastructure software market segments, our operating
results may suffer.
Although our current products are designed for one of the most significant
segments of the storage networking infrastructure software market, demand may
shift to other market segments. Accordingly, we may need to develop and
manufacture new products that address additional storage networking
infrastructure software market segments and emerging technologies to remain
competitive in the data storage software industry. We cannot assure you that we
will successfully qualify new storage networking infrastructure software
products with our customers by meeting customer performance and quality
specifications or quickly achieve high volume production of storage networking
infrastructure software products.
Any failure to address additional market segments could harm our business,
financial condition and operating results.
Our complex products may have errors or defects that could result in reduced
demand for our products or costly litigation.
Our IPStor platform is complex and designed to be deployed in large and complex
networks. Many of our customers will require that our products be designed to
interface with customers' existing networks, each of which may have different
specifications and utilize multiple protocol standards. Because our products are
critical to the networks of our customers, any significant interruption in their
service as a result of defects in our product within our customers' networks
could result in lost profits or damage to our customers. These problems could
cause us to incur significant service and warranty costs,
- 15 -
divert engineering personnel from product development efforts and significantly
impair our ability to maintain existing customer relationships and attract new
customers. In addition, a product liability claim, whether successful or not,
would likely be time consuming and expensive to resolve and would divert
management time and attention. Further, if we are unable to fix the errors or
other problems that may be identified in full deployment, we would likely
experience loss of or delay in revenues and loss of market share and our
business and prospects would suffer.
Our quarterly results may fluctuate significantly, which could cause our stock
price to decline.
Our future performance will depend on many factors, including:
o the average unit selling price of our products;
o existing or new competitors introducing better products at competitive
prices before we do;
o our ability to manage successfully the complex and difficult process
of qualifying our products with our customers;
o our customers canceling, rescheduling or deferring significant orders
for our products, particularly in anticipation of new products or
enhancements from us or our competitors;
o import or export restrictions on our proprietary technology; and
o personnel changes.
Many of our expenses are relatively fixed and difficult to reduce or modify. As
a result, the fixed nature of our expenses will magnify any adverse effect of a
decrease in revenue on our operating results.
The storage networking infrastructure software market is highly competitive and
intense competition could negatively impact our business.
The storage networking infrastructure software market is intensely competitive
even during periods when demand is stable. Our management believes that we
compete primarily with DataCore and StorageApps. Those competitors and other
potential competitors may be able to establish rapidly or expand storage
networking infrastructure software offerings more quickly, adapt to new
technologies and customer requirements faster and take advantage of acquisition
and other opportunities more readily.
Our competitors also may:
o consolidate or establish strategic relationships among themselves to
lower their product costs or to otherwise compete more effectively
against us; or
o bundle their products with other products to increase demand for their
products.
In addition, some OEMs with whom we do business, or hope to do business, may
enter the market directly and rapidly capture market share. If we fail to
compete successfully against current or future competitors, our business,
financial condition and operating results may suffer.
The loss of any of our key personnel could harm our business.
Our success depends upon the continued contributions of our key employees, many
of whom would be extremely difficult to replace. We do not have key person life
insurance on any of our personnel. Many of our senior management and a
significant number of our other employees have been with us for a short period
of time. Worldwide competition for skilled
- 16 -
employees in the storage networking infrastructure software industry is
extremely intense. If we are unable to retain existing employees or to hire and
integrate new employees, our business, financial condition and operating results
could suffer. In addition, companies whose employees accept positions with
competitors often claim that the competitors have engaged in unfair hiring
practices. We may be the subject of such claims in the future as we seek to hire
qualified personnel and could incur substantial costs defending ourselves
against those claims.
Our board of directors may selectively release shares of our common stock
received by the former FalconStor, Inc. stockholders from lock-up restrictions.
Our board of directors may, in its sole discretion, release any or all of the
shares of our common stock received by the former FalconStor stockholders from
lock-up restrictions at any time with or without notice. Any release of such
shares from lock-up restrictions may be applied to our former stockholders on a
proportionate or selective basis. If the release is selectively applied, the
stockholders whose shares are not released will be forced to hold such shares
while other stockholders may sell. In addition, the release of any of such
shares could depress our stock price.
If we are unable to protect our intellectual property, our business will suffer.
Our success is dependent upon our proprietary technology. Currently, the IPStor
software suite is the core of our proprietary technology. We have three pending
patent applications and pending trademark applications related to our IPStor
product. We cannot predict whether we will receive patents for our pending or
future patent applications, and any patents that we own or that are issued to us
may be invalidated, circumvented or challenged. In addition, the laws of certain
countries in which we sell and manufacture our products, including various
countries in Asia, may not protect our products and intellectual property rights
to the same extent as the laws of the United States.
We also rely on trade secret, copyright and trademark laws, as well as the
confidentiality and other restrictions contained in our respective sales
contracts and confidentiality agreements to protect our proprietary rights.
These legal protections afford only limited protection.
Our technology may be subject to infringement claims that could harm our
business.
We may become subject to litigation regarding infringement claims alleged by
third parties. We have received correspondence from a third party claiming that
some of our employees formerly employed by that third party may have disclosed
proprietary information of the third party in violation of certain agreements or
other obligations to that third party. This third party has also asserted that
our intellectual property may be based on or utilizes its intellectual property.
As of the date of this Form 10-Q filing, no formal action has been taken by the
third party. We believe these claims are without merit. However, if an action is
commenced against us, our management may have to devote substantial attention
and resources to defend these claims. An unfavorable result for the Company
could have a material adverse effect on our business, financial condition and
operating results and could limit our ability to use our intellectual property.
We have a significant amount of authorized but unissued preferred stock, which
may affect the likelihood of a change of control in our company.
Our Board of Directors has the authority, without further action by the
stockholders, to issue up to 2,000,000 shares of preferred stock on such terms
and with such rights, preferences and designations, including, without
limitation restricting dividends on our common stock, dilution of the voting
power of our common stock and impairing the liquidation rights of the holders of
our common stock, as the Board may determine without any vote of the
stockholders. Issuance of such preferred stock, depending upon the rights,
preferences and designations thereof may have the effect of delaying, deterring
or preventing a change in control. In addition, certain "anti-takeover"
provisions of the Delaware General Corporation Law, among other things, may
restrict the ability of our stockholders to authorize a merger, business
combination or change of control.
- 17 -
We have a significant number of outstanding options, the exercise of which would
dilute the then-existing stockholders' percentage ownership of our common stock.
As of September 30, 2001, we have outstanding options to purchase an aggregate
of 7,004,846 shares of our common stock at a weighted average exercise price of
$3.23 per share.
The exercise of all of the outstanding options would dilute the then-existing
stockholders' percentage ownership of common stock, and any sales in the public
market of the common stock issuable upon such exercise could adversely affect
prevailing market prices for the common stock. In addition, the existence of a
significant amount of outstanding options may encourage short selling by the
option holders since the exercise of the outstanding options could depress the
price of our common stock. Moreover, the terms upon which we would be able to
obtain additional equity capital could be adversely affected because the holders
of such securities can be expected to exercise or convert them at a time when we
would, in all likelihood, be able to obtain any needed capital on terms more
favorable than those provided by such securities.
Item 3. Qualitative and Quantitative Disclosures About Market Risk
Interest Rate Risks. Our return on our investments in cash, cash equivalents and
marketable securities is subject to interest rate risks. We regularly assess
these risks and have established policies and business practices to manage the
market risk of our marketable securities.
Foreign Currency Risk. We have several offices outside the United States.
Accordingly, we are subject to exposure from adverse movements in foreign
currency exchange rates. The effect of foreign currency exchange rate
fluctuations have not been material since our inception. We do not use
derivative financial instruments to limit our foreign currency risk exposure.
- 18 -
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
There were no material legal proceedings pending or, to our
knowledge, threatened against us.
Item 4. Submission of Matters to a Vote of Security Holders
(a) The 2001 annual meeting of stockholders was held on August 22,
2001.
(c) Matters voted on at the meeting and the number of votes cast:
Voted For Voted Against Abstentions Broker Non-Votes
--------- ------------- ----------- -----------------
(1) Approve merger of
FalconStor, Inc. and
Network Peripherals Inc. 7,278,933 133,005 6,860 5,265,721
(2) Amend restated certificate
of incorporation to increase
number of authorized
shares from 60,000,000
to 100,000,000 and to change
Network Peripherals Inc.'s
name to FalconStor
Software, Inc. 6,992,810 399,976 6,012 5,265,721
Item 6. Exhibits and Reports on Form 8-K
(b) Reports on Form 8-K
On August 24, 2001, we filed a Form 8-K under Item 5 and 7
announcing the completion of our merger with FalconStor, Inc.
On September 6, 2001, we filed a Form 8-K under Item 2 and 7
regarding the completion of our merger with Network
Peripherals Inc. and under Item 4 regarding a change in our
accountants.
- 19 -
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FALCONSTOR SOFTWARE, INC.
/s/ Jacob Ferng
---------------
Jacob Ferng
Chief Financial Officer and Vice President
(Principal Accounting Officer)
November 13, 2001
