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, 2003.
OR
/ / TRANSITION REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
For the transition period from __________ to __________
Commission file number 0-23970
FALCONSTOR SOFTWARE, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 77-0216135
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2 Huntington Quadrangle 11747
Melville, New York (Zip code)
(Address of principal executive offices)
Registrant's telephone number, including area code: 631-777-5188
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act: Common
Stock, $.001 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 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. |X|
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Exchange Act Rule 12b-2). Yes |X| No / /
Aggregate market value of Common Stock held by non-affiliates of the
Registrant as of June 30, 2003 was $150,059,513 which value, solely for the
purposes of this calculation excludes shares held by Registrant's officers,
directors, and their affiliates. Such exclusion should not be deemed a
determination by Registrant that all such individuals are, in fact, affiliates
of the Registrant. The number of shares of Common Stock issued and outstanding
as of February 29, 2004 was 46,905,432 and 46,670,432, respectively.
DOCUMENTS INCORPORATED BY REFERENCE:
The information required by Part III of Form 10-K will be
incorporated by reference to certain portions of a definitive proxy statement
which is expected to be filed by the Company pursuant to Regulation 14A within
120 days after the close of its fiscal year.
2
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
2003 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
Page
PART I.
Item 1. Business............................................................4
Item 2. Properties.........................................................10
Item 3. Legal Proceedings..................................................10
Item 4. Submission of Matters to a Vote of Security Holders................10
PART II.
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters................................................11
Item 6. Selected Consolidated Financial Data...............................11
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations..........................................14
Item 7A. Qualitative and Quantitative Disclosures About Market Risk.........29
Item 8. Consolidated Financial Statements and Supplementary Data...........30
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure................................52
Item 9A. Controls and Procedures............................................52
PART III.
Item 10. Directors and Executive Officers of the Registrant.................52
Item 11. Executive Compensation.............................................52
Item 12. Security Ownership of Certain Beneficial Owners and Management.....52
Item 13. Certain Relationships and Related Transactions.....................53
Item 14. Principal Accounting Fees and Services.............................53
PART IV.
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K....54
SIGNATURES....................................................................56
3
PART I
ITEM 1. BUSINESS
OVERVIEW
FalconStor Software, Inc. ("FalconStor" or the "Company") is a provider of
network storage infrastructure software solutions and related maintenance,
implementation and engineering services. FalconStor's unique open software
approach to storage networking enables companies to embrace state-of-the-art
equipment (based on SCSI, Fibre Channel or iSCSI) from any storage manufacturer
without rendering their existing or legacy solutions obsolete. Several strategic
partners have recognized the industrial strength of FalconStor's flagship
software, IPStor(R), and utilized it to power their special purpose storage
appliances to perform Real Time Data Migration, Data Replication, Virtual Tape
Library backup, and other advanced storage services. IPStor leverages the high
performance IP or FC based network to help corporate IT aggregate storage
capacity and contain the run-away cost of administering mission-critical storage
services such as snapshot, backup, data replication, and other storage services
in a distributed environment. Over 400 customers around the world have deployed
IPStor in production environments to manage their storage infrastructure with
minimal TCO (Total Cost of Ownership) and optimal ROI (Return on Investment).
FalconStor's products have been certified by such industry leaders as Adaptec,
Alacritech, ATTO Technology, Bell Microproducts, Brocade, Cisco, Emulex,
Fujitsu, Gadzoox, Hitachi Data Systems, Hitachi Engineering Co., Ltd., IBM,
Intel, LSI Logic, McDATA Corporation, Microsoft, NEC, Novell, NS Solutions
Corporation (subsidiary of The Nippon Steel Corporation, Japan), Oracle, QLogic,
Quantum, StorageTek, SUN and Tivoli. FalconStor has agreements with original
equipment manufacturers ("OEMs") including StorageTek, NEC, Runtop, Accton, and
MaXXan, to incorporate FalconStor's IPStor technology with such companies'
products.
Network Peripherals, Inc. ("NPI"), was incorporated in California in March 1989
and reincorporated in Delaware in 1994. FalconStor, Inc., was incorporated in
Delaware in February 2000. On August 22, 2001, FalconStor, Inc., merged with
NPI, a publicly traded company, with NPI as the surviving corporation. Although
NPI acquired FalconStor, as a result of the transaction, FalconStor, Inc.,
stockholders held a majority of the voting interests in the combined enterprise
after the merger. Accordingly, for accounting purposes, the acquisition was a
"reverse acquisition" and FalconStor, Inc., was the "accounting acquirer."
Further, as a result of NPI's decision on June 1, 2001 to discontinue its NuWave
and legacy business, at the time of the merger NPI was a non-operating public
shell with no continuing operations, and no intangible assets associated with
NPI were purchased by FalconStor. As a result, 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. In connection with the merger, the name of
NPI was changed to FalconStor Software, Inc. For more information relating to
the merger, see Note 2 of Notes to Consolidated Financial Statements.
INDUSTRY BACKGROUND
Corporations continue to face challenges that force them to better manage their
operations and the IT infrastructures they have in place to support their
current business and future growth. These challenges, coupled with the recent
economic environment have prompted a renewed focus on cost management,
efficiency, and return on investment.
Yankee Group estimates that storage budgets typically range from 10 to more than
20 percent of a company's overall IT infrastructure budget. The growing
importance of storage has triggered a move by companies to establish separate
storage groups within their IT organizations. Today, approximately 48 percent of
companies have separate storage groups, according to a 2003 Yankee Group survey
of 289 storage decision makers. Similar to other parts of companies' IT
strategies, a number of larger IT governance philosophies focus on how to
improve IT management in an effort to maximize storage budgets today. The
overriding goal is: measuring IT and storage operations value. The first step is
to fully understand the costs associated with various aspects of the IT
infrastructure, including storage.
For this reason, companies are focusing on:
o Lowering the costs of migration and the operational costs associated with
managing the environment.
4
o Preserving core operations and key business data in alignment with business
requirements and broader government regulations compliance, security of
data, and maintaining business operations through business continuity
strategies.
o Standardizing best practices in storage management, procurement, and
storage systems to achieve better economies of scale and make the storage
environment flexible enough to adapt to real-time changes in business needs
and demands.
According to Yankee Group, financial investments that once focused on storage
systems and supporting infrastructure are now distributed among storage systems,
management tools, networking, and salaries. In 2003, the most significant
portion of the storage budget went to storage systems, averaging 22 percent of
the budget. Storage management tools tied for second place with storage
networks, each accounting for 18 percent of the storage budget.
The growing complexities of storage environments are forcing companies to do a
number of things. First, to improve storage management, companies are more
aggressively moving to networked storage in 2004. Yankee Group predicts that in
2004 network storage will outpace traditional direct attached storage for
overall investment. Second, enterprises continue to face the issue of
heterogeneous storage management and will select products capable of supporting
multiple storage platforms from a single tool. Third, escalating regulatory
compliance requirements are forcing companies to gain better control of their
data. This includes classifying data based on overall priorities, retention
requirements, the value of the data to be retained, and how service levels can
be classified to support different types of data.
However, the most significant challenge remains the time needed to manage a
complex storage infrastructure. In measuring costs associated with the labor of
managing storage, the majority of companies viewed reduced maintenance costs as
proof of a return on investment (ROI), according to a 2003 Yankee Group survey.
Respondents to this survey also cited increasing the number of servers managed
per administrator (27 percent), as well as terabytes managed per full-time
employee (17 percent), as important measures. Labor costs associated with
storage management tasks can mount, depending on the operations. A significant
percentage of survey respondents indicated that they were spending more than 10
hours per week on a number of specific storage-related tasks. For example,
backup operations take the most time per week to manage, averaging six hours per
storage administrator.
Lastly, downtime remains a primary business concern. The Yankee Group estimates
that the financial services market has the largest cost of downtime of any
vertical market, with an average of $2.1 million an hour. A related industry,
banking, has an estimated hourly downtime cost of $1.5 million. In both cases,
the highly transactional nature of their businesses requires minimal downtime
without outages. Other industries, such as manufacturing, are also experiencing
significant costs for an hour of downtime of $680,000.
Over the next few years, key business technology initiatives established by
companies around the world will most likely be in the areas of storage
consolidation and upgrading existing storage management tools designed to
support disaster recovery and business continuity plans to reflect the growing
importance of compliance. Other initiatives will be in the areas of data
retention programs and the acceleration of data backup methods to ensure data
protection.
Companies continue to look for software that enables them to take better
advantage of their existing storage environment. Enterprises are considering
storage management tools focused on data migration, capacity planning and
provisioning -- all of which help improve the utilization and efficiency of
existing storage infrastructure.
PRODUCTS AND TECHNOLOGY
IPStor, FalconStor's flagship product, is a comprehensive set of state of the
art network storage infrastructure software solutions that delivers an open,
intelligent SAN/NAS infrastructure across heterogeneous environments by
providing advanced storage services for enterprise applications - optimizing
storage utilization, accelerating backup and recovery, maximizing performance
and ensuring business continuity.
5
SOFTWARE SOLUTIONS
The base software, running on either a layer of stand-alone or pair of
clustered, Linux/Solaris servers (the IPSTOR APPLIANCES) is responsible for
aggregating and provisioning storage capacity and services to application
servers via all industry standard protocols with speed, security, reliability,
interoperability, and scalability.
IPStor offers Storage Consolidation, Business Continuity/Disaster Recovery, I/O
Performance Optimization and Backup/Recovery Acceleration services designed to
help enterprise data centers minimize total cost of ownership (TCO) and maximize
return on investment (ROI).
IPSTOR'S STORAGE CONSOLIDATION SOLUTIONS consolidate heterogeneous storage
environments, centralize storage management under one simple interface, maximize
storage capacity utilization, consolidate servers, and/or migrate data.
IPSTOR BUSINESS CONTINUITY SOLUTIONS maintain continuous 24x7 availability and
usability of data storage in the event of non-catastrophic unplanned or planned
hardware outages and software errors.
IPSTOR DISASTER RECOVERY SOLUTIONS enable rapid recommencement of business in
the event of catastrophic outages, for example, a flood in the main data center.
IPSTOR'S I/O PERFORMANCE OPTIMIZATION SOLUTIONS were developed specifically to
leverage Solid-State Disk to increase overall storage performance to optimize
return on existing investments in IT infrastructure.
IPSTOR'S BACKUP AND RECOVERY ACCELERATION SOLUTIONS enable the customer to
leverage the network storage infrastructure to accelerate transparently the
performance of third-party backup software, to minimize the risk window, and to
shorten the recovery time without impacting the performance of production
servers.
IPSTOR'S VIRTUAL TAPE LIBRARY OPTION increases the speed and reliability of
off-the-shelf backup and archiving applications by using IPStor-managed disks to
emulate tape drives or libraries. With backup windows shrinking and rapid data
restoration more critical than ever, IPStor's Virtual Tape Library Option allows
users to utilize disk storage to emulate multiple tape libraries concurrently
and to accelerate the backup/restore speed.
STORAGE APPLIANCES
FalconStor has entered into agreements with resellers and with OEMs to develop
"storage appliances" that combine certain aspects of IPStor functionality with
third party hardware to create single purpose turnkey solutions that are easy to
deploy. Currently, FalconStor's resellers and/or OEM partners offer the
following storage appliances:
REALTIME DATA MIGRATION. Uses fibrechannel SAN to transport data across
different vendors' storage subsystems without reconfiguring or shutting down the
host.
VIRTUALTAPE LIBRARY. Utilizes rotating disk to emulate tape drive/library to
turbo-charge backup/restore and to facilitate vaulting over IP.
ISCSI STORAGE. Aggregates and provisions storage capacity and offers Business
Continuity/Disaster Recovery for hosts attached to an iSCSI SAN.
MAINTENANCE, IMPLEMENTATION AND ENGINEERING SERVICES.
FalconStor offers customers a variety of annual maintenance services which
entitle customers to periodic software updates and various levels of technical
support. Although the implementation of IPStor does not generally require the
assistance of FalconStor, the Company offers software implementation services.
FalconStor also offers customers software engineering services.
6
BUSINESS STRATEGY
FalconStor intends to solidify its position as a leading network storage
software provider to enterprises and Internet Data Centers worldwide. FalconStor
intends to achieve this objective through the following strategies:
o MAINTAIN A LEADERSHIP POSITION IN NETWORK STORAGE SOFTWARE. FalconStor
intends to leverage its protocol-agnostic architecture to maintain a
leadership position in the network storage software market. The network
storage software market is defined by rapid change, and FalconStor plans to
continue to focus its research and development efforts to invent and to
bring to market innovative solutions.
o EXPAND PRODUCT OFFERINGS. During the past year, FalconStor offered
additional options for its IPStor software. In addition, FalconStor
expanded its offerings of storage appliances consisting of third-party
hardware loaded with IPStor functionality. FalconStor intends to continue
to expand the options available for IPStor and to offer additional storage
appliances.
o INCREASE MARKET PENETRATION AND BRAND RECOGNITION. FalconStor plans to
promote its products and corporate awareness by
o forming strategic partnerships with leading industry players;
o participating in industry events, conferences and trade shows; and
o continuing targeted promotions and public relations campaigns.
FalconStor believes that establishing a strong brand identity as a network
storage software solution provider is important to its future success.
o ESTABLISH A GLOBAL PRESENCE. FalconStor believes that significant market
share can be achieved in Europe and Asia. FalconStor, through its European
headquarters, plans to expand its operational capabilities in Europe. In
addition, through its Asia headquarters, FalconStor believes that it is
developing a strong business presence in the Asia/Pacific Rim.
o EXPAND TECHNOLOGIES AND CAPABILITIES THROUGH STRATEGIC ACQUISITIONS AND
ALLIANCES. FalconStor believes that opportunities exist to expand its
technological capabilities, product offerings and services through
acquisitions and strategic alliances. When evaluating potential
acquisitions and strategic alliances, FalconStor will focus on transactions
that enable it to acquire:
o important enabling technology;
o complementary applications;
o marketing, sales, customer and technological synergies; and/or
o key personnel.
As of the date of this filing, FalconStor has no agreements, commitments or
understanding with respect to any such acquisitions or strategic alliances,
which have not been consummated.
o SEEK OEM RELATIONSHIPS WITH INDUSTRY LEADERS. FalconStor intends to
continue to enter into original equipment manufacturer ("OEM") agreements
with strategic switch, storage, appliance and operating system vendors.
Besides accelerating overall marketing growth, the OEM relationships should
bolster FalconStor's product recognition, corporate credibility and revenue
stream.
7
SALES, MARKETING AND CUSTOMER SERVICE
FalconStor plans to continue to sell its products primarily through agreements
with OEMs, value-added resellers and distributors.
o ORIGINAL EQUIPMENT MANUFACTURER RELATIONSHIPS. OEMs collaborate with
FalconStor to integrate FalconStor's products into their own product
offerings or resell FalconStor's products under their own label.
o VALUE-ADDED RESELLER AND DISTRIBUTOR RELATIONSHIPS. FalconStor has entered
into value-added reseller and distributor agreements to help sell its
product in various geographic areas. FalconStor's value-added resellers and
distributors market the entire IPStor product suite and receive a discount
off list price on products sold.
o STORAGE APPLIANCES. FalconStor has entered into agreements with strategic
partners in which IPStor is adapted to the strategic partner's
special-purpose storage appliances to offer Real-Time Data Migration, Data
Replication, Storage Consolidation, Virtual Tape Library, and other
services specifically for the partner's customers.
FalconStor's marketing department consists of marketing professionals dedicated
to advertising, public relations, marketing communications, events and channel
partner programs. FalconStor's marketing efforts focus on building brand
recognition and developing leads for the sales force.
FalconStor Professional Services personnel are also available to assist
customers and partners throughout the product life cycle of IPStor deployments.
The Professional Services team includes seasoned "Storage Architects" who can
assist in the assessment, planning/design, deployment, and testing phases of an
IPStor deployment project, and a Technical Support group for post-deployment
assistance and on-going trouble-shooting.
RESEARCH AND DEVELOPMENT
The network storage services industry is subject to rapid technological
advancements, changes in customer requirements, developing industry standards,
and regular new product introductions and enhancements. As a result,
FalconStor's success, in part, depends upon its ability to continue to improve
existing solutions and to develop and introduce new products on a cost-effective
and timely basis. FalconStor believes its continued investment in research and
development is critical to its ability to continue to provide new and enhanced
products addressing emerging market needs. There can be no assurance that
FalconStor will successfully develop new products to address new customer
requirements and technological changes, or that such products will achieve
market acceptance. FalconStor's research and development staff consisted of 83
employees as of December 31, 2003. Research and development expenses, primarily
consisting of personnel expenses, were, approximately $5.0 million, $6.3 million
and $7.1 million in 2001, 2002 and 2003, respectively. FalconStor anticipates
that research and development expenses will increase in 2004.
COMPETITION
As the demand for network-based storage products and services increases, more
competitors will enter this high-growth market segment. Although there are
several companies attempting to offer unified storage services to application
hosts attached to CIFS, NFS, iSCSI and Fibre Channel (FC) networks, FalconStor
believes it is the only software-based solution capable of accommodating storage
devices with industry-standard interfaces and provisioning the virtualized
resource over FC, IP/iSCSI, NFS and CIFS with comprehensive storage services and
end-to-end manageability. However, some of FalconStor's product capabilities
compete with products from a number of companies with substantially greater
financial resources, such as Network Appliance, Inc., and Veritas Software
Corporation. FalconStor is not aware of any other software company providing
unified storage services running on a standard Linux or Solaris based appliance.
FalconStor believes that the principal competitive factors affecting its market
include product features such as scalability, data availability, ease of use,
price, reliability, hardware/platform neutrality, customer service and support.
8
Additionally, as FalconStor executes upon its Storage Appliance Kit (SAK)
initiative, which is based on the advanced network-storage services currently
available in the IPStor software suite, the Company may experience supplemental
competitive pressures from smaller, niche players in the industry. However,
FalconStor believes these potential competitors currently do not offer the depth
or breadth of storage services delivered by FalconStor, nor do they possess the
experience and technological innovation needed to develop and deliver reliable,
fully integrated, and proven storage services.
FalconStor's success will depend largely on its ability to generate market
demand and awareness of the IPStor software suite and to develop additional or
enhanced products in a timely manner. FalconStor's success will also depend on
its ability to convince potential partners of the benefits of licensing its
software rather than competing technologies. FalconStor's future and existing
competitors could introduce products with superior features, scalability and
functionality at lower prices than FalconStor's products and could also bundle
existing or new products with other more established products to compete with
FalconStor. Increased competition could result in price reductions and reduced
gross margins, which could harm FalconStor's business.
INTELLECTUAL PROPERTY
FalconStor's success is dependent in part upon its proprietary technology.
Currently, the IPStor software suite is the core of its proprietary technology.
FalconStor currently has eighteen pending patent applications, six registered
trademarks - including "FalconStor," "FalconStor Software" and "IPStor" - and
many pending trademark applications related to FalconStor and the IPStor
product.
FalconStor seeks to protect its proprietary rights and other intellectual
property through a combination of copyright, trademark and trade secret
protection, as well as through contractual protections such as proprietary
information agreements and nondisclosure agreements. The technological and
creative skills of its personnel, new product developments, frequent product
enhancements and reliable product maintenance are essential to establishing and
maintaining a technology leadership position.
FalconStor generally enters into confidentiality or license agreements with its
employees, consultants and corporate partners, and generally controls access to
and distribution of its software, documentation and other proprietary
information. Despite FalconStor's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use its
products or technology. Monitoring unauthorized use of its products is
difficult, and there can be no assurance that the steps taken by FalconStor will
prevent misappropriation of its technology, particularly in foreign countries
where laws may not protect its proprietary rights as fully as do the laws of the
United States.
MAJOR CUSTOMERS
For the year ended December 31, 2003, FalconStor did not have any customers that
accounted for over 10% of revenues.
EMPLOYEES
As of December 31, 2003, FalconStor had 178 full-time employees, consisting of
42 in sales and marketing, 43 in service, 83 in research and development and 10
in general administration. FalconStor is not subject to any collective
bargaining agreements and believes its employee relations are good.
INTERNET ADDRESS AND AVAILABILITY OF FILINGS
FalconStor's internet address is www.falconstor.com. FalconStor makes available
free of charge on or through its Internet website, FalconStor's Annual Report on
Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Sections 13(a) or
9
15(d) of the Securities Exchange Act of 1934 as soon as reasonably practicable
after FalconStor electronically files such material with, or furnishes it to,
the SEC. FalconStor complied with this policy for every Securities Exchange Act
of 1934 report filed during the year ended December 31, 2003.
ITEM 2. PROPERTIES
FalconStor's headquarters are located in an approximately 45,000 square foot
facility located in Melville, New York, of which 22,000 square feet is currently
being utilized. Offices are also leased for development, sales and marketing
personnel, which total an aggregate of approximately 39,900 square feet in
Euless, Texas; Le Chesnay, France; Taichung, Taiwan; Tokyo, Japan; Shanghai,
China; Munich, Germany; and Seoul, Korea. Initial lease terms range from one to
eight years, with multiple renewal options.
ITEM 3. 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
None
10
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
Our Common Stock is listed on The Nasdaq National Market ("Nasdaq") under
the symbol "FALC". The following table sets forth the range of high and
low closing sales prices of our Common Stock for the periods indicated as
reported by Nasdaq:
2003 2002
---- ----
High Low High Low
---- --- ---- ---
Fourth Quarter $ 9.15 $ 6.11 $ 4.99 $ 3.61
Third Quarter $ 6.89 $ 4.54 $ 6.20 $ 4.08
Second Quarter $ 7.11 $ 3.56 $ 7.44 $ 4.02
First Quarter $ 4.57 $ 3.47 $11.97 $ 6.20
HOLDERS OF COMMON STOCK
We had approximately 211 holders of record of Common Stock as of March 1,
2004. This does not reflect persons or entities whom hold Common Stock in
nominee or "street" name through various brokerage firms.
DIVIDENDS
We have not paid any cash dividends on our common stock since inception.
We expect to reinvest any future earnings to finance growth, and therefore
do not intend to pay cash dividends in the foreseeable future. Our board
of directors may determine to pay future cash dividends if it determines
that dividends are an appropriate use of Company capital.
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data with respect to our consolidated
balance sheets as of December 31, 2003, 2002, 2001 and 2000 and the
related consolidated statements of operations data for the years ended
December 31, 2003, 2002 and 2001 and the period from inception (February
10, 2000) through December 31, 2000 have been derived from our audited
consolidated financial statements. The following selected consolidated
financial data should be read in conjunction with the consolidated
financial statements and the notes thereto and the information contained
in Item 7, "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
11
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Period from Inception
Year Ended Year Ended Year Ended (February 10, 2000)
December 31, December 31, December 31, through December 31,
2003 2002 2001 2000
-------------------------------- ----------------------------------------
(In thousands, except per share data)
Revenues:
Software license revenue ......................... $ 12,251 $ 8,667 $ 4,714 $ --
Maintenance revenue .............................. 2,473 1,297 17 --
Software services and other revenue .............. 2,220 665 861 143
-------- -------- --------- --------
16,944 10,629 5,592 143
-------- -------- --------- --------
Operating expenses:
Amortization of purchased and capitalized software 1,394 899 273 --
Cost of maintenance, software services and other
revenue ....................................... 2,580 1,309 897 224
Software development costs ....................... 7,068 6,281 5,004 1,379
Selling and marketing ............................ 10,967 9,856 8,085 327
General and administrative ....................... 2,878 2,592 2,732 534
Lease abandonment charge ......................... 550 -- -- --
Impairment of prepaid royalty .................... -- 483 -- --
-------- -------- --------- --------
25,437 21,420 16,991 2,464
-------- -------- --------- --------
Operating loss ........................... (8,493) (10,791) (11,399) (2,321)
-------- -------- --------- --------
Interest and other income ........................... 1,122 1,585 1,365 225
Impairment of long-lived assets ..................... 35 (2,300) -- --
-------- -------- --------- --------
Loss before income taxes ................... (7,336) (11,506) (10,034) (2,096)
Provision for income taxes ......................... 33 37 22 --
-------- -------- --------- --------
Net loss ................................... $ (7,369) $(11,543) $(10,056) $ (2,096)
Beneficial conversion feature attributable to
convertible preferred stock....................... -- -- 3,896 --
-------- -------- --------- --------
Net loss attributable to common
shareholders ..................................... $ (7,369) $(11,543) $ (13,952) $(2,096)
======== ======== ========= ========
Basic and diluted net loss per share attributable to
common shareholders .............................. $ (0.16) $ (0.26) $ (0.40) $ (0.09)
======== ======== ========= ========
Basic and diluted weighted average common shares
outstanding.......................................... 45,968 45,233 35,264 24,383
======== ======== ========= ========
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CONSOLIDATED BALANCE SHEET DATA:
December 31, December 31, December 31, December 31,
2003 2002 2001 2000
-------------------------------------------------------------
(In thousands)
Cash and cash equivalents and
marketable securities $36,685 $51,102 $64,527 $ 7,727
Working capital 39,131 47,746 57,518 7,254
Total assets 56,493 64,710 74,471 8,594
Long-term obligations -- -- 283 --
Stockholders' equity 50,556 55,901 63,562 8,057
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ITEM 7. 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 CONSOLIDATED FINANCIAL STATEMENTS AND NOTES TO
THOSE FINANCIAL STATEMENTS INCLUDED ELSEWHERE IN THIS REPORT.
OVERVIEW
The year 2003 was a year of growth - and investment in future growth
- for our Company. Our revenues increased to $16.9 million from $10.6 million in
2002. We used these revenues and available cash to fund operations and to invest
in infrastructure to position the Company for future growth.
The major areas of investment were in our personnel and our
facilities.
To continue to create industry-leading cutting-edge network storage
solutions, we hired additional development engineers and quality assurance
engineers. We also hired engineers to design and test the products that are or
will be sold by our OEM partners. Continuing to deliver products to meet the
demands of the network storage market is necessary for us to remain competitive
and to continue our growth.
We also increased our sales force and our technical support team. An
increased sales force should expand the market exposure for our products. The
expanded technical support team responds to questions and technical issues from
end users of our products and from our resellers and OEM partners. Providing top
notch technical support to these groups enhances our ability to continue to make
sales. End users who are satisfied with our technical support are more likely to
order additional products from us. Resellers and OEM partners who are happy with
our technical support, and whose end users are satisfied, will be less likely to
look to other providers for future products.
In November 2003, we moved our global headquarters to a larger
facility in Melville, New York. Our previous office space had become inadequate
for our personnel and equipment needs. Our new headquarters has over 45,000
square feet, of which we are currently utilizing 22,000 square feet. Our lease
provides that we take possession and control of the space in stages, allowing us
to occupy more space as we grow. Because of work done in the space by the prior
tenant, a global computer services provider, we obtained a multi-million dollar
technology and office infrastructure at no cost. This pre-built infrastructure
includes computer labs and training rooms. The building has dual electrical
feeds and diesel-powered generators to assure business continuity during
unexpected events.
We also moved our Asia/Pacific headquarters in Taiwan to a larger
location. This move provides the space needed for our growing Asia/Pacific
presence.
The key factors we look to for our future business prospects are our
sales pipeline, our ability to establish relationships with key industry OEMs
and resellers, sales by our OEM partners, re-orders from existing customers,
additional orders from resellers, and the growth of the overall market for
network storage solutions.
Our sales "pipeline" consists of inquiries from end users and
resellers for possible purchases of our products. Our overall sales pipeline
steadily increased for each quarter of 2003 compared with the same quarter in
2002.
14
OEM relationships are important to us for two main reasons. First,
sales by our OEM partners contribute to our revenues. Second, having our
products selected by respected, established industry leaders signals to
potential customers, resellers and other potential OEM partners that our
products are quality products that add value to their enterprise.
During the past year, we announced strategic OEM relationships with
both StorageTek and CNT. Each of these partners undertook broad reviews of all
of the competing software solutions available and, after these reviews, each
selected IPStor to power network storage solutions for their customers. The
choice of IPStor by these major industry participants again validates the design
and the capabilities of our products.
In 2003 we signed two additional worldwide OEM agreements with two
major technology companies with global presences. These OEMs also conducted
in-depth evaluations of all available storage software solutions and chose
IPStor.
These four OEM relationships are in addition to the OEM partnerships
we already had with companies including Acer, NEC, and Maxxan. We will continue
to seek additional OEM opportunities in the future.
Many enterprises look to value added resellers or solution providers
to assist them in making their information technology purchases. These resellers
typically review an enterprise's needs and suggest a hardware, software, or
combined hardware and software solution to fulfill the enterprise's
requirements. Resellers have wide choices in fulfilling their customers' needs.
We have established strong relationships with many premier resellers. In 2003,
we signed agreements with many new resellers worldwide. We also terminated
relationships with several resellers who we felt were not properly selling our
products. We will continue to enter into relationships with resellers and to
discontinue relationships with resellers with whom we are not satisfied.
In 2003, approximately 20% of our sales came from our OEM partners
and approximately 80% of our sales came from resellers or distributors. We
expect an increase in the percentage of sales attributable to OEMs in 2004 as
our OEM relationships mature and expand.
The level of re-orders from existing end users of our products is a
significant measure of customer satisfaction. Information technology
professionals will only re-order products for their companies if they see that
the products have reduced total cost of ownership and have provided a good
return on investment. Re-orders are thus an indication that our products are
delivering as promised and that our support is meeting the end users' needs. In
2003, we began to see re-orders from some of our end-users. These end-users
ordered additional copies of IPStor or ordered additional options. If re-orders
decline, it would indicate that future sales might also decline. However, the
use of re-orders as an analytical tool is somewhat impaired because our OEM
partners typically do not provide us with information identifying the end user
for each order.
As service providers to companies, resellers' reputations are
dependent on satisfying their customers' needs efficiently and effectively. If
resellers determine that a product they have been providing to their customers
is not functioning as promised or is not providing adequate return on
investment, or if the customers are complaining about the level of support they
are receiving from the suppliers, the resellers will move quickly to offer
different solutions to their customers. Additional sales by resellers are
therefore an important indicator of our business prospects.
The network storage solutions market continues to grow. (Please see
the discussion on page 4.) In addition to growth based on the current demand for
storage server consolidation and replication, we expect to see growth in backup
acceleration.
Some of our strategic industry partners are applying IPStor in
different market segments and on additional platforms. The demand for disaster
recovery and backup solutions continues to expand. Our partners are offering
appliances and other solutions powered by IPStor for replication and for Virtual
Tape Library to meet this demand.
We are also seeing growing market acceptance of IP-based Storage
Area Networks. Previously, most SANs had been based on fibre-channel. We plan to
tap into the growth in this market through sales of our products by our
strategic partners.
15
Another area of growth is dedicated-purpose storage "appliances."
Storage appliances combine software with hardware to provide single-purpose
turnkey solutions to critical data storage needs. In response to the needs of
our customers and our resellers, we offer for sale various storage appliances.
(Please see discussion on page 6.) We expect that sales of storage appliances by
resellers and OEMs will form a higher percentage of our revenues in 2004 than in
2003.
Our critical accounting policies are those related to revenue
recognition and accounts receivable allowances. As described in note 1 to our
consolidated financial statements, we recognize revenue in accordance with the
provisions of Statement of Position 97-2, Software Revenue Recognition, as
amended. Software license revenue is recognized only when pervasive evidence of
an arrangement exists and the fee is fixed and determinable, among other
criteria. An arrangement is evidenced by a signed customer contract for
nonrefundable royalty advances received from OEMs or a customer purchase order
for each software license resold by an OEM, distributor or solution provider to
an end user. The software license fees are fixed and determinable as our
standard payment terms range from 30 to 90 days, depending on regional billing
practices, and we have not provided any of our customers extended payment terms.
When a customer licenses software together with the purchase of maintenance, we
allocate a portion of the fee to maintenance for its fair value based on the
contractual maintenance renewal rate.
We review accounts receivable to determine which are doubtful of
collection. In making the determination of the appropriate allowance for
uncollectible accounts and returns, we consider specific past due accounts,
analysis of our accounts receivable aging, customer payment terms, historical
collections, write-offs and returns, changes in customer demand and
relationships, concentrations of credit risk and customer credit worthiness.
Historically, we have not experienced a high level of write-offs and returns due
to our customer relationships, contract provisions and credit assessments.
Changes in the credit worthiness of customers, general economic conditions and
other factors may impact the level of future write-offs, revenues and our
general and administrative expenses.
RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2003 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2002
Revenues for the year ended December 31, 2003 increased 59% to $16.9
million compared to $10.6 million for the year ended December 31, 2002. Our
operating expenses increased 19% from $21.4 million in 2002 to $25.4 million in
2003. Net loss decreased 36% from $11.5 million in 2002 to $7.4 million in 2003.
The increase in revenues was mainly due to an increase in demand for our network
storage solution software. Over 80% of our revenues were generated from
resellers and distributors and the remaining revenue was derived from OEM
partners. Expenses increased in all departments to support our growth. We
invested in additional employees and our headcount increased from 138 employees
as of December 31, 2002 to 178 employees as of December 31, 2003. We also
invested in infrastructure by purchasing additional computers and equipment and
we moved our headquarters to a larger facility.
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue is comprised of software licenses sold
through our OEMs, value-added resellers and distributors to end users and, to a
lesser extent, directly to end users. These revenues are recognized when, among
other requirements, we receive a customer purchase order and the software and
permanent key codes are delivered to the customer. We also receive nonrefundable
royalty advances and engineering fees from some of our OEM partners. These
arrangements are evidenced by a signed customer contract, and the revenue is
recognized when the software product master is delivered and accepted, and the
engineering services, if any, have been performed.
Software license revenue increased 41% to $12.3 million in 2003 from
$8.7 million in 2002. Increased market acceptance and demand for our product
were the primary drivers of the increase in software license revenue. A
continued increase in the number of our channel partners and OEMs also helped
16
increase our revenues. We expect our software license revenue to continue to
grow and the percentage of software license revenue derived from our OEM
partners to increase.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenues are comprised of
software maintenance and technical support, professional services primarily
related to the implementation of our software, engineering services, and sales
of computer hardware. Revenue derived from maintenance and technical support
contracts is deferred and recognized ratably over the contractual maintenance
term. Professional services revenue is recognized in the period that the related
services are performed. Revenue from engineering services is primarily related
to customizing software product masters for some of our OEM partners. Revenue
from engineering services is recognized in the period the services are
completed. In 2003 and 2002, we had a limited number of transactions in which we
purchased hardware and bundled this hardware with our software and sold the
bundled solution to a customer. A portion of the contractual fees is recognized
as revenue when the hardware or software is delivered to the customer based on
the relative fair value of the delivered element(s). Through December 31, 2003,
the software and hardware in bundled solutions have almost always been delivered
to the customer in the same quarter. Maintenance, software services and other
revenue increased 139% to $4.7 million in 2003 from $2.0 million in 2002.
The major factor behind the increase in maintenance, software
services and other revenue was an increase in the number of maintenance and
technical support contracts we sold. As we are in business longer, and as we
license more software, we expect these revenues will continue to increase. The
majority of our new customers purchase maintenance and support and most
customers renew their maintenance and support after their initial contracts
expire. Maintenance revenue increased from $1.3 million for the year ended
December 31, 2002 to $2.5 million for the year ended December 31, 2003. Growth
in our professional services sales, which increased from $0.4 million in 2002 to
$0.9 million in 2003, also contributed to the increase in software services and
other revenues. This increase in professional services revenue was related to
the increase in our software license customers that elected to purchase
professional services. Additionally, our hardware sales increased from $0.2
million in 2002 to $1.3 million in 2003. This increase was the result of an
increase in demand from our customers for bundled solutions.
We expect maintenance, software services and other revenues to
continue to increase.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
To remain successful in the network storage solutions market, we
must continually upgrade our software by enhancing the existing features of our
products and by adding new features and products. We often evaluate whether to
develop these new offerings in-house or whether we can achieve a greater return
on investment by purchasing or licensing software from third parties. Based on
our evaluations we have purchased or licensed various software for resale since
2001. Amortization of purchased and capitalized software increased from $0.9
million for the year ended December 31, 2002 to $1.4 million for the year ended
December 31, 2003. The increase in amortization expense was due to our purchase
of an additional $1.8 million of software licenses in 2003. As of December 31,
2003, we had $4.9 million of purchased software licenses that are being
amortized over three years. For the year ended December 31, 2003, we recorded
$1.4 million of amortization related to these purchased software licenses. As of
December 31, 2002, we had $3.0 million of purchased software licenses and
recorded approximately $0.9 million of amortization for the year ended December
31, 2002 related to these purchased software licenses. We will continue to
evaluate third party software licenses and may make additional purchases, which
would result in an increase in amortization expense.
The Company did not capitalize any software development costs until
our initial product reached technological feasibility in March 2001. At that
point, we capitalized $0.1 million of software development costs, which are
being amortized at the greater of straight line over three years or the ratio of
current revenue of the related products to total current and anticipated future
revenue of these products. Amortization of capitalized software was $31,523 and
$31,524 for the years ended December 31, 2003 and 2002, respectively.
17
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenue consists
primarily of personnel costs and other costs associated with providing software
implementations, technical support under maintenance contracts, and training.
Cost of maintenance, software services and other revenues also includes the cost
of hardware purchased for resale. Cost of maintenance, software services and
other revenues for the year ended December 31, 2003 increased by 97% to $2.6
million compared to $1.3 million for the year ended December 31, 2002. The
increase in cost of maintenance, software services and other revenue was
primarily driven by an increase in hardware sales. As we sold more hardware, our
hardware costs for resale rose from $0.2 million in 2002 to $1.0 million in
2003. The increase in cost of maintenance, software services and other revenue
was also due to an increase in personnel. As a result of our increased sales of
maintenance and support contracts and professional services, we required a
higher number of employees to provide technical support and to implement our
software. Our cost of maintenance, software services and other revenue will
continue to grow in absolute dollars as our revenue increases.
Gross profit for the year ended December 31, 2003 was $13.0 million
or 77% of revenues compared to $8.4 million or 79% of revenues for the year
ended December 31, 2002. The increase in gross profit was directly related to
the increase in revenues. The decrease in gross margins was due to the increase
in amortization of purchased software licenses and was also partially related to
margins on hardware sales, which are typically lower than the margins on
software and services.
SOFTWARE DEVELOPMENT COSTS
Software development costs consist primarily of personnel costs for
product development personnel and other related costs associated with the
development of new products, enhancements to existing products, quality
assurance and testing. Software development costs increased 13% to $7.1 million
in 2003 from $6.3 million in 2002. The increase in software development costs
was primarily due to an increase in employees required to enhance and test our
core network storage software product, as well as to develop new innovative
features and options. In addition, as we negotiated and signed new OEM partners,
we required additional employees to test and customize our software with our OEM
partners' products. In 2003, we also opened a development office in China to
assist in our development work. We intend to continue recruiting and hiring
product development personnel to support our development process.
SELLING AND MARKETING
Selling and marketing expenses consist primarily of sales and
marketing personnel and related costs, travel, public relations expense,
marketing literature and promotions, commissions, trade show expenses, and the
costs associated with our foreign sales offices. Selling and marketing expenses
increased 11% to $11.0 million in 2003 from $9.9 million in 2002. As a result of
the increase in revenue and interest in our software, our commission expense and
travel expenses increased. In addition, we continued to hire new sales and sales
support personnel and expand our worldwide presence to accommodate our revenue
growth. We believe that to continue to grow sales, our sales and marketing
expenses will continue to increase.
GENERAL AND ADMINISTRATIVE
General and administrative expenses consist primarily of personnel
costs of general and administrative functions, public company related fees,
directors and officers insurance, legal and professional fees and other general
corporate overhead costs. General and administrative expenses increased 11% to
$2.9 million in 2003 from $2.6 million in 2002. One reason for the increase in
general and administrative expenses is due to an increase in salaries. As our
business grew, we required additional general and administrative personnel to
support the growth. Another reason for the increase was due to higher premiums
for our directors and officers insurance. We expect general and administrative
expenses to continue to increase in order to support the growth of the business.
18
INTEREST AND OTHER INCOME
We invest our cash, cash equivalents and marketable securities in
government securities and other low risk investments. Interest and other income
decreased 29% to $1.1 million in 2003 from $1.6 million in 2002. This decrease
in interest income was due to lower interest rates and lower average cash, cash
equivalent and marketable securities balances. We expect interest and other
income to decrease until the time we generate positive cash flows.
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 December 31,
2003, as we deemed that it was more likely than not that the deferred tax assets
will not be realized based on our early stage of operations. Accordingly, we
provided a full valuation allowance against our net deferred tax assets. Our
income tax provision consists of tax liabilities related to our foreign
subsidiaries.
LEASE ABANDONMENT CHARGE
In November 2003, we relocated our headquarters to a larger facility
to accommodate our future growth. As a result of this relocation, we vacated our
previous office space and recorded a charge for the estimated loss we expect to
incur on the remaining lease obligation. The charge of $0.6 million included the
remaining lease rental obligation reduced by cash flows we expect to generate
from an agreement to sub-lease the facility as well as the write off of
leasehold improvements at our previous facility. This expense is not expected to
recur.
IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS
In October 2001, we entered into an agreement with Network-1
Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2.8
million was paid to NSSI, of which $2.3 million was for the purchase of
convertible preferred stock of NSSI accounted for under the cost method, and
$0.5 million was for a non-refundable prepaid royalty recoupable against future
product sales of NSSI's product. Primarily due to the decline in the market
value of NSSI's common stock underlying the convertible preferred stock
significantly below the Company's cost, we concluded in 2002 that the decline in
the fair value of our investment in NSSI's preferred stock was other than
temporary. Accordingly, in 2002 we recorded an impairment charge to write-off
our investment in NSSI preferred stock. In addition, due to the lack of market
acceptance of the NSSI product, we concluded that the unrecouped prepaid royalty
was not recoverable and it was written off. As a result, in 2002, we recorded a
$2.8 million charge for the impairment of long-lived and other assets related to
our NSSI agreement, of which $0.5 million was an operating expense. In 2003, we
received a payment from NSSI of $35,000 in exchange for all of our preferred
stock of NSSI, which was reflected as a reduction to the impairment charge in
the statement of operations. While we continue to hold warrants to purchase NSSI
common stock, the exercise price of the warrants far exceeds the current market
price for NSSI's common stock. We do not expect to incur any additional income
or expenses from this investment.
19
RESULTS OF OPERATIONS - FOR THE YEAR ENDED DECEMBER 31, 2002 COMPARED TO THE
YEAR ENDED DECEMBER 31, 2001
REVENUES
SOFTWARE LICENSE REVENUE
Software license revenue increased 84% to $8.7 million in 2002 from
$4.7 million in 2001. The increase in software license revenue was partially due
to the release of our principal product at the end of the second quarter of
2001. Therefore in 2001, we only had two full quarters of software license
revenue compared to a full year of revenue in 2002. Another reason for the
increase in software license revenues was due to increased market acceptance of
our product as well as an increase in the number of our channel partners.
MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Maintenance, software services and other revenue increased 124% to
$2.0 million in 2002 from $0.9 million in 2001. The primary reason for the
increase in maintenance, software services and other revenue was an increase in
the number of our maintenance and technical support contracts. Since our
software was only released at the end of the second quarter of 2001, we had
limited maintenance and technical support revenue in 2001.
COST OF REVENUES
AMORTIZATION OF PURCHASED AND CAPITALIZED SOFTWARE
Amortization of purchased and capitalized software increased from
$0.3 million for the year ended December 31, 2001 to $0.9 million for the year
ended December 31, 2002. The increase in amortization expense was due to our
purchase of an additional $0.8 million of software licenses in 2002. As of
December 31, 2002, we had $3.0 million of purchased software licenses that are
being amortized over three years. For the year ended December 31, 2002, we
recorded $0.9 million of amortization related to these purchased software
licenses. As of December 31, 2001, we had $2.2 million of purchased software
licenses and recorded approximately $0.3 million of amortization for the year
ended December 31, 2001 related to these purchased software licenses.
Amortization of capitalized software was $23,643 and $31,524 for the years ended
December 31, 2001 and 2002, respectively.
COST OF MAINTENANCE, SOFTWARE SERVICES AND OTHER REVENUE
Cost of maintenance, software services and other revenues increased
46% to $1.3 million in 2002 from $0.9 million in 2001. The main reason for the
increase in cost of revenues was due to the increase in revenues. As a result of
the increase in revenues, we required a higher average number of employees to
provide technical support under our maintenance contracts and to help deploy our
software. The hardware costs associated with hardware revenue amounted to $0.2
million in 2002. There were no hardware costs in 2001.
Gross profit for the year ended December 31, 2002 was $8.4 million
or 79% compared with $4.4 million or 79% for the year ended December 31, 2001.
The absolute dollar increase in gross profit was due to the increase in total
revenue compared to the prior year.
SOFTWARE DEVELOPMENT COSTS
Software development costs increased 25% to $6.3 million in 2002
from $5.0 million in 2001. The increase in software development costs was mainly
due to an increase in development personnel. The increase in employees was
required to enhance and test our core network storage software product, as well
as to develop new innovative features and options.
20
SELLING AND MARKETING
Selling and marketing expenses increased 22% to $9.9 million in 2002
from $8.1 million in 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. In addition, as a result of the increase in revenues our
commission expense increased.
GENERAL AND ADMINISTRATIVE
General and administrative expenses decreased 5% to $2.6 million in
2002 from $2.7 million in 2001. The decrease in general and administrative
expenses was due to a non-cash consulting expense for option grants and higher
legal fees in 2001. These amounts were partially offset by a significant
increase in premiums for directors and officers insurance in 2002.
INTEREST AND OTHER INCOME
Interest and other income increased 16% to $1.6 million in 2002 from
$1.4 million in 2001. This increase in interest income was due to higher average
cash, cash equivalent and marketable securities balances as a result of the
merger with NPI.
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 December 30,
2002, 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.
Accordingly, we provided a full valuation allowance against our net deferred tax
assets. Our income tax provision consists of tax liabilities related to our
foreign subsidiaries.
IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS
In October 2001, we entered into an agreement with Network-1
Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2.8
million was paid to NSSI, of which $2.3 million was for the purchase of
convertible preferred stock of NSSI accounted for under the cost method, and
$0.5 million was for a non-refundable prepaid royalty recoupable against future
product sales of NSSI's product. Primarily due to a decline in the market value
of NSSI's common stock underlying the convertible preferred stock significantly
below the Company's cost, we concluded the decline in the fair value of our
investment in NSSI's preferred stock was other than temporary. Accordingly, in
2002 we recorded an impairment charge to write-off our investment in NSSI
preferred stock. In addition, due to the lack of market acceptance of the NSSI
product in its current state, we concluded that the unrecouped prepaid royalty
is not recoverable and it was written off. As a result, in 2002, we recorded a
$2.8 million charge for the impairment of long-lived and other assets related to
our NSSI agreement, of which $0.5 million was an operating expense.
LIQUIDITY AND CAPITAL RESOURCES
Our cash and cash equivalents totaled $8.5 million and marketable
securities totaled $28.2 million at December 31, 2003. As of December 31, 2002,
we had $14.2 million in cash and cash equivalents and $36.9 million in
marketable securities. The reasons for this decrease in cash and cash
equivalents and marketable securities are discussed below. Because we have not
yet been profitable, the major use of our cash has been to fund operations.
Until we reach profitability, we will continue to use our cash to fund
operations.
In 2003, we made investments in our infrastructure to support our
long-term growth. We moved our headquarters to a larger facility and made
investments in property and equipment. In addition, we increased the total
number of employees in 2003 to support our growth. As we continue to grow, we
21
will continue to make investments in property and equipment and will need to
continue to increase our headcount. In the past, we also used cash to purchase
software licenses and to make acquisitions. We will continue to evaluate
potential software license purchases and acquisitions and if the right
opportunity presents itself we may continue to use our cash in these areas.
We currently do not have any debt and our only commitments are
related to our office leases.
In connection with our acquisition of IP Metrics in July 2002, we
must make cash payments to the former shareholders of IP Metrics, which are
contingent on the level of revenues from IP Metrics products for a period of
twenty-four months subsequent to the acquisition. In 2003, we made payments to
the former shareholders of IP Metrics totaling $287,130. As of December 31,
2003, the Company has accrued $0.1 million of additional purchase consideration
related to sales of IP Metrics products.
In October 2001, our Board of Directors authorized the repurchase of
up to two million shares of our outstanding common stock. Since October 2001,
235,000 shares have been repurchased at an aggregate purchase price of $1.4
million. No shares were repurchased in 2003.
Net cash used in operating activities totaled $6.2 million for the
year ended December 31, 2003 compared to $7.5 million for the year ended
December 31, 2002 and $10.1 million for the year ended December 31, 2001. The
trend of decreasing cash used in operations is the result of our decreasing net
loss. In 2002, we incurred a non-cash expense of $2.8 million related to an
impairment of long-lived and other assets. The decrease in net loss is mainly
attributable to our increases in revenues. In addition to the decrease in net
loss, our non-cash charges, including depreciation and amortization and equity
based compensation increased from $1.5 million in 2001 to $2.5 million in 2002
and $3.3 million in 2003. These increases are mainly due to increases in
property and equipment and purchased software licenses. These amounts were
partially offset by increases in our accounts receivable balances of $2.5
million in 2001, $1.7 million in 2002 and $2.8 million in 2003. The increases in
our accounts receivable balances are due to our revenue growth. We expect cash
used in operating activities to continue to decrease as our net loss decreases.
Net cash provided by investing activities was $2.8 million in 2003
and net cash used in investing activities was $15.5 million in 2002. Cash
provided by investing activities in 2001 was $34.7 million. In 2001, we acquired
$48.2 million in cash related to our acquisition of NPI. We did not have any
similar transactions in 2002 or 2003. Included in investing activities for each
year are the sales and purchases of our marketable securities. These represent
the sales, maturities and reinvesting of our marketable securities. In 2003 the
net cash provided from the net sale of securities was $8.5 million, in 2002 and
2001 the cash used from the net purchase of marketable securities was $10.7 and
$7.4 million, respectively. These amounts will fluctuate from year to year
depending on the maturity dates of our marketable securities. The cash used to
purchase property and equipment has increased from $1.3 million in 2001 and 2002
to $3.0 million in 2003. The increase in 2003 was due to our investment in our
infrastructure and our relocation of our company headquarters. The cash used to
purchase software licenses was $2.2 million in 2001, $0.8 million in 2002 and
$1.8 million in 2003. In 2002, we used $2.6 million in cash related to two
acquisitions. We did not make any similar acquisitions in 2001 or 2003. We
continually evaluate potential software licenses and acquisitions and we may
continue to make these investments if we find opportunities that would benefit
our business.
Net cash provided by financing activities was $0.9 million in each
of 2003 and 2002 and $7.0 million in 2001. In 2001 we received $7.9 million in
proceeds from the issuance of preferred stock. In 2003 and 2002 we did not issue
any preferred stock. We received proceeds from the exercise of stock options of
$0.9 million in 2003, $1.1 million in 2002 and $0.3 million in 2001.
The Company's only contractual obligations relate to its operating
leases. The Company has an operating lease covering its primary office facility
that expires in February, 2012. The Company also has several operating leases
related to a domestic office and offices in foreign countries. The expiration
dates for these leases ranges from 2004 through 2012. The following is a
schedule of future minimum lease payments for all operating leases as of
December 31, 2003:
22
Year ending December 31,
2004..................................... $ 966,570
2005..................................... 1,174,510
2006..................................... 1,375,952
2007..................................... 1,238,840
2008..................................... 1,121,064
Thereafter............................... 3,778,261
-----------
$ 9,655,197
===========
For the years ended December 31, 2003, 2002 and 2001, we paid $3.0
million, $2.1 million and $0.8 million, respectively, related to discontinued
operations. As of December 31, 2003, all significant payments related to our
discontinued operations have been settled.
Based on our increasing revenues, decreasing net loss and decreasing
cash burn rate, 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 April 2003, the Financial Accounting Standards Board ("FASB")
determined that stock-based compensation should be recognized as a cost in the
financial statements and that such cost be measured according to the fair value
of the stock options. The FASB has not as yet determined the methodology for
calculating fair value and plans to issue an accounting standard that would
become effective in 2005. We will continue to monitor communications on this
subject from the FASB to determine the impact on our consolidated financial
statements.
In July 2003, the EITF reached a consensus on Issue 03-5,
Applicability of AICPA SOP 97-2 to Non-Software Deliverables. The consensus was
reached that SOP 97-2 is applicable to non-software deliverables if they are
included in an arrangement that contains software that is essential to the
non-software deliverables' functionality. The adoption of Issue 03-5 effective
October 1, 2003 did not have a material impact on our consolidated financial
statements.
RISK FACTORS
WE HAVE HAD LIMITED REVENUES AND A HISTORY OF LOSSES, AND WE MAY NOT ACHIEVE OR
MAINTAIN PROFITABILITY.
We have had limited revenues and a history of losses. For the year
ended December 31, 2003, we had revenues of $16.9 million. For the period from
inception (February 10, 2000) through December 31, 2003 and for the year ended
December 31, 2003, we had net losses of $31.1 million and $7.4 million,
respectively. We have signed contracts with resellers and original equipment
manufacturers, or OEMs, and believe that as a result of these contracts, our
revenues should increase in the future, although we are unable to predict
whether we will be profitable. Our business model depends upon signing
agreements with additional OEM customers, further developing our reseller sales
channel, and expanding our sales force. Any difficulty in obtaining these OEM
and reseller customers or in attracting qualified sales personnel will hinder
our ability to generate additional revenues and achieve or maintain
profitability.
FAILURE TO ACHIEVE ANTICIPATED GROWTH COULD HARM OUR BUSINESS AND OPERATING
RESULTS.
Achieving our anticipated growth will depend on a number of factors,
some of which include:
o retention of key management, marketing and technical personnel;
23
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.
We cannot assure you that the anticipated growth will be achieved.
The failure to achieve anticipated growth could harm our business, financial
condition and operating results.
OUR BOARD OF DIRECTORS MAY SELECTIVELY RELEASE SHARES OF OUR COMMON STOCK FROM
LOCK-UP RESTRICTIONS.
Currently, approximately 25.5 million shares of our common stock are
subject to contractual lock-up restrictions expiring on April 30, 2004. Our
board of directors may, in its sole discretion, release any or all of the shares
of our common stock from lock-up restrictions at any time with or without
notice. Any release of such shares from lock-up restrictions may be applied 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.
WE HAVE SIGNIFICANT LEASE COMMITMENTS THAT COULD IMPACT OUR PROFITABILITY.
During the third quarter of 2003, we signed a lease for new office
space that commenced on November 1, 2003 and continues through February, 2012.
The lease obligations are substantially greater than our prior lease
obligations. This commitment could impact our ability to achieve or to maintain
profitability.
DUE TO THE UNCERTAIN AND SHIFTING DEVELOPMENT OF THE NETWORK STORAGE
INFRASTRUCTURE SOFTWARE MARKET, WE MAY HAVE DIFFICULTY ACCURATELY PREDICTING
REVENUE FOR FUTURE PERIODS AND APPROPRIATELY BUDGETING FOR EXPENSES.
The rapidly evolving nature of the network storage infrastructure
software market in which we sell our products and other factors that are beyond
our control, reduces our ability to accurately forecast our quarterly and annual
revenue. However, we use our forecasted revenue to establish our expense budget.
Most of our expenses are fixed in the short term or incurred in advance of
anticipated revenue. As a result, we may not be able to decrease our expenses in
a timely manner to offset any shortfall in revenue.
OUR REVENUES DEPEND IN PART ON SPENDING BY CORPORATE CUSTOMERS.
The operating results of our business depend in part on the overall
demand for network storage infrastructure software. Because our sales are
primarily to major corporate customers, any softness in demand for network
storage infrastructure software may result in decreased revenues.
THE MARKETS FOR STORAGE AREA NETWORKS AND NETWORK ATTACHED STORAGE ARE NEW AND
UNCERTAIN, AND OUR BUSINESS WILL SUFFER IF THEY DO NOT DEVELOP AS WE EXPECT.
The rapid adoption of Storage Area Networks (SAN) and Network
Attached Storage (NAS) solutions is critical to our future success. The markets
for SAN and NAS solutions are still unproven, making it difficult to predict
their potential sizes or future growth rates. 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 are
uncertain whether a viable market for our products will develop or be
sustainable. If these markets fail to develop, or develop more slowly than we
expect, our business, financial condition and results of operations would be
adversely affected.
IF WE ARE UNABLE TO DEVELOP AND MANUFACTURE NEW PRODUCTS THAT ACHIEVE ACCEPTANCE
IN THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET, OUR OPERATING RESULTS MAY
SUFFER.
The network storage infrastructure software market continues to
evolve and as a result there is continuing demand for new products. Accordingly,
we may need to develop and manufacture new products that address additional
24
network storage infrastructure software market segments and emerging
technologies to remain competitive in the data storage software industry. We are
uncertain whether we will successfully qualify new network storage
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 PRODUCTS MUST CONFORM TO INDUSTRY STANDARDS IN ORDER TO BE ACCEPTED BY
CUSTOMERS IN OUR MARKETS.
Our current products are only one part of a SAN, NAS or Direct
Attached Storage ("DAS") system. All components of these systems must comply
with the same industry standards in order to operate together efficiently. We
depend on companies that provide other components of these systems to conform to
industry standards. Some industry standards may not be widely adopted or
implemented uniformly, and competing standards may emerge that may be preferred
by OEM customers or end users. If other providers of components do not support
the same industry standards as we do, or if competing standards emerge, our
products may not achieve market acceptance, which would adversely affect our
business.
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 is designed to be deployed in
large and complex networks. Many of our customers have unique infrastructures,
which may require additional professional services in order for our software to
work within their infrastructure. 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, 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.
FAILURE OF STORAGE APPLIANCES POWERED BY IPSTOR TO INTEGRATE SMOOTHLY WITH END
USER SYSTEMS COULD IMPACT DEMAND FOR THE APPLIANCES.
We have entered into agreements with our resellers and OEM partners
to develop storage appliances that combine certain aspects of IPStor
functionality with third party hardware to create single purpose turnkey
solutions that are designed to be easy to deploy. If the storage appliances are
not easy to deploy or do not integrate smoothly with end user systems, the basic
premise behind the appliances will not be met and sales would be impacted
negatively.
OUR OEM CUSTOMERS REQUIRE OUR PRODUCTS TO UNDERGO A LENGTHY AND EXPENSIVE
QUALIFICATION PROCESS THAT DOES NOT ASSURE PRODUCT SALES.
Prior to offering our products for sale, our OEM customers require
that each of our products undergo an extensive qualification process, which
involves interoperability testing of our product in the OEM's system as well as
rigorous reliability testing. This qualification of a product by an OEM does not
assure any sales of the product to the OEM. Despite this uncertainty, we devote
substantial resources, including sales, marketing and management efforts, toward
qualifying our products with OEMs in anticipation of sales to them. If we are
unsuccessful or delayed in qualifying any products with an OEM, such failure or
delay would preclude or delay sales of that product to the OEM, which may impede
our ability to grow our business.
WE RELY ON OUR OEM CUSTOMERS AND RESELLERS FOR MOST OF OUR SALES.
Almost all of our sales come from sales to end users of our products
by our OEM customers and by our resellers. These OEM customers and resellers
have limited resources and sales forces and sell many different products, both
25
in the network storage infrastructure software market and in other markets. The
OEM customers and resellers may choose to focus their sales efforts on other
products in the network storage infrastructure software market or other markets.
The OEM customers might also choose not to continue to develop or to market
products which include our products. This would likely result in lower revenues
to us and would impede our ability to grow our business.
ISSUES WITH THE HARDWARE SOLD BY OUR PARTNERS COULD RESULT IN LOWER SALES OF OUR
PRODUCTS.
As part of our sales channel, we license our software to OEMs and
other partners who install our software on their own hardware or on the hardware
of other third parties. If the hardware does not function properly or causes
damage to customers' systems, we could lose sales to future customers, even
though our software functions properly. Problems with our partners' hardware
could negatively impact our business.
THE NETWORK STORAGE INFRASTRUCTURE SOFTWARE MARKET IS HIGHLY COMPETITIVE AND
INTENSE COMPETITION COULD NEGATIVELY IMPACT OUR BUSINESS.
The network storage infrastructure software market is intensely
competitive even during periods when demand is stable. Some of our current and
potential competitors have longer operating histories, significantly greater
resources, broader name recognition and a larger installed base of customers
than we have. Those competitors and other potential competitors may be able to
establish or to expand network storage 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.
OUR FUTURE QUARTERLY RESULTS MAY FLUCTUATE SIGNIFICANTLY, WHICH COULD CAUSE OUR
STOCK PRICE TO DECLINE.
Our future performance will depend on many factors, including:
o the timing of securing software license contracts and the delivery of
software and related revenue recognition;
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.
26
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.
OUR STOCK PRICE MAY BE VOLATILE
The market price of our common stock has been volatile in the past
and may be volatile in the future. For example, during the past twelve months
ended December 31, 2003, the market price of our common stock as quoted on the
NASDAQ National Market System fluctuated between $3.47 and $9.15. The market
price of our common stock may be significantly affected by the following
factors:
o actual or anticipated fluctuations in our operating results;
o failure to meet financial estimates;
o changes in market valuations of other technology companies,
particularly those in the storage networking infrastructure
software market;
o announcements by us or our competitors of significant technical
innovations, acquisitions, strategic partnerships, joint
ventures or capital commitments;
o loss of one or more key OEM customers; and
o departures of key personnel.
The stock market has experienced extreme volatility that often has been
unrelated to the performance of particular companies. These market fluctuations
may cause our stock price to fall regardless of our performance.
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. Finally, we have entered into change of
control agreements with certain executives.
WE HAVE A SIGNIFICANT NUMBER OF OUTSTANDING OPTIONS AND WARRANTS, THE EXERCISE
OF WHICH WOULD DILUTE THE THEN-EXISTING STOCKHOLDERS' PERCENTAGE OWNERSHIP OF
OUR COMMON STOCK.
As of December 31, 2003, we had outstanding options and warrants to
purchase an aggregate of 10,610,425 shares of our common stock at a weighted
average exercise price of $4.42 per share. We also have 1,410,855 shares
reserved for issuance under our stock option plans with respect to options that
have not been granted.
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. 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.
27
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
eighteen pending patent applications and multiple 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. If an action is commenced against us, our management
may have to devote substantial attention and resources to defend that action. 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.
OUR EFFORTS TO PROTECT OUR INTELLECTUAL PROPERTY MAY CAUSE US TO BECOME INVOLVED
IN COSTLY AND LENGTHY LITIGATION, WHICH COULD SERIOUSLY HARM OUR BUSINESS.
In recent years, there has been significant litigation in the United
States involving patents, trademarks and other intellectual property rights.
Legal proceedings could subject us to significant liability for damages or
invalidate our intellectual property rights. Any litigation, regardless of its
outcome, would likely be time consuming and expensive to resolve and would
divert management's time and attention. Any potential intellectual property
litigation against us could force us to take specific actions, including:
o cease selling our products that use the challenged intellectual
property;
o obtain from the owner of the infringed intellectual property
right a license to sell or use the relevant technology or
trademark, which license may not be available on reasonable
terms, or at all; or
o redesign those products that use infringing intellectual
property or cease to use an infringing product or trademark.
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. Worldwide competition for
skilled employees in the network storage 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.
WE MAY NOT SUCCESSFULLY INTEGRATE THE PRODUCTS, TECHNOLOGIES OR BUSINESSES FROM,
OR REALIZE THE INTENDED BENEFITS OF ACQUISITIONS.
We have made, and may continue to make, acquisitions of other
companies or their assets. Integration of the acquired products, technologies
and businesses, could divert management's time and resources. Further, we may
not be able to properly integrate the acquired products, technologies or
28
businesses, with our existing products and operations, train, retain and
motivate personnel from the acquired businesses, or combine potentially
different corporate cultures. If we are unable to fully integrate the acquired
products, technologies or businesses, or train, retain and motivate personnel
from the acquired businesses, we may not receive the intended benefits of the
acquisitions, which could harm our business, operating results and financial
condition.
LONG TERM CHARACTER OF INVESTMENTS.
Our present and future equity investments may never appreciate in
value, and are subject to normal risks associated with equity investments in
businesses. These investments may involve technology risks as well as
commercialization risks and market risks. As a result, we may be required to
write down some or all of these investments in the future.
UNKNOWN FACTORS
Additional risks and uncertainties of which we are unaware or which
currently we deem immaterial also may become important factors that affect us.
ITEM 7A. 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.
29
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements Page
Independent Auditors' Report...........................................31
Consolidated Balance Sheets as of December 31, 2003 and 2002...........32
Consolidated Statements of Operations for the years ended
December 31, 2003, 2002 and 2001...................................33
Consolidated Statements of Stockholders' Equity and
Comprehensive Loss for the years ended
December 31, 2003, 2002 and 2001...................................34
Consolidated Statements of Cash Flows for the years ended
December 31, 2003, 2002 and 2001...................................35
Notes to Consolidated Financial Statements.............................37
30
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Stockholders
FalconStor Software, Inc.:
We have audited the accompanying consolidated balance sheets of
FalconStor Software, Inc. and subsidiaries as of December 31, 2003 and 2002, and
the related consolidated statements of operations, stockholders' equity and
comprehensive loss, and cash flows for each of the years in the three-year
period ended December 31, 2003. These consolidated financial statements are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with auditing standards
generally accepted in the United States of America. Those standards require that
we plan and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well as
evaluating the overall financial statement presentation. We believe that our
audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to
above present fairly, in all material respects, the financial position of
FalconStor Software, Inc. and subsidiaries as of December 31, 2003 and 2002, and
the results of their operations and their cash flows for each of the years in
the three-year period ended December 31, 2003, in conformity with accounting
principles generally accepted in the United States of America.
/s/ KPMG LLP
Melville, New York
February 4, 2004
31
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
December 31,
2003 2002
---- ----
Assets
Current assets:
Cash and cash equivalents ................................................ $ 8,486,144 $ 14,191,075
Marketable securities .................................................... 28,199,242 36,910,448
Accounts receivable, net of allowances of $1,837,934 and
$813,645, respectively.................................................. 7,109,922 4,285,892
Prepaid expenses and other current assets ................................ 1,273,125 1,167,174
------------ ------------
Total current assets ............................................ 45,068,433 56,554,589
Property and equipment, net ................................................. 3,861,069 2,068,001
Goodwill .................................................................... 3,366,642 3,301,599
Other intangible assets, net ................................................ 396,940 309,491
Other assets ................................................................ 3,799,949 2,476,306
------------ ------------
Total assets .................................................... $ 56,493,033 $ 64,709,986
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ......................................................... $ 562,305 $ 437,088
Accrued expenses ......................................................... 2,777,391 1,987,651
Deferred revenue ......................................................... 2,597,788 2,182,729
Liabilities of discontinued operations ................................... -- 4,201,465
------------ ------------
Total current liabilities ....................................... 5,937,484 8,808,933
------------ ------------
Commitments
Stockholders' equity:
Convertible preferred stock - $.001 par value, 2,000,000 shares authorized -- --
Common stock - $.001 par value, 100,000,000 shares authorized,
46,745,330 and 45,527,590 shares issued, respectively ................ 46,745 45,528
Additional paid-in capital ............................................... 83,277,981 81,423,661
Deferred compensation .................................................... (7,969) (471,445)
Accumulated deficit ...................................................... (31,063,589) (23,694,634)
Common stock held in treasury, at cost (235,000 shares) .................. (1,435,130) (1,435,130)
Accumulated other comprehensive (loss) income ............................ (262,489) 33,073
------------ ------------
Total stockholders' equity ...................................... 50,555,549 55,901,053
------------ ------------
Total liabilities and stockholders' equity ...................... $ 56,493,033 $ 64,709,986
============ ============
See accompanying notes to consolidated financial statements
32
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
Years Ended December 31,
2003 2002 2001
------------------------------------------------
Revenues:
Software license revenue ................................ $ 12,250,616 $ 8,666,583 $ 4,713,909
Maintenance revenue ..................................... 2,473,504 1,297,146 16,720
Software services and other revenue ..................... 2,220,015 665,163 861,100
------------ ------------ ------------
16,944,135 10,628,892 5,591,729
------------ ------------ ------------
Operating expenses:
Amortization of purchased and capitalized software 1,394,301 899,024 272,532
Cost of maintenance, software services and other revenue 2,580,141 1,309,139 897,145
Software development costs .............................. 7,067,605 6,280,936 5,004,953
Selling and marketing ................................... 10,966,548 9,856,496 8,084,588
General and administrative .............................. 2,878,192 2,591,430 2,731,551
Lease abandonment charge ................................ 550,162 -- --
Impairment of prepaid royalty ........................... -- 482,715 --
------------ ------------ ------------
25,436,949 21,419,740 16,990,769
------------ ------------ ------------
Operating loss .................................. (8,492,814) (10,790,848) (11,399,040)
------------ ------------ ------------
Interest and other income .................................. 1,121,391 1,585,351 1,364,780
Impairment of long-lived assets ............................ 35,000 (2,300,062) --
------------ ------------ ------------
Loss before income taxes .......................... (7,336,423) (11,505,559) (10,034,260)
Provision for income taxes ................................ 32,532 37,606 21,490
------------ ------------ ------------
Net loss .......................................... $ (7,368,955) $(11,543,165) $(10,055,750)
------------ ------------ ------------
Beneficial conversion feature attributable
to convertible preferred stock .......................... -- -- 3,896,287
------------ ------------ ------------
Net loss attributable to common
shareholders ............................................ $ (7,368,955) $(11,543,165) $(13,952,037)
============ ============ ============
Basic and diluted net loss per share attributable to
common shareholders ..................................... $ (0.16) $ (0.26) $ (0.40)
============ ============ ============
Basic and diluted weighted average common shares
outstanding ............................................. 45,967,830 45,232,595 35,264,277
============ ============ ============
See accompanying notes to consolidated financial statements.
33
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY AND COMPREHENSIVE LOSS
Accumulated
other
compre-
Convertible Additional Deferred hensive
preferred Common paid-in compen- Accumulated Treasury income
stock stock capital sation deficit stock (loss)
----------- ----------- ----------- ----------- ------------ ------------ -----------
Balance, December 31, 2000 $ 7,900 $ 10,900 $ 10,625,252 $ (469,351) $ (2,095,719) $ - $ (22,005)
Issuance of 3,193,678
shares of Series C
preferred stock 3,194 7,929,141 - - - -
Issuance of stock options and
common stock to
non-employees - - 450,802 - - - -
Exercise of stock options - 593 254,273 - - - -
Deferred compensation - - 1,028,640 (1,028,640) - - -
Amortization of deferred
compensation - - - 471,317 - - -
Net loss - - - - (10,055,750) - -
Conversion of preferred stock
into common stock (11,094) 20,207 (9,113) - - - -
Issuance of common stock in
connection with NPI merger - 13,349 57,713,001 - - - -
Acquisition of treasury stock - - - - - (1,220,730)
Net unrealized gain on
marketable securities - - - - - - 4,533
Foreign currency translation
adjustment - - - - - - (59,128)
-----------------------------------------------------------------------------------------
Balance, December 31, 2001 $ - $ 45,049 $77,991,996 $(1,026,674) $(12,151,469)$ (1,220,730) $ (76,600)
Issuance of stock options to
non-employees - - 32,890 - - - -
Compensation expense for
accelerated
vesting of stock options - - 231,415 - - - -
Exercise of stock options - 479 1,112,970 - - - -
Amortization of deferred
compensation and
option forfeitures - - (95,610) 555,229 - - -
Net loss - - - - ( 11,543,165) - -
Acquisition of treasury stock - - - - - (214,400) -
Adjustment to the fair
value of the net tangible
assets acquired
in the NPI merger - - 2,150,000 - - - -
Net unrealized gain on
marketable securities - - - - - - 90,904
Foreign currency translation
adjustment - - - - - - 18,769
----------- ----------- ----------- ----------- ------------ ------------ -----------
Balance, December 31, 2002 $ - $ 45,528 $81,423,661 $ (471,445) $ (23,694,634) $ (1,435,130) $ 33,073
Issuance of stock options to
non-employees - - 86,875 - - - -
Exercise of stock options - 1,217 850,600 - - - -
Amortization of deferred
compensation - - - 463,476 - - -
Net loss - - - - (7,368,955) - -
Adjustment to the fair value of the
net tangible assets acquired
in the NPI merger - - 916,845 - - - -
Net unrealized loss on
marketable securities - - - - - - (214,394)
Foreign currency translation
adjustment - - - - - - (81,168)
---------------------------------------------------------------------------- -----------
Balance, December 31, 2003 $ - $ 46,745 $83,277,981 $ (7,969) $(31,063,589) $(1,435,130)$ (262,489)
=========================================================================================
Total Compre-
stockholders' hensive
equity loss
------------ ------------
Balance, December 31, 2000 $ 8,056,977
Issuance of 3,193,678
shares of Series C
preferred stock 7,932,335 -
Issuance of stock options and
common stock to
non-employees 450,802 -
Exercise of stock options 254,866 -
Deferred compensation - -
Amortization of deferred
compensation 471,317 -
Net loss (10,055,750) (10,055,750)
Conversion of preferred stock
into common stock - -
Issuance of common stock in
connection with NPI merger 57,726,350 -
Acquisition of treasury stock (1,220,730) -
Net unrealized gain on
marketable securities 4,533 4,533
Foreign currency translation
adjustment (59,128) (59,128)
-------------------------
Balance, December 31, 2001 $63,561,572 $(10,110,345)
============
Issuance of stock options to
non-employees 32,890 -
Compensation expense for
accelerated
vesting of stock options 231,415 -
Exercise of stock options 1,113,449 -
Amortization of deferred
compensation and
option forfeitures 459,619 -
Net loss (11,543,165) (11,543,165)
Acquisition of treasury stock (214,400) -
Adjustment to the fair
value of the net tangible
assets acquired
in the NPI merger 2,150,000 -
Net unrealized gain on
marketable securities 90,904 90,904
Foreign currency translation
adjustment 18,769 18,769
------------ -------------
Balance, December 31, 2002 $55,901,053 $ (11,433,492)
=============
Issuance of stock options to
non-employees 86,875 -
Exercise of stock options 851,817 -
Amortization of deferred
compensation 463,476 -
Net loss (7,368,955) (7,368,955)
Adjustment to the fair value of the
net tangible assets acquired
in the NPI merger 916,845 -
Net unrealized loss on
marketable securities (214,394) (214,394)
Foreign currency translation
adjustment (81,168) (81,168)
---------------------------
Balance, December 31, 2003 $ 50,555,549 $ (7,664,517)
===========================
See accompanying notes to consolidated financial statements.
34
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
Years Ended December 31,
2003 2002 2001
-----------------------------------------------------
Cash flows from operating activities:
Net loss ............................................................. $ (7,368,955) $(11,543,165) $(10,055,750)
Adjustments to reconcile net loss to net cash used in operating
activities:
Depreciation and amortization .................................. 2,759,030 1,747,380 617,277
Non-cash professional services expenses ........................ 86,875 32,890 450,802
Equity-based compensation expense .............................. 463,476 691,034 471,317
Impairment of long-lived and other assets ...................... -- 2,782,777 --
Changes in operating assets and liabilities, net of effects of
acquisitions:
Accounts receivable, net ....................................... (2,824,030) (1,728,305) (2,524,173)
Prepaid expenses and other current assets ...................... (137,115) (571,635) (1,029,022)
Other assets ................................................... (227,711) (9,119) --
Accounts payable ............................................... 125,217 (121,685) 407,633
Accrued expenses ............................................... 474,697 55,868 1,321,774
Deferred revenue ............................................... 415,059 1,175,735 224,912
------------ ----------- ----------
Net cash used in operating activities ....................... (6,233,457) (7,488,225) (10,115,230)
------------ ----------- -----------
Cash flows from investing activities:
Purchase of marketable securities .................................... (8,537,284) (39,507,257) (9,312,973)
Sale of marketable securities ........................................ 17,034,096 28,843,893 1,868,430
Purchase of investment ............................................... (137,710) (75,000) (2,300,062)
Purchase of property and equipment ................................... (2,998,908) (1,272,104) (1,340,583)
Purchase of software licenses ........................................ (1,821,000) (800,000) (2,240,000)
Purchase of intangible assets ........................................ (246,697) (145,534) --
Net cash acquired from acquisition of NPI ............................ -- -- 48,208,649
Net cash paid for acquisition of IP Metrics .......................... -- (2,381,726) --
Net cash paid for acquisition of FarmStor ............................ -- (169,640) --
Security deposits .................................................... (500,000) (35,802) (210,166)
------------ ----------- -----------
Net cash provided by (used in) investing activities ............... 2,792,497 (15,543,170) 34,673,295
Cash flows from financing activities:
Net proceeds from issuance of preferred stock ........................ -- -- 7,932,335
Proceeds from exercise of stock options .............................. 851,817 1,113,449 254,866
Payments to acquire treasury stock ................................... -- (214,400) (1,220,730)
------------ ----------- -----------
Net cash provided by financing activities ......................... 851,817 899,049 6,966,471
------------ ----------- -----------
35
Cash flows from discontinued operations:
Payments of liabilities of discontinued operations (3,034,620) (2,066,285) (821,653)
------------ ----------- -----------
Effect of exchange rate changes ......................................... (81,168) 18,769 (59,128)
------------ ----------- -----------
Net (decrease) increase in cash and cash equivalents
(5,704,931) (24,179,862) 30,643,755
Cash and cash equivalents, beginning of year ............................ 14,191,075 38,370,937 7,727,182
------------ ----------- -----------
Cash and cash equivalents, end of year ................................. $ 8,486,144 $ 14,191,075 $ 38,370,937
============ =========== ===========
In connection with the merger with NPI (note 2) additional paid-in
capital increased as follows:
Cash acquired ...................................................... -- -- 57,091,647
Marketable securities acquired ..................................... -- -- 18,707,104
Merger related costs ............................................... -- -- (8,882,998)
Fair value of property and equipment acquired ...................... -- -- 50,000
Fair value of accounts receivable acquired ......................... -- -- 92,000
Liabilities of discontinued operations assumed ..................... 916,845 2,150,000 (9,331,403)
Par value of common stock issued ................................... -- -- (13,349)
------------ ----------- -----------
Increase in additional paid-in capital ............................. $ 916,845 $ 2,150,000 $ 57,713,001
------------ ----------- -----------
Cash paid for income taxes ............................................ $ 37,289 $ 34,082 $ --
============ =========== ===========
The Company did not pay any interest expense for the three years ended December
31, 2003.
See accompanying notes to consolidated financial statements
36
FALCONSTOR SOFTWARE, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 2003
(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 network storage infrastructure software solutions and
provides the related maintenance, implementation and engineering services.
(b) PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly owned subsidiaries. All significant intercompany balances and
transactions have been eliminated in consolidation.
(c) CASH EQUIVALENTS AND MARKETABLE SECURITIES
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
$8.2 million and $13.6 million at December 31, 2003 and 2002, respectively.
Marketable securities at December 31, 2003 and 2002 amounted to $28.2 million
and $36.9 million, respectively, and consisted of corporate bonds and government
securities, which are classified as available for sale, and accordingly,
unrealized gains and losses on marketable securities are reflected as a
component of stockholders' equity.
(d) REVENUE RECOGNITION
The Company recognizes revenue from software licenses in accordance with
Statement of Position ("SOP") 97-2, Software Revenue Recognition. Accordingly,
revenue for software licenses is recognized when persuasive evidence of an
arrangement exists, the fee is fixed and determinable, the software is delivered
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.
Revenues associated with software implementation and software engineering
services are recognized as the services are performed. Costs of providing these
services are included in cost of revenues.
The Company has entered into various distribution, licensing and joint
promotion agreements with OEMs and distributors, whereby the Company has
provided to the reseller a non-exclusive software license to install the
Company's software on certain hardware or to resell the Company's software in
exchange for payments based on the products distributed by the OEM or
distributor. Nonrefundable advances and engineering fees received by the Company
from an OEM are recorded as deferred revenue and recognized as revenue when
related software engineering services are complete, if any, and the software
product master is delivered and accepted.
For the years ended December 31, 2003 and 2002, the Company had a limited
number of transactions in which it purchased hardware and bundled this hardware
with the Company's software and sold the bundled solution to its customer. Since
the software is not essential for the functionality of the equipment included in
the Company's bundled solutions, and both the hardware and software have stand
37
alone value to the customer, a portion of the contractual fees is recognized as
revenue when the software or hardware is delivered based on the relative fair
value of the delivered element(s).
(e) PROPERTY AND EQUIPMENT
Property and equipment are recorded at cost. Depreciation is recognized
using the straight-line method over the estimated useful lives of the assets (3
to 7 years).
(f) GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill represents the excess of the purchase price over the estimated fair
value of net tangible and identifiable intangible assets acquired in business
combinations. Consistent with Statement of Financial Accounting Standards
("SFAS") 142, GOODWILL AND OTHER INTANGIBLE ASSETS, the Company has not
amortized goodwill related to its acquisitions, but has instead tested the
balance for impairment. The Company's annual impairment assessment is performed
on December 31st of each year, and additionally if events or changes in
circumstances indicate that it is more likely than not that the asset is
impaired. Identifiable intangible assets are amortized over a three-year period
using the straight-line method. Amortization expense was $159,248 and $52,893
for 2003 and 2002, respectively. The gross carrying amount and accumulated
amortization of other intangible assets as of December 31, 2003 and December 31,
2002 are as follows:
December 31, December 31,
2003 2002
---------- -----------
Customer relationships and purchased technology:
Gross carrying amount $ 216,850 $ 216,850
Accumulated amortization (108,425) (36,142)
---------- -----------
Net carrying amount $ 108,425 $ 180,708
========== ===========
Patents and trademarks:
Gross carrying amount $ 392,231 $ 145,534
Accumulated amortization (103,716) (16,751)
---------- -----------
Net carrying amount $ 288,515 $ 128,783
========== ===========
As of December 31, 2003, amortization expense on existing identifiable
intangible assets, purchased software technology and software development costs
will be $1,582,352, $900,675, and $303,626 for the years ended December 31,
2004, 2005 and 2006, respectively. Such assets will be fully amortized at
December 31, 2006.
(g) SOFTWARE DEVELOPMENT COSTS AND PURCHASED TECHNOLOGY
Costs associated with the development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility of the product has been established. Based on the
Company's product development process, technological feasibility is established
upon completion of a working model. The Company did not capitalize any software
development costs until its initial product reached technological feasibility at
the end of March 2001. Until such product was released, the Company capitalized
$94,570 of software development costs, of which $31,523, $31,524 and $23,643 was
amortized for the years ended December 31, 2003, 2002 and 2001, respectively.
Amortization of software development costs is recorded at the greater of
straight line over three years or the ratio of current revenue of the related
products to total current and anticipated future revenue of these products.
38
Purchased software technology of $2,381,833 and $1,923,611, net of
accumulated amortization of $2,479,167 and $1,116,389, is included in other
assets in the balance sheets as of December 31, 2003 and December 31, 2002,
respectively. Amortization expense was $1,362,778, $867,499 and 248,889 for the
years ended December 31, 2003, 2002 and 2001, respectively.
(h) INCOME TAXES
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases. Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be realized or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
(i) LONG-LIVED ASSETS
The Company reviews its long-lived assets for impairment whenever
events or changes in circumstances indicate that the carrying amount of the
asset may not be recoverable. If the sum of the expected future cash flows,
undiscounted and without interest, is less than the carrying amount of the
asset, an impairment loss is recognized as the amount by which the carrying
amount of the asset exceeds its fair value.
(j) ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company applies the intrinsic-value based method of accounting
prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting for
Stock Issued to Employees, and related interpretations including FASB
Interpretation No. 44, Accounting for Certain Transactions involving Stock
Compensation, an interpretation of APB Opinion No. 25 to account for its
fixed-plan stock options. Under this method, compensation expense is recorded
only if on the date of grant the current market price of the underlying stock
exceeded the exercise price. SFAS No. 123, Accounting for Stock-Based
Compensation, established accounting and disclosure requirements using a
fair-value-based method of accounting for stock-based employee compensation
plans. As allowed by SFAS No. 123, the Company has elected to continue to apply
the intrinsic-value-based method of accounting described above, and has adopted
the disclosure requirements of SFAS No. 123.
Had the Company determined stock-based compensation cost based upon the
fair value method under SFAS No. 123, the Company's pro forma net loss and
diluted net loss per share would have been adjusted to the pro forma amounts
indicated below:
2003 2002 2001
------------ ------------ ------------
Net loss attributable to common shareholders-as reported $ (7,368,955) $(11,543,165) $(13,952,037)
Add stock-based employee compensation expense included
in reported net income, net of tax 463,476 691,034 471,317
Deduct total stock-based employee compensation expense
determined under fair-value-based method for all
awards, net of tax (10,480,088) (5,830,622) (3,394,894)
------------ ------------ ------------
Net loss - pro forma $(17,385,567) $(16,682,753) $(16,875,614)
============ ============ ============
Basic net loss per common share-as reported $ (0.16) $ (0.26) $ (0.40)
Basic net loss per common share-pro forma $ (0.38) $ (0.37) $ (0.48)
39
The per share weighted average fair value of stock options granted during 2003,
2002 and 2001 was $5.60, $2.29 and $4.08, respectively, on the date of grant
using the Black-Scholes option-pricing method with the following weighted
average assumptions: 2003 - expected dividend yield of 0%, risk free interest
rate of 3%, expected stock volatility ranging from 68% to 153% and an expected
option life of five years for options granted to employees of the Company, and
an option life of ten years for options granted to non-employees;
2002 - expected dividend yield of 0%, risk free interest rate of 3%, expected
stock volatility of 44% and an expected option life of five years for options
granted to employees of the Company, and an option life of ten years for options
granted to non-employees;
2001 - expected dividend yield of 0%, risk free interest rate of 3%, expected
stock volatility of 118% and an expected option life of three years for options
granted to employees of the Company, and an option life of ten years for options
granted to non-employees.
(k) FINANCIAL INSTRUMENTS
As of December 31, 2003 and 2002, the fair value of the Company's
financial instruments including cash and cash equivalents, accounts receivable,
accounts payable and accrued expenses, approximates book value due to the short
maturity of these instruments.
(l) FOREIGN CURRENCY
Assets and liabilities of foreign operations are translated at rates of
exchange at the end of the period, while results of operations are translated at
average exchange rates in effect for the period. Unrealized gains and losses
from the translation of foreign assets and liabilities are classified as a
separate component of stockholders' equity. Realized gains and losses from
foreign currency transactions are included in the statements of operations.
(m) 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 net losses for the periods presented, all common stock
equivalents were excluded from diluted net loss per share. As of December 31,
2003, 2002 and 2001, potentially dilutive common stock equivalents included
9,860,425, 9,387,579 and 7,274,717 stock options outstanding, respectively. As
of December 31, 2003, potentially dilutive common stock equivalents also
included 750,000 warrants outstanding.
(n) COMPREHENSIVE INCOME (LOSS)
Comprehensive loss includes the Company's net loss, foreign currency
translation adjustments and unrealized (losses) gains on marketable securities.
(o) USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
40
(p) NEW ACCOUNTING PRONOUNCEMENTS
In April 2003, the Financial Accounting Standards Board ("FASB")
determined that stock-based compensation should be recognized as a cost in the
financial statements and that such cost be measured according to the fair value
of the stock options. The FASB has not as yet determined the methodology for
calculating fair value and plans to issue an accounting standard that would
become effective in 2005. The Company will continue to monitor communications on
this subject from the FASB to determine the impact on the Company's consolidated
financial statements.
In July 2003, the EITF reached a consensus on Issue 03-5, Applicability
of AICPA SOP 97-2 to Non-Software Deliverables. The consensus was reached that
SOP 97-2 is applicable to non-software deliverables if they are included in an
arrangement that contains software that is essential to the non-software
deliverables' functionality. The adoption of Issue 03-5 effective October 1,
2003 did not have a material impact on the Company's consolidated financial
statements.
(q) RECLASSIFICATIONS
Certain reclassifications have been made to prior years' consolidated
financial statements to conform to the current year's presentation.
(2) ACQUISITIONS
On July 3, 2002, FalconStor AC, Inc., a newly formed wholly-owned
subsidiary of the Company, acquired all of the common stock of IP Metrics
Software, Inc. ("IP Metrics"), a provider of intelligent trunking software for
mission-critical networks, for $2,432,419 in cash plus payments contingent on
the level of revenues from IP Metrics' products and services for a period of
twenty-four months. The acquisition was accounted for under the purchase method
and the results of IP Metrics are included with those of the Company from the
date of acquisition. As of December 31, 2003, the Company made contingent
acquisition payments totaling $287,130 related to the sale of IP Metrics'
products and services and accrued an additional $67,855 of incurred but unpaid
contingent consideration. Contingent consideration incurred through December 31,
2003 in excess of the amount accrued at the time of acquisition, of $65,043, was
added to goodwill in 2003.
The fair value of the net tangible liabilities of IP Metrics assumed
was $898,305, including $289,942 of accrued contingent consideration recorded at
the time of acquisition. The Company purchased certain intangible assets,
including customer relationships and purchased technology with a fair value of
$216,850. These intangible assets are being amortized under the straight-line
method over an estimated useful life of 3 years, the expected period of benefit.
The purchase price in excess of the fair value of the net tangible and
intangible assets acquired and liabilities assumed by the Company amounted to
$3,178,917 and has been recorded as goodwill.
On November 12, 2002, FalconStor AC, Inc., acquired all of the common
stock of FarmStor, a software sales organization in the Republic of Korea for
$180,000 in cash. The fair value of the net tangible liabilities of FarmStor
assumed was $7,725. The purchase price in excess of the fair value of the net
tangible assets acquired and liabilities assumed by the Company amounted to
$187,725 and has been recorded as goodwill.
The following unaudited pro forma consolidated financial information
gives effect to the above described acquisitions of IP Metrics and FarmStor, as
if they had occurred at the beginning of the period by consolidating the
continuing results of operations of the Company, IP Metrics and FarmStor for the
year ended December 31, 2002.
41
Year Ended
December 31,
2002
------------------
Revenues $ 11,089,570
Net Loss from continuing operations (11,972,835)
Basic and diluted net loss from continuing
operations per share $ (0.26)
Weighted average basic and diluted shares
outstanding 45,232,595
The pro forma information is provided for illustrative purposes only
and does 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.
On August 22, 2001, pursuant to an Agreement and Plan of Merger and
Reorganization (the "Merger Agreement"), FalconStor, Inc. ("FalconStor"), merged
with Network Peripherals, Inc. ("NPI"), with NPI 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 after the merger. Accordingly, for accounting purposes,
the acquisition was a "reverse acquisition" and FalconStor was the "accounting
acquirer." Further, as a result of NPI's decision on June 1, 2001 to discontinue
its NuWave and legacy business, at the time of the merger NPI was a
non-operating public shell with no continuing operations, and no intangible
assets associated with NPI were purchased by FalconStor. As a result, 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 13,348,605 common shares to NPI's pre-merger shareholders. In
connection with the merger, the name of NPI was changed to FalconStor Software,
Inc.
(3) PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
December 31, December 31,
2003 2002 Useful Lives
---------------------------------------------
Computer hardware and software $ 5,607,838 $ 2,913,989 3 years
Furniture and equipment 473,774 276,179 5-7 years
Leasehold improvements 231,578 124,115
----------- -----------
6,313,190 3,314,283
Less accumulated depreciation (2,452,121) (1,246,282)
----------- -----------
$ 3,861,069 $ 2,068,001
=========== ===========
Depreciation expense was $1,205,839, $826,989, and $368,388 in 2003,
2002, and 2001, respectively.
42
(4) MARKETABLE SECURITIES
The Company accounts for its short-term investments in accordance with
SFAS 115, Accounting for Certain Investments in Debt and Equity Securities
("SFAS 115"). SFAS 115 establishes the accounting and reporting requirements for
all debt securities and for investments in equity securities that have a readily
determinable fair market value. All short-term marketable securities must be
classified as one of the following: held-to-maturity, available-for-sale or
trading securities. The Company's short-term investments consist of
available-for-sale securities, which are carried at fair value, with unrealized
gains and losses reported as a separate component of stockholders' equity.
Unrealized gains and losses are computed on the basis of the specific
identification method. Realized gains, realized losses and declines in value
judged to be other-than-temporary, are included in other income. The cost of
available-for-sale securities sold are based on the specific identification
method and interest earned is included in interest and other income.
The cost and fair values of the Company's marketable securities as of
December 31, 2003 and 2002 are as follows:
Aggregate Cost Unrealized Unrealized
Fair Value Basis Gains Losses
---------- ----- ----- ------
Available-for-sales securities:
December 31, 2003 $ 28,199,242 $ 28,318,199 $ - $ (118,957)
December 31, 2002 $ 36,910,448 $ 36,815,011 $ 95,437 $ -
Marketable securities at December 31, 2003 and 2002 consist of
corporate bonds and government securities.
(5) ACCRUED EXPENSES
Accrued expenses are comprised of the following:
December 31, December 31,
2003 2002
-----------------------------
Accrued compensation $ 697,839 $ 826,721
Accrued consulting and professional fees 302,425 327,416
Accrued marketing and promotion 50,000 170,282
Other accrued expenses 965,774 441,654
Accrued IP Metrics contingent purchase price 67,855 221,578
Accrued hardware purchases 253,682 -
Accrued and deferred rent 439,816 -
---------- ----------
$2,777,391 $1,987,651
========== ==========
43
(6) INCOME TAXES
The provision for income taxes for the years ended December 31, 2003,
2002 and 2001 are comprised solely of foreign income taxes. The tax effects of
temporary differences that give rise to the Company's deferred tax assets
(liabilities) as of December 31, 2003 and 2002 are as follows:
2003 2002
---- ----
U.S. net operating loss carryforwards (FalconStor) $ 12,525,600 $ 8,285,700
U.S. net operating loss carryforwards (NPI) 31,756,000 31,756,000
Start-up costs not currently deductible for taxes 714,300 1,014,200
Depreciation (584,500) (47,200)
Compensation 367,900 412,800
Tax credit carryforwards 1,067,100 704,900
Liabilities of discontinued operations -- 2,667,400
Deferred revenue 957,700 783,300
Capital loss carryforward 951,300 --
Lease abandonment charge 231,100 --
Impairment of investment -- 966,000
Allowance for receivables 771,900 341,700
Other 103,600 (44,900)
------------ ------------
48,862,000 46,839,900
Valuation allowance (48,862,000) (46,839,900)
------------ ------------
$ -- $ --
============ ============
The difference between the provision for income taxes computed at the
Federal statutory rate and the reported amount of tax expense attributable to
loss before income taxes for the years ended December 31, 2003, 2002 and 2001,
are as follows:
2003 2002 2001
------------ ----------- -----------
Tax recovery at Federal statutory rate $ (2,494,400) $(3,911,900) $(3,411,700)
Increase (reduction) in income taxes resulting from:
State and local taxes, net of Federal income tax benefit (318,000) (788,400) (819,400)
Non-deductible expenses 41,900 41,400 34,600
Compensation 157,600 389,800 --
Foreign tax credit (90,000) (125,800) (21,490)
Net effect of foreign operations (900) 75,700 (610)
Research and development credit (272,200) (233,500) (345,600)
Increase in valuation allowance 3,008,600 4,590,300 4,585,690
------------ ----------- -----------
$ 32,600 $ 37,600 $ 21,490
============ =========== ===========
Income (loss) before provision for income taxes for the years ended December 31, 2003, 2002 and 2001 are as follows:
44
2003 2002 2001
------------ ------------ ------------
Domestic loss $ (7,434,000) $(11,393,000) $(10,099,000)
Foreign income (loss) 98,000 (113,000) 65,000
------------ ------------ ------------
$ (7,336,000) $(11,506,000) $(10,034,000)
============ ============ ============
As of December 31, 2003, the Company has U.S. net operating loss
carryforwards of approximately $29,823,000 which expire from 2020 through 2023.
In addition, as of the date of the merger, NPI had U.S. net operating loss
carryforwards of $93,400,000 that start to expire in December, 2012. At December
31, 2003 and 2002, the Company has established a valuation allowance against its
net deferred tax assets due to the Company's pre-tax losses and the resulting
likelihood that the deferred tax asset is not realizable. Due to the Company's
various equity transactions, which resulted in a change of control, the
utilization of certain tax loss carryforwards is subject to annual limitations
imposed by Internal Revenue Code Section 382. NPI experienced such ownership
change as a result of the merger. As such, the Company's ability to use its NOL
carryforwards to offset taxable income in the future may be significantly
limited. If the entire deferred tax asset were realized, $4,524,000 would be
allocated to paid-in-capital with the remainder reducing income tax expense. Of
the amount allocable to paid-in-capital, $2,593,000 related to the tax effect of
the deductions that will result from payments of the liabilities of discontinued
operations and the balance of $1,931,000 related to the tax effect of
compensation deductions from exercises of employee and consultant stock options.
(7) STOCKHOLDERS' EQUITY
In November 2000, in connection with a consulting agreement, the
Company, in addition to agreeing to pay a monthly consulting fee, sold 72,185
shares of restricted common stock to a consultant for $25,000 ($0.35 per share).
The consultant's rights vested for 23,821 shares on each of November 1, 2001 and
2002 and the remaining 24,543 shares vested on November 1, 2003. As of March 31,
2001, the services related to this consulting agreement were fully performed.
The excess of the fair value of the common stock over $0.35 of $122,000 and
$32,000 in 2001 and 2000, respectively, was recorded as cumulative consulting
expense in each period up until the services were fully performed.
In March 2000, the Company issued 3,000,000 shares of its Series A
convertible preferred stock ("Series A"). While outstanding, each share of
Series A was convertible, at the option of the holder, into five shares of
common stock. The Series A was not redeemable at the option of the holder.
In September 2000, the Company issued 4,900,000 shares of its Series B
convertible preferred stock ("Series B"). While outstanding each share of Series
B was convertible, at the option of the holder, into two shares of common stock.
The Series B was not redeemable at the option of the holder.
On May 4, 2001, the Company issued 3,193,678 shares of its Series C
preferred stock ("Series C") at 2.55 per share for net proceeds of $7,932,335.
While outstanding, each share of Series C was convertible, at the option of the
holder, into one share of common stock. The Series C automatically converted
into common stock upon the consummation of a merger or consolidation of the
Company with or into another company. The holders of Series C were entitled to
receive cumulative cash dividends at the same rate as dividends were paid with
respect to the common stock. The Series C was not redeemable at the option of
the holder and had a liquidation preference equal to the greater of $2.55 per
share plus all accumulated unpaid dividends, or the amount that the Series C
holders would have received had they converted all Series C into shares of
common stock.
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
45
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.
In connection with the Company's merger with NPI in August 2001, all of
FalconStor's preferred stock was converted into common stock which resulted in
an additional 20,207,460 shares of common stock outstanding and, for accounting
purposes, the merger resulted in the issuance of 13,348,605 common shares to
NPI's pre-merger shareholders.
In September, 2003, the Company entered into a worldwide OEM agreement
with a major technology company (the "OEM"), and issued warrants to the OEM to
purchase 750,000 shares of the Company's common stock with an exercise price of
$6.18 per share. A portion of the warrants will vest annually subject to the
OEM's achievement of pre-defined and mutually agreed upon sales objectives over
a three-year period. If the OEM generates cumulative revenues to the Company in
the mid-eight figure dollar range from reselling the Company's products then all
the warrants granted will vest. Any warrants that do not vest by the end of the
three-year period will expire. If and when it is probable that all or a portion
of the warrants will vest, the then fair value of the warrants earned will be
recorded as a reduction of revenue. Subsequently, each quarter the Company will
apply variable accounting to adjust such amount to reflect the fair value of the
warrants until they vest. The Company expects to begin deriving revenues from
sales by the OEM in 2004.
(8) STOCK OPTION PLANS
As of May 1, 2000, the Company adopted the FalconStor Software, Inc.
2000 Stock Option Plan (the "Plan"). The Plan is administered by the Board of
Directors and, as amended, provides for the issuance of up to 12,662,296 options
to employees, consultants and non-employee directors. Options may be incentive
("ISO") or non-qualified. Exercise prices of ISOs granted must be at least equal
to the fair value of the common stock on the date of grant, and have terms not
greater than ten years, except those to an employee who owns stock with greater
than 10% of the voting power of all classes of stock of the Company, in which
case they must have an option price at least 110% of the fair value of the
stock, and expire no later than five years from the date of grant.
Certain of the options granted to employees had exercise prices less
than the fair value of the common stock on the date of grant, which resulted in
deferred compensation of $1,028,640 and $496,960 in 2001 and 2000, respectively.
The amortization of deferred compensation amounted to $463,476, $459,619 and
$471,317 in 2003, 2002 and 2001, respectively.
The Company granted options to purchase an aggregate of 5,000, 50,000,
and 25,546 shares of common stock to certain non-employee consultants in
exchange for professional services during 2003, 2002 and 2001, respectively. The
aggregate fair value of these options as determined using the fair value method
under SFAS No. 123, is being expensed over the periods the services are
provided. The related expense amounted to $86,875, $32,890, and $328,802 in
2003, 2002 and 2001, respectively.
In February 2002, the Company accelerated the vesting of stock options
of one employee upon his death. Compensation costs of $231,415 were recorded
based on the intrinsic value of the options on the date of acceleration.
As of December 31, 2003, there were outstanding vested options to
purchase 186,667 common shares under one of the former NPI stock option plans.
The Company does not intend to grant any additional options under the NPI plans
except for the 1994 Outside Directors Stock Option Plan which, as amended, has
500,000 shares authorized for issuance upon the exercise of options, of which
options to purchase 260,000 shares were outstanding as of December 31, 2003.
Stock option activity for the periods indicated is as follows:
46
Weighted
average
Number of exercise
Options price
------- -----
Outstanding at December 31, 2000 ............... 4,735,027 $ 0.35
Granted ........................................ 2,591,451 $ 5.37
Assumed in connection with NPI acquisition .... 1,717,040 $ 10.78
Exercised ...................................... (593,297) $ 0.43
Canceled ....................................... (1,175,504) $ 8.46
----------
Outstanding at December 31, 2001 ............... 7,274,717 $ 3.28
Granted ........................................ 3,088,500 $ 4.60
Exercised ...................................... (478,038) $ 2.32
Canceled ....................................... (497,600) $ 7.53
----------
Outstanding at December 31, 2002 ............... 9,387,579 $ 3.55
----------
Granted ........................................ 2,678,300 $ 7.01
Exercised ...................................... (1,224,833) $ .70
Canceled ....................................... (980,621) $ 9.19
----------
Outstanding at December 31, 2003 ............... 9,860,425 $ 4.29
==========
Vested at December 31, 2001 .................... 2,177,265 $ 4.49
==========
Vested at December 31, 2002 .................... 3,829,793 $ 3.21
==========
Vested at December 31, 2003 .................... 4,950,046 $ 2.47
==========
Options available for grant at December 31, 2003 1,410,855
==========
During 2003, one employee paid for the exercise price of certain options with
7,094 shares of common stock that were held greater than six months. Such shares
which had a market value of $28,744 were retired.
The following table summarizes information about stock options
outstanding at December 31, 2003:
Options Outstanding Options Exercisable
-------------------------------------------------------- -------------------------------------
Weighted - Average Weighted
Range of Number Remaining Contractual Average Exercise Number Weighted - Average
Exercise Prices Outstanding Life (Years) Price Exercisable Exercise Price
------------------- ------------ --------------------- ---------------- ----------- ------------------
$0.00 - $1.10 3,059,065 6.50 $0.35 3,045,564 $0.35
$3.29 - $4.38 1,450,130 8.90 $4.03 444,559 $4.04
$4.38 - $5.48 2,377,586 8.10 $5.13 629,118 $4.91
$5.48 - $6.57 1,136,564 7.90 $6.12 563,786 $6.20
$7.67 - $8.76 1,435,300 9.90 $8.46 3,300 $7.98
$8.76 - $9.86 200,923 7.50 $9.69 129,147 $9.70
$9.86 - $10.95 200,857 7.10 $10.95 134,572 $10.95
--------- ---------
9,860,425 7.93 $4.29 4,950,046 $2.47
========= =========
(9) LEASE ABANDONMENT CHARGE
In November 2003, the Company relocated its headquarters to a larger
facility. As a result of this relocation, the Company vacated its previous
office space and recorded a lease abandonment charge of $550,162 for the
47
estimated loss expected to be incurred on the remaining lease obligation through
July 2007. The charge included the remaining lease rental obligation reduced by
cash flows the Company expects to generate from an agreement to sub-lease the
facility, as well as the write-off of leasehold improvements at the Company's
previous facility.
(10) IMPAIRMENT OF LONG-LIVED AND OTHER ASSETS
In October 2001, the Company entered into an agreement with Network-1
Security Solutions, Inc. ("NSSI"), a publicly traded company, whereby $2,800,062
was paid to NSSI, of which $2,300,062 was for the purchase of convertible
preferred stock accounted for under the cost method and $500,000 was for a
nonrefundable prepaid royalty recoupable against future product sales of NSSI's
product. Primarily due to the decline since May, 2002 in the market value of
NSSI's common stock underlying the convertible preferred stock to a value which
was significantly below the Company's cost, the Company concluded the decline in
the fair value of its investment in NSSI's preferred stock was other than
temporary. Accordingly, in 2002 the Company recorded an impairment charge of
$2,300,062 to write down its investment in NSSI to fair value. In addition, due
to the lack of market acceptance of the NSSI product in its then current state,
the unrecouped prepaid royalty was not recoverable and in 2002 the Company
recorded an impairment charge of $482,715 to write off this prepaid royalty. In
2003, the Company sold all its NSSI convertible preferred stock for $35,000,
which was reflected as a reduction to the impairment charge in the statement of
operations.
(11) LIABILITIES OF DISCONTINUED OPERATIONS
Liabilities of NPI's discontinued operations at December 31, 2002
totaled $4.2 million and consisted of warranty related liabilities, foreign
income taxes, severance related payments, professional fees and other related
liabilities, including estimated settlement costs for disputes. As of December
31, 2002, the Company had reduced liabilities of discontinued operations and
increased additional paid-in-capital by $2,150,000 for its then estimate of the
excess of the remaining liabilities for discontinued operations over the amounts
estimated to be paid.
On February 14, 2003, the Company settled a claim associated
with the liabilities of discontinued operations for $2,850,000. As of December
31, 2003 all significant contingent liabilities related to the discontinued
operations of NPI have been resolved and paid. As a result, the excess of the
remaining liabilities for discontinued operations over the amounts paid of
$916,845 has been reflected as an increase to additional paid-in-capital in the
accompanying balance sheet as of December 31, 2003 since this liability was
related to the merger with NPI, which was accounted for as a recapitalization.
(12) COMMITMENTS
The Company has an operating lease covering its primary office facility
that expires in February, 2012. The Company also has several operating leases
related to a domestic office and offices in foreign countries. The expiration
dates for these leases ranges from 2004 through 2012. The following is a
schedule of future minimum lease payments for all operating leases as of
December 31, 2003:
Year ending December 31,
------------------------
2004....................................... $ 966,570
2005....................................... 1,174,510
2006....................................... 1,375,952
2007....................................... 1,238,840
2008....................................... 1,121,064
Thereafter................................. 3,778,261
-----------
$ 9,655,197
===========
48
These leases require the Company to pay its proportionate share of real
estate taxes and other common charges. Total rent expense for operating leases
was $673,949, $596,578, and $381,260 for the years ended December 31, 2003, 2002
and 2001, respectively.
The Company typically provides its customers a warranty on its software
products for a period of no more than 90 days. Such warranties are accounted for
in accordance with SFAS No. 5, Accounting for Contingencies. To date, the
Company has not incurred any costs related to warranty obligations.
Under the terms of substantially all of its software license
agreements, the Company has agreed to indemnify its customers for all costs and
damages arising from claims against such customers based on, among other things,
allegations that the Company's software infringes the intellectual property
rights of a third party. In most cases, in the event of an infringement claim,
the Company retains the right to (i) procure for the customer the right to
continue using the software; (ii) replace or modify the software to eliminate
the infringement while providing substantially equivalent functionality; or
(iii) if neither (i) nor (ii) can be reasonably achieved, the Company may
terminate the license agreement and refund to the customer a pro-rata portion of
the license fee paid to the Company. Such indemnification provisions are
accounted for in accordance with SFAS No. 5. Through December 31, 2003, there
have not been any claims under such indemnification provisions.
(13) 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 may 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. As of December 31, 2003, the Company
repurchased a total of 235,000 shares for $1,435,130. The Company did not
repurchase any shares in 2003.
(14) SEGMENT REPORTING
The Company is organized in a single operating segment for purposes of making
operating decisions and assessing performance. Revenues from the United States
to customers in the following geographical areas for the years ended December
31, 2003, 2002 and 2001 and the location of long-lived assets as of December 31,
2003, 2002 and 2001 are summarized as follows:
2003 2002 2001
--------------------------------------------
Revenues:
United States $ 9,834,526 $ 6,629,147 $ 1,755,823
Asia and other international 7,109,609 3,999,745 3,835,906
----------- ----------- -----------
Total Revenues $16,944,135 $10,628,892 $ 5,591,729
=========== =========== ===========
Long-lived assets (includes all non-current assets):
United States $10,329,876 $ 7,655,900 $ 5,963,235
Asia and other international 1,094,724 499,497 363,599
----------- ----------- -----------
Total long-lived assets $11,424,600 $ 8,155,397 $ 6,326,834
=========== =========== ===========
49
For the year ended December 31, 2003, the Company did not have any customers
that accounted for over 10% of revenues. For the year ended December 31, 2002,
the Company had one customer that accounted for 16% of revenues. For the year
ended December 31, 2001, the Company had one customer that accounted for 13% of
revenues.
(15) VALUATION AND QUALIFYING ACCOUNTS - ALLOWANCE FOR DOUBTFUL ACCOUNTS
Balance at Balance at
Beginning of Additions charged End of
Period Ended, Period to Expense Deductions Period
------------- ------ ---------- ---------- ------
December 31, 2003 $ 813,645 $ 1,700,100 $ 675,811 $ 1,837,934
December 31, 2002 $ 375,541 $ 930,150 $ 492,046 $ 813,645
December 31, 2001 $ -- $ 375,541 $ -- $ 375,541
(16) QUARTERLY FINANCIAL DATA (UNAUDITED)
The following is a summary of selected quarterly financial data for the
years ended December 31, 2003 and 2002:
Fiscal Quarter
First Second Third Fourth
----- ------ ----- ------
2003
Revenue $ 3,678,907 $ 4,090,877 $ 4,082,617 $ 5,091,734
Net loss $ (1,738,853) $ (1,578,925) $ (1,894,198)$ (2,156,979)
Basic and diluted net
loss per share $ (0.04) $ (0.03) $ (0.04) $ (0.05)
Basic and diluted
weighted average common
shares outstanding 45,499,862 45,848,994 46,134,816 46,376,183
2002
Revenue $ 1,980,842 $ 2,376,618 $ 2,855,522 $ 3,415,910
Net loss $ (2,581,385) $ (2,464,671) $ (3,562,455) $ (2,934,654)
Basic and diluted net
loss per share $ (0.06) $ (0.05) $ (0.08) $ (0.06)
Basic and diluted
weighted average common
shares outstanding 45,184,257 45,238,657 45,239,977 45,266,504
50
The sum of the quarterly net loss per share amounts do not always equal
the annual amount reported, as per share amounts are computed independently for
each quarter and the annual period based on the weighted average common shares
outstanding in each such period.
51
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
Item 9A. CONTROLS AND PROCEDURES.
The company maintains "disclosure controls and procedures", as such
term is defined in Rules 13a-15e and 15d-15e of the Securities and
Exchange Act of 1934, as amended (the "Exchange Act"), that are
designed to ensure that information required to be disclosed in its
reports, pursuant to the Exchange Act, is recorded, processed,
summarized and reported within the time periods specified in the SEC's
rules and forms, and that such information is accumulated and
communicated to its management, including its Chief Executive Officer
and Principal Accounting Officer, as appropriate, to allow timely
decisions regarding the required disclosures. In designing and
evaluating the disclosure controls and procedures, management has
recognized that any controls and procedures, no matter how well
designed and operated, can provide only reasonable assurances of
achieving the desired control objectives, and management necessarily is
required to apply its judgment in evaluating the cost benefit
relationship of possible controls and procedures.
The Company's Chief Executive Officer and Principal Accounting Officer
(its principal executive officer and principal accounting officer,
respectively) have evaluated the effectiveness of its "disclosure
controls and procedures" as of the end of the period covered by this
Annual Report on Form 10-K. Based on their evaluation, the principal
executive officer and principal financial officer concluded that its
disclosure controls and procedures are effective. There were no
significant changes in internal controls or in other factors that could
significantly affect these controls subsequent to the date the controls
were evaluated.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information called for by Part III, Item 10, regarding the Registrant's
directors will be included in our Proxy Statement relating to our
annual meeting of stockholders scheduled to be held in May 2004, and is
incorporated herein by reference. The information appears in the Proxy
Statement under the captions "Election of Directors", "Management" and
"Committees of the Board of Directors". The Proxy Statement will be
filed within 120 days of December 31, 2003, our year-end.
ITEM 11. EXECUTIVE COMPENSATION
Information called for by Part III, Item 11, will be included in our
Proxy Statement relating to our annual meeting of stockholders
scheduled to be held in May 2004, and is incorporated herein by
reference. The information appears in the Proxy Statement under the
caption "Executive Compensation." The Proxy Statement will be filed
within 120 days of December 31, 2003, our year-end.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information called for by Part III, Item 12, will be included in our
Proxy Statement relating to our annual meeting of stockholders
scheduled to be held in May 2004, and is incorporated herein by
reference. The information appears in the Proxy Statement under the
captions "Beneficial Ownership of Shares" and "Equity Compensation Plan
52
Information." The Proxy Statement will be filed within 120 days of
December 31, 2003, our year-end.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information regarding our relationships and related transactions will
be included in our Proxy Statement relating to our annual meeting of
stockholders scheduled to be held in May 2004, and is incorporated by
reference. The information appears in the Proxy Statement under the
caption "Certain Relationships and Related Transactions." The Proxy
Statement will be filed within 120 days of December 31, 2003, our
year-end.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
Information called for by Part III, Item 14, will be included in our
Proxy Statement relating to our annual meeting of stockholders
scheduled to be held in May 2004, and is incorporated herein by
reference. The information appears in the Proxy Statement under the
caption "Principal Accounting Fees and Services." The Proxy Statement
will be filed within 120 days of December 31, 2003, our year-end.
53
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
The information required by subsections (a)(1) and (a)(2) of this item
are included in the response to Item 8 of Part II of this annual report
on Form 10-K.
(b) Reports on Form 8-K
On November 5, 2003, we filed a Form 8-K under Items 7 and 12.
(c)
2.1 Agreement and Plan of Merger and Reorganization, dated as of
May 4, 2001, among FalconStor, Inc., Network Peripherals
Inc., and Empire Acquisition Corp, incorporated herein by
reference to Annex A to the Registrant's joint
proxy/prospectus on Form S-4, filed May 11, 2001.
3.1 Restated Certificate of Incorporation, incorporated herein
by reference to Exhibit 3.1 to the Registrant's registration
statement on Form S-1 (File no. 33-79350), filed on April
28, 1994.
3.2 Bylaws, incorporated herein by reference to Exhibit 3.2 to
the Registrant's quarterly report on form 10-Q for the
period ended March 31, 2000, filed on May 10, 2000.
3.3 Certificate of Amendment to the Certificate of
Incorporation, incorporated herein by reference to Exhibit
3.3 to the Registrant's annual report on Form 10-K for the
year ended December 31, 1998, filed on March 22, 1999.
3.4 Certificate of Amendment to the Certificate of
Incorporation, incorporated herein by reference to Exhibit
3.4 to the Registrant's annual report on Form 10-K for the
year ended December 31, 2001, filed on March 27, 2002.
4.1 2000 Stock Option Plan, incorporated herein by reference to
Exhibit 4.1 of the Registrant's registration statement on
Form S-8, filed on September 21, 2001.
4.2 2000 Stock Option Plan, as amended May 15, 2003,
incorporated herein by reference to Exhibit 99 to the
Registrant's quarterly report on Form 10-Q for the period
ended June 30, 2003, filed on August 14, 2003.
4.3 1994 Outside Directors Stock Plan, as amended May 17, 2002
incorporated herein by reference to Exhibit 4.2 to the
Registrant's annual period on Form 10-K for the year ended
December 31, 2002, filed on March 17, 2003.
10.1 Agreement of lease between Huntington Quadrangle 2, LLC, and
FalconStor Software, Inc., dated August, 2003, incorporated
herein by reference to Exhibit 99.1 to the Registrant's
quarterly report on Form 10-Q for the period ended September
30, 2003, filed on November 14, 2003.
10.2 ReiJane Huai Employment Agreement, dated September 1, 2001
between Registrant and ReiJane Huai, incorporated herein by
reference to Exhibit 10.3 to the Registrant's annual report
on Form 10-K for the year ended December 31, 2001, filed on
March 27, 2002.
54
10.3 Change of Control Agreement dated December 10, 2001 between
the Registrant and ReiJane Huai, incorporated herein by
reference to Exhibit 10.4 to the Registrant's annual report
on Form 10-K for the year ended December 31, 2001, filed on
March 27, 2002.
10.4 Change of Control Agreement dated December 7, 2001 between
the Registrant and Wayne Lam, incorporated herein by
reference to Exhibit 10.5 to the Registrant's annual report
on Form 10-K for the year ended December 31, 2001, filed on
March 27, 2002.
14 *Code of Conduct
21.1 Subsidiaries of Registrant - FalconStor, Inc., FalconStor
AC, Inc.
23.1 *Consent of KPMG LLP.
31.1 *Certification of the Chief Executive Officer
31.2 *Certification of the Chief Financial Officer
32.1 *Certification of Chief Executive Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 (18
U.S.C. ss.1350)
32.2 *Certification of Chief Financial Officer pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002 (18
U.S.C. ss.1350)
*- filed herewith.
55
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has signed this report by the undersigned,
thereunto duly authorized in Melville, State of New York on March 12, 2004.
FALCONSTOR SOFTWARE, INC.
By: /s/ ReiJane Huai Date: March 12, 2004
-----------------------------------------
ReiJane Huai, President, Chief Executive
Officer of FalconStor Software, Inc.
POWER OF ATTORNEY
FalconStor Software, Inc. and each of the undersigned do hereby appoint
ReiJane Huai and James Weber, and each of them severally, its or his true and
lawful attorney to execute on behalf of FalconStor Software, Inc. and the
undersigned any and all amendments to this Annual Report on Form 10-K and to
file the same with all exhibits thereto and other documents in connection
therewith, with the Securities and Exchange Commission; each of such attorneys
shall have the power to act hereunder with or without the other.
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 date indicated.
By: /s/ ReiJane Huai March 12, 2004
---------------------------------------------------- ---------------
ReiJane Huai, President, Chief Executive Officer and Date
Chairman of the Board
(Principal Executive Officer)
By: /s/ James Weber March 12, 2004
---------------------------------------------------- ---------------
James Weber, Chief Financial Officer, Vice President Date
and Treasurer
(Principal Accounting Officer)
By: /s/ Patrick B. Carney March 12, 2004
---------------------------------------------------- ---------------
Patrick B. Carney, Director Date
By: /s/ Lawrence S. Dolin March 12, 2004
---------------------------------------------------- ---------------
Lawrence S. Dolin, Director Date
By: /s/ Steven R. Fischer March 12, 2004
---------------------------------------------------- ---------------
Steven R. Fischer, Director Date
By: /s/ Steven H. Owings March 12, 2004
---------------------------------------------------- ---------------
Steven H. Owings, Director Date
56
