Item 1. Business
Introduction
Evolving Systems is a software, consulting and integration company enabling next generation telecommunications companies. Evolving Systems helps address the technical challenges relating to their Operations Support Systems (OSS) and Business Support Systems (BSS) created by the industry's rapidly changing technology, competitive pressures and regulatory environment. The Company has significant technical expertise and business acumen in each of these domains.
From its inception in 1985 through 1996, the Company focused on providing custom software development services to a limited number of telecommunications companies. Beginning in 1996, the Company made a strategic decision to expand its focus to include development of Local Number Portability (LNP) software products. The Company is using its technical strengths to position itself both as a leading custom software developer as well as a provider of next-generation (NextGen) OSS and Network Element (NE) solutions.
The Company's LNP software solution, enabling carriers to meet the requirement that customers retain their local phone numbers when changing service providers, has been selected for use by a majority of the Regional Bell Operating Companies (RBOCs) and two leading local and long distance carriers. The Company believes that the implementation of LNP will require significant changes in a broad range of carriers' software and systems that perform mission critical functions such as ordering, provisioning, service assurance and billing, collectively known as OSS.
The Company developed and continues to maintain the software currently in use by all Number Portability Administration Centers (NPACs) in the United States and Canada. The software receives ported telephone number information as changes occur, and distributes the data to all subscribing carriers in the region. The software is provided under contract to NeuStar Corporation, formerly a division of Lockheed Martin IMS.
The Company provides a wide range of custom solutions to incumbent local exchange carriers (ILECs) and competitive local exchange carriers (CLECs) for the provisioning and fulfillment of customer orders. These solutions focus on the flow-through provisioning of Advanced Intelligent Network (AIN) services within a carrier's network environment.
As part of its systems integration focus the Company provides billing solutions to IP technology-based carriers utilizing software products form third parties. In addition, the Company uses workflow technology from third parties in conjunction with systems integration techniques to provide solutions to carriers' needs for improved efficiency, effectiveness and reduced cycle times in order management, provisioning and other service fulfillment functional areas.
The Company developed and continues to maintain and enhance software for wireless data network elements which are owned and marketed by Lucent Technologies (Lucent).
Industry Background
The Telecommunications Industry
Historically, telecommunications carriers have operated in a highly regulated environment, with local and long distance telephone service providers operating as near monopolies with little competition. More recently, however, the U.S. and many foreign governments have begun to deregulate the telecommunications industry in order to reduce prices and improve telecommunications services through increased competition.
Deregulation and the widespread adoption of new telecommunications technologies, such as fiber optics, packet-data networks, digital wireless telephony and Internet-based services, have significantly increased the number of telecommunications carriers and created an increasingly competitive market. New entrants to the telecommunications service market include CLECs, alternate access providers, internet service providers (ISPs) and wireless service providers. To be competitive in this new environment, telecommunications service providers are seeking to rapidly enter new markets by offering new or differentiated services in a cost-effective manner. These new carriers must build their OSS and NE infrastructure to quickly introduce and support these services.
Competition and Deregulation
The U.S. long distance market was opened to competition beginning in the early 1970s. More recently, the Telecommunications Act of 1996 (the Act) provides for the introduction of competition in local telephone service, allowing long distance, wireless and other carriers to enter local telephone markets. The Act, among other things, requires RBOCs and other ILECs to offer LNP, which allows customers to retain their local phone numbers regardless of the carrier providing local telephone service. The Act also requires that carriers unbundle local services and facilities, which requires an interface to be made available to their new competitors for ordering, service provisioning maintenance and billing systems.
These new competitive and regulatory pressures have created significant technological challenges for existing and new carriers. Existing carriers must develop new systems that are interoperable with their legacy systems to enable them to respond to increasing competitive challenges. In addition, new entrants to local telephone markets require solutions that do not depend on an existing OSS infrastructure and that can be deployed quickly and cost-effectively. Thus, the Company believes that carriers' OSS are evolving from back-office legacy systems to strategic business systems that play an increasingly important role in enhancing competitiveness as well as enabling compliance with the requirements of the Act.
Operations Support Systems
OSS encompass a broad array of software and systems that perform critical functions for telecommunications carriers, including ordering, provisioning, service assurance and billing. Ordering systems allow carriers to collect customer information, retrieve current service information, capture and validate new service requests, verify the availability of selected services and transmit completed orders to one or more provisioning OSS. Carriers use provisioning systems to install services for new customers and to change or add services for existing customers. Service assurance systems allow carriers to perform the testing, monitoring and reporting necessary to maintain network availability and feed operational data to other business systems. Carriers use billing systems to collate, manage and report billing information. Some industry trade press also include customer care systems in the OSS market segment.
Historically, as existing carriers have added new services, such as wireless or Internet-based services, they have developed multiple, distinct OSS. These legacy, proprietary OSS have typically been mainframe-based systems that in many cases utilize incompatible software and technologies, making communication among systems difficult. These OSS are further strained by the many incremental changes that have been made in order to accommodate new technologies, such as client/server technology and advancements in data networking, and the proliferation of value-added services, such as call waiting, call forwarding and voice mail.
Despite these difficulties, carriers are unable to completely replace existing OSS due to the large investments and vast amounts of historical data contained in these systems. As a result, carriers continue to make incremental modifications to these OSS, further increasing their complexity and interoperability difficulties.
LNP Challenges to Current OSS
The LNP requirements of the Act pose significant technological challenges to existing carriers' OSS, which are already strained by the changes caused by increasing competition, new technologies and the introduction of value-added services. LNP invalidates a fundamental design assumption of many existing OSS, which is the association between a customer's telephone number and the geographic location of a carrier's particular physical switch. Provisioning systems now must be able to receive and distribute on a real-time basis certain customer data in order to assure proper call handling, routing and completion. If the LNP data from ported numbers are not properly distributed to all involved carriers, any call to and from that number will not be routed correctly, causing service problems for customers. Moreover, carriers that have not implemented LNP may incur substantial call termination or "dip" charges if they direct calls to locations where LNP has been mandated.
After altering provisioning systems, carriers must then implement changes throughout many of their other OSS. These OSS are "hard-coded" in that each telephone number corresponds to a physical switch for the ordering, service assurance and billing systems. The implementation of LNP also requires new systems to pool, allocate and assign telephone numbers. Changes will be required to existing billing systems, which currently associate a telephone number with a fixed geographic location. As a result of these challenges, the Company believes a significant market opportunity exists for providing solutions to carriers that must address these OSS problems.
New Technologies and Experience
New Network Technologies. The wireless carriers continue to deploy networks using new technologies such as Code Division Multiple Access (CDMA), Time Division Multiple Access (TDMA) and Global System for Mobile Communications (GSM). They require the ability to transfer packet data using these protocols and this environment creates a continuing opportunity for the Company.
IP Telephony. Historically, telephone companies built separate network infrastructures to offer new technology options requiring technology-specific OSS to support these unique networks. The isolated networks separate voice from data traffic and force the customers to maintain multiple subscriptions with the carrier. Network technology options that combine network traffic are developing today at an ever-increasing pace due to the heavy investments in research and development. CLECs and ISPs are developing convergent networks that combine voice and data on the same network. Virtual Private Networks (VPN) is one technology that is rapidly being accepted to combine the voice and data networks. The VPN technology digitizes voice into packets for transfer on data networks. IP Telephony is often referred to as next generation or "NextGen" telephony.
Experienced and Reliable Implementation Provider. To provide necessary support services for these changes in the industry, the company believes carriers will need vendors with significant communications software, OSS, and NE related domain expertise. Because of competitive pressure and short time frames, these carriers will look for solutions, including integration, and not just products. ILECs need such vendors in order to integrate their multiple legacy systems. CLECs and ISPs that do not have the personnel with the required expertise will need vendors to provide such services and expertise.
Evolving Systems Strategy
Recognizing the opportunity created by the ongoing deregulation of local telephone service, the Company has capitalized on its historic strength as a leading architect and developer of solutions for technically
challenging OSS requirements. The Company positions itself as a leading provider of next generation OSS solutions for the telecommunications industry. As the industry expands to include ISPs and cable companies, Evolving Systems has positioned its software to enable those potential carriers with LNP capabilities. The Company's heritage of custom development for service activation, wireless technology and LNP provides a base of domain expertise necessary to continue its leadership position in the industry. Account Managers and Service Directors utilize this knowledge to develop new business with existing customers and to attract new customers needing the Company's technological expertise.
The Company expects to combine its heritage for custom services with product components to offer NextGen solutions tailored to each carrier. Evolving Systems' resources are organized to pursue a customer-focused "solution" strategy. Customer-facing employees utilize the Company's domain expertise and requirements definition skills to identify an opportunity. Once the opportunity is validated, a solution is created and tailored to the customer's buying needs. Sometimes the solution will be totally custom designed, but more often it will be a variation to the Company's standard products or the integration of "off the shelf" products of third parties. The Company plans to build, and/or partner with strategic alliances to build a full suite of solutions integrating its domain expertise, product components, custom development, integration and support services with strategic partners in several business areas. Coupling this approach with an expanded sales force, targeted focus on new products and expanded services offerings, the Company plans to expand its customer base in several areas:
Product--The Company develops and packages products for the telecommunications market. These products are designed for integration into the customer's environment through adapters. The Company uses an end-to-end process for managing product lifecycles. The Company's products are licensed under perpetual licenses and may be licensed separately or bundled as a complete solution. The Company provides a 90-day warranty against defects, 24X7 help desk support and problem resolution as part of the warranty and offers extended warranty support services on an optional annual support agreement.
Custom Software--The Company provides custom software development services spanning the complete system development lifecycle from feasibility and requirements planning through development and production rollout. By offering these custom development services to leading telecommunications service providers for over a decade, the Company has developed a broad-based telecommunications domain expertise that it believes provides it with a competitive advantage.
Systems Integration--The Company has strategic partnerships in place to perform systems integration services for leading infrastructure providers. The Company also provides systems integration services for third-party software products. As an example, the Company has a relationship with TIBCO Software Inc. to integrate its workflow product for carriers. Additionally, the Company has a relationship with EHPT where the Company sells, installs and integrates EHPT OSS/BSS products. The Company provides a range of systems integration services, including system design, database and network design, network configuration and other system development areas of expertise.
Customer Support--The Company provides a broad array of customer support services, including 24X7 help desk support, problem resolution, software maintenance and scheduled software upgrades, complete training and documentation for products and services, and quality assurance. The Company's typical software maintenance agreement has a 12-month term.
Evolving Systems Business Structure
The Company is organized into eight main business groups that build on its core competencies and domain expertise to form an end-to-end solution for each customer's specific requirements. The business groups combine domain expertise with product components and professional services to create next generation OSS solutions for the carrier. Of the eight business groups described below, four are product groups and four are services related groups:
LNP Products Group. The Company's current LNP products enable carriers to accommodate customer requests to change service providers while retaining the same phone number, and to exchange call routing data to carriers' networks via the NPAC. The Company currently offers four LNP products, which began release in the first half of 1997. The Company's LNP products are licensed under perpetual licenses and may be licensed separately or bundled as a complete solution. The LNP group's product offerings in this area include OrderPath(R) (a Local Service Order Administration component), NumberManager(TM) (a Local Service Management System component), NodeMaster(R) (optional interface component from NumberManager(TM) to multiple Service Control Points) and also Data Server(TM) (a database tool currently under development for independent data analysis). The group is also responsible for ongoing maintenance of these products and has been responsible for the development and support of integration software needed to integrate the products with customers' legacy systems.
Customers typically engage the Company to provide installation, integration and testing of the LNP products in connection with these licenses as stated below. Customers also rely on the Company for ongoing support and enhancement of the solution. General software upgrades and enhancements for all products are planned.
The Company intends to offer its LNP products through Application Services Providers (ASP). Customers that do not wish to incur the capital and operating expense of an in-house solution can now choose to subscribe with the Company for use of LNP products. The customer will be charged a monthly subscription fee and a separate fee based on usage levels.
LNP Integration Group. This group is comprised of staff experienced in requirements definition, solution synthesis, implementation and integration of the company's overall LNP solution. This group is a specialized systems integration group with substantial telecommunications domain knowledge that offers rapid LNP implementation capabilities to LNP customers.
NPAC Business Group. The Company developed and continues to maintain the software currently in use by all NPACs in the United States and Canada. The software receives ported telephone number information as changes occur and distributes the data to all subscribing carriers in the region. The software is provided under contract to Neustar Corporation.
Wireless Technology Business Group. This business group provides custom software products for Lucent, a leading equipment supplier. The infrastructure products enable Cellular Digital Packet Data (CDPD), CDMA, and Over-the-Air- Service Provisioning (OTASP) in wireless network environments. The Company provides full lifecycle support for these products including the initial development and ongoing maintenance releases. The Wireless Technologies business group maintains a service bureau offering for the billing of wireless data.
Service Activation and Fulfillment Business Group. The Service Activation business group provides a wide range of custom solutions to ILECs and CLECs for the provisioning and fulfillment of customer orders. The solutions focus on the flow-through provisioning of Advanced Intelligent Network (AIN) services within a carrier's network environment. The Company is investigating the viability of packaging components of the solution developed in the Service Activation business group for sale as products to the general marketplace. The products would provide interfaces to available order management OSS and network elements for seamless integration.
Workflow-Enabled Group. This group has its origin in 1999 as a result of a relationship established with InConcert, which is owned by TIBCO Software, Inc. The InConcert product, a workflow solution tool, is used by Evolving Systems as part of an overall solution in selected functional areas within the telecommunications industry. The strategy for this solution area is to focus on the broadly defined fulfillment process domain for carriers (e.g. order management, provisioning, activation, etc.). The intent is to also leverage the process domain experience the Company has from its custom work in provisioning and activation.
IP Telephony Solutions Group. This group began in the 4th quarter of 1999 and its focus is delivering IP billing solutions to next generation telecommunications carriers. This group is staffed with specialists in billing processes and the IP domain with specific training in the EHPT product suite. The Company expects this group to grow substantially in the next year.
Knowledge and Training Services Group. This group provides training and documentation support to customers using Evolving Systems products and for custom designed systems utilized by network infrastructure customers. They are also skilled in working with third parties to design training programs for products which Evolving Systems may integrate for customers.
Marketing and Sales
The primary objectives of the Company's marketing efforts are to build Evolving Systems' expanded capabilities image, generate market awareness and produce qualified leads. The Company's marketing efforts include direct sales to targeted accounts, participation in selected trade shows, a strong website presence, print and electronic advertising and story placement in telecom industry trade media, presentations at industry conferences and forums, press releases to the industry, and certain other marketing initiatives.
The Company's sales activities are conducted through a direct sales force and the services support organization, both of which are complemented by other sales channels. The Company intends to rely on resellers and alternate channels to further penetrate the LNP market. The Company also assigns a dedicated account and business manager to each major customer to ensure that both the sales relationship and the business relationship are managed well. The sales closing cycle can be quite long in the telecommunications business due to both the complexity of products and integration issues that make major systems decisions difficult. Typically, the sales cycle takes three months to one year.
The alternate channels, such as strategic distribution partners, help to identify and qualify leads. The Company plans to increase the focus on resellers and alternate sales channels in 2000 to further penetrate the LNP market. The Company believes that a limited window of opportunity exists to capture a larger market share of these customers. The Company's marketing and sales efforts have been focused primarily on facility-based local exchange, interexchange and wireless service providers in the United States, and this group has comprised the majority of the Company's customers. In 2000, the Company will continue efforts among these markets and expand its focus to include non-facilities-based service providers, ISPs and VPN providers with additional product and service offerings beyond LNP.
The Company believes that significant demand for new OSS products and services exists outside of the U.S. due to increased deregulation and resulting competition. The Company intends to expand it sales and marketing efforts internationally through a series of partnerships with specific third-party systems integrators and software suppliers, as well as the extension of its relationships with existing customers as they expand into international markets.
Research and Development
The Company's research and development efforts are focused on identifying market requirements and performing design and development functions. These activities follow the Company's product development process that governs the product lifecycle from concept through product launch and subsequent retirement from the marketplace, all through the use of cross-functional teams. This process provides the Company's senior management with a series of decision milestones that allows the evaluation of ongoing projects on a regular basis. Normally, the Company does not fund significant development efforts without first having a customer to buy the resulting product.
Competition
The market for telecommunications software is intensely competitive and is subject to rapid technological change, evolving industry standards and regulatory developments. The Company faces continuous demand for
improved product performance, new product features and reduced prices, as well as intense pressure to accelerate the release of new products and product enhancements. The Company's existing and potential competitors include many large domestic and international companies, including certain customers of the Company, that have substantially greater financial, manufacturing, technological, marketing, distribution and other resources, larger installed customer bases and longer-standing relationships with telecommunications customers than the Company. Although the Company concentrates on providing software and services for the telecommunications industry, the market for telecommunications software is extremely large and the Company currently holds only a very small portion of the market share outside of the LNP segment. The Company differentiates itself from competitors through its combination of products, services and strategic alliances. The Company consults, develops software, integrates third party software and interconnects customers existing operating systems. Very few competitors can offer all of these capabilities and depth of knowledge.
The principal competitors of the Company's LNP products include DSET, Telcordia (formerly known as Bellcore), Lucent, Nortel Networks (Nortel), and Tekelec, Inc. (Tekelec). The Company expects competition to increase in the future from existing suppliers and from other companies that may enter the Company's existing or future markets with solutions which may be less costly, provide higher performance or additional features or be introduced earlier than the Company's solutions.
Many telecommunications companies have large internal development organizations which develop software solutions and provide services similar to the Company's products and services. In addition, customers who have purchased custom software solutions from the Company are not precluded from competing with the Company. ILECs that have implemented LNP solutions are well suited to provide LNP services for smaller CLECs within their regions. Recent independent market research data indicate that more telecommunications companies are outsourcing their software solutions due to time to market considerations.
The Company believes that its ability to compete successfully depends on a wide range of internal and externally controlled factors. The Company plans to compete by providing quality solutions that are tailored specifically to the customer. The company is organized to provide core products and complimentary services that provide a total solution for the application area. The Company then creates a long-term relationship with the customer by providing ongoing support, extensions of the original solution, and new related solutions.
Intellectual Property
The Company relies on a combination of copyright, trademark and trade secret laws, as well as confidentiality agreements and licensing arrangements, to establish and protect its proprietary right. The Company presently has no patents, but has patent applications pending in the U.S. on elements of its three LNP products: NumberManager, OrderPath and NodeMaster and an Internet call processing engine.
Employees
As of December 31, 1999, the Company employed 302 people, of which 69% were involved in service provision, consulting practices and product development. Additionally, 10% of staff are in marketing and sales, and 21% in general administration.
RISK FACTORS
Fluctuations in Quarterly Results of Operations
The Company's operating results have fluctuated significantly in the past and are likely to continue to fluctuate significantly in the future. Fluctuations in operating results may result in volatility in the price of the Company's Common Stock. These quarterly fluctuations may result from a number of factors, including the magnitude, timing and signing of new contracts; the Company's rate of progress under such contracts; the timing of customer and market acceptance of the Company's products and service offerings; actual or anticipated changes in government laws and regulations related to the telecommunications market or judicial or administrative actions with respect to such laws or regulations; the nature and pace of enforcement of the Act; product lifecycles; the mix of products and services sold; changes in demand for the Company's products and services; the timing of third-party contractors' delivery of software and hardware; budgeting cycles of the Company's customers; changes in the renewal rate of support agreements; the timing and amount of expenditures made by the Company for research and development and sales, general and administrative expenses; competition by existing and emerging competitors in the telecommunications software markets; the Company's success in developing and marketing new products, controlling cost, attracting and retaining qualified personnel and expanding its sales and marketing programs; regional office expansion; software defects and other product quality problems; changes in the Company's strategy; the extent of industry consolidation and general economic conditions. A significant portion of the Company's revenue has been and is expected to continue to be derived from a small number of customers. Accordingly, the loss of any significant customer, delays in delivery or acceptance of any of the Company's products or delays in the performance of services could have a material adverse effect on the Company's business, financial condition and results of operations.
The Company's expense levels are based in significant part on its expectations regarding future revenue. The Company's revenue is difficult to forecast because the market for the Company's products and services is rapidly evolving, and the Company's sales cycle and the size and timing of significant contracts vary substantially among customers. Accordingly, the Company may be unable to adjust spending in a timely manner to compensate for any unexpected shortfall in revenue.
Based on all of the foregoing, the Company believes that future revenue, expenses and operating results are likely to vary significantly from quarter to quarter. As a result, quarter to quarter comparisons of operating results are not necessarily meaningful or indicative of future performance. Furthermore, the Company believes it is likely that in some future quarter the Company's operating results will be below the expectations of public market analysts or investors. In such event, or in the event that adverse conditions prevail, or are perceived to prevail, with respect to the Company's business or generally, the market price of the Company's Common Stock would likely be materially adversely affected.
Dependence Upon Telecommunications Industry; Regulatory Uncertainties
The market for the Company's products was created and has primarily been driven by the adoption of regulations under the Act requiring RBOCs to implement LNP as a condition to being permitted to provide long distance services. Therefore any changes to such regulations, or the adoption of new regulations by federal or state regulatory authorities under the Act, or any legal challenges to the Act, could have a material adverse effect upon the market for the Company's products and services. Recently, for example, the FCC delayed implementation of the Act with respect to wireless carriers until November, 2002. These delays have had, and continue to have, an impact on the Company's revenue from its LNP products and services. Additional delays in the deadlines imposed by the Act or the FCC, or any invalidation, repeal or modification in the requirements imposed by the Act or the FCC, could have a material adverse effect on the Company's business, financial condition and results of operations. Moreover, customers may require, or the Company otherwise may deem it necessary or advisable, that the Company modify its products or services to address actual or anticipated changes in the regulatory environment. Any other delay in implementation of the Act, or other regulatory changes, could materially adversely affect the Company's business, financial condition and results of operations.
Reliance on Significant Customers
Historically, a substantial portion of the Company's revenue has been derived from a limited number of customers. During the years ending December 31, 1997, 1998 and 1999, the Company recognized approximately 89%, 87% and 84% of total revenue from six, six and five customers, respectively, all in the telecommunications industry. The Company expects to continue to depend on large contracts with a small number of significant customers, which can cause its revenue and earnings to fluctuate between quarters based on the timing of contracts and installation of the Company's products by these customers. None of the Company's major customers has any obligation to purchase additional products or services. Consequently, the failure by the Company to maintain existing relationships or develop relationships with significant new customers would have a material adverse effect on the Company's business, financial condition and results of operations. Additionally, business or marketplace consolidations affecting one or more of the Company's major customers has caused delays in customer contracts and could result in the loss of that customer, which also could have a material adverse effect on the Company's business, financial condition and results of operations.
Lengthy Implementation Process; Customer Acceptance of Company Solutions
Implementation of the Company's solutions is a relatively complex and lengthy process that involves significant allocation of resources by the Company in order to adapt and customize such solutions for each customer's unique environment. Moreover, certain of the Company's customers may require rapid deployment of the Company's software solutions, resulting in pressure on the Company to meet demanding delivery and implementation schedules. Delays in implementation may result in customer dissatisfaction and/or damage to the Company's reputation and could have a material adverse effect on the Company's business, financial condition and results of operations.
The majority of the Company's existing contracts provide for acceptance testing by the customer before the contract is considered complete. Unanticipated difficulties or delays in the customer acceptance process could result in higher costs and delayed payments. Moreover, if the Company fails to satisfy acceptance criteria within prescribed times, the customer may be entitled to cancel its contract and receive a refund of all or a portion of amounts previously paid or other amounts as liquidated damages, which could exceed related contract revenue and which could result in a future charge to earnings. Any failure or delay in achieving final acceptance of the Company's software and services could have a material adverse effect on the Company's business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Lengthy Sales Cycle / Consolidations in the Industry
The Company's software products and services are generally used by large telecommunications service providers for enterprise-wide, mission-critical purposes, involving significant capital expenditures and lengthy implementation plans. Prospective customers typically commit significant resources to the technical evaluation of the Company's products and services and require the Company to expend substantial time, effort and money providing education regarding the Company's solutions. This evaluation process often results in an extensive and lengthy sales cycle, typically ranging between three and 12 months, making it difficult for the Company to forecast the timing and magnitude of sales contracts. Delays associated with customers' internal approval and contracting procedures, procurement practices, and testing and acceptance process are common. For example, customers' budgetary constraints and internal acceptance reviews may cause potential customers to delay or forego a purchase. The delay or failure to complete one or more large contracts could have a material adverse effect on the Company's business, financial condition or results of operations and cause the Company's operating results to vary significantly from quarter to quarter.
The telecommunications industry is currently experiencing significant reorganization and consolidation. Mergers and acquisitions of large telecommunications companies, as well as the formation of new alliances, has resulted in a constantly changing marketplace for the Company's products and services. Delays associated with these changes are common. The delay or failure to complete one or more large contracts could have a
material adverse effect on the Company's business, financial condition or results of operations and cause the Company's operating results to vary significantly from quarter to quarter.
Fixed-Price Contracts
The Company historically derived a majority of its revenue from contracts that were billed on a time-and-materials basis. Beginning in mid-1996, a majority of the Company's revenue has been derived from contracts that were billed on a fixed-price basis. The Company in the past has incurred budget overruns on certain fixed-price contracts, resulting in lower than anticipated margins, and there can be no assurance that the Company will not incur such budget overruns in the future. If the Company incurs such budget overruns, the Company's gross margins and results of operations may be materially adversely affected. To the extent that the Company continues to provide custom software development or consulting services, it anticipates that customers will continue to request that the Company provide software and implementation services as a total solution on a fixed-price basis. These contracts specify certain obligations and deliverables to be met by the Company regardless of actual costs incurred by the Company. There can be no assurance that the Company can successfully complete these contracts on budget, and the Company's inability to do so could have a material adverse effect on its business, financial condition and results of operations. See "Management's Discussion and Analysis of Financial Condition and Results of Operations."
Rapid Technological Change; Risks Associates with New Versions and New Products; Risks of Software Defects
The market for the Company's products and services is subject to rapid technological changes, evolving industry standards, changes in carrier requirements and preferences and frequent new product introductions and enhancements. The introduction of products that incorporate new technologies and emergence of new industry standards can render existing products obsolete and unmarketable. To compete successfully, the Company must continue to design, develop and sell enhancements to existing products and new products that provide higher levels of performance and reliability in a timely manner, take advantage of technological advancements and changes in industry standards and respond to new customer requirements. There can be no assurance that the Company will successfully identify new product opportunities or will achieve market acceptance of new products brought to market. Products developed by others may render the Company's products obsolete or noncompetitive. Any failure by the Company to anticipate or respond adequately to changes in technology and customer preferences, any failure of the Company's products to perform satisfactorily or any significant delay in product development or introductions could have a material adverse effect on its business, financial condition and results of operations.
The Company intends to issue interim and new releases of its family of software products periodically. As a result of the complexities inherent in software development, major new product enhancements and new products can require long development and testing periods before they are commercially released. There can be no assurance that delays will not occur in the future.
Competition; Risks Associated with Recruiting and Retaining Personnel
The Company's primary markets are intensely competitive and are subject to rapid technological changes, evolving industry standards and regulatory developments. The Company faces continuous demand for improved product performance, new product features and reduced prices, as well as intense pressure to accelerate the release of new products and product enhancements. The Company's existing and potential competitors include many large domestic and international companies, including certain of the Company's customers, that have substantially greater financial, manufacturing, technological, marketing, distribution and other resources, larger installed customer bases and longer- standing relationships with customers than the Company. The Company's principal competitors in the LNP market include DSET, Telcordia, Lucent, Nortel and Tekelec. One of the Company's principal customers, Lucent, competes with the Company with respect to certain of the Company's products and services that it offers in competition with the Company. In addition, NeuStar has retained rights to
the NPAC software developed for NeuStar by the Company, and NeuStar potentially could compete with the Company with respect to LNP products and related services. There also can be no assurance that other customers will not offer competitive products or services in the future. The Company expects competition to increase in the future from ASPs, existing competitors and from other companies that may enter the Company's existing or future markets with solutions which may be less costly, provide higher performance or additional features or be introduced earlier than the Company's solutions. Many telecommunications companies have large internal development organizations which develop software solutions and provide services similar to the Company's products and services. Moreover, customers who have purchased custom software solutions from the Company are not precluded from competing with the Company.
The Company believes that its ability to compete successfully depends on numerous factors, both within and outside of its control, including responsiveness to service providers' needs, quality and reliability of the Company's and its competitors' products and services, price, project management capabilities, technical subject matter expertise, quality of customer service and support, the emergence of new industry standards, the development of technical innovations, the attraction and retention of qualified personnel, regulatory changes and general market and economic conditions. A variety of potential actions by the Company's competitors, including a reduction of product prices or increased promotion, announcement or accelerated introduction of new or enhanced products, or cooperative relationships among competitors, could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to compete successfully with existing or new competitors or will properly identify and address the demands of new markets. The failure by the Company to adapt to emerging market demands, respond to regulatory and technological changes or compete successfully with existing and new competitors would have a material adverse effect on the Company's business, financial condition and results of operations.
The Company's ability to manage future expansion, if any, effectively will require it to attract, train, motivate and manage new employees successfully, to integrate new management and employees into its overall operations and to continue to improve its operations, financial and management systems. The Company anticipates that it will need to hire additional development personnel. Competition for development and other technical personnel is intense, and there can be no assurance that the Company will be able to retain personnel or to hire additional personnel on a timely basis, if at all. Because of the complexity of the Company's software solutions, a significant time lag exists between the hiring date of technical and sales personnel and the time at which they become fully productive. The Company has at times experienced and continues to experience difficulty in recruiting and retaining such personnel. Any failure by the Company to retain personnel or to hire qualified personnel on a timely basis could materially adversely affect the Company's business, financial condition and results of operations.
The Company is continuing its implementation of new financial and project accounting software packages. The Company's ability to implement these new systems is likely to place substantial demands on certain of the Company's managerial resources. In addition, if the Company is unable to implement these software packages effectively, the Company's ability to accurately forecast and manage its business may be adversely affected. The Company's failure to manage any expansion effectively, including any failure to integrate new management and employees or failure to continue to implement and improve financial, operations and management controls, systems and procedures, could have a material adverse effect on the Company's business, financial condition and results of operations.
Product Liability
The Company's agreements with its customers typically contain provisions designed to limit the Company's exposure to potential liability for damages arising out of the use of or defects in the Company's products. The nature and extent of such limitations, however, tend to vary from customer to customer and it is possible that such limitations of liability provisions may not be effective as a result of federal, state or local laws or ordinances or unfavorable judicial decisions. In addition, the Company currently has errors and omissions insurance which, subject to customary exclusions, covers claims resulting form failure of the
Company's software products or services to perform the function or to serve the purpose intended. To the extent that any successful product liability claim is not covered by such insurance, the Company's business, financial condition and results of operations may be materially adversely affected, particularly since the Company's software products may be used in critical business applications. Defending such a suit, regardless of its merits, could involve substantial expense and require the time and attention of key management personnel, either of which could have a material adverse effect on the Company's business, financial condition and results of operations. In addition, the Company's business reputation could be adversely affected by product liability claims, regardless of their merit or the eventual outcome of such claims.
Year 2000 Capability
To date, the Company has not encountered any significant problems with either the software sold to customers or to internal systems run by the Company. The Company had developed a detailed contingency plan and worked closely with customers and vendors to avoid Y2K problems. In 1999, expenses related to this effort were approximately $1,000,000.
Protection of Intellectual Property; Risks of Infringement
The Company's success and ability to compete are dependent to a significant degree on its proprietary technology. The Company relies on a combination of copyright, trademark and trade secret laws, as well as confidentiality agreements and licensing arrangements, to establish and protect its proprietary rights. The Company presently has no patents, but has patent applications pending in the U.S. on elements of its three LNP products, NumberManager, OrderPath and NodeMaster, and an internet call processing engine. In addition, the Company has registered or filed for registration of certain of its trademarks. Despite these precautions, it may be possible for a third party to copy or otherwise obtain and use the Company's products or technology without authorization or to develop similar technology independently through reverse engineering or other means. In addition, the laws of some foreign countries do not adequately protect the Company's proprietary rights. There can be no assurance that the Company's means of protecting its proprietary rights in the U. S. or abroad will be adequate or that others will not independently develop technologies that are similar or superior to the Company's technology, duplicate the Company's technology or design around any patent of the Company. There can also be no assurance that the Company will not inadvertently infringe upon the intellectual property rights of a third party. Moreover, litigation may be necessary in the future to enforce the Company's intellectual property rights, to determine the validity and scope of the proprietary rights of others or to defend against claims of infringement or invalidity. Such litigation could result in substantial costs and diversion of management time and resources and could have a material adverse effect on the Company's business, financial condition and results of operations.
Possible Volatility of Stock Price
The trading price of the Company's Common Stock has been and may continue to be subject to wide fluctuations in response to quarterly variations in operating results, announcements of technological innovations or new products by the Company or its competitors, changes in financial estimates by securities analysts, the operating and stock price performance of other companies that investors may deem comparable to the Company, general stock market and economic considerations and other events or factors. In addition, the stock market has experienced volatility that has particularly affected the market prices of equity securities of many technology companies and that often has been unrelated to the operating performance of such companies. These broad market fluctuations may adversely affect the trading price of the Company's Common Stock. As a result of the foregoing factors, there can be no assurance that the Company's Common Stock will trade at or higher than its current price.
Item 2.
Item 2. Properties
The Company leases office space at three locations in the Denver, Colorado metropolitan area, including two in the Englewood area (Meridian and Southgate), and one in the Boulder area (Louisville), and in Santa
Maria, California. The Company also leases sales offices in New Jersey, St. Louis and Vienna, Virginia. The Company's leases in the Denver, Colorado metropolitan area and California are shown below:
The Company no longer has operations in its Southgate location and subleases the Southgate facility for the remainder of its lease commitment.
Item 3.
Item 3. Legal Proceedings
In June 1998, four securities class action complaints were filed against the Company and certain of its current and former officers and directors in the U.S. District Court for the District of Colorado alleging violations of the federal securities laws. The complaints were consolidated. The plaintiffs purported to represent a class of persons who purchased the Company's securities during the period of May 12, 1998 through July 23, 1998. The complaints alleged that the Company and certain of its officers misled the investing public regarding the financial prospects of the Company. The Company denied these allegations. The parties reached a settlement of $10 million, of which the Company paid $2.5 million in April 1999. The settlement was approved by the Court on October 4, 1999. The Company incurred approximately $719,000 in legal costs associated with the lawsuit.
The Company is currently involved in a dispute with an employee concerning amounts allegedly owed to the employee in connection with his employment. The Company believes the employee's claims are without merit and the parties are currently seeking to resolve the dispute through mediation. Although it is too early to evaluate the outcome of this dispute, in the event the parties are unable to reach a mutually agreeable resolution and the employee subsequently succeeds in his claim, the outcome could have a material adverse effect on the Company's business, financial condition and results of operation.
From time to time the Company is involved in various legal proceedings arising in the normal course of business operations. Management does not expect that any such proceedings will have a material adverse effect on the Company's financial position or results of operations.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
During the fourth quarter of 1999, no matters were submitted to a vote of the Company's stockholders.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholders Matters
The Company's Common Stock began trading publicly through the NASDAQ National Market under the symbol "EVOL" on May 12, 1998. Prior to that date, there was no public market for the Common Stock. The closing price of the Company's Common Stock as reported on the NASDAQ National Market as of March 1, 2000 was $12.50 per share. The following table sets forth for the periods indicated the high and low closing sale quotations for the Common Stock as reported on the NASDAQ National Market. The prices reported do not include retail mark-ups, mark downs or commissions.
As of March 1, 2000, there were approximately 196 holders of record of the Company's Common Stock.
The Company has not declared or paid a cash dividend on its Common Stock. The Company currently intends to retain any future earnings, if any, to finance the growth and development of its business and, therefore, does not anticipate paying cash dividends in the foreseeable future.
Use of Initial Public Offering Proceeds
The Company used the net proceeds of its IPO for repayment of its obligations under its Subordinated Notes and Stockholder Notes, working capital and other corporate purpose. The respective principal amounts (exclusive of $56,517 in accrued interest) outstanding under the Subordinated Notes and Stockholder Notes were $6,792,885 and $5,059,539 and bore interest at the rates of 9% (with deferred interest accrued at the rate of 12%) and 7.25%, respectively, with respective maturity dates of June 1, 2004 and January 2, 2006. The Company also used proceeds to pay prepayment penalties to the holders of the Notes in the amount of $446,000, net of taxes. The Company also used proceeds to fund the general business operations including research and development expenses related to its LNP products. The balance of the proceeds were invested in investment grade, short-term investments bearing various interest rates.
Item 6.
Item 6. Selected Financial Data
The selected financial data set forth below for each of the years in the five-year period ended December 31, 1999, have been derived from the Company's consolidated financial statements and should be read in conjunction with "Management's Discussion and Analysis of Financial Condition and Results of Operations", the financial statements and the notes thereto and other financial information included elsewhere in this annual report on Form 10-K.
- -------- (1) Prior to January 6, 1996, the Company was an S corporation for federal and state income tax purposes, and accordingly, the Company's income was taxed directly to the Company's stockholders at that time. Net income (loss) for 1996 and 1995 do not reflect the estimated federal and state income taxes that would have been payable if the Company had not been an S corporation prior to January 6, 1996. (2) Included in net loss for 1998 is an extraordinary loss on early extinguishment of debt of approximately $446,000, net of $220,000 in income tax benefit. See note 3 of Notes to Financial Statements.
The following table presents, for the periods indicated, certain items contained in the Company's statement of operations reflected as a percentage of total revenue:
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
This section contains forward-looking statements which involve risks and uncertainties. The Company's actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in this section and in the section entitled "Risk Factors."
Introduction
Evolving Systems, Inc., formed in 1985, began its first year as a publicly traded company on May 12, 1998. The Company's core business is designing and integrating software systems for the telecommunications industry. Software projects are bid at either a fixed price or as time and materials custom software projects. From the Company's inception in 1985 through 1996, the Company focused on providing custom software development services, primarily to two large customers. Beginning in 1996, the Company broadened its focus to include proprietary software products in response to declining demand from key customers for custom software development services that reflected the changing industry patterns for software procurement. In addition, the Company aggressively sought new customers for its custom software development business.
The Company had an excellent market for its LNP products in 1997 as a result of the mandated requirements for LNP capabilities in the Act. License fees and related services revenues for 1997 were over $20,000,000. Other services of the business also increased due to considerable integration support needed to implement LNP. This market demand did not carry forward into 1998 for those LNP products. The Company refocused its LNP products sales efforts to other market segments such as wireless and CLECs but these
segments are much smaller than the wire line portion of the telecommunications market and FCC approved delays in implementation of LNP for the wireless industry had an impact on sales of LNP products to wireless carriers. The end result has been a substantial decline in license fee and related services in 1998 when compared to 1997 and 1999 is still below 1997 levels.
Revenue Recognition
For contracts entered into subsequent to January 1, 1998, the Company recognizes revenue in accordance with the provisions of Statement of Position 97-2, "Software Revenue Recognition". The Company derives revenue from license fees and services under the terms of both fixed price and time and materials contracts. License fees and related services revenue consists of revenue from contracts involving the Company's LNP software products and related services. Other services revenue consists of revenue from custom programming, systems integration of third party products, annual maintenance contracts and training.
License fees and related services revenue is generated from fixed price contracts that provide for both licenses and services. Revenue under these arrangements, where the services are essential to the functionality of the delivered software, is generally recognized using the percentage-of-completion method of accounting. The percentage of completion for each contract is determined based on the ratio of direct labor hours incurred to total estimated direct labor hours. Amounts billed in advance of services being performed are recorded as unearned revenue. Unbilled work in-progress represents revenue earned but not yet billable under the terms of the fixed price contracts and all such amounts are expected to be billed and collected during the succeeding 12 months.
In arrangements where the services are not essential to the functionality of the delivered software, the Company recognizes license revenue when a license agreement has been signed, delivery has occurred, the fee is fixed or determinable and collectibility is probable. Where applicable, fees from multiple element arrangements are unbundled and recorded as revenue as the elements are delivered to the extent that vendor specific objective evidence of fair value exists. If vendor specific objective evidence of fair value does not exist, fees from such arrangements are deferred until the earlier of the date that vendor specific objective evidence of fair value does exist or all of the elements are delivered.
Services revenue provided under fixed price contracts is generally recognized using the percentage-of-completion method of accounting described above. Revenue from other services provided pursuant to time-and-materials contracts is recognized as the services are performed.
Annual maintenance revenue is recorded as deferred revenue and is recognized ratably over the service period, which is generally 12 months. Revenue from training services is recognized as the training services are performed. When maintenance or training services are bundled with the original license fee arrangement, their fair value is deferred and recognized during the periods such services are provided.
The Company may encounter budget and schedule overruns on fixed price contracts caused by increased material, labor or overhead costs. Adjustments to cost estimates are made in the periods in which the facts requiring such revisions become known. Estimated losses, if any, are recorded in the period in which current estimates of total contract revenue and contract costs indicate a loss.
For contracts entered into prior to January 1, 1998, the Company recognized revenue in accordance with Statement of Position 91-1, "Software Revenue Recognition." The Company's revenue recognition was substantively the same as that discussed above.
RESULTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1999 COMPARED TO THE YEAR ENDED DECEMBER 31, 1998
Revenue. Total revenue increased 9% from $37.2 million in 1998 to $40.5 million in 1999. License fees and related services revenue declined 20% although the Company added new customers in fourth quarter of 1999, primarily because the demand for LNP systems declined as the wire line portion of the telecommunications industry substantially completed implementation of LNP in 1998. Other services revenue, consisting primarily of custom system development revenue, increased 19% from $27.1 million in 1998 to $32.3 million in 1999 as the Company focused on other services to counteract the software revenue shortfall. As a percentage of revenue, license fees and related services revenue declined from 27% in 1998 to 20% in 1999. Other services revenue increased from 73% in 1998 to 80% in 1999.
Cost of Revenue. Cost of revenue consists primarily of personnel costs, equipment depreciation, facilities costs and the cost of third party software. Cost of license fees and related services decreased by $54,000, or 1%, even though the related revenue declined by 20% for the year ended December 31, 1999. Cost of revenue was favorably impacted as a result of lower cost of sales for certain arrangements where services were minimal. This favorable impact was offset as the Company maintained a relatively consistent labor base and facilities compared to the prior year. As a result of the consistent cost base and declining revenues, the gross margin on license fees and related services declined to a negative 1% for the year ended December 31, 1999 compared to 19% for the year ended December 31, 1998. In the fourth quarter of 1998, the Company recorded $302,000 in additional costs in connection with a contract for which all revenue had previously been recorded. The cost of revenue for other services decreased 1% in 1999 even though revenue increased 19%. The gross margin for other services improved from 30% to 42% for the years ending December 31, 1998 and December 31, 1999, respectively, as staff utilization rates improved.
Sales and Marketing. Sales and marketing expenses consist primarily of compensation costs (including commissions), travel expenses, field sales office expenses and marketing communication expenses. Sales and marketing expenses decreased by $1.2 million, or 21%, to $4.5 million for the year ended December 31, 1999 from $5.7 million for the year ended December 31, 1998. The decrease was primarily due to the Company's refocus of sales plans that reduced promotion expenses. In the second half of 1999, the Company increased the sales staff, causing the 4th quarter 1999 expenses to increase substantially.
General and Administrative. General and administrative expenses consist principally of compensation costs for administration, facilities, finance, legal, human resources, quality assurance and general management personnel. General and administrative expenses increased by $1.1 million or 13% to $9.7 million for the year ending December 31, 1999 from $8.6 million for the year ended December 31, 1998. The increase in cost was attributable to increased real estate rents, property taxes and insurance premium costs.
Research and Development. Research and development expenses consist primarily of compensation costs, equipment and software development tools. Research and development expenses decreased 85%, or $6.1 million to $1.1 million in the year ended December 31, 1999, from $7.2 million in the year ended December 31, 1998. As a percentage of revenue, research and development decreased from 19% in 1998 to 3% in 1999. This decrease resulted from the Company's change in product development strategy of next generation software products as well as significant research and development cost being recorded in 1998 to complete the LNP product line.
Other Income (expense), Net. Other expense, net of other income, includes interest expense on the Company's debt financing and capital leases and interest income on cash. The net expense increased to $2.4 million in the year ended December 31,1999, from $60,000 in the year ended December 31, 1998 as a result of the $3.2 million settlement of the shareholder lawsuit including $719,000 in associated legal fees. (See Item 3, Legal Proceedings)
Extraordinary Item. The Company recorded an extraordinary item of $445,702 net of taxes relating to early retirement penalties and the write off of capitalized debt issue costs resulting from the repayment of debt associated with completion of the Company's initial public offering in the year ended December 31, 1998. The Company recorded a tax benefit of $220,000 relating to the extraordinary item.
Provision for (benefit from) Income Taxes. The Company has recorded a partial valuation allowance against its carryforward tax benefits to the extent that it believes that it is more likely than not that all of such benefits will not be realized in the foreseeable future. The Company's assessment of this valuation allowance was made using all available evidence, both positive and negative. In particular, the Company considered both its historical results and its projections of profitability for only reasonably foreseeable future periods. The Company recorded no income tax benefit related to 1999 operating losses as management deems it inappropriate to book such benefits until projected operating results reflect greater certainty of profitability and the ability to realize such benefits. The Company's realization of its recorded net deferred tax assets is dependent on future taxable income and therefore, the Company is not assured that such benefits will be realized.
RESULTS OF OPERATIONS--YEAR ENDED DECEMBER 31, 1998 COMPARED TO THE YEAR ENDED DECEMBER 31, 1997
Revenue. Total revenue decreased 13% from $42.7 million in 1997 to $37.2 million in 1998. License fees and related services revenue declined 49% because the demand for LNP systems declined as the wire line portion of the telecommunications industry substantially completed implementation of LNP in 1998. Other services revenue, consisting primarily of custom system development revenue, increased 19% from $22.7 million in 1997 to $27.0 million on 1998 as the Company focused on other services to counteract the software revenue shortfall. As a percentage of revenue, license fees and related services revenue declined from 47% in 1997 to 27% in 1998. Other services revenue increased from 53% in 1997 to 73% in 1998.
Cost of Revenue. Cost of revenue consists primarily of personnel costs, equipment depreciation, facilities costs and the cost of third party software. Cost of license fees and related services increased by $1.9 million, or 30% even though the related revenue declined by 49% for the year ended December 31, 1998 as the Company incurred considerable labor expenses due to underutilization of personnel assigned to LNP projects. As a result, the gross margin on license fees and related services declined to 19% for the year ended December 31, 1998 compared to 68% for the year ended December 31, 1997. In the fourth quarter of 1998, the company recorded additional costs in connection with a contract for which all revenue had previously been recorded. The cost of revenue for other services decreased .2% in 1998 even though revenue increased 19%. The gross margin for other services improved from 17% to 30% for the years ending December 31, 1997 and December 31, 1998, respectively, as staff utilization rates improved.
Sales and Marketing. Sales and marketing expenses consist primarily of compensation costs (including commissions), travel expenses, field sales office expenses and marketing communication expenses. Sales and marketing expenses increased by $295,000, or 6%, to $5.4 million for the year ended December 31, 1998 from $5.1 million for the year ended December 31, 1997. The increase was primarily due to the Company's continued active sales efforts for its next generation products.
General and Administrative. General and administrative expenses consist principally of compensation costs for administration, facilities, finance, legal, human resources, quality assurance and general management personnel. General and administrative expenses increased to 23% of revenue from 20% of revenue for the years ending December 31, 1998 and December 31, 1997, respectively. The increase in cost was attributable to turnover in staffing at all levels of the Company resulting in increased severance and recruiting costs. In absolute dollars, general and administrative expense remained flat from 1997 to 1998.
In October 1998, Mr. Abramson, the CEO of the Company, resigned and was replaced by Mr. Hallenbeck, the former CEO and co-founder of the Company. Shortly thereafter, the CFO resigned and was replaced by a new hire from outside of the Company and several other management changes occurred through out late 1998. As a result of these management changes an expense of $378,981 in severance costs.
Research and Development. Research and development expenses consist primarily of compensation costs, equipment and software development tools. Research and development expenses increased 147%, or $4.3 million in the year ended December 31, 1998, from $2.9 million in the year ended December 31, 1997. As a percentage of revenue, research and development increased from 7% in 1997 to 19% in 1998. This increase resulted from the Company's continued commitment to the development of next generation software products as well as significant research and development cost being recorded as cost of sales in 1997.
Other Income (expense), Net. Other expense, net of other income, includes interest expense on the Company's debt financing and capital leases and interest income on cash. The net expense declined 96% from $1.4 million in the year ended December 31,1997, to $60,000 in the year ended December 31, 1998 as a result of debt being retired from the proceeds of the initial public offering of common stock in the second quarter of 1998, and the increase in interest income as a result of investing those proceeds.
Extraordinary Item. The Company recorded an extraordinary item of $445,702 net of taxes relating to early retirement penalties and the write off of capitalized debt issue costs resulting from the repayment of debt associated with completion of the Company's initial public offering. The Company recorded a tax benefit of $220,000 relating to the extraordinary item. A similar charge was not recorded in 1997.
Provision for (benefit from) Income Taxes. The Company has recorded a partial valuation allowance against its carryforward tax benefits to the extent that it believes that it is more likely than not all of such benefits will not be realized in the foreseeable future. The Company's assessment of this valuation allowance was made using all available evidence, both positive and negative. In particular, the Company considered both its historical results and its projections of profitable for only reasonably foreseeable future periods. The Company's realization of its recorded net deferred tax assets is dependent on future taxable income and therefore, the Company is not assured that such benefits will be realized.
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically financed its operations through a combination of cash flow from operations and borrowings. On May 12, 1998, the Company completed its initial public offering of common stock and subsequently repaid most outstanding borrowings. At December 31, 1999, the Company's principal sources of liquidity included $4.3 million in cash and cash equivalents, $18.0 million in short term investments, and a $5.0 million secured bank line of credit, which expires in September 2000. As of December 31, 1999, the Company had no outstanding balance under the line of credit and the Company was in compliance with all related covenants.
Net cash provided by operating activities was $5.9 million in the year ended December 31, 1999 compared to a cash usage of $14.4 million in the year ended December 31, 1998. The main contributors to cash from operations in the year ended December 31, 1999 were funding deposits from customers on new projects and a decrease in contract receivables net of a large increase in unbilled work in progress due to an earlier cutoff for receivable billings in 1999 as part of the Y2K preparedness program.
Net cash used in investing activities during the years ended December 31, 1999 and December 31, 1998 was $13.2 million and $9.1 million, respectively, to fund purchases of short term investments and purchases of equipment to support operations. The Company purchased $11.1 million, net of sales, in short-term investments as part of treasury management to increase interest income in the year ended December 31, 1999.
Financing activities used $155,000 in cash in the year ended December 31, 1999 compared to providing $34.0 million in the year ended December 31, 1998. The Company's initial public offering generated approximately $48 million and all outstanding debt of the Company, except for capital lease obligations, was repaid during 1998. The Company continued to retire outstanding equipment leases in 1999.
The Company believes that its current cash and short-term investments, together with anticipated cash flow from operations and its existing credit facilities, and the remaining net proceeds from the initial public offering will be sufficient to meet its working capital and capital expenditure requirements for at least the next twelve months. Thereafter, the Company may require additional funds to support such activity through public or private equity financing or from other sources. There can be no assurance that additional financing will be available at all or that if available, such financing will be obtainable on terms favorable to the Company and would not be dilutive.
Impact of Inflation. Inflation has not had a significant effect on the Company's operations during the past three years ended December 31, 1999.
Impact of the Year 2000 Issue. To date, the Company has not been significantly adversely affected by the Year 2000 computer issues. The Company formed a Year 2000 project team early in 1999 and implemented a comprehensive project plan to identify internal and external information technology and non- information technology systems which required modification or upgrade to be made Year 2000 ready. As part of the plan, the Company analyzed and tested its software products and corrected for Year 2000 issues prior to December 31, 1999. All products functioned across the millennium crossover without incident. The Company developed and tested contingency plans which identified workarounds in the event of malfunction of a system designated as a priority. These contingency plans were in place, but none was required to be enacted. Furthermore, there were no significant Year 2000 issues with the Company's internal software, hardware, or infrastructure.
The Company recently received a request from one of its customers concerning patent claims made against the customer by Bruce Dickens. Mr. Dickens asserts a patent to a "windowing" technique that was used by many companies to resolve Year 2000 issues. The Company believes that it has adequate defenses to any claims from its customer.
Costs: Funding of all Year 2000 efforts was expensed as occurred. The Company has spent approximately $1 million dollars. The Company believes that any additional resources needed to address Year 2000 issues will not be material. However, there any be no assurance that currently unidentified Year 2000 issues, if any, will not arise; that these issues will not have a material adverse effect on the Company; or, that additional resources needed to address Year 2000 issues will not be material.
Recent Accounting Pronouncements
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes methods of accounting for derivative financial instruments and hedging activities related to those instruments as well as other hedging activities. SFAS No. 133, as amended, is effective for fiscal years beginning after June 15, 2000. To date, we have not entered into any derivative financial instruments or hedging activities.
In December 1999, the SEC issued Staff Accounting Bulletin No. 101 (SAB 101), "Revenue Recognition in Financial Statements." SAB 101 provides specific guidance, among other things, as to the recognition of revenue related to up- front non-refundable fees and services charges received in connection with a contractual arrangement. We have applied the provisions of SAB 101 for the year ended December 31, 1999. The adoption of SAB 101 did not have a material impact on our financial condition or results of operations.
Item 8.
Item 8. Consolidated Financial Statements and Supplementary Data
The consolidated financial statements and related notes thereto required by this item are listed and set forth herein beginning on page.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
Incorporated by reference to the section of the Company's 2000 Proxy Statement, anticipated to be filed within 120 days of December 31, 1999, entitled "Proposal 1--Election of Directors," and the section entitled "Management."
Item 11.
Item 11. Executive Compensation
Incorporated by reference to the section of the Company's 2000 Proxy Statement, anticipated to be filed within 120 days of December 31, 1999, entitled "Executive Compensation."
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management
Incorporated by reference to the section of the Company's 2000 Proxy Statement, anticipated to be filed within 120 days of December 31, 1999, entitled "Security Ownership of Certain Beneficial Owners and Management."
Item 13.
Item 13. Certain Relationships and Related Transactions
Incorporated by reference to the section of the Company's 2000 Proxy Statement, anticipated to be filed within 120 days of December 31, 1999, entitled "Certain Relationships and Related Transactions."
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) The following documents are filed as part of this Annual Report on Form 10-K.
1. Consolidated Financial Statements: The consolidated financial statements of Evolving Systems, Inc. are included as Appendix F of this report. See Index to Consolidated Financial Statements on page.
2. Financial Statement Schedules.
3. Exhibits.
- -------- + Incorporated by reference to the Registrant's Registration Statement on Form S-1 No. 333-43973. * Indicates each management contract or compensatory plan or arrangement required to be filed as an exhibit to this Form 10-K.
(b) Reports on Form 8-K.
The Company filed a current report on Form 8-K dated November 3, 1999 describing the appointment of James M. Ross to President and Chief Operating Officer and also naming him as a director of the Company.
The Company filed a current report on Form 8-K dated July 8, 1999 describing the adoption of a Rights Plan.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned; thereunto duly authorized, on the 20th day of March, 2000.
Evolving Systems, Inc.
By: /s/ George A. Hallenbeck George A. Hallenbeck Chief Executive Officer (Principal Executive Officer)
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints George A. Hallenbeck and Anita T. Moseley, or any of them, his or her attorney-in-fact, each with the power of substitution, for him or her in any and all capacities, to sign any amendments to this Report, and to file the same, with exhibits thereto and other documents in connections therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that each of said attorneys-in-fact, or his or her substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
EVOLVING SYSTEMS, INC.
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of Evolving Systems, Inc.
In our opinion, the accompanying balance sheets and the related statements of operations, statement of changes in stockholders' equity and statement of cash flows present fairly, in all material respects, the financial position of Evolving Systems, Inc. at December 31, 1999 and 1998 and the results of its operations and its cash flows for the three years in the period ended December 31, 1999, in conformity with accounting principles generally accepted in the United States. 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 of these statements in accordance with auditing standards generally accepted in the United States which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above.
PricewaterhouseCoopers LLP
Broomfield, Colorado March 1, 2000
EVOLVING SYSTEMS, INC.
BALANCE SHEETS
The accompanying notes are an integral part of these financial statements.
EVOLVING SYSTEMS, INC.
STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these financial statements.
EVOLVING SYSTEMS, INC.
STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
The accompanying notes are an integral part of these financial statements.
EVOLVING SYSTEMS, INC.
STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS
1. Organization and Summary of Significant Accounting Policies
Organization
The Company designs, develops, markets and supports OSS products and solutions for the telecommunications industry and provides a broad range of both fixed price and time and materials software solutions. The Company provides these systems and software products through a combination of its own proprietary software integrated with software packages purchased from other companies to form complete software solutions for its customers.
Initial Public Offering
In May 1998, the Company completed an initial public offering (IPO). Of the 5.3 million shares of common stock sold to the public at $14.00 per share, the Company issued 3.8 million shares and selling shareholders sold 1.5 million shares. The Company realized approximately $48 million from the offering after deducting expenses of the offering of approximately $5.2 million.
Use of Estimates
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting period. Significant estimates have been made by management with respect to the collectibility of accounts receivable and the estimates to complete long-term contracts. Actual results could differ from these estimates.
Revenue Recognition
For contracts entered into subsequent to January 1, 1998, the Company recognizes revenue in accordance with the provisions of Statement of Position 97-2, "Software Revenue Recognition". The Company derives revenue from license fees and services under the terms of both fixed price and time and materials contracts. License fees and related services revenue consists of revenue from contracts involving the Company's LNP software products and related services. Other services revenue consists of revenue from custom programming, systems integration of third party products, annual maintenance contracts and training.
License fees and related services revenue is generated from fixed price contracts that provide for both licenses and services. Revenue under these arrangements, where the services are essential to the functionality of the delivered software, is generally recognized using the percentage-of-completion method of accounting. The percentage of completion for each contract is determined based on the ratio of direct labor hours incurred to total estimated direct labor hours. Amounts billed in advance of services being performed are recorded as unearned revenue. Unbilled work in-progress represents revenue earned but not yet billable under the terms of the fixed price contracts and all such amounts are expected to be billed and collected during the succeeding 12 months.
In arrangements where the services are not essential to the functionality of the delivered software, the Company recognizes license revenue when a license agreement has been signed, delivery has occurred, the fee is fixed or determinable and collectibility is probable. Where applicable, fees from multiple element arrangements are unbundled and recorded as revenue as the elements are delivered to the extent that vendor specific objective evidence of fair value exists. If vendor specific objective evidence of fair value does not exist, fees from such arrangements are deferred until the earlier of the date that vendor specific objective evidence of fair value does exist or all of the elements are delivered.
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Services revenue provided under fixed price contracts is generally recognized using the percentage-of-completion method of accounting described above. Revenue from other services provided pursuant to time-and-materials contracts is recognized as the services are performed.
Annual maintenance revenue is recorded as deferred revenue and is recognized ratably over the service period, which is generally 12 months. Revenue from training services is recognized as the training services are performed. When maintenance or training services are bundled with the original license fee arrangement, their fair value is deferred and recognized during the periods such services are provided.
The Company may encounter budget and schedule overruns on fixed price contracts caused by increased material, labor or overhead costs. Adjustments to cost estimates are made in the periods in which the facts requiring such revisions become known. Estimated losses, if any, are recorded in the period in which current estimates of total contract revenue and contract costs indicate a loss.
For contracts entered into prior to January 1, 1998, the Company recognized revenue in accordance with Statement of Position 91-1, "Software Revenue Recognition." The Company's revenue recognition was substantively the same as that discussed above.
Software Research and Development Costs
Expenditures for software research and development are expensed as incurred. Such costs are required to be expensed until the point that technological feasibility of the product is established after which time such costs are capitalized until general availability of the product. The period between achieving technological feasibility and the general availability of such software has historically been short. Consequently, costs otherwise capitalizable after technological feasibility is achieved are expensed because they are insignificant.
Cash and Cash Equivalents
All highly liquid investments and investments with a maturity of three months or less when purchased are considered to be cash equivalents. All cash equivalents are carried at cost, which approximates fair value. Short-term investments consist of high grade commercial paper, maturing within one year. Such short-term investments are classified as held-to-maturity and accordingly carried at amortized cost.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash and cash equivalents, short term investments and accounts receivable. The Company has cash investment policies that limit investments to investment grade securities and certificates of deposit. The Company performs ongoing evaluations of its customers' financial condition and, generally, requires no collateral from its customers. During the years ending December 31, 1997, 1998 and 1999, the Company recognized approximately 89%, 87% and 84% of total revenue from six, six and five customers, respectively, all in the telecommunications industry. As of December 31, 1998 and 1999, these customers accounted for 92% and 78% of contract receivables, respectively.
Fair Value of Financial Instruments
For certain of the Company's financial instruments, including cash and cash equivalents, certificates of deposit, contract receivables, accounts payable and accrued expenses, management believes that the carrying amounts approximate fair value due to their short maturities. Additionally, based on borrowing rates currently available to the Company for debt agreements with similar terms and average maturities, management believes the carrying amount of the notes payable to the bank approximates fair market value.
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
Property and Equipment
Property and equipment are stated at cost and are depreciated over their estimated useful lives, generally four to seven years or the lease term, if shorter, using the straight-line method. Leasehold improvements are stated at cost and are depreciated over the life of the leases using the straight-line method.
Stock-based Compensation
The Company applies Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" (APB No. 25), in accounting for stock based compensation arrangements. The Company has included the pro-forma disclosures required under SFAS No. 123 in Note 4.
Income Taxes
Deferred tax assets and liabilities are recorded for the estimated future tax effects of temporary differences between the tax bases of assets and liabilities and amounts reported in the accompanying balance sheets, as well as operating loss and tax credit carryforwards. Deferred tax assets may be reduced by a valuation allowance if based on the weight of available evidence it is more likely than not that these benefits will not be realized.
Earnings Per Common Share
Basic earnings per share (EPS) is computed by dividing net income by the weighted average number of shares outstanding during the period. Diluted EPS is computed using the weighted average number of shares outstanding plus all dilutive potential common shares outstanding.
The following is the reconciliation of the numerators and denominators of the basic and diluted EPS computations for the years ended December 31:
All options and warrants outstanding during 1998 and 1999 were excluded from computation of diluted EPS because of their anti-dilutive effect on the net loss per share.
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
2. Balance Sheet Components
Certain balance sheet components are as follows:
Included in property and equipment at December 31, 1998 and 1999 are assets under capital lease of $10,308,106 and $2,786,429, respectively. Related accumulated depreciation is $8,239,850 and $2,400,813 as of December 31, 1998 and 1999, respectively.
3. Long-term Obligations, Including Related Party Obligations and Commitments
Long-term obligations, including capitalized lease obligations, consist of the following:
Line of Credit to Bank
Under a borrowing arrangement with a bank, the Company has a revolving line of credit with $5,000,000 of maximum available credit at December 31, 1999 which bears interest at the bank's prime rate. The line of credit is collateralized by short-term commercial paper investments of $5,920,111. No borrowings were outstanding under the line of credit at December 31, 1998 or 1999.
The Company also had a term debt facility under which the Company could draw up to a maximum of $5,000,000. The term debt facility expired September 16, 1999 and there were no borrowings against the facility at the time of termination.
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The Company had no additional debt covenants or debt facilities as of December 31, 1999.
Extraordinary Item
In connection with the early retirement in 1998 of notes payable to stockholders and senior subordinated promissory notes payable to stockholders, the Company recorded an extraordinary loss of $445,702, net of $220,000 in tax benefit. The extraordinary loss is comprised of the prepayment penalties and the write-off of capitalized debt issuance costs.
Lease Commitments
The Company leases its office and operating facilities and various equipment under non-cancelable operating leases. Rent expense was $3,746,954, $3,804,613 and $1,916,912 for the years ended December 31, 1997, 1998 and 1999, respectively. Rent expense is net of sublease rental income of $1,276,419, $515,638 and $1,110,826 for the years ending December 31, 1997, 1998, and 1999, respectively. In connection with its obligations under certain of its office facility leases, the Company has letters of credit totaling $664,216 and $100,000 outstanding at December 31, 1998 and 1999, respectively.
Future minimum non-cancelable commitments as of December 31, 1999 for capital leases and non-cancelable operating leases with initial terms in excess of one year are as follows:
4. Stock Options and Employee Stock Purchase Plan
Stock Options
On January 19, 1996, the Company's board of directors approved a stock option plan. Under the stock option plan, 4,350,000 shares of the Company's common stock are reserved for issuance, of which 528,302 shares are available for grant as of December 31, 1999. The Company has also reserved 910,633 shares of common stock for the issuance of warrants. Options issued under the stock option plan shall be at the discretion of the Board of Directors, including the provisions of each stock option granted, which need not be identical. Options generally vest over four years and expire no more than ten years from the date of grant. Certain options were automatically vested upon the effectiveness of the IPO. On December 30, 1997 the Board of Directors approved the repricing of all options granted from September 1, 1997 through December 30, 1997 to
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
a new exercise price of $9.50. On September 25, 1998, 61,734 stock options for non-officer employees were repriced to $2.75, the fair market value at that date. On November 5, 1998, 238,250 options for officers were repriced to $2.75, a price above the fair value at that date but equal to the price set for non- officer employees. No compensation expense was recorded, as the options were repriced to an exercise price greater than or equal to fair market.
Generally, stock options are granted with an exercise price not less than fair value of common stock as determined by the Board of Directors at the date of grant, and accordingly no compensation cost was recognized prior to 1997. During the year ended December 31, 1997, the Company recorded $1,347,534 as deferred compensation, representing the excess of the deemed fair value of the Company's common stock over the exercise price of options granted during 1997. Such deferred compensation cost is being amortized over the vesting period of the options. Of the total amount, $416,663 and $255,015 were recognized as expense during the years ended December 31, 1998 and 1999, respectively.
Based on calculations using the minimum value and Black-Scholes option- pricing models, the weighted average grant date fair value of options and warrants was $1.29, $1.76 and $3.40 in 1997, 1998 and 1999, respectively. The fair value has been estimated using the minimum value and Black-Scholes option- pricing models with the following assumptions used for grants in 1997, 1998 and 1999, respectively: no dividend yield for all periods; an expected life of 3 years for all periods; volatility of 0%, 104% and 91%; and weighted average risk free interest rates of 6.3%, 4.7%, and 5.8%.
The pro forma impact on the Company's net income (loss) and net income (loss) per share had compensation cost been recorded at the date of grant based on the method prescribed by SFAS No. 123 is shown below:
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The status of total stock options and warrants outstanding and exercisable under the Plan as of December 31, 1999 follows:
The following is a summary of stock option activity:
Included in total options and warrants exercisable at December 31, 1997, 1998 and 1999, are 910,633 warrants issued in connection with a 1996 debt financing. The warrants are exercisable at $.80 per share and expire May 31, 2003. Subsequent to December 31, 1999, the Company granted options to purchase 121,500 shares of common stock at a weighted average exercise price of $9.16 per share.
Employee Stock Purchase Plan
Under the Employee Stock Purchase Plan, the Company is authorized to issue up to 350,000 shares of common stock to its full-time employees, nearly all of whom are eligible to participate. Under the terms of the plan, employees may elect to have up to 15% of their gross salaries withheld by payroll deduction to purchase the Company's common stock. The purchase price of the stock is 85% of the lower of market price at the beginning or end of each six-month participation period. Under the plan employees purchased 66,143 and 94,377 shares in 1998 and 1999, respectively.
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The fair value of each stock purchase plan grant was estimated on the date of grant using the Black-Scholes model with the following assumptions for 1998 and 1999 respectively: no dividend yield for all periods; an expected life of .14 years and .5 years, and .49 years and .5 years; volatility of 104% and 91%; and a risk free interest rate of 5.5% and 5.62%.
5. Income Taxes
The provision for (benefit from) income taxes consists of the following:
Of the total 1998 benefit from income taxes, $220,000 is reflected in the extraordinary item on the income statement.
Components of the Company's deferred tax assets and liabilities are as follows as of December 31:
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The provision for (benefit from) income taxes differs from the amounts computed by applying the federal statutory rate to loss before income taxes and extraordinary item. The amounts are reconciled as follows for the years ended December 31:
The tax effect of $220,000 related to the extraordinary item in 1998 approximates the federal statutory rate.
As of December 31, 1999, the Company has research and development tax credit carryforwards for federal income tax purposes of $1,701,244, which begin to expire in 2011. Additionally, the Company has net operating loss carryforwards of $16,258,022 which expire beginning in 2018.
The Company has recorded a partial valuation allowance against its carryforward tax benefits to the extent that it believes that it is more likely than not all of such benefits will not be realized in the foreseeable future. The Company's assessment of this valuation allowance was made using all available evidence, both positive and negative. In particular, the Company considered both its historical results and its projections of profitability for only the reasonably foreseeable future periods. The Company's realization of its recorded net deferred tax assets is dependent on future taxable income and therefore, the Company is not assured that such benefits will be realized.
6. Benefit Plans
The Company has established a 401(k) Plan that is available to all employees 21 years of age or older with one quarter year service to the Company. Employees may contribute up to 15% of gross compensation not to exceed the maximum statutory contribution amount. The Company may make discretionary matching contributions and has done so. All employee contributions are fully vested immediately and employer contribution vest 100% after completion of three years service. During 1997, 1998 and 1999, the Company contributed $1,017,896, $1,244,842 and $1,250,480 respectively, under the 401(k) Plan.
7. Legal Proceedings
In June 1998, four securities class action complaints were filed against the Company and certain of its current and former officers and directors in the Federal Court for the District of Colorado alleging violations of the federal securities laws. The complaints were consolidated. The plaintiffs purported to represent a class of persons who purchased the Company's securities during the period of May 12, 1998 through July 23, 1998. The complaints alleged that the Company and certain of its officers misled the investing public regarding the financial prospects of the Company. The Company denied these allegations. The parties reached a settlement of $10 million, of which the Company paid $2.5 million in April 1999. The settlement was approved by the Court on October 4, 1999. The Company incurred approximately $719,000 in legal costs associated with the lawsuit.
EVOLVING SYSTEMS, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
The Company is currently involved in a dispute with an employee concerning amounts allegedly owed to the employee in connection with his employment. The Company believes the employee's claims are without merit and the parties are currently seeking to resolve the dispute through mediation. Although it is too early to evaluate the outcome of this dispute, in the event the parties are unable to reach a mutually agreeable resolution and the employee subsequently succeeds in his claim, the outcome could have a material adverse effect on the Company's business, financial condition and results of operation.
From time to time the Company is involved in various legal proceedings arising in the normal course of business operations. Management does not expect that any such proceedings will have a material adverse effect on the Company's financial position or results of operations.