Item 1. Business
This Annual Report on Form 10-K ("Annual Report") contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended, and is subject to the "safe harbor" created by those sections. Some of the forward-looking statements can be identified by the use of forward-looking terms such as "believes," "expects," "may," "will," "should," "could," "seek," "intends," "plans," "estimates," "anticipates" or other comparable terms. Forward-looking statements involve inherent risks and uncertainties. A number of important factors could cause actual results to differ materially from those in the forward-looking statements. We urge you to consider the risks and uncertainties discussed elsewhere in this Annual Report under "Item 1A.
Item 1A. Risk Factors
We operate in a rapidly changing environment that involves a number of risks, some of which are beyond our control. This discussion highlights some of the risks which may affect future operating results. These are the risks and uncertainties we believe are most important for you to consider. Additional risks and uncertainties not presently known to us, which we currently deem immaterial or which are similar to those faced by other companies in our industry or business in general, may also impair our business operations. If any of the following risks or uncertainties actually occurs, our business, financial condition and operating results would likely suffer.
Risks Related to Our Company
Our operating results may fluctuate and could cause the market price of our common stock to fall rapidly and without notice.
Our revenues and operating results are difficult to predict and may fluctuate from quarter to quarter, particularly because of the evolving market in which we operate and our term license model. Our results of operations in any given quarter will be based on a number of factors, including:
•the timing and mix of license and services revenues, and the amount and type of service required in delivering certain projects;
•changes in and timing of our operating expenses;
•the timing of our product sales and the length of our sales and implementation cycles;
•changes in our customers' purchasing patterns;
•the timing, size and integration success of potential future acquisitions;
•our ability to introduce new products and services and enhancements to our existing products and services on a timely basis;
•new competitors and introduction of enhanced products from new or existing competitors;
•the extent to which our software products, services and hosted solutions achieve or maintain market acceptance;
•our ability to hire and retain qualified personnel;
•changes in the regulatory environment related to the clinical trial and safety evaluation and monitoring market;
•the financial condition of our current and potential customers; and
•unforeseen legal expenses, including litigation costs.
A significant portion of our operating expense is relatively fixed in nature and planned expenditures are based in part on expectations regarding future revenues. Accordingly, unexpected revenue shortfalls or operating expenses may decrease our gross margins and could cause significant changes in our operating results from quarter to quarter. Results of operations in any quarterly period should not be considered indicative of the results to be expected for any future period. In addition, our
future quarterly operating results may fluctuate and may not meet the expectations of securities analysts or investors. If this occurs, the trading price of our common stock could fall substantially either suddenly or over time.
The loss of one or more major customers could materially and adversely affect our results of operations and financial condition.
Our top five customers accounted for approximately 39% of our revenues during 2007. One customer, GlaxoSmithKline, accounted for approximately 15% of our total revenues for the same period. The loss of any of our major customers could have a material adverse effect on our results of operations or financial condition. We may not be able to maintain our customer relationships, and our customers may delay performance under or fail to renew their agreements with us, which could adversely affect our results of operations or financial condition. Any reduction in the amount of revenue that we derive from these customers, without an offsetting increase in new sales to other customers, could have a material adverse effect on our operating results. A significant change in the liquidity or financial position of any of these customers could also have a material adverse effect on the collectability of our accounts receivables, our liquidity and our future operating results.
We may acquire or make investments in companies or technologies that could cause disruption of our business and loss of value or dilution to our stockholders.
From time to time, we evaluate potential investments in, and acquisitions of, complimentary technologies, services and businesses. We have made in the past, and may make in the future, acquisitions or significant investments in other businesses. For example, we acquired Lincoln Technologies, Inc. ("Lincoln") in 2005 and Green Mountain Logic, Inc. ("Green Mountain") in 2007. Entering into an acquisition entails many risks, any of which could harm our business, including:
•managing the risks and challenges of entering markets or types of businesses in which we have limited or no direct experience;
•difficulties in integrating the operations, technologies, products, existing contracts and personnel of the target company and realizing the anticipated synergies of the combined businesses;
•the price we pay or other resources that we devote may exceed the value we eventually realize or the value we could have realized if we had allocated the purchase price or other resources to another opportunity;
•potential loss of key employees, customers and strategic alliances from either our current business or the target company's business;
•the diversion of management's attention from other business concerns; and
•assumption of unanticipated problems or latent liabilities, such as problems with the quality of the target company's products.
In addition, we could discover deficiencies withheld from us in an acquisition due to fraud or otherwise not uncovered in our due diligence prior to the acquisition. These deficiencies could include problems in internal controls, data adequacy and integrity, product quality and regulatory compliance, any of which could result in us becoming subject to penalties or other liabilities. Acquisitions also frequently result in the recording of goodwill and other intangible assets which are subject to potential impairments in the future that could harm our financial results. If any of the foregoing were to occur, our financial condition and results of operations could be materially adversely impacted. In addition, if we finance any future acquisitions by issuing equity securities or convertible debt, our existing stockholders may be diluted or the market price of our stock may be adversely affected. The failure to successfully evaluate and execute acquisitions or investments or otherwise adequately address these risks could materially harm our business and financial results.
Our business could be seriously harmed by our dependence on a limited number of suppliers.
We depend upon a limited number of suppliers for specific components of our software products and hosted solutions. We may increase our dependence on certain suppliers as we continue to develop and enhance our software and service solutions. Our dependence on a limited number of suppliers leaves us vulnerable to having an inadequate supply of required components, services capacity, price increases, delayed supplier performance and poor component and services quality. For instance, we rely on Oracle Corporation to supply the database component of our software solutions and on Equinix, Inc. and SunGard Data Systems Inc. to provide server facilities for some of our hosting services. Oracle Corporation also offers a software package that is competitive with our products and services. If we are unable to obtain components for our software solutions from third-party suppliers in the quantities and of the quality that we need, on a timely basis or at acceptable prices, we may not be able to deliver our software products, services and hosted solutions on a timely or cost-effective basis to our customers, and our business, results of operations and financial condition could be seriously harmed. Moreover, delays or interruptions in our service, including without limitation delays or interruptions resulting from a change in suppliers, may reduce our revenues, cause customers to terminate their contracts and adversely affect our customer renewals. If these companies were to terminate their arrangements with us or we were otherwise required to find alternative suppliers to provide the required capacity and quality on a timely basis, sales of our products and services would be delayed. To qualify a new supplier and familiarize it with our products, quality standards and other requirements is a costly and time-consuming process. We cannot assure you that we would be able to establish alternative relationships on acceptable terms.
If we are unable to retain our personnel and hire additional skilled personnel, we may be unable to achieve our goals.
Our future success depends upon our ability to attract, train and retain highly skilled employees and contract workers, particularly our management team, sales and marketing personnel, professional services personnel and software engineers. Each of our executive officers and other employees could terminate his or her relationship with us at any time. The loss of any member of our management team might significantly delay or prevent the achievement of our business or development objectives and could materially harm our business. In addition, because of the technical nature of our software products, services and hosted solutions and the dynamic market in which we compete, any failure to attract and retain qualified direct sales, professional services and product development personnel, as well as our contract workers, could have a material adverse affect on our ability to generate sales, successfully develop new software products, services and hosted solutions or software enhancements or deliver services and solutions as requested by our customers.
We may be required to spend substantial time and expense before we recognize a significant portion of the revenues, if any, attributable to our customer contracts.
The sales cycle for some of our software solutions frequently takes in excess of nine months from initial customer contact to contract execution. During this time, we may expend substantial time, effort and financial resources without realizing any revenues with respect to the potential sale. In addition, while we generally begin recognizing revenues upon the execution of our agreements for software term licenses and related services, it may be difficult for us to rapidly increase our revenues through additional sales in any period, as license revenues and, when applicable, related services revenues, from new customers are recognized over the applicable license term, typically one to five years. As a result, we may not recognize significant revenues, if any, from some customers despite incurring considerable expense related to our sales, implementation, and service delivery processes. Even if we do realize revenues from a contract, our term license model may keep us from recognizing a significant portion of these revenues (including revenues for related services) during the same period in which sales,
implementation, and service delivery expenses were incurred. Timing differences of this nature could cause our service gross margins and profitability to fluctuate significantly from quarter to quarter. In addition, if we enter into an agreement with a customer that specifies or otherwise requires that we deliver a specific product or version that is not yet generally available, our term license pricing model may prevent us from recognizing a significant portion of the license and related service revenues under that contract until delivery of such specified product or version occurs. Accordingly, delays in product or version release dates, whether caused by factors such as unforeseen technology issues or otherwise, could further negatively impact the timing of our revenue under such contracts. Similarly, a decline in new or renewed software term licenses in any one quarter will not necessarily be fully reflected in the revenues in that quarter and may negatively affect our revenues in future quarters. This could also cause our operating results to fluctuate from quarter to quarter.
Interruptions or delays in service from our third-party providers could impair the delivery of our hosted solutions and harm our business.
We host some of our software solutions at third-party facilities. Consequently, the occurrence of a natural disaster, technical or service lapses, or other unanticipated problems at the facilities of our third-party providers could result in unanticipated interruptions in our customers' access to our hosted solutions. Our hosted services may also be subject to sabotage, intentional acts of malfeasance and similar misconduct due to the nature of the Internet. In the past, Internet users have occasionally experienced difficulties with Internet and online services due to system or security failures. We cannot assure you that our business interruption insurance will adequately compensate our customers or us for losses that may occur. Even if covered by insurance, any failure or breach of security of our systems could damage our reputation and cause us to lose customers. Further, certain of our hosted solutions are subject to service level agreements that guarantee up to 99% server availability. In the event that we fail to meet those levels, whether resulting from an interruption in service caused by our technology or that of a third-party provider, we could be subject to customer credits or termination of these customer contracts.
Our software products and hosted solutions are at varying stages of market acceptance and the failure of any of our products to achieve or maintain wide acceptance would harm our operating results.
We began offering our InForm electronic data capture software solution for clinical trials in December 1998. Although the Clintrial and Empirica Trace (formerly Clintrace) products were introduced over 10 years ago, we did not begin offering these products until after our acquisition of Clinsoft Corporation, or Clinsoft, in 2001. We only began begin offering our WebVDME, CTSD and WebSDM products after our August 2005 acquisition of Lincoln, and our LabPas product after our October 2007 acquisition of Green Mountain. Continued use of our InForm, Clintrial and Empirica Trace software products, and broad and timely acceptance of our WebVDME, CTSD, WebSDM and LabPas products, as well as integrated solutions combining one or more of our software products, is critical to our future success and is subject to a number of significant risks, some of which are outside our control. These risks include:
•our customers' and prospective customers' desire for and acceptance of our electronic data capture, data management, safety software and Phase I automation solutions;
•our ability to meet product development and release schedules;
•our software products and hosted solutions' ability to support large numbers of users and manage vast amounts of data;
•our customers' ability to use our software products and hosted solutions, train their employees and successfully deploy our technology in their clinical trial and safety evaluation and monitoring activities; and
•our ability to significantly expand our internal resources and increase our capital and operating expenses to support the anticipated growth and continued integration of our software products, services and hosted solutions.
Our failure to address, mitigate or manage these risks would seriously harm our business, particularly if the failure of any or all of our software products or hosted solutions to achieve market acceptance negatively affects our sales of our other products and services.
Failure to manage our rapid growth effectively could harm our business.
We have been experiencing a period of rapid growth as a result of personnel hiring and acquisitions that places a significant strain on our operational and financial resources and our personnel. For example, from January 1, 1999 to December 31, 2007, the number our employees increased from 35 to 509. We have also experienced rapid growth in the number of clinical trials we host and the number of customer relationships we manage. To manage our anticipated future growth effectively, we must continue to maintain and may need to enhance our information technology infrastructure, financial and accounting systems and controls and manage expanded operations in geographically distributed locations. We will also be required to attract, integrate, train and retain a significant number of qualified sales and marketing personnel, professional services personnel, software engineers and other management personnel. Our failure to manage our rapid growth effectively could have a material adverse effect on our business, operating results or financial condition.
Claims that we or our technologies infringe upon the intellectual property or other proprietary rights of a third party may require us to incur significant costs, to enter into royalty or licensing agreements or to develop or license substitute technology.
We have been, and may in the future be, subject to claims that our technologies infringe upon the intellectual property or other proprietary rights of a third party. For instance, in February 2006, we settled a lawsuit filed in 2004 by Dr. Mark L. Kozam, doing business under the name MLK Software and Datasci, LLC, or Datasci, against us and one of our customers which alleged that we infringed a patent claimed to be owned by them. We incurred substantial professional fees in connection with this claim and agreed to make a one-time payment of $8.5 million to Datasci in order to settle this litigation. In addition, the vendors who provide us with technology that we use in our technology could become subject to similar infringement claims. Although we believe that our software solutions do not infringe the patents or other intellectual property rights of any third party, we cannot assure you that our technology does not infringe patents or other intellectual property rights held or owned by others or that they will not in the future. Any future claims of infringement could cause us to incur substantial costs defending against the claim, even if the claim is without merit, and could distract our management from our business. Moreover, any settlement or adverse judgment resulting from the claim could require us to pay substantial amounts or obtain a license to continue to use the technology that is the subject of the claim, or otherwise restrict or prohibit our use of the technology. There can be no assurance that we would be able to obtain a license from the third party asserting the claim on commercially reasonable terms, if at all, that we would be able to successfully develop alternative technology on a timely basis, if at all, or that we would be able to obtain a license from another provider of suitable alternative technology to permit us to continue offering, and our customers to continue using, the applicable technology. In addition, we generally provide in our customer agreements that we will indemnify our customers against third-party infringement claims relating to our technology provided to the customer, which could obligate us to fund significant amounts. Infringement claims asserted against us or our vendors may have a material adverse effect on our business, results of operations or financial condition.
We may be unable to adequately protect, and we may incur significant costs in defending, our intellectual property and other proprietary rights.
Our success depends on our ability to protect our intellectual property and other proprietary rights. We rely upon a combination of trademark, trade secret, copyright, patent and unfair competition laws, as well as license agreements and other contractual provisions, to protect our intellectual property and other proprietary rights. In addition, we attempt to protect our intellectual property and proprietary information by requiring our employees and consultants to enter into confidentiality, non-competition and assignment of inventions agreements. To the extent that our intellectual property and other proprietary rights are not adequately protected, third parties might gain access to our proprietary information, develop and market products or services similar to ours, or use trademarks similar to ours, each of which could materially harm our business. Existing U.S. federal and state intellectual property laws offer only limited protection. Moreover, the laws of other countries in which we market our software products, services and hosted solutions may afford little or no effective protection of our intellectual property. If we resort to legal proceedings to enforce our intellectual property rights or to determine the validity and scope of the intellectual property or other proprietary rights of others, the proceedings could be burdensome and expensive, even if we were to prevail. The failure to adequately protect our intellectual property and other proprietary rights may have a material adverse effect on our business, results of operations or financial condition.
We may lose or delay revenues related to our hosted solutions and consulting services if our customers terminate or delay their contracts with us.
Certain of our hosted and other service and consulting contracts are subject to cancellation by our customers at any time with limited notice. Entities engaged in clinical trials may terminate or delay a clinical trial for various reasons including the failure of the tested product to satisfy safety or efficacy requirements, unexpected or undesired clinical results, decisions to de-emphasize a particular product or forego a particular clinical trial, decisions to downsize clinical development programs, insufficient patient enrollment or investigator recruitment and production problems resulting in shortages of required clinical supplies. In the case of our hosted solutions, any termination or delay in the clinical trials would likely result in a consequential delay or termination in those customers' service contracts. We have experienced terminations and delays of our customer service contracts in the past and expect to experience additional terminations and delays in the future. Because we do not recognize any portion of a hosted service contract's revenues until the implementation cycle is complete, the termination or delay of our customers' clinical trials could result in decreased or delayed revenues under these contracts which could materially harm our business.
Failure of our technology and products could harm our business and operating results.
The technology underlying our software products and hosted solutions processes vast amounts of clinical and safety data. Customers relying on our products to collect, to manage and report clinical and safety information may have a greater sensitivity to product errors and security vulnerabilities than customers of software products in general. In the past, failures of our technology and human error have negatively impacted the data capture, management or reporting capabilities of our products, and new errors may be detected in the future. Any delay or failure of our technology may result in the disruption of our customers' clinical trial or safety evaluation and monitoring processes and could harm our business and operating results. Product or service errors, as well as any difficulties in introducing, installing and maintaining new products and versions or difficulties training customers and their staffs on the utilization of new products and versions, could materially and adversely affect our reputation, result in loss of revenue or delay in revenue recognition, result in significant costs to us and impair our ability to sell our products and services in the future. The costs incurred in correcting any defects or errors may be substantial and could adversely affect our operating margins. In addition, security
breaches, whether intentional or accidental, could expose us to a risk of loss of data, litigation and possible liability.
The global nature of our business exposes us to multiple risks.
For 2007, approximately 49% of our revenues were derived from international operations. We expect that our international operations will continue to account for a significant portion of our revenues. As a result of our international operations, we are exposed to many risks and uncertainties, including:
•fluctuations in foreign currency exchange and interest rates;
•difficulties in staffing, managing and supporting operations in multiple countries;
•difficulties in enforcing agreements and collecting receivables through foreign legal systems and other relevant legal issues;
•tariff and international trade barriers;
•fewer legal protections for intellectual property and contract rights abroad;
•different and changing legal and regulatory requirements in the jurisdictions in which we currently operate or may operate in the future;
•difficulties in obtaining any necessary governmental authorizations for the export of our products to certain foreign jurisdictions;
•potential fluctuations in foreign economies;
•government currency control and restrictions on repatriation of earnings; and
•political and economic changes, hostilities and other disruptions in regions where we currently operate or may operate in the future.
Negative developments in any of these areas in one or more countries could result in a reduction in demand for our software products, services and hosted solutions, the cancellation or delay of orders already placed, threats to our intellectual property, difficulty in collecting receivables, and a higher cost of doing business, any of which could adversely affect our business, results of operations or financial condition. Moreover, with regard to our international operations, we frequently enter into transactions in currencies other than the U.S. dollar and we incur operating expenses in currencies other than the U.S. dollar. This creates a foreign currency exchange risk for us that could have a material adverse effect on our results of operations and financial condition.
Some of our investments are subject to significant market risk.
At December 31, 2007, we held $182.6 million in cash, cash equivalents, short-term and long-term investments. Although we do not issue or invest in financial instruments or their derivatives for trading or speculative purposes, these assets are exposed to a variety of market risks, including changes in interest rates and the market value of our investments. Included within our investment portfolio at December 31, 2007 were $34.5 million of auction rate securities ("ARS"). The types of ARS that we own are backed by student loans, 95% of which are guaranteed under the Federal Family Education Loan Program, and all had credit ratings of AAA (or equivalent) from a recognized rating agency. The ARS are classified as available for sale in our accompanying consolidated balance sheet included in this Annual Report, and are recorded at cost. Historically, the carrying value of ARS approximated fair market value due to the frequent resetting of the interest rates. The auctions have provided a liquid market for these securities as investors historically could readily sell their investments at auction. Auctions are held every 28 days. Following successful auctions in January 2008, all of our ARS have
experienced failed auctions in February and March 2008, as the amount of securities submitted for sale has exceeded the amount of purchase orders due to the liquidity issues experienced in the global credit and capital markets. The result of a failed auction is that these ARS continue to pay interest in accordance with their terms until the next successful auction; however, liquidity will be limited until there is a successful auction or until such time as other markets for these ARS investments develop. If the issuers of such ARS are unable to successfully close future auctions and their credit ratings deteriorate, the fair value of those ARS decline, we may be required to adjust the carrying value of the investment through an impairment charge. Additionally, if such issuers default with respect to such securities, we may no longer continue to receive interest and may have to further impair such investments. If in the future we determine that any decline in value of the ARS is other-than-temporary, we would be required to recognize the loss in our statement of income, which could have a material impact on our operating results in the period it is recognized. If we are unable to liquidate these investments when we need such liquidity for business purposes, we may need to change or postpone such business purposes or find alternative financing for such business purposes, if available.
In the course of conducting our business, we possess or could be deemed to possess personal medical information in connection with the conduct of clinical trials, which if we fail to keep properly protected, could subject us to significant liability.
Our software solutions are used to collect, manage and report information in connection with the conduct of clinical trial and safety evaluation and monitoring activities. This information is or could be considered to be personal medical information of the clinical trial participants or patients. Regulation of the use and disclosure of personal medical information is complex and growing. Increased focus on individuals' rights to confidentiality of their personal information, including personal medical information, could lead to an increase of existing and future legislative or regulatory initiatives giving direct legal remedies to individuals, including rights to damages, against entities deemed responsible for not adequately securing such personal information. In addition, courts may look to regulatory standards in identifying or applying a common law theory of liability, whether or not that law affords a private right of action. Since we receive and process personal information of clinical trial participants and patients from customers utilizing our hosted solutions, there is a risk that we could be liable if there were a breach of any obligation to a protected person under contract, standard of practice or regulatory requirement. If we fail to properly protect this personal information that is in our possession or deemed to be in our possession, we could be subjected to significant liability.
We may not be able to obtain capital when desired on favorable terms, if at all, or without dilution to our stockholders.
We anticipate that our current cash and cash equivalents will be sufficient to meet our current needs for general corporate purposes for at least the next twelve months. However, we may need or desire additional financing to execute on our current or future business strategies, including to:
•develop new or enhance existing software products, services and hosted solutions;
•enhance our operating infrastructure;
•acquire businesses or technologies; or
•otherwise respond to competitive pressures.
If we raise additional funds through the issuance of equity or convertible debt securities, the percentage ownership of our stockholders could be significantly diluted, and these newly issued securities may have rights, preferences or privileges senior to those of existing stockholders. If we incur additional debt financing, a substantial portion of our operating cash flow may be dedicated to the payment of principal and interest on such indebtedness, thus limiting funds available for our business
activities. We cannot assure you that additional financing will be available on terms favorable to us, or at all. If adequate funds are not available or are not available on acceptable terms, when we desire them, our ability to fund our operations, take advantage of unanticipated opportunities, develop or enhance our software products, services and hosted solutions, or otherwise respond to competitive pressures would be significantly limited.
We could incur substantial costs resulting from product liability claims relating to our products or services or our customers' use of our products or services.
Any failure or errors in a customer's clinical trial, post-approval or adverse event reporting obligations caused or allegedly caused by our products or services could result in a claim for substantial damages against us by our customers or the clinical trial participants, regardless of our responsibility for the failure. Although we are generally entitled to indemnification under our customer contracts against claims brought against us by third parties arising out of our customers' use of our products, we might find ourselves entangled in lawsuits against us that, even if unsuccessful, divert our resources and energy and adversely affect our business. Further, in the event we seek indemnification from a customer, we cannot assure you that a court will enforce our indemnification right if challenged by the customer obligated to indemnify us or that the customer will be able to fund any amounts for indemnification owed to us. We also cannot assure you that our existing general liability insurance coverage will continue to be available on reasonable terms or will be available in amounts sufficient to cover one or more large claims, or that the insurer will not disclaim coverage as to any future claim.
We and our products and services could be subjected to governmental regulation, requiring us to incur significant compliance costs or to cease offering our products and services.
The clinical trial process and safety evaluation, monitoring and reporting activities are subject to extensive and strict regulation by the FDA, as well as other regulatory authorities worldwide. Our electronic data capture, management and safety products and services could be subjected to state, federal and foreign regulations. We cannot assure you that our products and service offerings will comply with applicable regulations and regulatory guidelines as they develop or as they may be applied in the future. If our products or services fail to comply with any applicable government regulations or guidelines, we could incur significant liability or be forced to cease offering our applicable products or services. Also, conforming our products and services to any applicable regulations and guidelines could substantially increase our operating expenses.
Risks Related to Our Industry
We operate in a highly competitive industry and if we are not able to compete effectively, our business and operating results will be harmed.
The market for our software products, services and hosted solutions is characterized by rapidly changing technologies, evolving industry standards and frequent new product and service introductions and enhancements that may render existing products and services obsolete. Accordingly, we are susceptible to rapid and significant declines in market share due to unforeseen changes in the features, functions or pricing of competing products. Barriers to entry are relatively low and, with the introduction of new technologies and new market entrants, we expect that competition will increase. Increased competition is likely to result in pricing pressures, which could negatively impact our sales, gross margins or market share. Our failure to compete effectively could materially adversely affect our business, financial condition or results of operations.
Some of our current competitors, as well as many of our potential competitors, have greater name recognition, longer operating histories and significantly greater resources. As a result, our competitors may be able to respond more quickly and effectively than we can to new or changing opportunities,
technologies, standards or customer requirements. In addition, current and potential competitors have established, and may in the future establish, cooperative relationships with vendors of complementary products, technologies or services to increase the availability of their products to the marketplace. Accordingly, new competitors or alliances may emerge that have greater market share, larger customer bases, more widely adopted proprietary technologies, greater marketing expertise and larger sales forces than we have, which could put us at a competitive disadvantage. Further, in light of these advantages, even if our products and services are more effective than the product or service offerings of our competitors, current or potential customers might accept competitive products and services in lieu of purchasing our software products, services and hosted solutions. We cannot assure you that we can maintain or enhance our competitive position against current and future competitors.
Changing customer or prospective customer requirements could decrease the demand for our products and services, which would adversely affect our revenues and operating results.
Our future success will depend in large part on our ability to enhance and broaden our software products, services and hosted solutions to meet the evolving needs of our customers and prospective customers. To achieve our goals, we need to effectively respond to our customers' and prospective customers' needs, technological changes and new industry standards and developments in a timely manner. If we are unable to enhance our existing product and service offerings or develop or acquire new products and services to meet changing requirements, demand for our software products, services and hosted solutions could suffer and our revenues and operating results could be materially adversely affected. We could also incur substantial costs if we need to modify our products or services, or information technology infrastructure, to adapt to technological changes or new industry standards or developments.
We depend primarily on the pharmaceutical, biotechnology and medical device industries and are therefore subject to risks relating to changes in these industries.
Our business depends on the clinical trial, post-approval and safety evaluation and monitoring activities conducted or sponsored by pharmaceutical, biotechnology and medical device companies and other entities engaged in these activities. General economic downturns, increased consolidation or decreased competition in the industries in which these companies operate could result in fewer products under development or decreased pressure to accelerate product approval which, in turn, could materially adversely impact our revenues. Our operating results may also be adversely impacted by other developments that affect these industries generally, including:
•the discovery of safety issues with approved products or products in clinical development;
•changes in the purchasing patterns of entities conducting clinical research and monitoring safety;
•changes in government regulation;
•changes in general business conditions;
•the assertion of product liability claims;
•changes in governmental price controls or third-party reimbursement practices; and
•changes in medical practices.
Any decrease in research and development expenditures or in the size, scope or frequency of clinical trial, post approval and safety evaluation and monitoring activities conducted or sponsored by pharmaceutical, biotechnology or medical device companies or other entities as a result of the foregoing or other factors could materially adversely affect our operations or financial condition.
Changes in regulations and regulatory guidance applicable to our customers or potential customers and the approval process for their products may result in our inability to continue to do business.
Demand for our software products, services and hosted solutions is largely a function of regulation and regulatory guidance associated with the approval and safety tracking of drugs, biological products and medical devices imposed upon the clinical trial process and post-approval activities by the U.S. federal government and related regulatory authorities such as the U.S. Food and Drug Administration, or FDA, and by foreign governments. In recent years, efforts have been made to streamline the FDA approval process and coordinate U.S. standards with those of other developed countries. Any change in the scope of applicable regulations and regulatory guidance could alter the type or amount of clinical trial or safety evaluation and monitoring spending or negatively impact interest in our software products, services and hosted solutions. Any regulatory reform that limits or reduces the research and development or safety spending of our customers or potential customers upon which our business depends could have a material adverse effect on our revenues or gross margins.
In addition, any failure to conform our software products, services and hosted solutions to domestic or international changes in regulations and regulatory guidance applicable to our customers or potential customers and the approval process for their products may result in our inability to continue to do business. Changing our software products, services and hosted solutions to allow our customers to comply with future changes in regulation or regulatory guidance, either domestically or internationally, could cause us to incur substantial costs. We cannot assure you that our product and service offerings will allow our customers and potential customers to stay in compliance with regulations and regulatory guidance as they develop. If our product and service offerings fail to allow our customers and potential customers to operate in a manner that is compliant with applicable regulations and regulatory guidance, clinical trial sponsors and other entities engaged in clinical trial and safety evaluation and monitoring activities may be unwilling to use our software products, services and hosted solutions.
Consolidation among our clients could cause us to lose clients, decrease the market for our products and result in a reduction of our revenues.
Our customer base could decline because of consolidation, and we may not be able to expand sales of our products and services to new clients. Consolidation in the pharmaceutical, biotechnology and medical device industries and among CROs has accelerated in recent years, and this trend could continue. In addition, new companies or organizations that result from such consolidation may decide that our products and services are no longer needed because of their own internal processes or the use of alternative systems. As these entities consolidate, competition to provide products and services to industry participants will become more intense and the importance of establishing relationships with large industry participants will become greater. These industry participants may try to use their market power to negotiate price reductions for our products and services. Also, if consolidation of larger current customers occurs, the combined organization may represent a larger percentage of business for us and, as a result, we are likely to rely more significantly on the combined organization's revenues to continue to achieve growth.
If entities engaged in clinical trials do not shift from traditional paper-based methods of collecting clinical trial data to electronic system, we may not achieve the market penetration necessary to maintain profitability.
If entities engaged in clinical trials are unwilling to use our electronic data capture solutions or to change the way of collecting clinical trial data, our future growth and market share may be limited. Most clinical trials today rely on pre-printed paper case report forms for data collection. Our efforts to establish an electronic process to capture clinical trial data are a significant departure from the traditional paper-based methods of collecting clinical trial data. As is typical for new and rapidly evolving industries, customer demand for recently-introduced technology is highly uncertain. We may not be successful in persuading entities engaged in clinical trials to change the manner in which they have traditionally collected clinical trial data and to accept our software products, services and hosted
solutions. If we fail to convince entities engaged in clinical trials to use our electronic data capture solutions over traditional methods, our revenues may be limited and we may fail to maintain profitability.
Risks Related to our Common Stock
The market price and trading volume of our common stock may be volatile, which could result in substantial losses for investors purchasing shares in the public markets and subject us to securities class action litigation. The current market price of our common stock may not be indicative of future market prices and we may be unable to sustain or increase the value of an investment in our common stock.
Market prices for securities of software, technology and health care companies have been volatile. The trading price of our common stock may fluctuate significantly and, accordingly, may not be indicative of future trading prices and we may be unable to sustain or increase the value of an investment in our common stock. Some of the factors that may cause the market price of our common stock to fluctuate include:
•changes in estimates of our financial results or recommendations by securities analysts;
•financial results that are below estimate of such results;
•sales or transfers of large blocks of stock by existing investors;
•investors' general perception of us;
•changes in general economic, industry and market conditions;
•period-to-period fluctuations in our financial results or those of companies that are perceived to be similar to us;
•changes in market valuations of similar companies;
•announcements by us or our competitors of significant products, contracts, acquisitions or strategic alliances;
•future issuances of securities or the incurrence of debt by us, or other changes in our capital structure;
•success of competitive products and technologies;
•the failure of any of our software products, services and hosted solutions to achieve or maintain commercial success;
•regulatory developments in the United States and foreign countries;
•changes in industry analyst recommendations;
•additions or departures of key personnel; and
•litigation involving our company or our general industry or both.
In addition, if the market for software, technology or health care stocks or the stock market in general experiences a loss of investor confidence, the trading price of our common stock could decline for reasons unrelated to our business, operating results or financial condition. If any of the foregoing occurs, it could cause our stock price to fall and may expose us to class action lawsuits that, even if unsuccessful, could be costly to defend and a distraction to management.
Sales of large blocks of our common stock could cause the market price of our common stock to drop significantly, even if our business is doing well.
Some stockholders may acquire or own large blocks of shares of 5% or more of our outstanding capital. We cannot predict the effect that public sales of these shares or the availability of these shares for sale will have on the market price of our common stock, if any. If our stockholders, and particularly
our directors and officers, sell substantial amounts of our common stock in the public market, or if the public perceives that such sales could occur, this could have an adverse impact on the market price of our common stock, even if there is no relationship between such sales and the performance of our business.
In the future, we may also issue additional shares to our employees, directors or consultants, in connection with corporate alliances or acquisitions, and issue additional shares in follow-on offerings to raise additional capital. Due to these factors, sales of a substantial number of shares of our common stock in the public market could occur at any time. Such sales could reduce the market price of our common stock.
Delaware law and our corporate documents may prevent or frustrate a change in control or a change in management that stockholders believe is desirable.
Provisions of our certificate of incorporation and bylaws and Delaware law may discourage, delay or prevent a merger, acquisition or other change in control that stockholders may consider favorable, including transactions in which you might otherwise receive a premium for your shares. These provisions may also prevent or frustrate attempts by our stockholders to replace or remove our management. These provisions include:
•limitations on the removal of directors;
•advance notice requirements for stockholder proposals and nominations;
•the inability of stockholders to act by written consent or to call special meetings; and
•the ability of our board of directors to designate the terms of and issue new series of preferred stock without stockholder approval, which could be used to institute a stockholders rights plan, or a poison pill, that would work to dilute the stock ownership of a potential hostile acquirer, likely preventing acquisitions that have not been approved by our board of directors.
The affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote is necessary to amend or repeal the above provisions of our certificate of incorporation. In addition, absent approval of our board of directors, our bylaws may only be amended or repealed by the affirmative vote of the holders of at least 75% of our shares of capital stock entitled to vote.
In addition, Section 203 of the Delaware General Corporation Law prohibits a publicly held Delaware corporation from engaging in a business combination with an interested stockholder, generally a person which together with its affiliates owns, or within the last three years has owned, 15% of our voting stock, for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner.
The existence of the foregoing provisions could limit the price that investors might be willing to pay in the future for shares of our common stock.
Item 1B.
Item 1B. Unresolved Staff Comments
As of the date of the filing of this Annual Report, there were no unresolved comments regarding our periodic or current reports from the staff of the Securities and Exchange Commission that were issued 180 days or more preceding the end of our 2007 fiscal year.
Item 2.
Item 2. Properties
Our corporate headquarters are located at 880 Winter Street, Waltham, Massachusetts, where we lease approximately 126,588 square feet under three leases. These leases expire in February 2009. We also lease 14,960 square feet of office space in Maidenhead, England for our European headquarters under a lease that expires in May 2012, and we lease smaller offices in: Montpelier, Vermont; Paris, France; Sydney, Australia; Waterloo, Belgium; and Tokyo, Japan. We also lease individual offices in
various locations to accommodate field sales personnel. We believe these facilities and additional or alternative space available to us will be adequate to meet our needs for the foreseeable future.
On February 13, 2008, we entered into a lease (the "Lease"), to secure office space for our future corporate headquarters at 77 Fourth Avenue, Waltham, Massachusetts. The estimated commencement date for occupancy under the Lease is December 2008.
Item 3.
Item 3. Legal Proceedings
From time to time and in the ordinary course of business, we are subject to various claims, charges and litigation. Although the outcome of litigation cannot be predicted with certainty and some lawsuits, claims or proceedings may be disposed of unfavorably to us, we do not believe that we are currently a party to any material legal proceedings.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of security holders in the quarter ended December 31, 2007.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Stock Market Information
Our common stock is traded on the NASDAQ Global Market under the symbol PFWD. The following table sets forth the high and low sales prices as quoted on the NASDAQ Global Market for the periods indicated, as adjusted to the nearest cent. These over-the-counter market quotations reflect inter-dealer prices, without retail mark-up, mark-down or commission and may not necessarily represent actual transactions.
On March 7, 2008 the last reported sale price of our common stock on The NASDAQ Global Market was $16.20 per share.
Holders
As of March 7, 2008 there were approximately 242 stockholders of record of our common stock based on the records of our transfer agent.
Dividends
We currently intend to retain any earnings to fund the operation, development, and expansion of our business. We have not paid any cash dividends on our capital stock in the last two fiscal years and do not currently anticipate paying any cash dividends on our capital stock in the foreseeable future.
Issuer Purchases of Equity Securities
During the year ended December 31, 2007, there were no repurchases made by us or on our behalf, or by any "affiliated purchaser," of shares of our common stock registered pursuant to Section 12 of the Securities Exchange Act of 1934, as amended.
Equity Compensation Plan Information
See Part III, Item 12 for information regarding securities authorized for issuance under our equity compensation plans.
Stock Performance Graph
The information contained in the performance graph shall not be deemed to be "soliciting material" or to be "filed" with the SEC, and such information shall not be incorporated by reference into any future filing under the Securities Act or Exchange Act, except to the extent that Phase Forward specifically incorporates it by reference into such filing.
The following graph sets forth the total cumulative stockholder return on our common stock since our common stock began trading on the NASDAQ Global Market on July 15, 2004 as compared to the NASDAQ Composite Index and the NASDAQ Computer & Data Processing Stocks Index. This graph assumes a $100 investment in Phase Forward common stock at the $9.35 per share closing price on July 15, 2004. Historical stock performance is not necessarily indicative of future price performance.
COMPARISON OF 42 MONTH CUMULATIVE TOTAL RETURN*
Among Phase Forward Incorporated, The NASDAQ Composite Index
And The NASDAQ Computer & Data Processing Index
*$100 invested on 7/15/04 in stock or on 6/30/04 in index-including reinvestment of dividends. Fiscal year ending December 31.
Item 6.
Item 6. Selected Financial Data
SELECTED CONSOLIDATED FINANCIAL DATA
(in thousands, except per share data)
The selected historical financial data set forth below as of December 31, 2006 and 2007 and for the years ended December 31, 2005, 2006 and 2007 are derived from our consolidated financial statements, which have been audited by Ernst & Young LLP, our independent registered public accounting firm, and which are included elsewhere in this Annual Report. The selected historical financial data set forth below as of December 31, 2003, 2004 and 2005 and for the years ended December 31, 2003 and 2004 are derived from audited consolidated financial statements, which are not included in this Annual Report.
The following selected consolidated financial data should be read in conjunction with our consolidated financial statements, the related notes and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Annual Report. The historical results are not necessarily indicative of the results to be expected for any future period.
(1)On August 25, 2005, we acquired all of the outstanding capital stock of Lincoln Technologies, Inc. ("Lincoln"), which was accounted for as a purchase under SFAS No. 141. Accordingly, the results of Lincoln have been included in the accompanying consolidated financial statements since the date of acquisition. The Lincoln acquisition is further described in Note 3 of the notes to our 2007 consolidated financial statements contained in this Annual Report.
(2)Cost of revenues and operating expenses include stock-based compensation expense as follows:
(3)For information regarding the computation of per share amounts refer to Note 2 of the notes to our 2007 consolidated financial statements contained in this Annual Report.
(4)Working capital consists of current assets less current liabilities, net of deferred revenue.
(5)On October 30, 2007, we acquired all of the outstanding capital stock of Green Mountain Logic, Inc. ("Green Mountain"), which was accounted for as a purchase under SFAS No. 141. Accordingly, the results of Green Mountain have been included in the accompanying consolidated financial statements since the date of acquisition. The Green Mountain acquisition is further described in Note 3 of the notes to our 2007 consolidated financial statements contained in this Annual Report.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
The information contained in this section has been derived from our consolidated financial statements and should be read together with our consolidated financial statements and related notes included elsewhere in this Annual Report.
Overview
Phase Forward Incorporated is a provider of integrated enterprise-level software products, services and hosted solutions for use in our customers' global clinical trial and drug safety monitoring activities. Our customers include pharmaceutical, biotechnology and medical device companies, as well as academic institutions, governmental regulatory agencies, contract research organizations, or CRO's, and other entities engaged in clinical trial and drug safety monitoring activities. By automating essential elements of the clinical trial and drug safety monitoring processes, we believe our products allow our customers to accelerate the market introduction of new medical therapies and corresponding revenues, reduce overall research and development expenditures, enhance existing data quality control efforts, increase drug safety compliance and reduce clinical and economic risk.
Fiscal Year
Our fiscal year ends on December 31. Reference to 2007, for example, refers to the fiscal year ended December 31, 2007.
Acquisitions
From time to time we have expanded our product and service offerings through the acquisition of other businesses or technologies. The most significant of these transactions are the acquisitions of Clinsoft Corporation and Lincoln Technologies, Inc. We also recently completed the acquisition of Green Mountain Logic, Inc. These transactions are described below.
Green Mountain Logic
On October 30, 2007, we acquired all of the outstanding capital stock of Green Mountain Logic, Inc. ("Green Mountain"), a process automation software company that provides targeted solutions for the life sciences industry, including the LabPas Phase I clinic automation software. The acquired technology and products of Green Mountain provide us with a solution targeted for Phase I clinical trials. The aggregate purchase price was $5.4 million. The acquisition of Green Mountain was accounted for as a purchase under Statement of Financial Accounting Standards ("SFAS") No. 141, Business Combinations. Accordingly, the results of Green Mountain have been included in our consolidated financial statements since the date of acquisition.
Lincoln Technologies
On August 25, 2005, we acquired all of the outstanding capital stock of Lincoln Technologies, Inc. ("Lincoln"), a provider of products and services for drug safety, clinical trial safety signal detection, and applied data standards. Lincoln's products consisted of WebVDME, CTSD and WebSDM. The aggregate purchase price was $16.7 million. The acquisition agreement called for additional cash consideration to be paid subject to achievement of certain financial targets in 2005 and 2006, of up to $2.0 million and $4.0 million, respectively. The defined 2005 financial targets were achieved and, accordingly, we accrued additional consideration of $2.0 million in 2005 which was paid in May 2006. The acquisition agreement was amended in September 2006 to amend the terms of the remaining contingent earn-out payment for which the securityholders of Lincoln could be eligible in 2007 under the acquisition agreement. Pursuant to the amendment, we agreed to pay the securityholders of Lincoln an aggregate of $3.5 million in cash on December 26, 2007 in satisfaction of our remaining payment obligations under
the acquisition agreement. The acquisition of Lincoln was accounted for as a purchase under SFAS No. 141. Accordingly, the results of Lincoln have been included in our consolidated financial statements since the date of acquisition.
Clinsoft Corporation
On August 14, 2001, we acquired Clinsoft Corporation ("Clinsoft"), a developer, marketer and provider of clinical data management and adverse event reporting and tracking products and services. Clinsoft's products consisted of Clintrial and Clintrace (now Empirica Trace).
Litigation Settlement
In February, 2006, we entered into a Settlement Agreement and related License Agreement with Dr. Mark L. Kozam d/b/a MLK Software and Datasci, LLC. The Settlement Agreement relates to a lawsuit filed by Datasci in 2004 alleging that certain of our products and services and certain products and services of one of our customers, Quintiles, Inc., infringe a United States patent claimed to be owned by Datasci. Under the Settlement Agreement and related License Agreement, we agreed to make a one-time, lump-sum payment to Datasci in the amount of $8.5 million to settle the claim and obtain a perpetual, irrevocable, fully paid worldwide, non-exclusive license to the patent that was the subject of the claim by Datasci. The confidential settlement, in which neither party admits liability, provides for mutual releases and dismissal of all actions between the parties.
Pursuant to SFAS No. 142, Goodwill and Other Intangible Assets, we reviewed the attributes of the license obtained and estimated that the license obtained had no value or useful life and that the license would not contribute to our future cash flows, either directly or indirectly. In addition we do not anticipate changing any of our products as a result of the license to this patent. As such, the settlement amount was recorded as a charge to operations. Since the contingency existed as of December 31, 2005 and the settlement was concluded prior to the issuance of our 2005 audited consolidated financial statements, in accordance with SFAS No. 5, Accounting for Contingencies, we recorded the impact of the settlement in 2005 as a charge to operations. The settlement was paid during the first quarter of fiscal 2006.
Sources of Revenues
We derive our revenues from software licenses and services. Our product line is comprised of three general categories that include the following software products:
•Electronic Data Capture (EDC)
•InForm, our Internet-based electronic data capture solution for collection and transmission of patient information in clinical trials; and
•LabPas, our system for Phase I clinic automation.
•Clinical Data Management
•Clintrial, our clinical data management solution; and
•WebSDM, our system for validating and reviewing clinical trial data represented in formats meeting industry standards, such as those established by the Clinical Data Interchange Standards Consortium, or CDISC.
•Safety
•Empirica Trace (formerly Clintrace™), our adverse event management solution for monitoring drug safety and reporting adverse events that occur during and after conclusion of the clinical trial process;
•WebVDME, our data mining and signal detection solution for post-marketing data; and
•CTSD, our signal detection solution for data from clinical trials.
License revenues are derived principally from the sale of term licenses for our software products. Service revenues are derived principally from our delivery of the hosted solution of our InForm, WebVDME, CTSD and WebSDM software products, and consulting services and customer support, including training, for all of our products. We generally recognize revenues ratably over the life of a license or service contract. This allows us to maintain a backlog that provides multi-year visibility in revenues.
One customer, GlaxoSmithKline, accounted for approximately 18% and 15% of our total revenues in the years 2006 and 2007, respectively, and $2.6 million and $1.8 million of accounts receivable outstanding as of December 31, 2006 and 2007, respectively. Our top 20 customers accounted for approximately 68% and 65% of our total revenues, net of reimbursable out-of-pocket expenses, in the years 2006 and 2007, respectively.
License Revenues
We derive our license revenues principally from the sale of term licenses for the following software products: InForm, our Internet-based electronic data capture, or EDC, solution; Clintrial and WebSDM, our clinical data management solutions; our drug safety solutions, including our Empirica Trace, WebVDME and CTSD products; and our LabPas Phase I clinic automation solution. Although each of our software solutions is available as a stand-alone enterprise application, we offer integrated enterprise solutions incorporating certain of our electronic data capture, data management and drug safety products.
License revenues for our InForm electronic data capture software solution, either on a stand-alone or integrated basis, are determined primarily by the number, complexity and duration of the clinical trials and the number of participants in each clinical trial. License revenues for our Clintrial, WebSDM, Empirica Trace, WebVDME, CTSD and LabPas software solutions are determined primarily by the number of users accessing the software solution. Except as discussed below, we enter into software license agreements for our InForm, Clintrial and Empirica Trace products with terms generally of three to five years with payment terms generally annually in advance. License agreements for our other products are generally annual or multi-year with payment terms generally annually in advance. License revenues are recognized ratably over the duration of the software term license agreement, to the extent that amounts are fixed or determinable and collectable.
Following our acquisition of Clinsoft in August 2001, we began converting holders of Clinsoft perpetual software licenses to our software term license arrangements. We continue to sell additional perpetual licenses of these products in certain situations to our existing customers with the option to purchase customer support, and may in the future do so for new customers based on customer requirements or market conditions. We recognize revenues on the perpetual licenses upon delivery of the software when all other revenue recognition criteria are met. We continue to provide and charge for maintenance and support on our products to those customers who do not convert to our software term license arrangements. We will continue our efforts to convert the remaining former Clinsoft customer base to software term license arrangements. However, we anticipate that some customers will not convert and instead will continue to make annual customer support payments.
Service Revenues
Application Hosting Services. In addition to making our software products available to customers through licenses, we offer our InForm, WebVDME, CTSD and WebSDM software as hosted application solutions delivered through a standard web-browser, with customer support and training services.
Service revenues from application hosting services are derived principally from our InForm hosted solution.
Revenues resulting from the InForm hosting service consist of three stages for each clinical trial:
•First stage-trial and application set up, including design of electronic case report forms and edit checks, installation and server configuration of the system;
•Second stage-application hosting and related support services; and
•Third stage-services required to close out, or lock, the database for the clinical trial.
Services provided for the first and third stages are provided on a fixed fee basis depending upon the complexity of the trial and system requirements. Services for the second stage are charged separately as a fixed monthly fee. We recognize revenues from all stages of the hosting service ratably over the hosting period. Fees charged and costs incurred for the trial system design, set up and implementation are deferred until the start of the hosting period and are amortized and recognized ratably over the estimated hosting period. The deferred costs include direct costs related to the trial and application set up. Fees for the first and third stages of the services are billed based upon milestones. Fees for application hosting and related services in the second stage are generally billed quarterly in advance. Bundled into this revenue element are the revenues attributable to the software license used by the customer.
In the event that an application hosting customer cancels a clinical trial and its related statement of work, all deferred revenues are recognized and all deferred set up costs are expensed. In addition, certain termination-related fees may be charged and if so, such fees are recognized in the period of termination.
Revenues resulting from hosting services for our WebVDME, CTSD and WebSDM products consist of installation and server configuration, application hosting and related support services. Services for this offering are charged monthly as a fixed fee. Revenues are recognized ratably over the period of the service.
In addition, application hosting service revenues include hosting services associated with term license customers and reimbursable out-of-pocket expenses.
Consulting Services. Consulting services include the design and documentation of the processes related to our customers' use of our products and services in their clinical trials and safety monitoring activities. Consulting services also include project planning and management services, guidance on best practices in using our software products, data management and configuration services for data mining and reporting, as well as implementation services consisting of application architecture design, systems integration, installation and validation. Consulting services can be sold on a stand-alone basis or as part of a bundled arrangement. In some circumstances, we sell additional follow on consulting services to a customer at a later date even if the customer purchased consulting services at the time of the initial license purchase under a bundled arrangement. Revenues from consulting services included in either a multiple element software license agreement or in an application hosting agreement are recognized ratably over the term of the arrangement. The value of our consulting services sold within a bundled arrangement is equal to the value of consulting services sold on a stand-alone basis, as the activities performed under both types of arrangements are similar in nature. The associated costs are expensed as incurred. Revenues from consulting services that are not included in a multiple element software license arrangement or an application hosting arrangement are recognized as services are performed. Fixed priced arrangements are billed based upon contractual milestones, and time-and-materials arrangements are billed monthly.
Customer Support. We have a multinational services organization to support our software products and hosted solutions worldwide. Customer support includes training services, telephone support and
software maintenance. We bundle customer support in our software term licenses and allocate 10% of the value of the license to customer support revenues. The customer support services rate of 10% for multi-year term-based licenses reflects a significant discount from the rate for customer support services associated with perpetual licenses due to the reduction in the time period during which the customer can utilize the upgrades and enhancements. We believe this rate is substantive and represents an amount we believe reasonable to be allocated. Our customer support revenues also consist of customer support fees paid by perpetual license customers. Customer support revenues are recognized ratably over the period of the customer support or term license agreement, with payment terms generally annually in advance.
Cost of Revenues and Operating Expenses
We allocate overhead expenses such as rent and occupancy charges and employee benefit costs to all departments based on headcount. As such, general overhead expenses are reflected in cost of service revenues and in the sales and marketing, research and development, and general and administrative expense categories.
Cost of Revenues. Cost of license revenues consists primarily of the amortization of royalties paid for certain modules within our Clintrial software product as well as our InForm software product. In addition, costs of revenues include expense for the amortization of acquired technologies associated with the acquisition of Lincoln. The cost of license revenues vary based upon the mix of revenues from software licenses for our products. We operate our service organization on a global basis as one distinct unit, and do not segment costs for our various service revenue elements. These services include performing application hosting, consulting and customer support services. Costs for these services consist primarily of employee-related costs associated with these services, amortization of the deferred clinical trial set up costs, allocated overhead, outside contractors, royalties associated with providing customer support for use with the Clintrial and InForm software products and reimbursable out-of-pocket expenses. Cost of services also includes hosting costs that primarily consist of hosting facility fees and server depreciation.
The cost of service revenue varies based upon the number of employees in the service organization, the type of work performed, and royalties associated with revenues derived from providing customer support, as well as costs associated with the flexible use of outside contractors to support internal resources. We supplement the trial design and set up activity for our InForm application hosting services through the use of outside contractors. This allows us to utilize outside contractors in those periods where trial design and set up activity is highest while reducing the use of outside contractors in those periods where trial activity lessens, allowing for a more flexible delivery model. The percentage of the services workforce represented by outside contractors varies from period to period depending on the volume of specific support required. The cost of services is significantly higher as a percentage of revenues as compared to our cost of license revenues primarily due to the employee-related and outside contractor expenses associated with providing services.
Gross Margin. Our gross margin on license revenues varies based on the mix of royalty- and non-royalty-bearing license revenues and the amount of amortization of acquired technologies. Our gross margin on service revenues varies primarily due to variations in the utilization levels of the professional service team and the timing of expense and revenue recognition under our service arrangements. In situations where the service revenues are recognized ratably over the software license term our costs associated with delivery of the services are recognized as the services are performed, which is typically during the first 6 to 12 months of the contract period. Accordingly, our gross margin on service revenues will vary significantly over the life of a contract due to the timing, amount and type of service required in delivering certain projects. In addition, consolidated gross margin will vary depending upon the mix of license and service revenues.
Sales and Marketing. Sales and marketing expenses consist primarily of employee-related expenses, including travel, marketing programs which include product marketing expenses such as trade shows, workshops and seminars, corporate communications, other brand building and advertising, allocated overhead and the amortization of commissions. In addition, sales and marketing include expense for the amortization of acquired technologies associated with the acquisition of Lincoln. We expect that sales and marketing expenses will continue to increase in absolute dollars as commission expense increases with our revenues and as we continue to expand sales coverage and to build brand awareness through what we believe are the most cost effective channels available, but may fluctuate quarter over quarter due to the timing of marketing programs.
Research and Development. Research and development expenses consist primarily of employee-related expenses, allocated overhead and outside contractors. We focus our research and development efforts on increasing the functionality, performance and integration of our software products. We expect that in the future, research and development expenses will increase in absolute dollars as we continue to add features and functionality to our products, introduce additional integrated software solutions to our product suite and expand our product and service offering.
General and Administrative. General and administrative expenses consist primarily of employee-related expenses, professional fees, primarily consisting of expenses for accounting, compliance with the Sarbanes-Oxley Act of 2002, and legal services, including litigation, information technology and other corporate expenses and allocated overhead. We expect that in the future our general and administrative expenses will increase in absolute dollars as we add personnel and incur additional costs related to the growth of our business and operations.
Restructuring. We recorded a $4.5 million restructuring charge in 2003 which related to the relocation of our corporate headquarters. This charge includes approximately $2.5 million relating to the estimated future obligation under the non-cancelable lease and an approximate $2.0 million write-off of the related abandoned leasehold improvements and fixed assets. As of March 31, 2005, payments for all remaining expenses were completed and as a result we recorded a restructuring benefit of $92,000 representing the elimination of accrued expenses associated with the restructuring charge.
In-process Research and Development. In-process research and development expense represents product development efforts that were under way at Green Mountain at the time of acquisition for which technological feasibility had not yet been established. Technological feasibility is established when either of the following criteria is met: (1) detailed program design has been completed, documented and traced to product specifications and its high-risk development issues have been resolved; or (2) a working model of the product has been finished and determined to be complete and consistent with the product design. As of the date of the acquisition, Green Mountain had not completed product designs or working models for the in-process technology, and we determined that there was no future alternative use for the technologies beyond the stated purpose of the specific research and development projects. The fair value of the in-process research and development effort was, therefore, expensed at the time of the acquisition. The estimated fair market value was determined using a discounted cash flow model, based on a discount rate which took into consideration the nature of the expected product to be developed, history of successful new product introduction, and the project's relatively short development time. Key assumptions used in the in-process research and development valuation consisted of the expected completion date for the in-process project, revenue and expense projections assuming future release of the product, and a risk-adjusted discount rate.
Stock-Based Compensation Expenses. Our cost of service revenues, sales and marketing, research and development, and general and administrative expenses include stock-based compensation expense. Stock-based compensation expense is the fair value of outstanding stock options and restricted stock awards, which are recognized over the respective stock option and award service periods. It also
includes amortization of the excess of the deemed fair market value over the exercise price of stock options granted prior to when we became a public company. During the years 2005, 2006 and 2007, we recorded $607,000, $3.0 million and $5.6 million of aggregate stock-based compensation expense, respectively.
Foreign Currency Translation
With regard to our international operations, we frequently enter into transactions in currencies other than the U.S. dollar. As a result, our revenues, expenses and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the euro, British pound, Australian dollar and Japanese yen. In 2005, 2006 and 2007, approximately 47%, 49% and 49%, respectively, of our revenues were generated in locations outside the United States. The majority of these revenues are in currencies other than the U.S. dollar, as are many of the associated expenses. In periods when the U.S. dollar declines in value as compared to the foreign currencies in which we conduct business, our foreign currency-based revenues and expenses generally increase in value when translated into U.S. dollars.
Critical Accounting Policies and Estimates
Our financial statements are prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, 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 periods. On an ongoing basis, we evaluate our estimates and assumptions with our audit committee, including those related to revenue recognition, deferred set up costs, commissions and royalties, accounts receivable reserves, stock-based compensation expense, long-lived assets, intangibles assets and goodwill, income taxes, restructuring, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. There have been no material changes to these estimates for the periods presented in this Annual Report. Our actual results may differ from these estimates under different assumptions or conditions.
We believe that of our significant accounting policies, which are described in Note 2 of the notes to our 2007 consolidated financial statements included in this Annual Report, the following accounting policies involve a greater degree of judgment and complexity. Accordingly, these are the policies we believe are the most critical to aid in fully understanding and evaluating our consolidated financial condition and results of operations.
Revenue Recognition and Deferred Set Up Costs. We recognize software license revenues in accordance with Statement of Position (SOP) No. 97-2, Software Revenue Recognition, as amended, issued by the American Institute of Certified Public Accountants, while revenues resulting from application services are recognized in accordance with Emerging Issues Task Force ("EITF") Issue No. 00-3, Application of AICPA Statement of Position 97-2 to Arrangements that Include the Right to Use Software Stored on Another Entity's Hardware and Securities and Exchange Commission's (SEC) Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition. On August 1, 2003, we adopted EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables. The adoption of EITF Issue No. 00-21 did not have a material impact on our financial position or results of operations.
Customers generally have the ability to terminate application hosting, consulting and training service agreements upon 30 days notice. License agreements, multiple element arrangements, including license and services agreements and certain application hosting services can generally be terminated by either party for material breach of obligations not corrected within 30 days after notice of the breach.
We recognize revenues when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the product or service has been provided to the customer; (3) the collection of our fees is probable; and (4) the amount of fees to be paid by the customer is fixed or determinable.
We generally enter into software term licenses for our InForm, Clintrial and Empirica Trace products with our customers for 3- to 5-year periods. License agreements for our other products are generally annual or multi-year terms. These arrangements typically include multiple elements: software license, consulting services and customer support. We bill our customers in accordance with the terms of the underlying contract. Generally, we bill license fees annually in advance for each year of the license term. Our payment terms are generally net 30 days.
Our software license revenues are earned from the sale of off-the-shelf software requiring no significant modification or customization subsequent to delivery to the customer. Consulting services, which can also be performed by third-party consultants, are deemed to be non-essential to the functionality of the software and typically are for trial configuration, implementation planning, loading of software, building simple interfaces and running test data and documentation of procedures.
Customer support includes training services, telephone support and software maintenance. We generally bundle customer support with the software license for the entire term of the arrangement. As a result, we generally recognize revenues for all elements, including consulting services, ratably over the term of the software license and support arrangement. We allocate the revenues recognized for these arrangements to the different elements based on management's estimate of the relative fair value of each element. For our term-based licenses, we allocate to consulting services the anticipated service effort and value throughout the term of the arrangement at an amount that would have been allocated had those services been sold separately to the customer. The value of our consulting services sold within a bundled arrangement is equal to the value of consulting services sold on a stand-alone basis, as the activities performed under both types of arrangements are similar in nature. The remaining value is allocated to license and support services, with 10% of this amount allocated to support services. The customer support services rate of 10% for multi-year term-based licenses reflects a significant discount from the rate for customer support services associated with perpetual licenses due to the reduction in the time period during which the customer can utilize the upgrades and enhancements. We believe this rate is substantive and represents a reasonable basis of allocation. We have allocated the estimated fair value to our multiple element arrangements to provide meaningful disclosures about each of our revenue streams. The costs associated with the consulting and customer support services are expensed as incurred. There are instances in which we sell software licenses based on usage levels. These software licenses can be based on estimated usage, in which case the license fee charged to the customer is fixed based on this estimate. When the fee is fixed, the revenues are generally recognized ratably over the contractual term of the arrangement. If the fee is based on actual usage, and therefore variable, the revenues are recognized in the period of use. Revenues from certain follow-on consulting services, which are sold separately to customers with existing software licenses and are not considered part of a multiple element arrangement, are recognized as the services are performed.
We continue to sell additional perpetual licenses for the Clintrial and Empirica Trace software products in certain situations to our existing customers with the option to purchase customer support and may in the future do so for new customers based on customer requirements or market conditions. We have established vendor specific objective evidence of fair value for the customer support. Accordingly, license revenues are recognized upon delivery of the software and when all other revenue recognition criteria are met. Customer support revenues are recognized ratably over the term of the underlying support arrangement. We continue to generate customer support and maintenance revenues from our perpetual license customer base. Training revenues are recognized as earned.
In addition to making our software products available to customers through licenses, we offer our InForm, WebVDME, CTSD and WebSDM software solutions through a hosted application solution delivered through a standard web-browser.
Revenues resulting from InForm application hosting services consist of three stages for each clinical trial: the first stage involves application set up, including design of electronic case report forms and edit checks, implementation of the system and server configuration; the second stage involves application hosting and related support services; and the third stage involves services required to close out, or lock, the database for the clinical trial. Services provided for the first and third stages are provided on a fixed fee basis based upon the complexity of the trial and system requirements. Services for the second stage are charged separately as a fixed monthly fee. We recognize revenues from all stages of the InForm hosting service ratably over the hosting period. Fees charged and costs incurred for the trial system design, set up and implementation are deferred as applicable, until the start of the hosting period and then amortized and recognized, as applicable, ratably over the estimated hosting period. The deferred costs include incremental direct costs with third parties and certain internal direct costs related to the trial and application set up, as defined under SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Indirect Costs of Leases. These costs include salary and benefits associated with direct labor costs incurred during trial set up, as well as third-party subcontract fees and other contract labor costs. Work performed outside the original scope of work is contracted for separately as an additional fee and is generally recognized ratably over the remaining term of the hosting period. Fees for the first and third stages of the services are billed based upon milestones. Fees for application hosting and related services in the second stage are billed quarterly in advance. Bundled into this revenue element are the revenues attributable to the software license used by the customer.
Revenues resulting from hosting services for our WebVDME, CTSD and WebSDM products consist of installation and server configuration, application hosting and related support services. Services for this offering are charged monthly as a fixed fee. Revenues are recognized ratably over the period of the service.
In the event that an application hosting customer cancels a clinical trial and its related statement of work, all deferred revenues are recognized and all deferred set up costs are expensed. In addition, certain termination related fees may be charged and if so, such fees are recognized in the period of termination.
We deferred $2.3 million, $2.7 million and $3.4 million of set up costs and amortized $1.7 million, $2.1 million and $2.7 million of set up costs during the years 2005, 2006 and 2007, respectively. The amortization of deferred set up costs is a component of cost of services.
Deferred revenues represent amounts billed or cash received in advance of revenue recognition.
Provisions for estimated losses on uncompleted contracts are made on a contract-by-contract basis and are recognized in the period in which such losses become probable and can be reasonably estimated. To date, we have not experienced any material losses on uncompleted application hosting contracts.
Accounting for Prepaid Sales Commissions and Royalties. For arrangements where we recognize revenues over the relevant contract period, we defer related commission payments to our direct sales force and software license royalties paid to third parties and amortize these amounts over the same period that the related revenues are recognized. This is done to better match commission and royalty expenses with the related revenues. Commission payments are nonrefundable unless amounts due from a customer are determined to be uncollectible or if the customer subsequently changes or terminates the level of service, in which case commissions which were paid are recoverable by the Company. We deferred $3.6 million, $6.4 million and $9.4 million of commissions and amortized to sales and
marketing expense $3.7 million, $5.4 million and $7.5 million during the years 2005, 2006 and 2007, respectively. Royalties are paid on a percentage of billings basis for certain of our products, and we have the right to recover royalties in the event an arrangement is cancelled. We deferred $3.3 million, $2.3 million and $2.5 million of royalties and amortized to cost of revenues $2.9 million, $3.1 million and $2.6 million during the years 2005, 2006 and 2007, respectively.
Accounts Receivable Reserve. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We regularly evaluate the collectability of our trade receivables based on a combination of factors, which may include dialogue with the customer to determine the cause of non-payment, the use of collection agencies, and/or the use of litigation. In the event it is determined that the customer may not be able to meet its full obligation to us, we record a specific allowance to reduce the related receivable to the amount that we expect to recover given all information available to us. We continuously monitor collections from our customers and maintain a provision for estimated credit losses based upon our historical experience and any specific customer collection issues that we have identified. While such credit losses have historically been within our expectations and the provisions established, we cannot guarantee that we will continue to experience the same credit loss rates in the future. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Our accounts receivable reserves were $318,000, $384,000 and $270,000 as of December 31, 2005, 2006 and 2007, respectively.
Accounting for Income Taxes. We are subject to income taxes in both the United States and foreign jurisdictions, and we use estimates in determining our provision for income taxes. We account for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes, which is the asset and liability method for accounting and reporting for income taxes. We adopted the provisions of FASB Interpretation No. ("FIN") 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109, on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109 and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. At the adoption date and as of December 31, 2007, we had no material unrecognized tax benefits and no adjustments to liabilities or operations were required.
Under SFAS No. 109, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. This process requires that we project our current tax liability and estimate our deferred tax assets and liabilities, including net operating loss and tax credit carryforwards. In assessing the need for a valuation allowance, we have considered our recent operating results, future taxable income projections and all prudent and feasible tax planning strategies. In 2005, we determined that it was more likely than not that we would realize a portion of our deferred tax assets and therefore reduced the valuation allowance by $7.8 million. The benefit of the release in valuation allowance was realized through reductions to income tax expense of $4.5 million and to goodwill of $3.2 million. In 2006, we determined that it was more likely than not that we would realize an additional portion of our deferred tax asset and therefore reduced the valuation allowance by an additional $5.6 million. The benefit of the release in valuation allowance was realized through reductions to income tax expense of $5.4 million and to goodwill of $207,000. In 2007, we determined that it was more likely than not that we would realize the full value of our deferred tax asset and therefore reduced the valuation allowance by an additional $22.7 million. The benefit of the release in valuation allowance was realized through reductions to income tax expense of $16.5 million and to goodwill of $6.1 million.
Accounting for Stock-Based Awards. On January 1, 2006, we adopted the provisions of SFAS No. 123(R), Share-based Payment, which requires us to recognize expense related to the fair value of stock-based compensation awards. We elected to use the modified prospective transition method as permitted by SFAS No. 123(R) and therefore have not restated our financial results for prior periods. Under this transition method, stock-based compensation expense for 2006 includes compensation expense for all stock-based compensation awards granted on or after March 15, 2004 (the filing date for the initial registration statement for our initial public offering), based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R).
Stock options granted prior to March 15, 2004 are minimum value options pursuant to SFAS No. 123, Accounting for Stock-Based Compensation. Under the provisions of SFAS No. 123(R), the value of these options will not be recorded in the statement of income subsequent to the date of our adoption of SFAS No. 123(R). Instead, we will continue to account for these options using Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.
For service-based options accounted for under SFAS No. 123(R), we recognize compensation expense on a straight-line basis over the requisite service period of the award. For performance-based options, we recognize expense over the estimated performance period. In addition, SFAS 123(R) requires the benefits of tax deductions in excess of recognized stock-based compensation to be reported as a financing activity rather than an operating activity in the statements of cash flows. This requirement can have the effect of reducing our net operating cash flows and increasing our net financing cash flows in certain periods. To date, we have not recorded these benefits as they have not been realized.
Prior to the adoption of SFAS No. 123(R), we applied SFAS No. 123, amended by SFAS No. 148, Accounting for Stock-based Compensation-Transition and Disclosure, which allowed companies to apply the existing accounting rules under APB Opinion No. 25. Pursuant to APB Opinion No. 25, we accounted for our stock-based awards to employees using the intrinsic-value method, under which compensation expense was measured on the date of grant as the difference between the fair value of our common stock and the option exercise price multiplied by the number of options granted. Generally, we granted stock options with exercise prices equal to the estimated fair value of our common stock; however, to the extent that the fair value of the common stock exceeded the exercise price of stock options granted to employees on the date of grant, we recorded deferred compensation and amortized the expense over the vesting schedule of the options, generally four years. During 2003 and 2004, in accordance with APB Opinion No. 25, we recorded deferred stock-based compensation resulting from the grant of employee stock options with an exercise price less than the fair value of common stock. As of December 31, 2007, all of the deferred stock-based compensation had been recognized.
Effective with the adoption of SFAS No. 123(R), we have elected to use the Black-Scholes option pricing model to determine the weighted average fair value of options granted. See Note 2 of the notes to our 2007 consolidated financial statements included in this Annual Report.
During 2006 and 2007, we recorded $3.0 and $5.6 million of aggregate stock-based compensation expense respectively, of which $2.6 and $5.4 million, respectively, was a result of the adoption of SFAS No. 123(R). The remaining stock-based compensation expense is due to the amortization of stock-based compensation associated with previously issued stock options which amounted to $387,000 and $136,000 in 2006 and 2007, respectively. For 2006, we allocated stock-based compensation expense as follows: $258,000 to cost of service revenues, $394,000 to research and development, $502,000 to sales and marketing and $1.9 to general and administrative. For 2007, we allocated stock-based compensation expense as follows: $702,000 to cost of revenues, $813,000 to research and development, $1.1 million to sales and marketing and $3.0 million to general and administrative. As of December 31, 2007, we had
$17.8 million of unrecognized stock-based compensation expense related to stock-based stock awards that we expect to recognize over a weighted average period of 3.0 years.
Other Significant Estimates
Goodwill and Intangible Assets Impairment. We review the carrying value of goodwill and intangible assets periodically based upon the expected future discounted operating cash flows of our business. Our cash flow estimates are based on historical results adjusted to reflect our best estimate of our operating results in future periods. Actual results may differ materially from these estimates. The timing and size of impairment charges, if any, involves the application of management's judgment regarding the estimates and could significantly affect our operating results.
Overview of Results of Operations for the Years Ended December 31, 2006 and 2007
In 2007, we signed contracted orders of $195.8 million representing an increase of 43% compared to $137.3 million in 2006. Our backlog grew in 2007 to $279.1 million at December 31, 2007, which is an increase of 29% from $216.8 million of backlog at December 31, 2006. The license portion of our backlog increased from $93.2 million at December 31, 2006 to $113.6 million at December 31, 2007, representing a 22% increase. The service portion of our backlog increased by 34% during this same period, from $123.6 million to $165.5 million. Approximately $126 million of the December 31, 2007 total backlog is expected to be recognized as revenue in 2008. Approximately 23% of the value of our backlog as of December 31, 2007 represented contractual commitments that may be cancelled by our customers at any time with limited notice. Based on historical cancellations since our inception in 1997, 2% of the value of our total backlog is expected to be canceled prior to completion.
Total revenues increased by 26% or $27.7 million in 2007 compared to the same period in 2006 primarily due to an increase in total service revenues of 30% and license revenues of 19%, and to a lesser extent, the addition of 55 new customers in 2007.
Our gross margin increased by 21%, or $13.6 million, in 2007 compared to the same period in 2006, primarily due to the increase in revenues.
Operating income in 2007 of $13.0 million increased by $3.7 million, or 40%, compared to the same period in 2006. Operating income for 2006 and 2007 included $3.0 million and $5.6 million of stock-based compensation expense, respectively.
The results for 2007 were impacted by foreign exchange rate fluctuations, resulting in increases in both revenue and expenses for the period of 3%.
Revenues
(1)Revenues by Product Line include product license revenues and product-related service revenues.
The increase in electronic data capture revenues is primarily due to increases in application hosting services and license revenues of $15.8 million and $5.4 million, respectively. In addition, we had increases in both consulting services and customer support, totaling $3.4 million. The increase in safety revenues can be attributed to an increase in license revenues and consulting services revenues of $2.8 million and $926,000, respectively. These increases are partially offset by decreases in clinical data management customer support and consulting services revenues, totaling $639,000.
Total revenues increased in 2007 as compared to the same period in 2006, primarily due to increases in application hosting and license revenues. The increase in revenues associated with our application hosting services in 2007 was primarily due to an approximately 26% increase in production trials under management from approximately 610 at the end of 2006 to approximately 770 at the end of 2007, which includes both application hosting services trials as well as trials hosted for our electronic data capture license customers. The increase in license, consulting and customer support revenues were primarily the result of additional revenue from electronic data capture and safety products, which grew across all applicable revenue categories and resulted from both new and existing customers. Our revenues were not significantly impacted by price increases or decreases. Inflation had only a nominal impact on our revenues. Revenues were impacted by foreign exchange rate fluctuations, resulting in an increase in revenues for the period of 3%.
The increase in revenues worldwide was primarily due to an increase in application hosting service and license revenues. The increase in U.S. revenues is primarily related to additional application hosting services as well as an increase in electronic data capture and safety license revenues. The growth in international revenues is primarily related to additional application hosting services as well as an increase in license revenues relating to all of our products.
Cost of Revenues
The costs of license revenues decreased in 2007 primarily due to a $491,000 decrease in the cost of royalties associated with our electronic data capture software product. The increase in cost of services in 2007 was primarily due to increases in employee-related and contractor expenses of $5.9 million and $3.7 million, respectively, associated with a headcount increase of 46 people and the delivery of increased services revenues. We also had expense increases for depreciation, computer-related, and facilities of $1.3 million, $953,000 and $623,000, respectively. Computer-related expenses include hardware and software support agreements as well as computer accessories. In addition, there were also increases in stock-based compensation, telephone and recruiting expense of $444,000, $427,000 and $406,000, respectively.
Gross Margin
The license gross margin percentage increased in 2007 due to a decrease in royalty expense primarily relating to our electronic data capture software. The services gross margin percentage decreased during 2007 as our expense increases outpaced our revenue growth. These expense increases were due to investments we made to enhance our ability to manage additional current and future application service provider related business. The overall gross margin percentage decreased in 2007 due to the decline in license revenue as a percentage of total revenues and the lower services gross margin percentage. It is likely that gross margin, as a percentage of revenue, will fluctuate quarter by quarter due to the timing and mix of license and service revenues, and the type, amount and timing of service required in delivering certain projects.
Operating Expenses
*Not Meaningful
Sales and Marketing. Sales and marketing expenses increased in 2007 primarily due to a $2.0 million increase in commission expense related to an increase in orders and revenues and in the effective commission rate, as well as due to a $559,000 increase in stock-based compensation expense. We also experienced increases in employee related expenses of $540,000 and in travel of $482,000. In addition, there were increases in marketing programs and outside contractor expense of $164,000 and $119,000, respectively. We expect that our sales and marketing expense will continue to increase in absolute dollars as commission expense increases with our revenues and as we continue to expand sales coverage and to build brand awareness through what we believe are the most cost effective channels available. We expect that such increases may fluctuate, however, due to the timing of marketing programs.
Research and Development. Research and development expenses increased in 2007 primarily due to employee-related expenses of $1.7 million associated with a headcount increase of 11 people. There were also expense increases for outside contractors and stock -based compensation expense of $863,000 and $419,000, respectively. Further, there were increases in depreciation and facilities expense of $323,000 and $171,000, respectively. We expect that our research and development costs will continue to increase in absolute dollars as we continue to add features and functionality to our products, introduce additional integrated software solutions to our product suite and expand our product and service offerings.
General and Administrative. General and administrative expenses increased in 2007 primarily due to an increase in stock-based compensation expense of $1.1 million and employee-related expenses of $807,000 related to a headcount increase of 3 people as well as an increase in bonuses. In addition, there were also expense increases in taxes and fees, computer related expense, depreciation expense, and employee development expenses of $195,000, $167,000, $154,000 and $165,000, respectively. Computer related expenses include hardware and software support agreements as well as computer accessories. These expense increases were partially offset by an overall decrease in professional fees of $592,000, which included $430,000 of expense related to an acquisition opportunity that was evaluated in 2006, but which we did not pursue, as well as a decrease in bad debt expense of $149,000. We expect that in the future our general and administrative expenses will increase in absolute dollars as we add personnel and incur additional costs related to the growth of our business and operations.
In-Process Research and Development. In-process research and development expenses were $300,000 in 2007, resulting from the 2007 acquisition of Green Mountain. In-process research and development expense represents product development efforts that were under way at Green Mountain at the time of acquisition for which technological feasibility had not yet been established. Technological
feasibility is established when either of the following criteria is met: (1) detailed program design has been completed, documented and traced to product specifications and its high-risk development issues have been resolved; or (2) a working model of the product has been finished and determined to be complete and consistent with the product design. As of the date of the acquisition, Green Mountain had not completed product designs or working models for the in-process technology, and we determined that there was no future alternative use for the technologies beyond the stated purpose of the specific research and development projects. The fair value of the in-process research and development effort was, therefore, expensed at the time of the acquisition.
Operating Income
Operating Income. The increase in operating income in 2007 was primarily due to an increase in revenues, as well as the reduction in operating expenses as a percentage of revenues.
Other Income (Expense)
Other Income (Expense). The increase in interest income in 2007 was primarily due to an increase in the amount of our interest bearing cash, cash equivalents, and short-term investments. Our cash, cash equivalents and short-term investments increased primarily due to the $89.1 million of net proceeds received from our offering of 6.3 million shares of common stock (including shares sold upon the exercise of the underwriters' overallotment option), which was completed in June 2007.
Benefit from Income Taxes
*Not meaningful.
Benefit from Income Taxes. The effective tax rate benefit for 2007 increased to 46% compared to an effective tax rate benefit of 2% for 2006. In 2007, we determined that it was more likely than not
that we would realize the full value of our remaining deferred tax asset and therefore reduced the valuation allowance by an additional $22.7 million. The benefit of the release in valuation allowance was realized through reductions to income tax expense of $16.5 million which resulted in an 80% benefit to the effective tax rate and to goodwill of $6.1 million. We recorded a tax reserve of $531,000 on federal and state research and development tax credits, in accordance with FIN 48, which resulted in a 2.7% increase to the effective tax rate. In 2006, we determined that it was more likely than not that we would realize an additional portion of our deferred tax assets and therefore reduced the valuation allowance by $5.6 million. This benefit of the release in valuation allowance was realized through reductions to income tax expense of $5.4 million which resulted in a 45% benefit to the effective tax rate and to goodwill of $207,000. See Note 7 of the notes to our 2007 consolidated financial statements contained in this Annual Report.
Overview of Results of Operations for the Years Ended December 31, 2005 and 2006
In 2006, we signed contracted orders of $137.3 million compared to $90.4 million in 2005, an increase of 52%. Our backlog grew in 2006 to $216.8 million at December 31, 2006, an increase of 17% from $185.3 million of backlog at December 31, 2005. The license portion of our backlog increased from $89.0 million at December 31, 2005 to $93.2 million at December 31, 2006, representing a 5% increase. The service portion of our backlog increased by 28.2% during this same period from $96.4 million to $123.6 million. Approximately 20% of the backlog as of December 31, 2006 represented contract commitments that may be cancelled by our customers at any time with limited notice. Total revenues increased by 22% or $19.6 million in 2006 compared to the same period in 2005 primarily due to an increase in service revenues of 26%.
Our gross margin increased by 22% or $11.9 million in 2006 compared to the same period in 2005, primarily due to the increase in revenues.
Operating income in 2006 of $9.3 million increased by $9.6 million compared to the same period in 2005. The operating income in 2005 included an $8.5 million charge relating to a litigation settlement. The operating income for 2005 and 2006 also included $607,000 and $3.0 million of stock-based compensation expense, respectively.
The results for 2006 were impacted by foreign exchange rate fluctuations, resulting in a decrease in revenue for the period of 2% and no impact on expenses.
Revenues
(1)Revenues by Product Line include product license revenues and product-related service revenues. The increase in electronic data capture revenues is primarily due to increases in application hosting services and license revenues of $11.1 million and $3.0 million. Consulting services and
customer support also increased by a total of $2.2 million. The increase in safety is primarily due to increase of license revenues of $1.9 million.
Total revenues increased in 2006 as compared to the same period in 2005, primarily due to increases in application hosting and license revenues. The increase in revenues associated with our application hosting services in 2006 was primarily due to an increase in trials under management, which include both application hosting services trials as well as trials hosted for our InForm license customers. The increase in license revenues was the result of growth across all of our products but was primarily the result of additional InForm revenue from both new and existing customers. The increase in consulting revenues was primarily attributable to additional InForm revenues which were related to both new and existing customers as well as services relating to new business relationships relating to the WebVDME product we began offering after the August 2005 acquisition of Lincoln. The increase in customer support revenues in 2006 was primarily due to an increase in InForm customer support revenues. Our revenues were not significantly impacted by price increases or decreases. Inflation had only a nominal impact on our revenues. Revenues were impacted by foreign exchange rate fluctuations, resulting in a decrease in revenues for the period of 2%.
The increase in revenues worldwide was primarily due to an increase in application hosting service and license revenues. The increase in U.S. revenues is primarily related to additional application hosting services as well as an increase in license revenue across all of our products, while the increase in international revenues is primarily the result of additional InForm application hosting services revenues with both new and existing customers.
Cost of Revenues
The cost of license revenues increased in 2006 primarily due to a full year of amortization expense from acquired technologies relating to our recent acquisition of Lincoln of $247,000. The increase in cost of services in 2006 was primarily due to increases in employee-related and contractor expenses of $3.8 million and $1.8 million, respectively, associated with a headcount increase of 25 people and the delivery of increased services revenues. We also had expense increases for depreciation, computer-related, and travel expenses of $439,000, $434,000 and $373,000, respectively. Computer-related expenses include hardware and software support agreements as well as computer accessories. In addition, there were also increases in facilities and royalty expense of $252,000 and $227,000, respectively.
Gross Margin
The license gross margin percentage was unchanged in 2006 as compared to 2005 at 93% of related revenue as expenses grew proportionately with revenues. The services gross margin percentage increased during 2006 due to lower services expenses as a percentage of related revenues, due to increased efficiencies resulting in an increase in services revenue per services employee. In addition, there was an increase in revenue from consulting services performed on a time and material basis for some of our enterprise customers, rather than services performed under bundled arrangements. When services are performed on a time and material basis, the timing of expense and revenue recognition is more closely aligned than when services are performed under bundled arrangements, where the revenue is recognized ratably over the license period, while the expenses are recognized as incurred.
Operating Expenses
*Not meaningful Sales and Marketing. Sales and marketing expenses increased in 2006 primarily due to a $1.8 million increase in employee-related expenses related to a headcount increase of 6 people and a $1.7 million increase in commission expense due to both an increase in revenues and an increase in the effective commission rate. We also experienced increases in amortization expense of $510,000 associated with our purchase of Lincoln in August 2005, as well as travel and marketing programs of $337,000 and $302,000, respectively. In addition, stock-based compensation expense increased by $472,000.
Research and Development. Research and development expenses increased in 2006 primarily due to employee-related expenses of $1.4 million. In addition, there were also expense increases for recruiting, outside contractors and depreciation of $185,000, $161,000 and $133,000, respectively. In addition, stock-based compensation expense increased by $228,000.
General and Administrative. General and administrative expenses increased in 2006 primarily due to an increase in stock-based compensation expense of $1.5 million. In addition, there were also expense increases in employee-related expenses of $789,000 related to a headcount increase of 6 people as well as additional outside contractor expenses of $392,000. Furthermore, expenses increased in depreciation and computer related by $320,000 and $272,000, respectively. Computer related expenses include hardware and software support agreements as well as computer accessories. There were also expense increases in insurance and facilities of $168,000 and $144,000, respectively. These expense increases were partially offset by an overall decrease in professional fees of $532,000, which included a reduction of legal expense associated with defending our intellectual property of $903,000 and $438,000 of additional expense related to an acquisition opportunity that was evaluated during the period, but which we decided not to pursue.
Operating Income
*Not meaningful
Operating Income. The increase in operating income in 2006 was primarily due to the litigation settlement of $8.5 million in 2005 and an increase in gross margin from both license and services which was partially offset by an increase in operating expenses.
Other Income (Expense)
Other Income (Expense). The increase in interest income in 2006 was primarily due to an increase in the aggregate of cash, cash equivalents, and short-term investments and an increase in the yield on investments. The decrease in interest expense was due to the pay off of our debt in the quarter ended March 31, 2005. Other, net expense decreased primarily due to a decrease in foreign exchange losses compared to the same period in 2005.
Benefit from Income Taxes
Benefit from Income Taxes. The effective tax rate benefit for 2006 decreased to 2% as compared to an effective tax rate benefit of 185% for 2005. In 2006, we determined that it was more likely than not that we would realize an additional portion of our deferred tax assets and therefore reduced the valuation allowance by $5.6 million. This benefit of the release in valuation allowance was realized through reductions to income tax expense of $5.4 million which resulted in a 45% benefit to the effective tax rate and to goodwill of $207,000. In 2005, we determined that it was more likely than not that we would realize a portion of our deferred tax assets and therefore reduced the valuation allowance by $7.8 million in December 2005. This benefit of the release in valuation allowance was realized through reductions to income tax expense of $4.5 million and to goodwill of $3.2 million, resulting in an effective tax rate benefit of 240%.
Liquidity and Capital Resources
Our principal sources of liquidity were cash, cash equivalents, and short-term and long-term investments totaling $69.6 million and $182.6 million at December 31, 2006 and December 31, 2007, respectively, and accounts receivable of $29.7 million and $35.5 million, respectively.
Cash provided by and used in operating activities has historically been affected by changes in working capital accounts, primarily deferred revenues, accounts receivable and accrued expenses, and add-backs of non-cash expense items such as depreciation and amortization and stock-based
compensation expense. Fluctuations within accounts receivable and deferred revenues are primarily related to the timing of billings of our term license customers and the associated revenue recognition. Movements in deferred costs are related to the volume and stages of hosted clinical trials and movements in accrued expenses and accounts payable are due to the timing of certain transactions.
Net cash provided by operating activities was $42.4 million in 2007, which was more than net income of $29.2 million. The difference is primarily due to non-cash charges of depreciation and amortization of $6.9 million and stock-based compensation expense of $5.6 million and increases in deferred revenue of $16.3 million and accrued expenses of $6.2 million. These increases were partially offset by a non-cash benefit of deferred income taxes of $10.8 million, increases in accounts receivable of $5.2 million and deferred costs of $2.5 million, a decrease in accounts payable of $1.7 million, and an increase in prepaid expenses and other current assets of $1.5 million.
Net cash used by investing activities was $44.1 million during 2007. We received $78.9 million of proceeds from the maturities of short-term investments. This increase was offset due to the purchase of short-term investments of $100.7 million, capital expenditures of $13.4 million, and cash paid for business acquisitions of $8.9 million.
Net cash provided by financing activities was $92.8 million in 2007, most of which consists of net proceeds from the offering of approximately 6.3 million shares of common stock (including shares sold upon the exercise of the underwriters' overallotment option), which was completed in June 2007.
At both December 31, 2006 and December 31, 2007, we had a $500,000 outstanding letter of credit related to our leased facilities. The letter of credit reduces the amount available under our line of credit with a bank.
Substantially all of our long-lived assets as of December 31, 2006 and December 31, 2007 are located in the United States.
We generally do not enter into long-term binding purchase commitments. Our principal commitments consist of obligations under non-cancelable operating leases for office space.
The following table of our material contractual obligations as of December 31, 2007 summarizes the aggregate effect that these obligations are expected to have on our cash flows in the periods indicated:
The above table does not include the new lease we entered into subsequent to December 31, 2007. On February 13, 2008, we entered into a lease ("Lease") with BP Fourth Avenue, L.L.C. (the "Landlord") to secure office space for our future corporate headquarters at 77 Fourth Avenue, Waltham, Massachusetts. The estimated commencement date for occupancy under the Lease is December 2008. The lease for our current corporate headquarters at 880 Winter Street in Waltham is due to expire in February 2009.
The Lease provides for the rental of 165,129 rentable square feet of space and has an initial term of 10 years and three months. We can, subject to certain conditions, extend this term by exercising up to two consecutive five year options. We are not required to pay any rent for the first three months of the initial Lease term. Thereafter, the annual rent on the new lease for years one through five will be $6.6 million, or approximately $548,000 per month. For years six through ten, the annual rent will be
$7.2 million, or approximately $603,000 per month. The total base rent payable in the initial term is $69.1 million.
In addition to base rent, commencing on January 1, 2010, the Lease requires us to pay our proportionate share of the amount by which defined operating expenses incurred by the Landlord exceed the base year (2009) operating expenses, as defined in the Lease. The Lease also requires us to pay our proportionate share of the amount by which real estate taxes paid or incurred by the Landlord exceed the tax base year (fiscal 2010), as defined in the Lease. In addition, we will be receiving lease incentives, including free rent for the first three months of occupancy and allowances for tenant improvements.
In connection with the signing of the Lease, we have deposited with the Landlord an unconditional, irrevocable letter of credit in Landlord's favor in the amount of $962,000.
As of December 31, 2006 and 2007, we had a working capital line of credit with a bank that enables us to borrow up to $2.0 million. As of December 31, 2006 and 2007, there were no amounts outstanding under the working capital line of credit. At December 31, 2006 and 2007, there was $1.5 million available under the line of credit and $500,000 reserved under a letter of credit associated with our leased facilities.
At December 31, 2007, we had $54.8 million of net operating loss carryforwards that may be used to offset future U.S. federal taxable income. These attributes may reduce our future cash tax liability. In addition, we had $15.6 million of net operating losses resulting from excess tax deductions related to stock-based compensation. We will realize the benefit of these excess tax deductions through increases to stockholders' equity in the periods in which the losses are utilized to reduce tax payments. In addition, we had $1.7 million of federal research and development tax credit carryforwards that may be utilized to offset future U.S. taxes. The net operating loss and tax credit carryforward periods extend through 2026 and 2027, respectively. In addition, we had $3.6 million of foreign net operating loss carryforwards that may be used to offset future foreign taxable income. These foreign net operating loss carryforwards have an unlimited carryforward period. We also had $3.1 million of research and development tax credit carryforwards that may be utilized to offset future Massachusetts state taxable income. The Massachusetts tax credit carryforward period extends through 2022. The federal and state net operating loss carryforwards and research and development tax credits are subject to review and possible adjustment by the taxing authorities. Also, the Internal Revenue Code contains provisions that may limit the net operating loss and tax credit carryforwards available in any given year in the event of certain changes in the ownership interests of significant stockholders. We currently expect to realize the benefit of recorded deferred tax assets as of December 31, 2007 of $26.6 million. Our conclusion that such assets will be recovered is based upon our expectation that our future earnings combined with tax planning strategies available to us will provide sufficient taxable income to realize recorded tax assets.
We may be required to make cash outlays related to our unrecognized tax benefits. However, due to the uncertainty of the timing of future cash flows associated with our unrecognized tax benefits, we are unable to make reasonably reliable estimates of the period of cash settlement, if any, with the respective taxing authorities. Accordingly, unrecognized tax benefits of $1.2 million as of December 31, 2007 have been excluded from the contractual obligations table above. For further information on unrecognized tax benefits, see Note 7 in the notes to our 2007 consolidated financial statements included in this Annual Report.
On April 24, 2007, we filed a shelf registration statement on Form S-3, which the Securities and Exchange Commission ("SEC") declared effective on May 8, 2007, with respect to the issuance of up to $100 million aggregate principal amount of common stock. One June 1, 2007, we completed an offering of 6.3 million shares of common stock (including shares sold upon the exercise of the underwriters' overallotment option) under this shelf registration statement which generated net proceeds of $89.1 million. We currently intend to use the estimated net proceeds from the sale of these
securities for working capital and other general corporate purposes and possible acquisitions of other companies, products or technologies. We may from time to time issue securities under the remaining balance of the shelf registration statement for general corporate purposes.
We believe our existing cash, cash equivalents, short-term investments and cash provided by operating activities and our debt facility will be sufficient to meet our working capital and capital expenditure needs over at least the next 12 months. Our future capital requirements will depend on many factors, including our rate of revenue growth, the expansion of our marketing and sales activities, the timing and extent of spending to support product development efforts, the timing of introductions of new products and services and enhancements to existing products and services and the continuing market acceptance of our products and services. From time to time, we may also enter into agreements with respect to potential investments in, or acquisitions of, businesses, services or technologies, which could also require us to seek additional equity or debt financing. To the extent that existing cash and securities and cash from operations are insufficient to fund our future activities, we may need to raise additional funds through public or private equity or debt financing.
Included within our investment portfolio at December 31, 2007 were $34.5 million of auction rate securities ("ARS"). These ARS are debt instruments issued by various states throughout the United States to finance student loans. The types of ARS that we own are backed by student loans, 95% of which are guaranteed under the Federal Family Education Loan Program, and all of which had credit ratings of AAA (or equivalent) from a recognized rating agency. The ARS are classified as available for sale in our consolidated balance sheet included in this Annual Report and are recorded at cost. Historically, the carrying value of ARS approximated fair market value due to the frequent resetting of the interest rates. The auctions have provided a liquid market for these securities as investors historically could readily sell their investments at auction. Auctions are held every 28 days. Following successful auctions in January 2008, all of our ARS have experienced failed auctions in February and March 2008, as the amount of securities submitted for sale has exceeded the amount of purchase orders due to the liquidity issues experienced in the global credit and capital markets. The result of a failed auction is that these ARS continue to pay interest in accordance with their terms until the next successful auction; however, liquidity will be limited until there is a successful auction or until such time as other markets for these ARS investments develop. As of March 13, 2008, we have liquidated $10.5 million of the securities, and have classified these securities as current assets in our consolidated balance sheet included in this Annual Report as of December 31, 2007. As of March 13, 2008, the par value of the ARS that we continue to own, which is equal to cost, totals $24.0 million and these ARS are classified as long-term investments in the consolidated balance sheet at December 31, 2007, based on the our ability and intent to hold these securities until market conditions improve with successful auctions. We believe that, based on our unrestricted cash, cash equivalents and short term marketable securities balances of $158.6 million at December 31, 2007, excluding ARS of $24.0 million, the current lack of liquidity in the credit and capital markets will not have a material impact on our liquidity, cash flow or our ability to fund our operations. If in the future we determine that any decline in value of the ARS is other-than-temporary, we would be required to recognize the loss in our statement of income, which could have a material impact on our operating results in the period it is recognized.
Recently Issued Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The adoption of SFAS No. 157 is not expected to have a material effect on our consolidated financial position and results of operations.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Liabilities, which is effective for fiscal years beginning after November 15, 2007. This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 became effective for the us in 2008. The adoption of SFAS No. 159 is not expected to have a material effect on our consolidated financial position and results of operations.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations. SFAS No. 141(R) retains the fundamental requirements in SFAS 141 that the acquisition method of accounting (which SFAS No. 141 called the "purchase method") be used for all business combinations and for an acquirer to be identified for each business combination. SFAS 141(R) requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions specified in the Statement. This approach replaces SFAS No. 141's cost-allocation process, which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. SFAS No. 141(R) retains the guidance in SFAS No. 141 for identifying and recognizing intangible assets separately from goodwill. SFAS 141(R) will now require acquisition costs to be expensed as incurred, restructuring costs associated with a business combination must generally be expensed prior to the acquisition date and changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, which is our 2009 fiscal year. Earlier adoption is prohibited.
Off-Balance Sheet Arrangements
We do not have any special purpose entities or off-balance sheet arrangements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
We are exposed to a variety of market risks, including changes in interest rates and the market value of our investments.
Financial Instruments, Other Financial Instruments
SFAS No. 107, Disclosure of Fair Value of Financial Instruments, requires disclosure about fair value of financial instruments. Financial instruments consist of cash equivalents, short-term investments, accounts receivable, accounts payable, forward foreign exchange contracts and a line of credit. The fair value of these financial instruments approximates their carrying amount.
Foreign Currency Exchange Risk
Our results of operations and cash flows are subject to fluctuations due to changes in foreign currency exchange rates, particularly changes in the euro, British pound, Australian dollar and Japanese yen. During 2005, 2006 and 2007, 47%, 49% and 49%, respectively, of our revenues were generated in locations outside the United States. The majority of these revenues are denominated in currencies other than the U.S. dollar, as are many of the associated expenses. Except for revenue transactions in Japan, we enter into transactions directly with substantially all of our foreign customers. This creates a foreign currency exchange risk for us.
As of December 31, 2006 and 2007, we had $10.5 million and $12.5 million, respectively, of receivables denominated in currencies other than the U.S. dollar. We also maintain cash accounts
denominated in currencies other that the local currency which expose us to foreign exchange rate movements.
In addition, although our foreign subsidiaries have intercompany accounts that eliminate upon consolidation, such accounts expose us to foreign currency rate movements. Exchange rate fluctuations on short-term intercompany accounts are recorded in our consolidated statements of operations under "other income (expense)", while exchange rate fluctuations on long-term intercompany accounts are recorded in our consolidated balance sheets under "accumulated other comprehensive loss" in stockholders' equity, as they are considered part of our net investment and hence do not give rise to gains or losses.
We have implemented a risk management program under which we measure foreign currency exchange risk monthly and manage those exposures through the use of various operating strategies As more fully described in Note 2 in the notes to our 2007 consolidated financial statements included in this Annual Report, we regularly hedge our non-U.S. dollar-based exposures by entering into short-term forward foreign exchange contracts. This process is designed to minimize foreign currency translation exposures that could otherwise affect consolidated results of operations. The terms of these contracts are for periods generally for one month. The short-term nature of these contracts has resulted in these instruments having insignificant fair values at December 31, 2006 and 2007.
Currently, our largest foreign currency exposure is the British pound, primarily because our European operations have a higher proportion of our local currency denominated expenses. Relative to foreign currency exposures existing at December 31, 2006 and 2007, a 10% unfavorable movement in foreign currency exchange rates would not expose us to significant losses in earnings or cash flows or significantly diminish the fair value of our foreign currency financial instruments. This is primarily due to the short lives of the affected financial instruments that effectively hedge substantially all of our year-end exposures against fluctuations in foreign currency exchange rates. The calculation assumes that each exchange rate would change in the same direction relative to the U.S. dollar.
As of December 31, 2006 and 2007 we entered into forward foreign exchange contracts to hedge approximately $14.9 million and $19.8 million, respectively, of receivables, intercompany accounts and cash balances denominated in currencies other than the U.S. dollar.
Interest Rate Sensitivity
We had unrestricted cash, cash equivalents, short-term and long-term investments totaling $69.6 million and $182.6 million at December 31, 2006 and 2007, respectively. Investments in securities are invested primarily in high quality securities of a short duration and are not materially affected by fluctuations in interest rates. The unrestricted cash and cash equivalents are held for working capital purposes. We do not enter into investments for trading or speculative purposes. Included within our investment portfolio at December 31, 2007 were $34.5 million of auction rate securities ("ARS"). These ARS are debt instruments issued by various states throughout the United States to finance student loans. The types of ARS that we own are backed by student loans, 95% of which are guaranteed under the Federal Family Education Loan Program, and all had credit ratings of AAA (or equivalent) from a recognized rating agency. The ARS are classified as available for sale in our consolidated balance sheet included in this Annual Report and are recorded at cost. Historically, the carrying value of ARS approximated fair market value due to the frequent resetting of the interest rates. The auctions have provided a liquid market for these securities as investors historically could readily sell their investments at auction. Auctions are held every 28 days. Following successful auctions in January 2008, all of our ARS have experienced failed auctions in February and March 2008, as the amount of securities submitted for sale has exceeded the amount of purchase orders due to the liquidity issues experienced in the global credit and capital markets. The result of a failed auction is that these ARS continue to pay interest in accordance with their terms until the next successful auction; however, liquidity will be
limited until there is a successful auction or until such time as other markets for these ARS investments develop. As of March 13, 2008, we have liquidated $10.5 million of the securities, and have classified these securities as current assets in our consolidated balance sheet included in this Annual Report as of December 31, 2007. As of March 13, 2008, the par value of the ARS that we continue to own, which is equal to cost, totals $24.0 million and are classified as long-term investments in the consolidated balance sheet at December 31, 2007, based on the our ability and intent to hold these securities until market conditions improve with successful auctions. We believe that, based on our unrestricted cash, cash equivalents and short term marketable securities balances of $158.6 million at December 31, 2007, excluding ARS of $24.0 million, the current lack of liquidity in the credit and capital markets will not have a material impact on our liquidity, cash flow or our ability to fund our operations. If in the future we determine that any decline in value of the ARS is other-than- temporary, we would be required to recognize the loss in our statement of income, which could have a material impact on our operating results in the period it is recognized.
We have a working capital line of credit which bears interest based upon the prime rate. At December 31, 2006 and 2007, there were no amounts outstanding under our working capital line of credit.
Item 8.
Item 8. Financial Statements and Supplementary Data
The consolidated financial statements and supplementary data of Phase Forward Incorporated are listed under Part IV, Item 15, in this Annual Report.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
Item 9A.
Item 9A. Controls and Procedures.
(1) Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, as ours are designed to do, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of December 31, 2007, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective at that reasonable assurance level in (i) enabling us to record, process, summarize and report information required to be included in our periodic Securities and Exchange Commission filings within the required time period and (ii) ensuring that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure.
(2) Report of Management on Internal Control over Financial Reporting
We are responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is defined in Rule 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended, as a process designed by, or under the supervision of our principal executive and principal financial officers and effected by our board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles and includes those policies and procedures that:
•pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and disposition of our assets;
•provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that our receipts and expenditures are being made only in accordance with authorization of our management and directors; and
•provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Our internal control system was designed to provide reasonable assurance to our management and board of directors regarding the preparation and fair presentation of published financial statements. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
We have assessed the effectiveness of our internal control over financial reporting as of December 31, 2007. In making this assessment, we used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based on our assessment, we believe that, as of December 31, 2007, our internal control over financial reporting is effective at a reasonable assurance level based on these criteria.
Our independent registered public accounting firm, Ernst & Young, LLP, issued an attestation report on our internal control over financial reporting. This report is contained in Section 4 below.
(3) Changes in Internal Controls Over Financial Reporting
There have been no changes in our internal control over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
(4) Report of Independent Registered Public Accounting Firm
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Phase Forward Incorporated
We have audited Phase Forward Incorporated 's internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Phase Forward Incorporated 's management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial
reporting included in the accompanying Report of Management on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Phase Forward Incorporated maintained, in all material respects, effective internal control over financial reporting as of December 31, 2007, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Phase Forward Incorporated as of December 31, 2006 and 2007, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2007 of Phase Forward Incorporated and our report dated March 12, 2008 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Boston, Massachusetts
March 12, 2008
Item 9B.
Item 9B. Other Information.
None.
PART III
Information required by Items 10, 11, 12, 13 and 14 of Part III is omitted from this Annual Report and will be filed in a definitive proxy statement or by an amendment to this Annual Report not later than 120 days after the end of the fiscal year covered by this Annual Report.
Our policy governing transactions in our securities by directors, officers and employees permits our officers, directors and certain other persons to enter into trading plans complying with Rule 10b5-1 under the Securities Exchange Act of 1934, as amended. We have been advised that: our Vice President of Quality and Regulatory Compliance, Michael Owings; our Senior Vice President and General Counsel, D. Ari Buchler; our Senior Vice President and Chief Financial Officer, Rodger Weismann; our Vice President of Worldwide Sales, Stephen J. Powell; our President, Lincoln Technologies, Inc., Channing Russell, and our Vice President, Corporate Development, Martin Young have each entered into a trading plan covering periods after the date of this Annual Report in accordance with Rule 10b5-1 and our policy governing transactions in our securities. Generally, under these trading plans, the individual relinquishes control over the transactions once the trading plan is put into place. Accordingly, sales under these plans may occur at any time, including possibly before, simultaneously with, or immediately after significant events involving our company.
We anticipate that, as permitted by Rule 10b5-1 and our policy governing transactions in our securities, some or all of our officers, directors and employees may establish trading plans in the future. We intend to disclose the names of executive officers and directors who establish a trading plan in compliance with Rule 10b5-1 and the requirements of our policy governing transactions in our securities in our future quarterly and annual reports on Form 10-Q and 10-K filed with the Securities and Exchange Commission. However, we undertake no obligation to update or revise the information provided herein, including for revision or termination of an established trading plan, other than in such quarterly and annual reports.
PART IV
Item 15.
Item 15. Exhibits, Financial Statements and Schedules
(a)The following documents are filed as part of this report:
(1)Financial Statements
Report of Independent Registered Public Accounting Firm on Consolidated Financial Statements
Consolidated Balance Sheets as of December 31, 2006 and 2007
Consolidated Statements of Income for the years ended December 31, 2005, 2006 and 2007
Consolidated Statements of Stockholders' Equity and Comprehensive Income for the years ended December 31, 2005, 2006 and 2007
Consolidated Statements of Cash Flows for the years ended December 31, 2005, 2006 and 2007
Notes to Consolidated Financial Statements
(2)Financial Statement Schedules
All schedules have been omitted because they are not required or because the required information is given in the Consolidated Financial Statements or Notes thereto.
EXHIBIT INDEX
Exhibit No.
Description
2.1 # Agreement and Plan of Merger by and among Phase Forward, Merger Sub, Lincoln and Lincoln SR dated as of August 16, 2005. (Incorporated by reference herein to Exhibit 2.1 of the Company's Current Report on Form 8-K filed with the SEC on August 31, 2005).
2.2
Amendment No. 1 to Agreement and Plan of Merger by and among Phase Forward, Lincoln and Lincoln SR dated as of September 13, 2006. (Incorporated by reference herein to Exhibit 10.1 of the Company's Current Report on Form 8-K filed with the SEC on September 15, 2006).
3.1
Amended and Restated Certificate of Incorporation of the Registrant dated July 20, 2004. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
3.2
Amended and Restated Bylaws of the Registrant. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
4.1
Specimen Certificate for shares of the Registrant's Common Stock. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.1 + 1997 Stock Option Plan. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.2 + Amended and Restated 2003 Non-Employee Director Stock Option Plan, as amended. (Incorporated by reference herein to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q filed with the SEC on August 10, 2005).
10.3 + 2004 Stock Option and Incentive Plan As Amended and Restated March 2006. (Incorporated by reference herein to Exhibits 10.1 to the Company's Current Report on Form 8-K filed with the SEC on May 8, 2006).
10.4 + Amendment No. 1 to the 2004 Stock Option and Incentive Plan as Amended and Restated March 2006. (Incorporated by reference herein to Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q filed with the SEC on May 3, 2007.)
10.5 + Amended and Restated 2004 Employee Stock Purchase Plan. (Incorporated by reference herein to Exhibit 10.4 of the Company's Annual Report on Form 10-K filed with the SEC on March 13, 2006).
10.6 + Form of Incentive Stock Option Agreement. (Incorporated by reference herein to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q filed with the SEC on November 10, 2004).
10.7 + Form of Non-Statutory Stock Option Agreement. (Incorporated by reference herein to Exhibit 10.5 of the Company's Quarterly Report on Form 10-Q filed with the SEC on November 10, 2004).
10.8 + Form of Non-Statutory Stock Option Agreement (U.K.). (Incorporated by reference herein to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q filed with the SEC on August 10, 2005).
10.9 + Form of Stock Option Grant Certificate under the Registrant's Amended and Restated 1997 Stock Option Plan. (Incorporated by reference herein to Exhibit 10.1 of the Company's Current Report on Form 8-K filed with the SEC on December 30, 2005).
10.10 + Form of Restricted Stock Award Agreement. (Incorporated by reference herein to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on June 12, 2006).
10.11 + Form of Restricted Stock Unit Award Agreement. (Incorporated by reference herein to Exhibit 10.24 to the Company's Annual Report on Form 10-K filed with the SEC on March 1, 2007).
10.12 + Form of Restricted Stock Unit pursuant to Amended and Restated 2004 Stock Option and Incentive Plan (Incorporated by reference herein to Exhibit 10.3 of the Company's Current Report on Form 8-K filed with the SEC on March 6, 2007).
10.13 +* 2008 Management Incentive Plan.
10.14 +* 2008 Global Sales Executive Incentive Compensation Plan.
10.15 +* Summary of cash compensation practices for non-employee directors.
10.16 + Form of Executive Agreement between the Registrant and its officers, as amended March 7, 2005. (Incorporated by reference herein to Exhibit 10.22 of the Company's Annual Report on Form 10-K filed with the SEC on March 9, 2005).
10.17 + Amendment to Executive Agreement dated June 6, 2006 (Incorporated by reference herein to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on June 12, 2006).
10.18 +* Form of Executive Agreement between the Registrant and its officers, as amended June 6, 2006 and restated on February 28, 2008.
10.19 + Senior Executive's Service Agreement between Phase Forward Europe Limited and Stephen Powell. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.20 + Form of Indemnification Agreement between the Registrant and each of its directors and certain executive officers. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.21 # Software License and Services Agreement between the Registrant and GlaxoSmithKline Services Unlimited. (Incorporated by reference herein to Exhibit 10.1 of the Company's Current Report on Form 8-K filed with the SEC on August 10, 2004).
10.22
Settlement Agreement by and among Mark L. Kozam d/b/a MLK Software and Datasci, LLC, the Company, and Quintiles, Inc. (Incorporated by reference herein to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006).
10.23
License Agreement by and among Mark L. Kozam d/b/a MLK Software and Datasci, LLC, and the Company. (Incorporated by reference herein to Exhibit 10.5 of the Company's Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006).
10.24
Sublease Agreement between the Registrant and BMC Software, Inc. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.25
Lease dated February 13, 2008 between Phase Forward Incorporated and BP Fourth Avenue, L.L.C. (Incorporated by reference herein to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on February 19, 2008).
10.26
Seventh Loan Modification Agreement with Silicon Valley Bank (Incorporated by reference herein to Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006)..
21.1 * Subsidiaries of the Registrant.
23.1 * Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm.
31.1 * Certification of CEO pursuant to Rule 13a-14(a) and 15d-14(s) under the Securities Exchange Act of 1934.
31.2 * Certification of CFO pursuant to rules 13a-14(a) and 15d-14(s) under the Securities Exchange Act of 1934.
32.1 * Certification of CEO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 * Certification of CFO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
+Indicates a management contract or any compensatory plan, contract or arrangement.
#Confidential treatment requested for portions of this document.
*Filed herewith.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, as amended, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized on the 17th day of March, 2008.
PHASE FORWARD INCORPORATED
By:
/s/ ROBERT K. WEILER Robert K. Weiler
President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, this Annual Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature
Title
Date
/s/ ROBERT K. WEILER Robert K. Weiler
President, Chief Executive Officer and Director (principal executive officer)
March 17, 2008
/s/ RODGER WEISMANN Rodger Weismann
Senior Vice President and Chief Financial Officer
(principal accounting officer and principal financial officer)
March 17, 2008
/s/ PAUL A. BLEICHER, M.D., PH.D. Paul A. Bleicher, M.D., Ph.D
Chairman of the Board
March 17, 2008
/s/ AXEL BICHARA Axel Bichara
Director
March 17, 2008
/s/ JAMES I. CASH, JR., PH.D James I. Cash, Jr., Ph.D
Director
March 17, 2008
/s/ RICHARD A. D'AMORE Richard A. D'Amore
Director
March 17, 2008
/s/ GARY E. HAROIAN Gary E. Haroian
Director
March 17, 2008
/s/ KENNETH I. KAITIN, PH.D Kenneth I. Kaitin, Ph.D
Director
March 17, 2008
/s/ DENNIS R. SHAUGHNESSY Dennis R. Shaughnessy
Director
March 17, 2008
Phase Forward Incorporated
Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of Phase Forward Incorporated
We have audited the accompanying consolidated balance sheets of Phase Forward Incorporated as of December 31, 2006 and 2007, and the related consolidated statements of income, stockholders' equity and comprehensive income, and cash flows for each of the three years in the period ended December 31, 2007. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Phase Forward Incorporated at December 31, 2006 and 2007, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2007, in conformity with U.S. generally accepted accounting principles.
As discussed in Note 2 to the consolidated financial statements, on January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Phase Forward Incorporated's internal control over financial reporting as of December 31, 2007, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 12, 2008 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Boston, Massachusetts
March 12, 2008
Phase Forward Incorporated
Consolidated Balance Sheets
(in thousands, except per share amounts)
See accompanying notes.
Phase Forward Incorporated
Consolidated Statements of Income
(in thousands, except per share amounts)
(1)Amounts include stock-based compensation expense, as follows:
See accompanying notes.
Phase Forward Incorporated
Consolidated Statements of Stockholders' Equity
and Comprehensive Income
(in thousands, except per share amounts)
Phase Forward Incorporated
Consolidated Statements of Stockholders' Equity
and Comprehensive Income (Continued)
(in thousands, except per share amounts)
See accompanying notes.
Phase Forward Incorporated
Consolidated Statements of Cash Flows
(in thousands)
See accompanying notes.
Phase Forward Incorporated
Consolidated Statements of Cash Flows (Continued)
(in thousands)
See accompanying notes.
Phase Forward Incorporated
Notes to Consolidated Financial Statements
Years Ended December 31, 2005, 2006 and 2007
(in thousands, except share and per share amounts)
1. Organization and Operations
Phase Forward Incorporated (the Company or Phase Forward) is a provider of integrated enterprise-level software products, services and hosted solutions for use in its customers' global clinical trial and drug safety monitoring activities. The Company's customers include pharmaceutical, biotechnology and medical device companies, as well as academic institutions, governmental regulatory agencies, contract research organizations, or CRO's, and other entities engaged in clinical trial and safety monitoring activities.
The Company has operations in the United States, the United Kingdom, France, Belgium, Japan, Australia and India.
2. Summary of Significant Accounting Policies
The accompanying consolidated financial statements reflect the application of certain accounting policies as described in this note and elsewhere in the accompanying consolidated financial statements.
The Company believes that a critical accounting policy is one that is both important to the portrayal of the Company's financial condition and results and requires management's most difficult, subjective or complex judgments, often as the result of the need to make estimates about the effect of matters that are inherently uncertain.
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.
Management's Estimates and Uncertainties
The preparation of financial statements in conformity with accounting principles generally accepted in the United States 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 periods.
Significant estimates relied upon in preparing these consolidated financial statements include revenue recognition, allowances for doubtful accounts, provisions for losses on uncompleted contracts, expected future cash flows used to evaluate recoverability of long-lived assets, estimated fair values of long-lived assets used to record impairment charges related to intangible assets and goodwill, amortization periods, restructuring and other related charges, any contingent liabilities, stock-based compensation expense and the recoverability of the Company's net deferred tax assets and related valuation allowance.
Although the Company regularly assesses these estimates, actual results could differ materially from these estimates. Changes in estimates are recorded in the period in which they become known. The Company bases its estimates on historical experience and various other assumptions that it believes to be reasonable under the circumstances. Actual results may differ from management's estimates if these results differ from historical experience or other assumptions do not turn out to be substantially accurate, even if such assumptions are reasonable when made.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
The Company is subject to a number of risks similar to those of other companies of similar size in its industry, including, but not limited to, rapid technological changes, competition, limited number of suppliers, customer concentration, integration of acquisitions, government regulations, management of international activities, protection of proprietary rights, patent litigation and dependence on key individuals.
Revenue Recognition and Deferred Set Up Costs
The Company derives revenues from software licenses and services. License revenues are derived principally from the sale of term licenses for the Company's software products including: InForm™, Clintrial™, WebSDM™, Empirica Trace™ (formerly Clintrace™), WebVDME™ and CTSD™. Service revenues are derived principally from the Company's delivery of the hosted solutions of its InForm, WebVDME, CTSD and WebSDM software products, and consulting services and customer support, including training, for all of the Company's products.
The components of revenues are as follows:
The Company recognizes software license revenues in accordance with Statement of Position ("SOP") No. 97-2, Software Revenue Recognition, as amended, issued by the American Institute of Certified Public Accountants ("AICPA"), while revenues resulting from application hosting services are recognized in accordance with Emerging Issues Task Force ("EITF") Issue No. 00-3, Application of AICPA Statement of Position 97-2 to Arrangements that include the Right to Use Software Stored on Another Entity's Hardware, SEC Staff Accounting Bulletin ("SAB") No. 104, Revenue Recognition, and EITF Issue No. 00-21, Revenue Arrangements with Multiple Deliverables.
Customers generally have the ability to terminate application hosting, consulting and training service agreements upon 30 days notice to the Company. License agreements, multiple element arrangements, including license and service agreements and certain application hosting services can generally be terminated by either party for material breach of obligations not corrected within 30 days after notice of the breach.
The Company recognizes revenues when all of the following conditions are satisfied: (1) there is persuasive evidence of an arrangement; (2) the product or service has been provided to the customer; (3) the collection of fees is probable; and (4) the amount of fees to be paid by the customer is fixed or determinable.
The Company generally enters into software term licenses for its InForm, Clintrial and Empirica Trace products with its customers for 3- to 5-year periods. License agreements for other products are generally for annual or multi-year terms. These arrangements typically include multiple elements: software license, consulting services and customer support. The Company bills its customers in
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
accordance with the terms of the underlying contract. Generally, the Company bills license fees annually in advance for each year of the license term. Payment terms are generally net 30 days.
The Company's software license revenues are earned from the sale of off-the-shelf software requiring no significant modification or customization subsequent to delivery to the customer. Consulting services, which can also be performed by third-party consultants, are deemed to be non-essential to the functionality of the software and typically are for trial configuration, implementation planning, loading of software, building simple interfaces and running test data and documentation of procedures.
Customer support includes training services, telephone support and software maintenance. The Company generally bundles customer support with the software license for the entire term of the arrangement. As a result, the Company generally recognizes revenues for all elements, including consulting services, ratably over the term of the software license and support arrangement. The Company allocates the revenues recognized for these arrangements to the different elements based on management's estimate of the relative fair value of each element. For its term-based licenses, the Company allocates to consulting services the anticipated service effort and value throughout the term of the arrangement at an amount that would have been allocated had those services been sold separately to the customer. The value of the Company's consulting services sold within a bundled arrangement is equal to the value of consulting services sold on a stand-alone basis, as the activities performed under both types of arrangements are similar in nature. The remaining value is allocated to license and support services, with 10% of this amount allocated to support services. The customer support services rate of 10% for multi-year term-based licenses reflects a significant discount from the rate for customer support services associated with perpetual licenses due to the reduction in the time period during which the customer can utilize the upgrades and enhancements. The Company believes this rate is substantive and represents an amount it believes reasonable to be allocated. The Company has allocated the estimated fair value to its multiple element arrangements to provide meaningful disclosures about each of its revenue streams. The costs associated with the consulting and customer support services are expensed as incurred. There are instances in which the Company sells software licenses based on usage levels. These software licenses can be based on estimated usage, in which case the license fee charged to the customer is fixed based on this estimate. When the fee is fixed, the revenues are generally recognized ratably over the contractual term of the arrangement. If the fee is based on actual usage, and therefore variable, the revenues are recognized in the period of use. Revenues from certain follow-on consulting services, which are sold separately to customers with existing software licenses and are not considered part of a multiple element arrangement, are recognized as the services are performed.
The Company continues to sell additional perpetual licenses for the Clintrial and Empirica Trace software products in certain situations to its existing customers with the option to purchase customer support. The Company has established vendor specific objective evidence of fair value for the customer support. Accordingly, license revenues are recognized upon delivery of the software and when all other revenue recognition criteria are met. Customer support revenues are recognized ratably over the term of the underlying support arrangement. The Company continues to generate customer support and maintenance revenues from its perpetual license customer base. Training revenues are recognized as earned.
In addition to making its software products available to customers through licenses, the Company offers its InForm, WebVDME, CTSD and WebSDM software solutions through a hosted application solution delivered through a standard web-browser.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
Revenues resulting from InForm application hosting services consist of three stages for each clinical trial: the first stage involves application set up, including design of electronic case report forms and edit checks, implementation of the system and server configuration; the second stage involves application hosting and related support services; and the third stage involves services required to close out, or lock, the database for the clinical trial. Services provided for the first and third stages are provided on a fixed fee basis based upon the complexity of the trial and system requirements. Services for the second stage are charged separately as a fixed monthly fee. The Company recognizes revenues from all stages of the InForm hosting service ratably over the hosting period. Fees charged and costs incurred for the trial system design, set up and implementation are deferred until the start of the hosting period and are amortized and recognized ratably over the estimated hosting period. The deferred costs include incremental direct costs with third parties and certain internal direct costs related to the trial and application set up, as defined under SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Indirect Costs of Leases. These costs include salary and benefits associated with direct labor costs incurred during trial set up, as well as third-party subcontract fees and other contract labor costs. Work performed outside the original scope of work is contracted for separately as an additional fee and is generally recognized ratably over the remaining term of the hosting period. Fees for the first and third stages of the service are billed based upon milestones. Fees for application hosting and related services in the second stage are generally billed quarterly in advance. Bundled into this revenue element are revenues attributable to the software license used by the customer.
Revenues resulting from hosting services for the WebVDME, CTSD and WebSDM products consist of installation and server configuration, application hosting and related support services. Services for this offering are charged monthly as a fixed fee. Revenues are recognized ratably over the period of the service.
In the event that an application hosting customer cancels a clinical trial and its related statement of work, all deferred revenues are recognized and all deferred set up costs are expensed. In addition, certain termination related fees may be charged and if so, such fees are recognized in the period of termination.
The Company deferred $2,307, $2,685 and $3,423 of set up costs and amortized $1,707, $2,084 and $2,663 of set up costs during the years ended December 31, 2005, 2006 and 2007, respectively. The amortization of deferred set up costs is a component of cost of services.
Deferred revenues represent amounts billed or cash received in advance of revenue recognition.
Provisions for estimated losses on uncompleted contracts are made on a contract-by-contract basis and are recognized in the period in which such losses become probable and can be reasonably estimated. To date, the Company has not experienced any material losses on uncompleted application hosting or consulting contracts.
In accordance with EITF Issue No. 01-14, Income Statement Characterization of Reimbursements Received for "Out-of-Pocket" Expenses Incurred, the Company included $720, $635 and $776 of reimbursable out-of-pocket expenses in service revenues and cost of service revenues in the years ended December 31, 2005, 2006 and 2007, respectively.
Internal Use Software and Website Development Costs
The Company follows the guidance of EITF Issue No. 00-2, Accounting for Web Site Development Costs which sets forth the accounting for website development costs based on the website development
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
activity. The Company follows the guidance set forth in SOP No. 98-1, Accounting for the Cost of Computer Software Developed or Obtained for Internal Use, in accounting for the development of its on demand use systems. SOP No. 98-1 requires companies to capitalize qualifying computer software costs which are incurred during the application development stage, and to amortize them over the software's estimated useful life. The Company capitalized $396 during the year ended December 31, 2005, related to Company-wide financial systems and a user management system and has included these amounts in purchased computer software in the accompanying consolidated financial statements. No amounts were capitalized during the years ending December 31, 2006 and 2007. The Company amortizes such costs when the systems become operational. These costs are being amortized over an estimated life of three years. Amortization expense was $95, $162 and $148 during 2005, 2006 and 2007, respectively.
Computer Software Development Costs and Research and Development Expenses
The Company has evaluated the establishment of technological feasibility of its products in accordance with SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed. The Company sells products in a market that is subject to rapid technological change, new product development and changing customer needs; accordingly, the Company has concluded that technological feasibility is not established until the development stage of the product is nearly complete. The Company defines technological feasibility as the completion of a working model. The time period during which costs could be capitalized, from the point of reaching technological feasibility until the time of general product release, is very short, and consequently, the amounts that could be capitalized are not material to the Company's financial position or results of operations. Therefore, the Company has charged all such costs to research and development in the period incurred.
Prepaid Sales Commissions and Royalties
For arrangements where revenues are recognized over the relevant contract period, the Company defers related commissions paid to its direct sales force and software license royalties paid to third parties, and amortizes these expenses over the period in which the related revenues are recognized.
Commission payments are nonrefundable unless amounts due from a customer are determined to be uncollectible or if the customer subsequently changes or terminates the level of service, in which case commissions which were paid are recoverable by the Company. The Company deferred $3,597, $6,410 and $9,381 of commissions and amortized to sales and marketing expense $3,685, $5,409 and $7,455 during the years ended December 31, 2005, 2006 and 2007, respectively.
The Company's royalty obligation is based upon the license and customer support revenues earned for certain products in an arrangement. The Company has the right to recover the royalties in the event the arrangement is cancelled. The Company deferred $3,306, $2,260 and $2,497 of royalties and amortized to cost of revenues $2,913, $3,117 and $2,591 during the years ended December 31, 2005, 2006 and 2007, respectively.
Warranties and Indemnification
The Company's software license arrangements and hosting services are typically warranted to perform in a manner consistent with general industry standards that are reasonably applicable and substantially in accordance with the Company's product documentation under normal use and circumstances. The Company's arrangements also include certain provisions for indemnifying customers
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
against liabilities if its products or services infringe a third party's intellectual property rights. See the discussion of possible indemnification obligations in Note 9.
The Company has entered into service level agreements with some of its hosted application customers warranting certain levels of uptime reliability and permitting those customers to receive credits against monthly hosting fees or terminate their agreements in the event that the Company fails to meet those levels.
To date, the Company has not incurred any material costs as a result of such indemnifications and has not accrued any liabilities related to such obligations in the accompanying consolidated financial statements.
Net Income Per Share
Basic and diluted net income per share is presented in conformity with Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings Per Share. Basic net income per common share for all periods presented was determined by dividing net income applicable to common stockholders by the weighted average number of common shares outstanding during the period. Weighted average shares outstanding exclude unvested restricted common stock. Diluted net income per share in 2005, 2006 and 2007 includes the effects of all dilutive, potentially issuable common shares using the treasury stock method.
The calculation of basic and diluted net income per share is as follows:
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
The following common share equivalents and unvested restricted shares have been excluded from the computation of diluted weighted average common shares outstanding as of December 31, 2005, 2006 and 2007 respectively, as their effect would have been anti-dilutive.
Foreign Currency Translation
The financial statements of the Company's foreign subsidiaries are translated in accordance with SFAS No. 52, Foreign Currency Translation. The reporting currency for the Company is the U.S. dollar. The functional currency of the Company's subsidiaries in the United Kingdom, France, Belgium, Germany, Japan, India and Australia are the local currencies of those countries. Accordingly, the assets and liabilities of the Company's foreign subsidiaries are translated into U.S. dollars using the exchange rate in effect at each balance sheet date. Revenue and expense accounts are translated generally using an average rate of exchange during the period. Gains and losses arising from transactions denominated in foreign currencies are primarily related to intercompany accounts that have been determined to be temporary in nature and cash and accounts receivable denominated in non-functional currencies. The Company has recorded foreign currency losses of approximately $169, $15 and $42 for the years ended December 31, 2005, 2006 and 2007, respectively, and such losses are included in other income (expense) in the accompanying consolidated statements of operations.
Foreign currency translation adjustments are accumulated as a component of other comprehensive income (loss) as a separate component of stockholders' equity.
Derivative Instruments
The Company has adopted the accounting and disclosure requirements of SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 requires that all derivative instruments be recorded on the balance sheet at their fair value. The Company enters into forward foreign exchange contracts to hedge transactions denominated in currencies other than the functional currencies of the Company or its subsidiaries against currency fluctuations. These forward contracts are used to reduce the Company's risk associated with foreign currency exchange rate changes, as the gains or losses on these contracts are intended to offset the gains or losses on the underlying exposures. The Company does not engage in foreign currency speculation. (See Note 11).
Cash, Cash Equivalents, Short-term and Long-term Investments
The Company accounts for its investments in accordance with SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. Under SFAS No. 115, securities that the Company has the intent and ability to hold to maturity are reported at amortized cost, which approximates market value, and are classified as held-to-maturity, while those securities for which it is not the Company's intent to hold to maturity are classified as available-for-sale securities and are reported at fair value, with unrealized gains and (losses) excluded from earnings and reported in a separate component of stockholders' equity. The Company considers all highly liquid investments with original maturities of 90 days or less at the time of purchase to be cash equivalents and investments with original maturities of between 91 days and one year to be short-term investments. All securities, with the exception of
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
auction rate securities, are classified as held-to-maturity securities. The auction rate securities are debt instruments issued by various municipalities throughout the United States and are classified as available for sale because it is the Company's intent not to hold them to maturity.
Cash, cash equivalents and short-term investments as of December 31, 2006 and 2007 consist of the following:
The Company has had no realized gains or losses from the sale of cash equivalents or short-term investments. To date, the Company has not recorded any unrealized gains or losses in connection with its auction rate securities.
At December 31, 2007, the Company had $34,500 in auction rate securities ("ARS"). These ARS are debt instruments issued by various states throughout the United States to finance student loans. The types of ARS that the Company owns are backed by student loans, 95% of which are guaranteed under the Federal Family Education Loan Program, and all had credit ratings of AAA (or equivalent) from a recognized rating agency. The ARS are classified as available for sale in the accompanying consolidated balance sheet, and are recorded at cost.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
Historically, the carrying value of ARS approximated fair market value due to the frequent resetting of the interest rates. The auctions have provided a liquid market for these securities as investors historically could readily sell their investments at auction. Auctions are held every 28 days. Following successful auctions in January 2008, all of the Company's ARS have experienced failed auctions in February and March 2008, as the amount of securities submitted for sale has exceeded the amount of purchase orders due to the liquidity issues experienced in the global credit and capital markets. The result of a failed auction is that these ARS continue to pay interest in accordance with their terms until the next successful auction; however, liquidity will be limited until there is a successful auction or until such time as other markets for these ARS investments develop. As of March 13, 2008, the Company has liquidated $10,450 of the securities, and has classified these securities as current assets in the accompanying consolidated balance sheet as of December 31, 2007. As of March 13, 2008, the par value of the ARS that the Company continues to own, which is equal to cost, totals $24,050 and these ARS are classified as long-term investments in the accompanying consolidated balance sheet at December 31, 2007, based on the Company's ability and intent to hold these securities until market conditions improve with successful auctions. The Company believes that, based on its unrestricted cash, cash equivalents and short term marketable securities balances of $158,572 at December 31, 2007, excluding ARS of $24,050, the current lack of liquidity in the credit and capital markets will not have a material impact on the Company's liquidity, cash flow or the Company's ability to fund its operations. If in the future the Company determines that any decline in value of the ARS is other-than-temporary, the Company would be required to recognize the loss in its statement of income, which could have a material impact on the Company's operating results in the period it is recognized.
Property and Equipment
Property and equipment are stated at cost. Depreciation and amortization are computed using the straight-line method based on the estimated useful lives of the related assets as follows:
Property and equipment consists of the following:
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
Depreciation expense for the years ended December 31, 2005, 2006, and 2007 was $3,399, $4,309 and $6,061, respectively. Repair and maintenance costs are expensed as incurred.
Long-Lived Assets
In accordance with SFAS No. 144, Accounting for the Impairment Disposal of Long-Lived Assets, the Company continually evaluates whether events or circumstances have occurred that indicate that the estimated remaining useful life of its long-lived assets, including intangible assets, except goodwill which is separately evaluated, may warrant revision or that the carrying value of these assets may be impaired. The Company evaluates the realizability of its long-lived assets based on profitability and cash flow expectations for the related asset. Any write-downs are to be treated as permanent reductions in the carrying amount of the assets. The Company believes that, as of each of the balance sheet dates presented, none of the Company's long-lived assets were impaired.
Concentration of Credit Risk
Except as follows, the Company has no significant off-balance-sheet risk or credit risk concentrations. Financial instruments that subject the Company to potential credit risks are principally cash equivalents, short-term investments, accounts receivable and forward foreign exchange contracts. The Company maintains its cash and cash equivalents and forward foreign exchange contracts with credit worthy financial institutions. Concentrated credit risk with respect to accounts receivable is limited to large, creditworthy customers. The Company's customers are principally located in the United States, Europe and Asia. Although the Company is directly affected by the overall financial condition of the pharmaceutical, biotechnology and medical device industries, management does not believe significant credit risk exists as of December 31, 2007. The Company has not experienced significant losses related to receivables from individual customers or groups of customers in any specific industry or geographic area. The Company maintains an allowance for doubtful accounts based on accounts past due according to contractual terms and historical collection experience. Actual losses when incurred are charged to the allowance. The Company's losses related to collection of accounts receivable have consistently been within management's expectations. Due to these factors, no additional credit risk beyond amounts provided for collection losses, which the Company reevaluates on a monthly basis based on specific review of receivable agings and the period that any receivables are beyond the standard payment terms, is believed by management to be probable in the Company's accounts receivable. The Company does not require collateral or enter into master netting agreements to mitigate credit risk.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
The following table summarizes the number of customers who individually comprise greater than 10% of total revenue and/or total accounts receivable and their aggregate percentage of the Company's total revenue and gross accounts receivable.
*Includes a customer (Eli Lilly and Company) that was the holder of record of approximately one percent of the Company's outstanding common stock. The Company serves all of its hosting customers from third-party web hosting facilities located in the United States. The Company does not control the operation of these facilities, and they are vulnerable to damage or interruption. The Company maintains redundant systems that can be used to provide service in the event third-party web hosting facilities become unavailable, although in such circumstances, the Company's service may be interrupted during the transition.
The following table summarizes activity in the Company's allowance for doubtful accounts.
Disclosure of Fair Value of Financial Instruments
SFAS No. 107, Disclosure of Fair Value of Financial Instruments, requires disclosure about fair value of financial instruments. Financial instruments consist of cash equivalents, short-term and long-term investments, accounts receivable, accounts payable, forward foreign exchange contracts and a line of credit. The fair value of these financial instruments approximates their carrying amount.
Comprehensive Income
SFAS No. 130, Reporting Comprehensive Income, establishes standards for reporting and displaying comprehensive income and its components in the consolidated financial statements. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances from non-owner sources. Other than reported net income, comprehensive income solely consists of foreign currency translation adjustments and is disclosed in the accompanying consolidated statements of stockholders' equity and comprehensive income.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
Stock-Based Compensation
On January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), Share-based Payment, which requires the Company to recognize expense related to the fair value of stock-based compensation awards. Management elected to use the modified prospective transition method as permitted by SFAS No. 123(R) and therefore has not restated the Company's financial results for prior periods. Under this transition method, stock-based compensation expense for the year ended December 31, 2006 includes compensation expense for all stock-based compensation awards granted on or after March 15, 2004 (the filing date for the initial registration statement for the Company's initial public offering), based on the grant-date fair value estimated in accordance with the provisions of SFAS No. 123(R).
Stock options granted prior to March 15, 2004, are minimum value options, pursuant to SFAS No. 123. Under the provisions of SFAS No. 123(R), the value of these options will not be recorded in the statement of operations subsequent to the adoption of SFAS No. 123(R). Instead, the Company will continue to account for these options using Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations.
For service-based options, accounted for under SFAS No. 123(R), the Company recognizes compensation expense on a straight-line basis over the requisite service period of the award. For performance-based options, the Company recognizes expense on a straight-line basis over the estimated performance period. In addition, SFAS 123(R) requires the benefits of tax deductions in excess of recognized stock-based compensation to be reported as a financing activity rather than an operating activity in the statements of cash flows. This requirement reduces net operating cash flows and increases net financing cash flows in certain periods.
Prior to the adoption of SFAS No. 123(R), the Company applied SFAS No. 123, Accounting for Stock-Based Compensation, amended by SFAS No. 148, Accounting for Stock-based Compensation-Transition and Disclosure, which allowed companies to apply the existing accounting rules under APB Opinion No. 25. Pursuant to APB Opinion No. 25, the Company accounted for its stock-based awards to employees using the intrinsic-value method, under which compensation expense was measured on the date of grant as the difference between the fair value of the Company's common stock and the option exercise price multiplied by the number of options granted. Generally, the Company granted stock options with exercise prices equal to the estimated fair value of its common stock; however, to the extent that the fair value of the common stock exceeded the exercise price of stock options granted to employees on the date of grant, the Company recorded deferred compensation and amortized the expense over the vesting schedule of the options, generally four years. During the years ended December 31, 2003 and 2004, in accordance with APB Opinion No. 25, the Company recorded deferred stock-based compensation resulting from the grant of employee stock options with an exercise price less than the fair value of common stock. As of December 31, 2007, the Company had no deferred stock-based compensation remaining to be amortized. Upon the adoption of SFAS No. 123(R) on January 1, 2006, the deferred stock-based compensation balance was netted against additional paid-in capital on the consolidated balance sheet and statement of stockholders equity.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
For the year ended December 31, 2005, had the Company's stock option grants to employees been determined based on the fair value at the grant dates, as prescribed by SFAS No. 123, the Company's net income and net income per share would have been as follows:
For options accounted for under SFAS No. 123(R), and for purposes of the SFAS No. 123 pro forma reconciliation above, the fair value of each option grant is estimated on the date of grant using the Black-Scholes pricing model. The assumptions used and the resulting estimated fair value for grants during the applicable period are as follows:
(1)In 2007, no stock options were granted.
For purposes of utilizing the Black-Scholes option pricing model and because there was a limited trading history for its common stock, the Company determined the expected life and the volatility for options based on an analysis of reported data for a peer group of companies that have issued stock options with substantially similar terms. The expected life of options granted by the Company has been determined based on the average expected life of the options as reported by this peer group of companies during a similar reporting period. The expected volatility of options granted has been determined using an average of the historical volatility measures of this peer group of companies as well as the historical volatility of the Company's common stock beginning in January 2005. The risk-free interest rate is based on a treasury instrument whose term is consistent with the expected life of the stock options. The Company has not paid and does not anticipate paying cash dividends on its shares of common stock; therefore, the expected dividend yield is assumed to be zero. In addition, while SFAS No. 123 permitted companies to record forfeitures based on actual forfeitures, which was the Company's historical policy under SFAS No. 123, SFAS No. 123(R) requires companies to utilize an
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Notes to Consolidated Financial Statements (Continued)
estimated forfeiture rate when calculating stock-based compensation expense for the period. The Company has issued the following types of equity awards which are taken into account when calculating stock-based compensation: (i) restricted stock awards, (ii) restricted stock units, (iii) stock options, referred to below as service-based stock options, that vest in accordance with a schedule determined at the time of grant and (iv) stock options, referred to as milestone options, that vest upon the earlier of attainment of specified milestones or a specified number of years from the date of grant. In 2005 and 2006, the Company applied a forfeiture rate of 8%, derived from an analysis of its historical data for restricted stock awards and units, service-based stock options and milestone options, in determining the expense recorded in the accompanying consolidated statements of income. In 2007, the Company has applied forfeiture rates of 4%, 8% and 12%, derived from an analysis of its historical data, for restricted stock awards and units, service-based stock options, and milestone options, respectively, in determining the expense recorded in the Company's consolidated statements of income.
In 2004, the Company adopted the Phase Forward Incorporated 2004 Employee Stock Purchase Plan (the "2004 ESPP") which was amended effective December 1, 2005 and is now considered a non-compensatory plan under SFAS No. 123(R) (see Note 10).
Prior to December 1, 2005, the price per share under the 2004 ESPP for each payment period was the lesser of (1) 85% of the last reported sale price of the Company's common stock on the first business day of the payment period and (2) 85% of the last reported sale price of the common stock on the last business day of the payment period. Effective December 1, 2005, the Company amended the price provision of the 2004 ESPP such that the option price is now set at 95% of the last reported sale price of the common stock on the last business day of the payment period. Accordingly, the 2004 ESPP is considered a non-compensatory plan under SFAS No. 123(R).
The Company has calculated the SFAS No. 123 pro forma expense for shares purchased under the 2004 ESPP using the following weighted-average assumptions:
During the years ended December 31, 2006 and December 31, 2007, the Company recorded $3,022 and $5,578 of aggregate stock-based compensation expense respectively, of which $2,635 and $5,442, respectively, was a result of the adoption of SFAS No. 123(R). The remaining stock-based compensation expense is due to the amortization of stock-based compensation associated with previously issued stock options which amounted to $387 and $136, in 2006 and 2007, respectively. For the year ended December 31, 2006, stock-based compensation expense was allocated as follows: $258 to cost of revenues, $394 to research and development, $502 to sales and marketing and $1,868 to general and administrative expense. For the year ended December 31, 2007, stock-based compensation expense was allocated as follows: $702 to cost of service revenues; $813 to research and development; $1,061 to sales and marketing; and $3,002 to general and administrative. For the year ended December 31, 2006, stock-based compensation expense reduced basic and diluted earnings per share by $0.09 and $0.08, respectively. As of December 31, 2007, there was $17,829 of unrecognized stock-based compensation expense related to stock-based awards that is expected to be recognized over a weighted average period of 3.0 years.
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Notes to Consolidated Financial Statements (Continued)
Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109. The statement requires the Company to recognize deferred tax assets and liabilities for the expected future tax consequences of events that have been recognized in the Company's financial statements or tax returns. Under this method, deferred tax assets and liabilities are determined based on differences between the financial statement carrying amounts and the tax bases of the assets and liabilities using the enacted tax rates in effect in the years in which the differences are expected to reverse. A valuation allowance against deferred tax assets is recorded if, based on the weight of the available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
The Company adopted the provisions of FASB Interpretation No. ("FIN") 48, an interpretation of SFAS No. 109, on January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with SFAS No. 109 and prescribes a recognition threshold and measurement process for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. At the adoption date and as of December 31, 2007, the Company had no material unrecognized tax benefits and no adjustments to liabilities or operations were required.
Advertising Expenses
Advertising costs are expensed as incurred. Advertising expenses totaled $133, $42 and $22 for the years ended December 31, 2005, 2006 and 2007, respectively.
Recently Issued Accounting Pronouncements
In September 2006, FASB issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value under generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require or permit fair value measurements. The new guidance is effective for financial statements issued for fiscal years beginning after November 15, 2007, and for interim periods within those fiscal years. The adoption of SFAS No. 157 is not expected to have a material effect on the Company's consolidated financial position and results of operations.
In February 2007, The FASB released SFAS No. 159, The Fair Value Option for Financial Assets and Liabilities, which is effective for fiscal years beginning after November 15, 2007. This statement permits entities to choose to measure many financial instruments and certain other items at fair value. The objective is to improve financial reporting by providing entities with the opportunity to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply complex hedge accounting provisions. SFAS No. 159 became effective for the Company in 2008. The adoption of SFAS No. 159 is not expected to have a material effect on the Company's consolidated financial position and results of operations.
In December 2007, the FASB issued SFAS No. 141 (Revised 2007), Business Combinations. SFAS No. 141(R) retains the fundamental requirements in SFAS No. 141 that the acquisition method of accounting (which SFAS No.141 called the purchase method) be used for all business combinations and for an acquirer to be identified for each business combination. SFAS 141(R) requires an acquirer to recognize the assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions specified in SFAS No. 141(R). That replaces Statement 141's cost-allocation process, which required the cost of an
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Notes to Consolidated Financial Statements (Continued)
acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. SFAS No. 141(R) retains the guidance in SFAS No. 141 for identifying and recognizing intangible assets separately from goodwill. SFAS 141(R) will now require acquisition costs to be expensed as incurred, restructuring costs associated with a business combination must generally be expensed prior to the acquisition date and changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. SFAS No. 141(R) applies prospectively to business combinations for which the acquisition date is on or after the beginning of the first annual reporting period beginning on or after December 15, 2008, which is the Company's 2009 fiscal year. Earlier adoption is prohibited.
3. Acquisitions
Lincoln Technologies, Inc.
On August 25, 2005, the Company acquired all of the outstanding capital stock of Lincoln Technologies, Inc. (Lincoln), a provider of products and services for drug safety, clinical trial safety signal detection, and applied data standards. The acquired technology and products of Lincoln provide the Company with an expanded drug safety offering and enhance the Company's ability to offer innovative software and services in the drug safety market. The Company paid a premium for Lincoln to enable it to expand its offerings in the drug safety market and to obtain a valuable workforce.
The aggregate purchase price was $16,667. The acquisition agreement called for additional cash consideration to be paid subject to achievement of certain financial targets in 2005 and 2006, of up to $2,000 and $4,000, respectively. The defined 2005 financial targets were achieved and, accordingly, the Company accrued additional consideration of $2,000 in 2005 which was paid in May 2006. The acquisition agreement was amended in September 2006 to amend the terms of the remaining contingent earn-out payment for which the security holders of Lincoln could be eligible in 2007 under the acquisition agreement. Pursuant to the amendment, the Company agreed to pay the security holders of Lincoln an aggregate of $3,500 in cash on December 26, 2007 in satisfaction of the Company's remaining payment obligations under the acquisition agreement. The $3,500 was accrued as of December 31, 2006. The acquisition of Lincoln was accounted for as a purchase under SFAS No. 141, Business Combinations. Accordingly, the results of Lincoln have been included in the audited consolidated financial statements since the date of acquisition.
The components of the consideration are as follows:
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Notes to Consolidated Financial Statements (Continued)
The following table summarizes the allocation of the initial purchase price to the fair value of the assets acquired and liabilities assumed at the date of acquisition and the additional cash consideration of $2,000 in 2005 and $3,500 in 2006:
Included in liabilities assumed is a provision for lease abandonment costs of approximately $270 relating to the leased facilities of Lincoln.
A rollforward of the liability for lease abandonment costs is as follows:
The following table presents selected unaudited financial information of the Company and Lincoln as if the acquisition had occurred on January 1, 2005. The unaudited pro forma results are not necessarily indicative of the results that would have occurred had the acquisition been consummated on January 1, 2005.
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Notes to Consolidated Financial Statements (Continued)
Green Mountain Logic, Inc.
On October 30, 2007, the Company acquired all of the outstanding capital stock of Green Mountain Logic, Inc. (Green Mountain), a process automation software company that provides targeted solutions for the life sciences industry, including LabPas Phase I clinic automation software. The Company paid a premium to acquire the technology and products of Green Mountain which provide the Company with a solution targeted for Phase I clinical trials.
The aggregate purchase price was $5,397. The acquisition of Green Mountain was accounted for as a purchase under SFAS No. 141. Accordingly, the results of Green Mountain have been included in the audited consolidated financial statements since the date of acquisition.
The components of the consideration are as follows:
The following table summarizes the allocation of the initial purchase price to the fair value of the assets acquired and liabilities assumed at the date of acquisition:
The Company has not furnished proforma financial information relating to the Green Mountain acquisition because such information is not material to the Company's financial results.
4. Goodwill and Intangible Assets
Goodwill and intangible assets that have indefinite lives are not amortized but are evaluated for impairment annually or whenever events or changes in circumstances indicate the carrying value may not be recoverable. Intangible assets that have finite lives are amortized over their useful lives.
The goodwill resulting from acquisitions is reviewed for impairment on an annual basis in accordance with SFAS No. 142, Goodwill and Other Intangible Assets. Consistent with prior years, the Company conducted its annual impairment test of goodwill during the fourth quarter of 2007. Based on
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Notes to Consolidated Financial Statements (Continued)
the results of the first step of the goodwill impairment test, the Company has determined that no impairment of goodwill existed at December 31, 2007, as the carrying amount of goodwill of the reporting unit was less than its fair value and therefore, the second step of the goodwill impairment test was not necessary.
A rollforward of the net carrying amount of goodwill is as follows:
The utilization of or release of the valuation allowance related to acquired net operating losses reflects an actual or anticipated reduction in cash payments to local taxing authorities for income taxes that are not reflected as a benefit in the income tax provision for financial statement purposes but rather as a reduction to goodwill. In 2006, the Company determined that it was more likely than not that it would realize an additional portion of its deferred tax assets and therefore reduced the valuation allowance by $5,620. This benefit of the release in valuation allowance was realized through reductions to income tax expense of $5,413 and to goodwill of $207. In 2007, the Company determined that it was more likely than not that it would realize the full value of its deferred tax asset and therefore reduced the remaining valuation allowance by an additional $22,665. The benefit of the release in valuation allowance was realized through reductions to income tax expense of $16,535 and to goodwill of $6,130.
During 2006, adjustments totaling $3,067 were recorded to goodwill associated with the acquisition of Lincoln. Goodwill was increased by the earn-out accrual of $3,500 (see Note 3) and reduced by the following: ($193) receipts of previously written-off accounts receivable; ($123) reduction to deferred revenues due to the completion of two services engagements; and ($117) associated with a sublease of the abandoned former Lincoln facility.
Intangible assets, all of which relate to the acquisitions of Lincoln Technologies and Green Mountain, consist of the following as of December 31, 2006 and 2007:
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Notes to Consolidated Financial Statements (Continued)
Amortization expense related to intangible assets for the years ended December 31, 2005, 2006 and 2007 was $306, $870 and $867, respectively.
The estimated remaining amortization expense for each of the five succeeding fiscal years:
5. Accrued Expenses
Accrued expenses consist of the following:
6. Restructuring Charge
The Company recorded a $4,503 restructuring charge for the year ended December 31, 2003 that related to the relocation of the Company's corporate headquarters in December 2003. Of this amount, $2,486 represented the loss on a facilities lease and $2,017 related to the abandonment of the related fixed assets and leasehold improvements. The facility lease loss represented 15 months of rent remaining under an existing lease and related operating expenses. As of March 31, 2005, payments for all remaining expenses were completed and as a result the Company recorded a benefit of $92 representing the elimination of accrued expenses associated with the restructuring charge.
7. Income Taxes
Income before the benefit from income taxes consists of the following:
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Notes to Consolidated Financial Statements (Continued)
The benefit from income taxes in the accompanying consolidated statements of income consists of the following:
Generally, tax laws require net operating loss carryforwards to be used in the order generated. As a result, in the years ended December 31, 2005, 2006 and 2007, a portion of the operating losses utilized by the Company related to net operating losses acquired in the Clinsoft acquisition to offset taxable income. The benefit of these net operating losses has been reflected as a reduction to goodwill (see Note 4). The current utilization of net operating losses reduces the income tax payable.
A reconciliation of the federal statutory rate to the Company's effective tax rate is as follows:
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Notes to Consolidated Financial Statements (Continued)
The approximate income tax effect of each type of temporary difference and carryforward as of December 31, 2006 and 2007 is as follows:
The Company is subject to income taxes in both the United States and foreign jurisdictions, and uses estimates in determining its provision for income taxes. The Company accounts for income taxes in accordance with SFAS No. 109, which is the asset and liability method for accounting and reporting for income taxes. Under SFAS No. 109, deferred tax assets and liabilities are recognized based on temporary differences between the financial reporting and income tax bases of assets and liabilities using statutory rates. This process requires the Company to project its current tax liability and estimate its deferred tax assets and liabilities, including net operating loss and tax credit carryforwards. In assessing the need for a valuation allowance, the Company considered its recent operating results, future taxable income projections and all prudent and feasible tax planning strategies. In the year ended December 31, 2005, the Company determined that it was more likely than not that the Company would realize a portion of its deferred tax assets and therefore reduced the valuation allowance by $7,772. The benefit of the release in valuation allowance was realized through reductions to income tax expense of $4,542 and to goodwill of $3,230. In the year ended December 31, 2006, the Company determined that it was more likely than not that the Company would realize an additional portion of its deferred tax asset and therefore reduced the valuation allowance by an additional $5,620. The benefit of the release in valuation allowance was realized through reductions to income tax expense of $5,413 and to goodwill of $207. In the year ended December 31, 2007, the Company determined that it was more likely than not that it would realize the full value of its remaining deferred tax asset and therefore reduced the valuation allowance by an additional $22,665. The benefit of the release in valuation allowance was realized through reductions to income tax expense of $16,535 and to goodwill of $6,130.
At December 31, 2007, the Company had $54,821 of net operating loss carryforwards that may be used to offset future U.S. federal taxable income. In addition, the Company had $15,630 of net operating losses resulting from excess tax deductions related to stock-based compensation. The Company will realize the benefit of these excess tax deductions through increases to stockholders equity in the periods in which the losses are utilized to reduce tax payments. The Company had $1,676 of federal research and development tax credit carryforwards that may be utilized to offset future U.S. taxable income. The net operating loss and tax credit carryforward periods extend through 2026 and 2027, respectively. The Company had $3,567 of foreign net operating loss carryforwards that may be used to offset future foreign taxable income. These foreign net operating loss carryforwards have an unlimited carryforward period. The Company also had $3,140 of research and development tax credit carryforwards that may be utilized to offset future Massachusetts state income tax. The Massachusetts tax credit carryforward period extends through 2022. The federal and state net operating loss carryforwards and research and development tax credit carryforwards are subject to review and possible adjustment by the taxing authorities. Also, the Internal Revenue Code contains provisions that may
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Notes to Consolidated Financial Statements (Continued)
limit the net operating loss and tax credit carryforwards available in any given year in the event of certain changes in the ownership interests of significant stockholders.
On January 1, 2007, the Company adopted the provisions of FIN 48. The Company did not record an increase in the liability for unrecognized income tax benefits as a result of the adoption of FIN 48. As of January 1, 2007 and December 31, 2007 the liability for unrecognized income tax benefits was $388 and $1,154, respectively. Of the balance as of December 31, 2007, $1,154 would favorably impact the Company's tax rate if recognized. The Company recognizes interest and penalties as a component of income tax expense. As of December 31, 2006 and 2007, the Company had an accrual of $107 and $123, respectively, for the payment of interest and penalties related to its unrecognized tax positions.
The reconciliation of the gross amount of unrecognized tax benefits from January 1, 2007 to December 31, 2007 is as follows:
As of December 31, 2007, the Company does not expect the amount of unrecognized tax benefits to change significantly over the next twelve months.
The Company files income tax returns in the US federal tax jurisdiction, various state jurisdictions and various foreign jurisdictions. The statute of limitations for federal and state tax authorities is closed for years prior to December 31, 2004 although carryforward attributes that were generated prior to 2004 may still be subject to examination if they either have been or will be utilized to offset taxable income in tax years 2004 and forward. The statute of limitations for foreign tax jurisdictions is closed for tax years prior to December 31, 2002.
The Company's current intention is to reinvest the total amount of its unremitted foreign earnings in the local jurisdiction, to the extent they are generated and available, or to repatriate the earnings only when tax-effective. As such, the Company has not provided U.S. tax expense on $1,245 of the unremitted earnings of its foreign subsidiaries. If such earnings were distributed, it would result in approximately $58 of incremental US tax expense.
8. Debt
As of December 31, 2006 and 2007, the Company had a working capital line of credit with a bank under which it can borrow up to $2,000. As of December 31, 2006 and 2007, there were no amounts outstanding under the working capital line of credit. At December 31, 2006 and 2007, there was $1,500 available under the line of credit, and $500 reserved under a letter of credit associated with the Company's leased facility (see Note 9).
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Notes to Consolidated Financial Statements (Continued)
9. Commitments and Contingencies
Operating Leases
The Company conducts its operations in facilities under non-cancelable operating leases expiring through December 2014. Under the terms of the leases the Company is required to make the following payments:
(1)This line item excludes the new lease signed in 2008. Refer to Note 15.
Certain of the Company's leases have escalating rent payments. The Company records rent expense on a straight line basis over the term of the lease. Rent expense for the periods ended December 31, 2005, 2006 and 2007 was approximately $2,897, $3,079, and $3,349 respectively.
The Company does not have any special purpose entities or any off balance sheet financing arrangements.
Contingencies
From time to time and in the ordinary course of business, the Company is subject to various claims, charges and litigation. Intellectual property disputes often have a risk of injunctive relief which, if imposed against the Company, could materially and adversely affect its financial condition, or results of operations. From time to time, third parties have asserted and may in the future assert intellectual property rights to technologies that are important to the Company's business and have demanded and may in the future demand that the Company license their technology. Although the outcome of litigation cannot be predicted with certainty and some lawsuits, claims or proceedings may be disposed of unfavorably to the Company, which could materially and adversely affect its financial condition or results of operations, the Company does not believe that it is currently a party to any material legal proceedings.
For example, the Company entered into a Settlement Agreement and related License Agreement with Dr. Mark L. Kozam d/b/a MLK Software and Datasci, LLC. The Settlement Agreement relates to a lawsuit filed by Datasci in 2004 alleging that certain of the Company's products and services and certain products and services of one of the Company's customers, Quintiles, Inc., infringe a United States patent claimed to be owned by Datasci. Under the Settlement Agreement and related License Agreement, the Company agreed to make a one-time, lump-sum payment to Datasci in the amount of $8,500 to settle the claim and obtain a perpetual, irrevocable, fully paid worldwide, non-exclusive license to the patent that was the subject of the claim by Datasci. The confidential settlement, in which
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Notes to Consolidated Financial Statements (Continued)
neither party admits liability, provides for mutual releases and dismissal of all actions between the parties.
Pursuant to SFAS No. 142, the Company reviewed the attributes of the license obtained and estimated that the license obtained had no value or useful life and that the license would not contribute to the Company's future cash flows, either directly or indirectly. In addition, the Company does not anticipate changing any of its products as a result of the license to this patent. As such, the settlement amount was recorded as a charge to operations. Since the contingency existed as of December 31, 2005 and the settlement was concluded prior to the issuance of the 2005 audited consolidated financial statements, in accordance with SFAS No. 5, the Company recorded the impact of the settlement in 2005 as a charge to operations. The settlement was paid during the first quarter of fiscal 2006.
10. Stockholders' Equity
Common Stock
For the years ended December 31, 2005, 2006 and 2007 the Company issued 1,159,380, 847,055, and 899,933 shares of common stock resulting in proceeds of $3,111, $3,220 and $3,837 respectively, from the exercise of common stock options. For the years ended December 31, 2005, 2006 and 2007, the Company issued 152,999, 25,210 and 16,156 shares of common stock resulting in proceeds of $856, $329, and $290 respectively, in connection with the Company's 2004 ESPP.
On May 29, 2007, the Company sold 5,500,000 shares of common stock at $15.00 per share in a public offering, resulting in proceeds of $77,455 after deducting underwriters' discounts and offering related expenses. The Company also granted the underwriters an option for 30 days to purchase up to an additional 825,000 shares to cover over-allotments, if any, which was exercised in full on June 1, 2007, resulting in net proceeds of $11,695 after deducting underwriters' discounts. A summary of the terms of the offering can be found in the Company's Registration Statement No. 333-142328 on Form S-3, as filed with the SEC.
In 2003, the Company repurchased 37,000 shares of common stock from two former employees in accordance with contractual rights of first refusal. The purchase price was $111, the then current fair market value. These shares have been reflected in treasury stock in the accompanying statement of stockholders' equity.
Stock-Based Compensation Plans
The Company currently has one plan under which it may grant stock-based compensation awards to its directors, employees and non-employees. The Company has two additional plans under which there are awards outstanding, but under which no future awards may be made.
In 2004, the Board of Directors and stockholders approved the Phase Forward Incorporated 2004 Stock Option and Incentive Plan (the "2004 Plan") which became effective upon the closing of the Company's initial public offering. The Company had reserved for issuance an aggregate of 1,500,000 shares of common stock under the 2004 Plan. Under the 2004 Plan, the Board of Directors may grant stock options and other equity interests in the Company to employees of the Company and non-employees. The exercise price of each option is determined by the Board of Directors. Stock options may not be granted with an exercise price less than the fair market value of the stock on the date of grant, as defined by the Board of Directors. Options granted under the 2004 Plan generally vest over a four to seven year period and expire ten years from the grant date. In February 2005, the
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Notes to Consolidated Financial Statements (Continued)
Company granted options to certain employees to purchase a total of 419,000 shares of common stock that vest upon the earlier of attainment of specified milestones or 7 years from the date of grant. Of these February 2005 option grants, 197,000 options have since vested due to the achievement of milestones, 50,000 options were forfeited, and 172,000 remain unvested. Generally, the remainder of equity awards granted were service-based and vest over a period of four years from the date of grant. On May 3, 2006, the Company's stockholders approved an amendment to the 2004 Plan to increase the number of shares available for issuance from 1,500,000 shares to 3,500,000 shares. In 2006, the Company issued 1,113,175 unvested restricted stock awards and restricted stock units under the 2004 Plan. Generally, the balances of these unvested restricted stock options and units vest 50% in two years; 75% in three years and 100% in four years. A total of 400,000 unvested restricted stock awards were granted to the Company's Chief Executive Officer and vest 25% in three years; 50% in four years and 100% in five years. In 2007, the Company issued 589,144 unvested restricted stock units under the 2004 Plan. Generally, the balances of these unvested restricted stock options and units vest 50% in two years; 75% in three years and 100% in four years. A total of 40,000 unvested restricted stock awards were granted to the Company's Chief Executive Officer and vests 50% in two years; 75% in three years and 100% in four years.
On May 2, 2007, the Company's stockholders approved an amendment to the 2004 Plan to increase the number of shares available for issuance under the plan by 481,505 shares, bringing total shares authorized for issuance under the 2004 Plan to 3,981,505. The increase is equal to the number of shares that were available for issuance under the Company's two other stock plans (the Phase Forward Incorporated 1997 Stock Option Plan and the Phase Forward Incorporated 2003 Non-Employee Director Stock Option Plan) at the date of the amendment. As part of that amendment, the Company decided that it will no longer issue any further shares under its two other plans. As of December 31, 2007, the Company had 996,802 shares available for grant under the 2004 Plan.
In 1997, the Company adopted the Phase Forward Incorporated 1997 Stock Option Plan (the "1997 Plan"). On May 2, 2007, the Company's stockholders approved an amendment to the 2004 Plan to increase the number of shares available for issuance under the plan. As part of that amendment, the Company decided that it will no longer issue any further shares under the 1997 Plan. Prior to the May 2, 2007 amendment to the 2004 Plan, under the 1997 Plan, the Board of Directors could grant incentive and nonqualified stock options to employees of the Company and non-employees. The exercise price of each option was determined by the Board of Directors. Incentive stock options could not be granted with an exercise price less than the fair market value of the stock on the date of grant, as defined by the Board of Directors. Options granted under the 1997 Plan generally vest over four or five year periods and expire ten years from the grant date. In January and March 2004, the Company granted options to certain employees to purchase a total of 205,000 shares of common stock that vest upon the earlier of 7 years from date of grant or the attainment of specified milestones. Options to purchase 178,750 shares have since either vested upon the attainment of specified milestones in accordance with the original provisions of the award or been modified to change the vesting provisions to a 4-year service period. Options to purchase 26,250 shares were accelerated in December 2004. There was no incremental stock-based compensation in excess of the amounts that were previously recorded as deferred compensation. On May 2, 2007, all shares available for issuance under this plan were transferred to the 2004 plan as discussed above.
In 2003, the Board of Directors and stockholders approved the Phase Forward Incorporated 2003 Non-Employee Director Stock Option Plan (the "2003 NED Plan"). On May 2, 2007, the Company's stockholders approved an amendment to the 2004 Plan to increase the number of shares available for issuance under the plan. As part of that amendment, the Company decided that it will no longer issue
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Notes to Consolidated Financial Statements (Continued)
any further shares under the 2003 NED Plan. The Company reserved for issuance an aggregate of 362,000 shares of common stock under the 2003 NED Plan. Effective April 20, 2004, the 2003 NED Plan was amended to increase the number of shares the Company could grant under this plan to 562,000 shares. The 2003 NED Plan provided solely for the automatic, one-time grant of a nonqualified stock option to a non-employee director upon initial election to the Company's Board of Directors to purchase 100,000 shares of common stock. On September 23, 2005, the 2003 NED Plan was amended to reduce the one-time grant from 100,000 to 50,000 stock options. The exercise price of the options could not be less than 100% of the fair market value on the grant date. Options vest fully on the fifth anniversary of the date of grant, so long as the non-employee director has continuously served on the Board of Directors through such vesting date. If the non-employee director meets certain board attendance criteria, options may vest earlier at a rate of one-sixteenth at the end of each fiscal quarter following the date of grant. On May 2, 2007, all shares available for issuance under this plan were transferred to the 2004 plan as discussed above.
Stock Option Activity
A summary of stock option activity under the 1997 Plan, the 2004 Plan and the 2003 NED Plan as of December 31, 2007, and changes during the years ended December 31, 2005, 2006 and 2007, is as follows:
(1)The vested or expected to vest options at December 31, 2007 include both the vested options and the number of options expected to vest calculated after applying an estimated forfeiture rate to the unvested options.
(2)The aggregate intrinsic value is calculated based on the positive difference between the fair value per share of the Company's common stock on December 31, 2007 or the date of exercise, as appropriate, and the exercise price of the underlying options.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
A summary of the status of the Company's unvested stock options as of December 31, 2007, and changes during the year ended December 31, 2007, is as follows:
The following table summarizes information regarding the Company's stock options outstanding and exercisable at December 31, 2007:
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
Restricted Stock Awards and Unit Activity
A summary of activity related to unvested restricted common stock awards and unit awards for the years ending December 31, 2006 and December 31, 2007, is as follows:
(1)The expected to be free of restrictions at December 31, 2007 was calculated by applying an estimated forfeiture rate to the unvested shares.
(2)The aggregate intrinsic value is calculated based on the fair value per share of the Company's common stock on December 31, 2007 of $21.75. Employee Stock Purchase Plan
In 2004, the Board of Directors and stockholders approved the Phase Forward Incorporated 2004 Employee Stock Purchase Plan (the "2004 ESPP"), which became effective after the completion of the Company's initial public offering on July 20, 2004. The Company has reserved for issuance under this plan an aggregate of 320,000 shares of common stock. The 2004 ESPP allows eligible employees the opportunity to purchase shares of the Company's common stock through payroll deductions of up to 10% of a participant's annual compensation with a maximum of 5,000 shares available per participant during each payment period, subject to statutory limitations. The first payment period began on September 2, 2004 and ended on November 30, 2004. All subsequent payment periods consist of six-month periods commencing on December 1 and June 1 and ending on the last day of May and November.
Prior to December 1, 2005, the price per share under the 2004 ESPP for each payment period was the lesser of (1) 85% of the last reported sale price of the Company's common stock on the first business day of the payment period and (2) 85% of the last reported sale price of the common stock on the last business day of the payment period. Effective December 1, 2005, the Company amended the price provision of the 2004 ESPP such that the option price is now set at 95% of the last reported
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
sale price of the common stock on the last business day of the payment period. Accordingly, the 2004 ESPP is considered a non-compensatory plan under SFAS No. 123(R).
11. Forward Foreign Exchange Contracts
The Company enters into transactions in currencies other than the U.S. dollar and holds cash in foreign currencies which expose the Company to transactions gains and losses as foreign currency exchange rates fluctuate against the U.S. dollar. The Company from time to time enters into forward foreign exchange contracts to hedge the foreign currency exposure of non-U.S. dollar denominated third-party and intercompany receivables and cash balances. The contracts which relate to the British pound, euro, and the Japanese yen, generally have terms of one month. These hedges are deemed fair value hedges and have not been designated for hedge accounting. The gains or losses on the forward foreign exchange contracts along with the associated losses and gains on the revaluation and settlement of the intercompany balances, accounts receivable and cash balances are recorded in current operations.
The following table summarizes the outstanding forward foreign exchange contracts held by the Company at December 31, 2006 and 2007:
The forward foreign exchange contracts are short-term and generally mature within one month of origination.
Due to the short period of time between entering into the forward foreign exchange contracts and December 31, 2007, the forward foreign exchange contract rate approximates the exchange rate as of the end of the reporting period.
Realized and unrealized foreign currency gains (losses), net of hedging are accounted for in non-operating income (expense). Foreign currency losses, net of hedging, were $169, $15 and $42 for the years ended December 31, 2005, 2006 and 2007, respectively. The Company settles forward foreign exchange contracts in cash.
12. Business Segments and Geographic Information
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information regarding operating segments in annual financial statements and requires selected information of those segments to be presented in interim financial reports issued to stockholders. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision-maker, or decision-making group, in making decisions on how to allocate resources and assess performance. The Company's chief decision maker, as defined under SFAS No. 131, is the chief executive officer. The Company views its operations and manages its business as one operating segment.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
Geographic Data
Financial information by geographic area for the three years ended December 31, 2005, 2006 and 2007 were as follows:
The following table summarizes revenues recorded in each of the Company's principal sales office locations:
The following table summarizes property and equipment, net by location within and outside the U.S.:
13. Employee Benefit Plan
On January 1, 1998, the Company adopted the Phase Forward Incorporated 401(k) Plan (the 401(k) Plan). The 401(k) Plan allows employees to make pretax contributions up to the maximum allowable amount set by the Internal Revenue Service. Under the 401(k) Plan, the Company may match a portion of the employee contribution up to a defined maximum. The Company may, but is not obligated to, provide profit sharing to employees. The Company has made no contributions to date to the 401(k) Plan.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
14. Quarterly Financial Data (unaudited)
The following table presents a summary of quarterly results of operations for 2006 and 2007:
15. Subsequent Events
New Lease
On February 13, 2008, the Company entered into a lease ("Lease") with BP Fourth Avenue, L.L.C. (the "Landlord") to secure office space for the Company's future corporate headquarters at 77 Fourth Avenue, Waltham, Massachusetts. The estimated commencement date for occupancy under the Lease is December 2008. The lease for the Company's current corporate headquarters at 880 Winter Street in Waltham is due to expire in February 2009.
The Lease provides for the rental of 165,129 rentable square feet of space and has an initial term of 10 years and three months. The Company can, subject to certain conditions, extend this term by exercising up to two consecutive five year options. The Company is not required to pay any rent for the first three months of the initial Lease term. Thereafter, the annual rent on the new lease for years one through five will be $6,580, or approximately $548 per month. For years six through ten, the annual rent will be $7,241, or approximately $603 per month. The total base rent payable in the initial term is $69,104.
In addition to base rent, commencing on January 1, 2010, the Lease requires the Company to pay its proportionate share of the amount by which defined operating expenses incurred by the Landlord exceed the base year (2009) operating expenses, as defined in the Lease. The Lease also requires the Company to pay its proportionate share of the amount by which real estate taxes paid or incurred by the Landlord exceed the tax base year (fiscal 2010), as defined in the Lease. In addition, the Company will be receiving lease incentives, including free rent for the first three months of occupancy and allowances for tenant improvements.
Phase Forward Incorporated
Notes to Consolidated Financial Statements (Continued)
In connection with the signing of the Lease, the Company has deposited with the Landlord an unconditional, irrevocable letter of credit in Landlord's favor in the amount of $962.
Auction Rate Securities
At December 31, 2007, the Company had $34,500 in auction rate securities ("ARS"). These ARS are debt instruments issued by various states throughout the United States to finance student loans. The types of ARS that the Company owns are backed by student loans, 95% of which are guaranteed under the Federal Family Education Loan Program (FFELP), and all had credit ratings of AAA (or equivalent) from a recognized rating agency. The ARS are classified as available for sale in the accompanying consolidated balance sheet, and are recorded at cost.
Historically, the carrying value of ARS approximated fair market value due to the frequent resetting of the interest rates. The auctions have provided a liquid market for these securities as investors historically could readily sell their investments at auction. Auctions are held every 28 days. Following successful auctions in January 2008, all of the Company's ARS have experienced failed auctions in February and March 2008, as the amount of securities submitted for sale has exceeded the amount of purchase orders due to the liquidity issues experienced in the global credit and capital markets. The result of a failed auction is that these ARS continue to pay interest in accordance with their terms until the next successful auction; however, liquidity will be limited until there is a successful auction or until such time as other markets for these ARS investments develop. As of March 13, 2008, the Company has liquidated $10,450 of the securities, and has classified these securities as current assets in the consolidated balance sheet as of December 31, 2007. As of March 13, 2008, the par value of the ARS that the Company continues to own, which is equal to cost, totals $24,050 and these ARS are classified as long-term investments in the consolidated balance sheet at December 31, 2007, based on the Company's ability and intent to hold these securities until market conditions improve with successful auctions. The Company believes that, based on its unrestricted cash, cash equivalents and short term marketable securities balances of $158,572 at December 31, 2007, excluding ARS of $24,050, the current lack of liquidity in the credit and capital markets will not have a material impact on the Company's liquidity, cash flow or the Company's ability to fund its operations. If in the future the Company determines that any decline in value of the ARS is other-than-temporary, the Company would be required to recognize the loss in its statement of income, which could have a material impact on the Company's operating results in the period it is recognized.
EXHIBIT INDEX
Exhibit No.
Description
2.1 # Agreement and Plan of Merger by and among Phase Forward, Merger Sub, Lincoln and Lincoln SR dated as of August 16, 2005. (Incorporated by reference herein to Exhibit 2.1 of the Company's Current Report on Form 8-K filed with the SEC on August 31, 2005).
2.2
Amendment No. 1 to Agreement and Plan of Merger by and among Phase Forward, Lincoln and Lincoln SR dated as of September 13, 2006. (Incorporated by reference herein to Exhibit 10.1 of the Company's Current Report on Form 8-K filed with the SEC on September 15, 2006).
3.1
Amended and Restated Certificate of Incorporation of the Registrant dated July 20, 2004. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
3.2
Amended and Restated Bylaws of the Registrant. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
4.1
Specimen Certificate for shares of the Registrant's Common Stock. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.1 + 1997 Stock Option Plan. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.2 + Amended and Restated 2003 Non-Employee Director Stock Option Plan, as amended. (Incorporated by reference herein to Exhibit 10.1 of the Company's Quarterly Report on Form 10-Q filed with the SEC on August 10, 2005).
10.3 + 2004 Stock Option and Incentive Plan As Amended and Restated March 2006. (Incorporated by reference herein to Exhibits 10.1 to the Company's Current Report on Form 8-K filed with the SEC on May 8, 2006).
10.4 + Amendment No. 1 to the 2004 Stock Option and Incentive Plan as Amended and Restated March 2006. (Incorporated by reference herein to Exhibit 10.4 to the Company's Quarterly Report on Form 10-Q filed with the SEC on May 3, 2007.)
10.5 + Amended and Restated 2004 Employee Stock Purchase Plan. (Incorporated by reference herein to Exhibit 10.4 of the Company's Annual Report on Form 10-K filed with the SEC on March 13, 2006).
10.6 + Form of Incentive Stock Option Agreement. (Incorporated by reference herein to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q filed with the SEC on November 10, 2004).
10.7 + Form of Non-Statutory Stock Option Agreement. (Incorporated by reference herein to Exhibit 10.5 of the Company's Quarterly Report on Form 10-Q filed with the SEC on November 10, 2004).
10.8 + Form of Non-Statutory Stock Option Agreement (U.K.). (Incorporated by reference herein to Exhibit 10.3 of the Company's Quarterly Report on Form 10-Q filed with the SEC on August 10, 2005).
10.9 + Form of Stock Option Grant Certificate under the Registrant's Amended and Restated 1997 Stock Option Plan. (Incorporated by reference herein to Exhibit 10.1 of the Company's Current Report on Form 8-K filed with the SEC on December 30, 2005).
10.10 + Form of Restricted Stock Award Agreement. (Incorporated by reference herein to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on June 12, 2006).
10.11 + Form of Restricted Stock Unit Award Agreement. (Incorporated by reference herein to Exhibit 10.24 to the Company's Annual Report on Form 10-K filed with the SEC on March 1, 2007).
10.12 + Form of Restricted Stock Unit pursuant to Amended and Restated 2004 Stock Option and Incentive Plan (Incorporated by reference herein to Exhibit 10.3 of the Company's Current Report on Form 8-K filed with the SEC on March 6, 2007).
10.13 +* 2008 Management Incentive Plan.
10.14 +* 2008 Global Sales Executive Incentive Compensation Plan.
10.15 +* Summary of cash compensation practices for non-employee directors.
10.16 + Form of Executive Agreement between the Registrant and its officers, as amended March 7, 2005. (Incorporated by reference herein to Exhibit 10.22 of the Company's Annual Report on Form 10-K filed with the SEC on March 9, 2005).
10.17 + Amendment to Executive Agreement dated June 6, 2006 (Incorporated by reference herein to Exhibit 10.2 to the Company's Current Report on Form 8-K filed with the SEC on June 12, 2006).
10.18 +* Form of Executive Agreement between the Registrant and its officers, as amended June 6, 2006 and restated on February 28, 2008.
10.19 + Senior Executive's Service Agreement between Phase Forward Europe Limited and Stephen Powell. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.20 + Form of Indemnification Agreement between the Registrant and each of its directors and certain executive officers. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.21 # Software License and Services Agreement between the Registrant and GlaxoSmithKline Services Unlimited. (Incorporated by reference herein to Exhibit 10.1 of the Company's Current Report on Form 8-K filed with the SEC on August 10, 2004).
10.22
Settlement Agreement by and among Mark L. Kozam d/b/a MLK Software and Datasci, LLC, the Company, and Quintiles, Inc. (Incorporated by reference herein to Exhibit 10.4 of the Company's Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006).
10.23
License Agreement by and among Mark L. Kozam d/b/a MLK Software and Datasci, LLC, and the Company. (Incorporated by reference herein to Exhibit 10.5 of the Company's Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006).
10.24
Sublease Agreement between the Registrant and BMC Software, Inc. (Incorporated by reference herein to the exhibits to the Company's Registration Statement on Form S-1 (File No. 333-113594), as amended).
10.25
Lease dated February 13, 2008 between Phase Forward Incorporated and BP Fourth Avenue, L.L.C. (Incorporated by reference herein to Exhibit 10.1 to the Company's Current Report on Form 8-K filed with the SEC on February 19, 2008).
10.26
Seventh Loan Modification Agreement with Silicon Valley Bank (Incorporated by reference herein to Exhibit 10.6 to the Company's Quarterly Report on Form 10-Q filed with the SEC on May 10, 2006)..
21.1 * Subsidiaries of the Registrant.
23.1 * Consent of Ernst & Young LLP, Independent Registered Public Accounting Firm.
31.1 * Certification of CEO pursuant to Rule 13a-14(a) and 15d-14(s) under the Securities Exchange Act of 1934.
31.2 * Certification of CFO pursuant to rules 13a-14(a) and 15d-14(s) under the Securities Exchange Act of 1934.
32.1 * Certification of CEO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 * Certification of CFO pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
+Indicates a management contract or any compensatory plan, contract or arrangement.
#Confidential treatment requested for portions of this document.
*Filed herewith.
PART I
Item 1. Business
Item 1A. Risk Factors
Risks Related to Our Industry
Item 1B. Unresolved Staff Comments
Item 2. Properties
Item 3. Legal Proceedings
Item 4. Submission of Matters to a Vote of Security Holders
PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
COMPARISON OF 42 MONTH CUMULATIVE TOTAL RETURN* Among Phase Forward Incorporated, The NASDAQ Composite Index And The NASDAQ Computer & Data Processing Index
Item 6. Selected Financial Data
SELECTED CONSOLIDATED FINANCIAL DATA (in thousands, except per share data)
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Item 8. Financial Statements and Supplementary Data
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A. Controls and Procedures.
Report of Independent Registered Public Accounting Firm
Item 9B. Other Information.
PART III
PART IV
Item 15. Exhibits, Financial Statements and Schedules
EXHIBIT INDEX
SIGNATURES
Phase Forward Incorporated Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Phase Forward Incorporated Consolidated Balance Sheets (in thousands, except per share amounts)
Phase Forward Incorporated Consolidated Statements of Income (in thousands, except per share amounts)
Phase Forward Incorporated Consolidated Statements of Stockholders' Equity and Comprehensive Income (in thousands, except per share amounts)
Phase Forward Incorporated Consolidated Statements of Cash Flows (in thousands)
Phase Forward Incorporated Notes to Consolidated Financial Statements Years Ended December 31, 2005, 2006 and 2007 (in thousands, except share and per share amounts)
EXHIBIT INDEX