ITEM 1. BUSINESS
General
Pharsight Corporation develops and markets software and provides consulting services that help pharmaceutical and biotechnology companies improve drug development decision making by reducing the costs and time of drug development and commercialization. Our products include proprietary software for clinical trial simulation and computer-aided trial design, the statistical analysis and mathematical modeling of data, the automation of scriptable pharmacokinetic data analysis, the storage, management, and regulatory reporting of derived data and models in data repositories, the validation of regulatory workflows, and the visualization of drug-disease simulations. Pharsight uses expertise in the sciences of pharmacology, drug and disease modeling, biostatistics and strategic decision-making. Our service offerings use this expertise to interpret and improve the design of scientific experiments and clinical trials and to optimize clinical trial design and portfolio decisions. By integrating scientific, clinical, and business decision criteria into a dynamic model-based methodology, we help our customers to optimize the value of their drug development programs and portfolios from discovery to post-launch marketing
Our goal is to enable pharmaceutical and biotechnology companies to reduce the time, cost and risks of drug development activities and improve the value of approved medicines. Our products and services are designed to help our customers use a more rigorous scientific and statistical process to identify earlier drug candidates that will not be successful, to enhance the likelihood that the remaining candidates will successfully complete clinical trials, and to maximize marketing impact upon approval. This process is significant because clinical development time has remained lengthy and unpredictable while the productivity of molecule discovery research has accelerated dramatically in recent years.
Our Strategic Consulting Services are used by 20 of the world’s largest 50 pharmaceutical companies. In addition, all of the world’s largest 50 pharmaceutical companies use our software products. Our software products are currently licensed for use on more than 6,700 researcher desktops.
We believe our products and services provide the following benefits to customers:
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Reduced time required for the validated transformation, analysis, and reporting of information required for drug approval;
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More effective trial designs with higher probability of success and greater information yield;
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More rapid, robust and objective decision-making with wider data availability and quantified assessment of value versus risk;
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Improved workflow and organizational efficiency with faster regulatory acceptance of trial results;
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Faster, more cost-effective validation of analysis and reporting workflows;
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More efficient development programs requiring fewer clinical trials and patients, less time and lower cost to reach the market; and
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Strengthened competitive position due to improved product labels and earlier opportunity to establish a competitive franchise.
The following illustrates several typical customer applications of our software products and services:
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In designing phase II clinical trials, companies often face significant uncertainty in selecting the appropriate doses to test. Our products and services integrate information from phase I and pre-clinical activities, information concerning related drugs that have been developed by the customer, information in scientific literature about other drugs in the same therapeutic area, and knowledge of the relevant physiological and disease processes. This information, along with carefully identified assumptions, is used to develop a mathematical model enabling a computer simulation of the proposed trial. Using this approach, customers are often able to identify proposed doses that have little chance of success and should be excluded, or to identify additional doses that are more likely to yield important information.
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In designing phase III clinical trials, companies often face significant uncertainty concerning the most appropriate treatment strategy, patient inclusion/exclusion criteria and/or clinical measurements. Our products and services for phase III clinical trials use an information gathering and modeling approach similar to that described for the phase II clinical trials above, but incorporate phase II data and detailed mathematical models of the intended patient populations. Our products and services are often able to identify patient groups unlikely to show efficacy, or groups with an unacceptable chance of demonstrating side effects, prior to conducting the actual trial. In addition, we may be able to predict which clinical measurements will be most likely to provide conclusive results in the proposed trial.
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In making drug portfolio decisions, companies need to integrate scientific and clinical results, such as those described above, with market and financial information for all of the drug candidates in the development pipeline. We believe that our products and services help companies make better decisions concerning “go/no-go” criteria, prioritization of potential label objectives to be pursued and optimal sequencing of clinical trials within a development program. Our products and services can also help customers adopt a more quantitative and scientific approach to resource allocation among programs within their drug portfolios.
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The production of industry standard pharmacokinetic, or PK, reports required by the United States Food and Drug Administration, or FDA, for a new drug submission are often time consuming, costly, and effort intensive. Much of an individual scientist’s time in a typical client organization may be involved with tasks such as data preparation needed for analysis, display of PK analysis in reports, and the quality control measures needed to ensure correct information is presented to the FDA. These tasks may reduce time available to focus on the quality and impact of the scientific decisions that drive compound development. The lack of industry standards and an integrated software platform to drive the adoption and automation of standards can often lead to lengthy report cycles and delays in regulatory submissions. By deploying our Pharsight Knowledgebase Server, or PKS, suite of applications and services (WinNonlin, IVIVC Toolkit for WinNonlin, WinNonlin Validation Suite, PKS Reporter, PKS
Validation Suite, WinNonlin AutoPilot, and PK Automation), we believe our clients can achieve sustainable productivity improvements in their regulatory submission process. Our PKS data repository affords integration to legacy laboratory and clinical data sources, reducing the time needed for data preparation prior to analysis by our clients’ scarce scientific resources. The PKS suite seamlessly integrates PKS with WinNonlin, PKS Reporter, and third-party applications and provides the opportunity to automate a majority of the standard PK reports required by the FDA.
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We believe many of our clients have achieved significant productivity improvements in creation of standard PK reports, including significant reductions in report cycle time, along with improvements in quality and consistency of analysis and display of analytical results. As a result of these increases in productivity, we believe our clients are able to reallocate resources to other aspects of the drug development process.
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Drug Model Explorer, or DMX, supports quantitative decision making when evaluating the benefit and risk of a potential new drug in a pharmaceutical company’s versus competing therapy. Pharsight collaborated with a pharmaceutical company to build model-based projections of the competitive landscape. The modeling effort combined internal study data with published trials and FDA submissions on competing compounds to generate an integrated and quantified assessment of the drug’s likely performance. The client’s clinical development project team used DMX to evaluate and communicate the modeling results. Through DMX, the team explored clinical effects and associated uncertainty for the drug and competitors across multiple endpoints, treatments, and patient populations based on pre-simulated responses from the model-building effort. The results showed that the new drug was unlikely to outperform its main competitor, and development was discontinued in the target patient population. The modeling project supported a more confident decision without investment in additional trials, and allowed team members to re-deploy earlier to other programs. It also provided an enduring, evolving knowledge database to support future development decisions.
The use of our software and leading edge methodology developed by our strategic consulting group greatly enhances the traditional drug-development process, which is heavily dependent upon clinical trials. Although our methodology does not displace the use of human trials in drug development, we believe our software and methodology renders human trials more efficient and relevant. The continued growth of our customer base, the importance ascribed to “Model-Based Drug Development” by the FDA in its Critical Path whitepaper, the increase in the number of contracts with our existing customers, and the increase in our average contract value over time have shown a trend that we believe demonstrates increased acceptance of our methodology and an increased demand for its use. This demand can be met by increased deployment of our software and services, by proprietary solutions developed by our clients, or by increased internal resources within our customers. We believe that these trends, in addition to increasing regulatory requirements from the FDA, demonstrate a potential for increased revenue growth resulting from increased demand for our current products and services, as well as long-term opportunities to expand the breadth and coverage of both our software products and services.
Pharsight Products and Services
Pharsight provides both consulting services and computer-based drug model development and database applications. In fiscal 1997, we first offered our WinNonlin, WinNonMix and Trial Simulator applications and scientific services. At the end of fiscal 2001, we combined our scientific, decision support, methodology and training groups into an integrated group renamed Strategic Consulting Services. In fiscal 2002, we began selling our Pharsight Knowledgebase Server, providing a means of capturing and managing both summary and detailed pharmacokinetic/pharmacodynamic, data across a large set of compounds and development phases. In fiscal 2004, we introduced and began selling DMX, a software for visualizing drug model simulations. WinNonlin Validation Suit and PKS Validation Suite were introduced in fiscal 2006 to streamline validation of our WinNonlin and PKS products. IVIVC Toolkit was introduced in fiscal 2007 to expand the capabilities of WinNonlin, enabling the use of WinNonlin for in vivo-in vitro correlations. During the first quarter of fiscal 2008, we launched a new client service offering, Reporting and Analysis Services. We also introduced during the quarter WinNonlin AutoPilot to automate the creation of presentation-quality output created through WinNonlin.
In fiscal 2007, 2006 and 2005, revenues from our software product offerings and related services generated 57%, 59% and 53% of our total revenues, respectively, and revenues from our Strategic Consulting Services generated 43%, 41% and 47% of our total revenues, respectively. In fiscal 2007, 2006 and 2005, revenues from our software product offerings and related services were $14.2 million, $13.4 million and $12.1 million, respectively, and revenues from our Strategic Consulting Services were $10.9 million, $9.3 million and $10.5 million, respectively.
We operated in two business segments comprised of Software Products and Strategic Consulting Services during fiscal 2007. At the beginning of fiscal 2008, we launched Reporting and Analysis Services as our third business segment. Our revenues from external customers, profit and loss and total assets, are set forth in our financial statements, which appear in “Item 8 - Consolidated Financial Statements and Supplementary Data.” Information regarding sales to customers by major geographic regions is set forth in Note 11 to our financial statements, which appears in “Item 8 - Financial Statements and Supplementary Data.”. All of our significant long-lived assets are located within the United States.
Software Products
Our software products and software deployment and integration services provide the analytical tools, data management infrastructure, and conceptual framework to help clinical researchers optimize the decision-making required to perform the clinical testing, analysis, and reporting needed to bring drugs to market. By applying mathematical modeling and simulation to all available information regarding the compound being tested, researchers can reach reportable conclusions faster and clarify and quantify which trial and treatment design factors will influence the success of clinical trials. We have four categories of software products: Analytics Software, Data Management & Compliance Software, Validation Software and Model Visualization Software.
Analytics Software
WinNonlin and WinNonMix. These software applications are used to efficiently analyze clinical and preclinical data, allowing the creation of PK/PD models and validating the assumptions and information on which the models are based. The analysis and modeling foster better understanding of the data and better decision making with respect to dosage and dosing regimens. Such analysis is both cost-effective and required by FDA regulations for new drug submissions.
IVIVC Toolkit for WinNonlin. The IVIVC Toolkit for WinNonlin, or IVIVC Toolkit, expands the capabilities of WinNonlin, enabling the use of WinNonlin for in vivo-in vitro correlations (IVIVC). The Toolkit brings enhanced deconvolution methods, numerical convolution, new plotting capability, and the “IVIVC Wizard” to pharmacokineticists and formulators. IVIVC Toolkit for WinNonlin allows faster development of new formulations, reduces the likelihood of bioequivalence test failures, and permits easier correlations to predict pharmacokinetics from new in vitro data.
Trial Simulator. Trial Simulator uses known information about a drug, or candidate drug, and about patient populations to help design and optimize proposed clinical trial protocols. Poor protocol design may result in ambiguous trial results that fail to identify ineffective candidates early, increase expense and time in identifying successful drugs and expose trial patients to unnecessary risk. Poor protocol dosing decisions may cause the rejection of a candidate drug that might otherwise be approved at an appropriate dose. Computer-aided trial design, using Trial Simulator, cannot guarantee successful trials, but can help to improve the efficiency, required time, and likelihood of definitive and successful results.
Data Management & Compliance Software
Pharsight Knowledgebase Server. PKS provides a means of capturing and managing both summary and detailed PK/PD data across a large set of compounds and development phases. PKS also provides a unified data environment for supporting clinical pharmacology modeling, analysis and reporting activities. PKS is directly
integrated with WinNonlin and other industry standard modeling and analysis tools. PKS was developed to help enable compliance with FDA regulation 21 CFR 11, which requires electronic data security and auditing on submissions to the FDA. We believe that industry acceptance of PKS has been positively affected by the client need for efficiency gains, as well as compliance with increased regulatory requirements.
PKS Reporter. PKS Reporter addresses the need for streamlined, systematic, and automated report generation and signature. Using PKS as an underlying source of secure, regulatory-compliant report content, PKS Reporter allows researchers to use familiar tools such as WinNonlin and Microsoft Word to construct, update, review and approve any type of report. PKS Reporter is directly integrated with PKS, as both a source of report content and a secure repository for report storage and version control. PKS Reporter links reports in Microsoft Word directly to PKS, where it draws report content from data and modeling results created in WinNonlin Enterprise, NONMEM, SAS and other industry-standard modeling and analysis tools. From within Microsoft Word, researchers can browse the PKS database, loading objects and values drawn from various PKS studies and analysis scenarios. When the source data change, PKS Reporter marks its content as out of date, ready for automatic update. QA staff can automate the verification of report data by simply opening the document and selecting to have all references checked. Development teams can create standardized report templates specifying report layout, formatting and specific content elements. Report sign-off is smooth and automatically tracked with Reporter’s signature tool and e-mail notification.
WinNonlin AutoPilot. WinNonlin AutoPilot, or Autopilot, is a configurable software application for WinNonlin that automates the creation of presentation-quality clinical pharmacokinetic analysis outputs from study data to be used in standard reports. Using WinNonlin AutoPilot, companies can vastly improve their productivity while improving the quality and consistency of analyses and reports. AutoPilot provides the infrastructure and tools to manage and effectively automate common or repetitive data transformations, PK analysis, and creation of report-ready tables and graphs. Because these outputs must reflect the requirements and Statements of Procedure of each research organization, AutoPilot provides a user-interface that allows extensive configuration of formatting and business rules that apply in the generation of these analyses. Customer-defined configurations do not require changes to the underlying computer code, and are stored in a settings file that enables clear communication of standards and immediate use across the organization.
Validation Software
WinNonlin Validation Suite. The WinNonlin Validation Suite streamlines on-site validation of the WinNonlin product. The Validation Suite provides a selection of automated tests, each of which runs a specific WinNonlin analysis or function and tests the results against standardized, known output. The Validation Suite efficiently and effectively provides documentation of on-site validation activities, through automated generation of validation reports via Microsoft Word. Clients use WinNonlin Validation Suite to reduce effort and time needed for validation planning, testing, and reporting.
PKS Validation Suite. The PKS Validation Suite streamlines on-site validation of the PKS product. The Validation Suite provides document templates, test data, and a collection of automated and manual test scripts. PKS Validation Suite cannot fully validate a client’s PK workflow, as full validation depends on many factors beyond the software, however, when used as a starting point for validation efforts PKS Validation Suite can save significant time needed for validation planning, testing, and reporting.
Model Visualization Software
Drug Model Explorer. DMX is a software program that communicates the essential findings of drug models while freeing the user from the need to understand the drug model’s complex underlying mathematics. With DMX, project teams made up of physicians, marketers, and other non-modelers can visualize and explore key modeled drug attributes, and the uncertainty around those attributes, given the current state of knowledge about a development program. DMX generates views of program data from queries of underlying drug-disease models and simulated responses over a defined problem-space (e.g., treatments, endpoints, covariates and competitors).
We believe that our continued growth depends on continuing to deliver new products to our current and prospective customers. These new products must address an ever-expanding set of customer needs for clinical development of drugs and thereby expand the number of prospective users within pharmaceutical companies to whom we may sell.
Strategic Consulting Services
Our Strategic Consulting Services consist of consulting, training and process redesign conducted by our clinical and decision scientists in the application and implementation of our core decision methodology. The methodology employed by our services group uses three types of models that can work independently or in concert. Illustrative models are listed below:
• Drug-Disease Models
Our drug-disease models predicatively characterize the distribution of treatment outcomes (safety, efficacy, surrogate outcomes) for a new chemical entity, or NCE, and for competitor compounds as a function of dosing strategy, disease and patient and trial characteristics.
• Trial Models
Our trial models predict probability distributions of outcomes and show how uncertainty can be reduced through dosing strategy, number of treatment arms, type of control, sample population characteristics, sample size and treatment duration.
• Market Models
Our market models characterize the demand for products (market size and share) under different scenarios for patient benefit, cost, compliance, and other factors and their evolution over time.
By using these models in an integrated fashion, our consultants are able to place key development decisions into quantitative terms of uncertainty and value. Drug development is a process by which uncertainty about a drug’s efficacy and safety is progressively reduced. Our methodology enables customers to identify which uncertainties are greatest and matter most, and then to design development programs, trial sequences, and individual trials in such a way that those trials systematically and cost effectively reduce the identified uncertainties.
This methodology is valuable at all stages of development. The integration of our models at the asset strategy phase (overall positioning of a new drug) and program/trial strategy phase (focusing on a specific disease endpoint or other indicator) enables us to help our customers position their drugs as competitively as possible in the market to do so while avoiding unnecessary trials (and only as large, lengthy and costly as is required), and to redeploy resources away from unpromising compounds at the earliest possible decision point.
The following chart depicts typical issues that we are asked to address in strategic consulting projects throughout development and post marketing:
Phase I
Phase II/Phase III
Phase IV
• Bridge animal results to humans.
• Balance efficacy with side effects.
• Explore new indications and label changes.
• Explore dose ranging and population variability.
• Explore trial sensitivity to patient compliance and dropout.
• Plan life-cycle strategy, e.g. generic defense and “over-the-counter” switch.
• Determine surrogate endpoint relevance, i.e. alternate indicators of efficacy.
• Investigate impact of population genetic variability.
• Evaluate special patient populations.
• Support early “go/no-go” decisions.
• Evaluate alternate protocols.
• Assess strategic fit in franchise.
Our Strategic Consulting Services personnel are located throughout the United States, Europe and Australia. Most have Ph.D. degrees with post-doctoral training in medicine, clinical pharmacology, biostatistics, pharmacokinetics, mathematics, engineering, decision analysis or other relevant disciplines. Our senior consultants each have more than a decade of experience in drug disease modeling, trial design or strategic consulting. We also utilize a network of consultants with expertise in various specialized disciplines and therapeutic areas.
We believe that our continued growth is dependent upon continually refining our strategic consulting methodologies and introducing new technologies, while also expanding our activities at the portfolio level and into new therapeutic areas.
Reporting and Analysis Services
A complementary service to our Strategic Consulting Services is being launched in the first quarter of fiscal 2008. Reporting and Analysis Services addresses the full spectrum of client needs for modeling and simulation in regulatory reports such as those required in Section 5 of the Common Technical Document. These services meet growing customer demand for analysis and reporting of pharmacokinetic/pharmacodynamic data generated in clinical and preclinical studies supporting new drug approvals. These studies include toxicokinetic, single- and multiple-ascending dose, drug-drug interaction, renal and hepatically impaired, fed-fasted, bioequivalence/bioavailability, QT prolongation, and others.
Customers
Our software customers range in size from the largest pharmaceutical companies to small and medium-sized pharmaceutical and biotechnology organizations.
Our Strategic Consulting Services customers range in size from the largest pharmaceutical companies to small pharmaceutical companies, and the focus of our work differs depending upon the size and maturity of the customer. In our smaller and medium-sized customers, we tend to engage in discrete projects often with challenging analytic and design problems, where modeling and simulation can be particularly valuable. This kind of work may or may not lead to subsequent engagements. By contrast, in our largest customers, we may have ongoing relationships which are more strategic in nature, and we focus on helping improve the process by which they develop drugs, broadening and deepening the application of modeling and simulation over time, with the intent of achieving systematic, lasting performance improvement.
During our fiscal year ended March 31, 2007, we provided products and services for which we recognized revenue to more than 1,100 customers. In fiscal 2007, Pfizer Inc., or Pfizer, our largest customer, accounted for 17% of our total revenue, and Eli Lilly and Company, or Lilly, accounted for 11% of our total revenue. In fiscal 2006, Pfizer accounted for 25% of our total revenue and Lilly accounted for 17% of our total revenue. While we were successful in diversifying our customer base and reducing our dependency on Pfizer and Lilly, we are still dependent on them for a substantial portion of our revenues. If we were to lose either Pfizer or Lilly as a customer, it would have a material adverse effect on our revenues and business. See “Item 1A
ITEM 1A. RISK FACTORS
We operate in a rapidly changing economic and technological environment that presents numerous risks. Many of these risks are beyond our control and are driven by factors that we cannot predict. The following discussion, as well as our discussion above of critical accounting policies and estimates, highlights some of these risks. You should carefully consider the risks and uncertainties described below and the other information in this report before deciding whether to invest in shares of our common stock. If any of the following risks actually occur, our business, financial condition or operating results could be materially adversely affected. This could cause the trading price of our common stock to decline, and you may lose part or all of your investment.
Risks That Affect Our Future Operations
We may not be able to generate sufficient revenues to sustain profitability.
We commenced our operations in April 1995 and incurred net losses for every quarter until attaining profitability in the fourth quarter of fiscal 2004. While we have maintained annual profitability for fiscal 2005, 2006 and 2007, as of March 31, 2007, we had an accumulated deficit of $74.3 million. We may incur losses again as we continue to develop our business. Our ability to sustain profitability is based on a number of assumptions, including some outside of our control, including the state of the overall economy and the demand for our products. If these assumptions do not prove to be accurate then we may not be able to generate sufficient revenues to sustain profitability. Furthermore, even if we do sustain profitability and positive operating cash flow, we may not be able to increase profitability or positive operating cash flow on a quarterly or annual basis. If our profitability does not meet the expectations of investors, the price of our common stock may decline.
We have a limited amount of capital resources and we may not be able to sustain or grow our business if we cannot sustain profitability or raise additional funds on a timely basis.
We believe we have adequate cash to sustain operations through the next 12 months, and we are managing the business to achieve positive cash flow utilizing existing assets. However, even if we sustain profitability, we may not be able to generate sufficient profits to grow our business. As a result, we may need to raise additional funds through public or private financings or other sources to fund our operations. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness.
The terms of our credit facilities contain covenants that limit our flexibility and prevent us from taking certain actions.
The terms governing our credit facilities with Silicon Valley Bank include a number of significant restrictive covenants. These covenants could adversely affect us by limiting our ability to plan for or react to market conditions, meet our capital needs and execute our business strategy. These covenants will, among other things, limit our ability to:
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incur additional debt;
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make certain investments;
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create liens; or
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sell certain assets.
These covenants may significantly limit our operating and financial flexibility and limit our ability to respond to changes in our business or competitive activities. Our failure to comply with these covenants could result in an event of default, which, if not cured or waived, could result in our being required to repay these borrowings before their scheduled due date. In addition, Silicon Valley Bank could foreclose on our assets.
Our quarterly operating results may fluctuate significantly and may not be predictive of future financial results.
Our quarterly operating results may fluctuate in the future, and may vary from investors’ expectations, depending on a number of factors, including:
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Variances in demand for our products and services;
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Timing of the introduction of new products or services and enhancements of existing products or services;
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Our ability to complete fixed-price service contracts without committing additional unplanned resources;
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Unanticipated changes in the capacity of our services organization;
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Delays or deferrals of customer implementations of our software products;
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Delays or deferrals of client drug development processes;
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The tendency of some of our customers to wait until the end of a fiscal quarter or fiscal year in the hope of obtaining more favorable terms;
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Changes in industry conditions affecting our customers, including industry consolidation; and
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Our ability to realize operating efficiencies through restructuring or other actions.
As a result, quarterly comparisons may not indicate reliable trends of future performance.
We manage our expense levels in part based upon our expectations concerning future revenue, and these expense levels are relatively fixed in the short term. If we have lower revenue than expected, we may not be able to reduce our spending in the short term in response. Any shortfall in revenue would have a direct impact on our results of operations.
In the past we have taken actions intended to reduce our expenses on an annualized basis. Our cost reduction measures have left us with less excess capacity to deliver our products and services. If there is a significant increase in demand from what we estimate, it will take us longer to address this demand, which would limit our ability to grow our business and sustain profitability.
We may be required to defer recognition of software license revenue for a significant period of time after entering into an agreement, which could negatively impact our results of operations.
We may have to delay recognizing license revenue for a significant period of time for a variety of types of transactions, including:
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transactions that include both currently deliverable software products and software products that are under development or contain other currently undeliverable elements;
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transactions where the customer demands services that include significant modifications, customizations or complex interfaces that could delay product delivery or acceptance;
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transactions that involve non-standard acceptance criteria or identified product-related performance issues; and
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transactions that include contingency-based payment terms or fees.
These factors and other specific accounting requirements for software revenue recognition require that we have very precise terms in our license agreements to allow us to recognize revenue when we initially deliver software or perform services. Although we have a standard form of license agreement that we believe meets the criteria for current revenue recognition on delivered elements, we negotiate and revise these terms and conditions
in some transactions. Therefore, it is possible that from time to time we may license our software or provide service with terms and conditions that do not permit revenue recognition at the time of delivery or even as work on the project is completed. In fiscal 2007, software license revenue accounted for 48% of our total revenue. The majority of our large PKS software transactions include services pertaining to modification and customization of the core PKS software product, which may result in delayed revenue recognition for a significant period of time.
An increase in services revenue as a percentage of total revenue, or a decrease in software license revenue as a percentage of total revenue, may decrease our overall margins.
We realize lower margins on services revenue than on license revenue. In addition, we may contract with certain third parties to supplement the services we provide to customers, which generally yields lower gross margins than those margins generated by our deployment organization or internal scientific staff. As a result, if services revenue increases as a percentage of total revenue or if we increase our use of third parties to provide such services, our gross margins would be lower and our operating results may be adversely affected.
Because our sales and implementation cycles are long and unpredictable, our revenues are difficult to predict and may not meet our expectations or those of our investors.
The lengths of our sales and implementation cycles are difficult to predict and depend on a number of factors, including the type of product or services being provided, the nature and size of the potential customer and the extent of the commitment being made by the potential customer. Our sales cycle is unpredictable and may take six months or more. Our implementation cycle is also difficult to predict and can be longer than one year. Each of these can result in delayed revenues, increased selling expenses and difficulty in matching revenues with expenses, which may contribute to fluctuations in our results of operations. A key element of our strategy is to market our product and service offerings to large organizations. These organizations can have particularly lengthy decision-making processes and may require evaluation periods, which could extend the sales and implementation cycle. Moreover, we often must provide a significant level of education to our prospective customers regarding the use and benefit of our product and service offerings, which may cause additional delays during the evaluation and acceptance process. We therefore have difficulty forecasting the timing and recognition of revenues from sales of our product and service offerings.
Our revenue is concentrated in a few customers, and if we lose any of these customers our revenue may decrease substantially.
We receive a substantial majority of our revenue from a limited number of customers. For fiscal 2007, 2006 and 2005, sales to our top two customers accounted for 28%, 42% and 45% of total revenue, respectively and sales to our top five customers accounted for 43%, 52% and 62%. In fiscal 2007, Pfizer, our largest customer, accounted for 17% of our total revenue, and Lilly accounted for 11% of our total revenue. In fiscal 2006, Pfizer accounted for 25% of our total revenue and Lilly accounted for 17% of our total revenue. In fiscal 2005, Pfizer accounted for 25% and Lilly accounted for 20% of our total revenue. Consequently, we are dependent on Pfizer and Lilly for a substantial portion of our revenues, and if we were to lose Pfizer or Lilly as a customer, it would have a material adverse effect on our revenues and business. We expect that a significant portion of our revenue will continue to depend on sales to a small number of customers. In addition, the worldwide pharmaceutical industry has undergone, and may in the future undergo, substantial consolidation, which may further reduce the number of our existing and potential customers. If we do not generate as much revenue from these major customers as we expect to, if revenue from such customers is delayed, or if we lose any of them as customers, our total revenue may be significantly reduced.
We may need to change our pricing models to compete successfully.
The markets in which we compete can put pressure on us to reduce our prices. If our competitors offer deep discounts on certain products in an effort to recapture or gain market share, we may then need to lower prices or offer other favorable terms in order to compete successfully. Any such changes would be likely to reduce
margins and could adversely affect operating results. We have periodically changed our pricing model and any broadly based changes to our prices and pricing policies could cause service and license revenues to decline or be delayed as our sales force implements and our customers adjust to the new pricing policies. If we do not adapt our pricing models to reflect changes in customer use of our products, our revenues could decrease.
If we are unable to generate additional sales from existing customers and/or generate sales to new customers, we may not be able to realize sufficient revenues to sustain or increase our profitability.
Our success depends on our ability to develop our existing customer relationships and establish relationships with additional pharmaceutical and biotechnology companies. If we lose any significant relationships with existing customers or fail to establish additional relationships, we may not be able to execute our business plan and our business will suffer. Developing customer relationships with pharmaceutical companies can be difficult for a number of reasons. These companies are often very large organizations with complex decision-making processes that are difficult to affect. In addition, because our products and services relate to the core technologies of these companies, these organizations are generally cautious about working with outside companies. Some potential customers may also resist working with us until our products and services have achieved more widespread market acceptance. Our existing customers could also reassess their commitment to us, not renew existing agreements or choose not to expand the scope of their relationship with us.
Our revenues and results of operations would be adversely affected if a customer cancels a contract for services or software deployment with us.
Our customers can cancel many of our services agreements upon prior notice. Additionally, due to the nature of our services and deployment engagements, customers sometimes delay projects because of timing of the clinical trials and the need for data and information that prevent us from proceeding with our projects. These delays and contract cancellations cannot be predicted with accuracy and we cannot assure you that we will be able to replace any delayed or canceled contracts with the customer or other customers. If we are unable to replace those contracts, our revenues and results of operations would be adversely affected.
We may lose existing customers or be unable to attract new customers if we do not develop new products and services or if our offerings do not keep pace with technological changes.
The successful growth of our business depends on our ability to develop new products and services and incorporate new capabilities, including the expansion of our product and services offerings to address a broader set of customer needs related to clinical development of drugs and thereby expand the number of our prospective users, on a timely basis. If we cannot adapt to changing technologies, emerging and evolving industry standards, new scientific developments and increasingly sophisticated customer needs, we may not achieve revenue growth and our products and services may become obsolete, and our business could suffer. We have suffered product delays in the past, resulting in lost product revenues. In addition, early releases of software often contain errors or defects. We cannot assure you that, despite our extensive testing, errors will not be found in our products before or after commercial release, which could result in product redevelopment costs and loss of, or delay in, market acceptance. Furthermore, a failure by us to introduce new products or services on schedule could harm our business prospects. Any delay or problems in the installation or implementation of new products or services may cause customers to forego purchases from us. We may need to accelerate product introductions and shorten product life cycles, which will require high levels of expenditures of research and development that could adversely affect our operating results. A failure by us to introduce new services on a timely and cost-effective basis to meet evolving customer requirements, or to integrate new services with existing services, could harm our business prospects.
If the security or confidentiality of our customers’ data is compromised or breached, we could be liable for damages and our reputation could be harmed.
As part of implementing our products and services, we inherently gain access to certain highly confidential proprietary customer information. It is critical that our facilities and infrastructure remain secure and are
perceived by the marketplace to be secure. Despite our implementation of a number of security measures, our infrastructure may be vulnerable to physical break-ins, computer viruses, programming errors, attacks by third parties or similar disruptive problems. We do not have insurance to cover us for losses incurred in many of these events. If we fail to meet our customers’ security expectations, we could be liable for damages and our reputation could suffer.
If we are unable to complete a project due to scientific limitations or otherwise meet our customers’ expectations, our reputation may be adversely affected and we may not be able to generate new business.
Because our projects may contain scientific risks, which are difficult to foresee, we cannot guarantee that we will always be able to complete them. Any failure to meet our customers’ expectations could harm our reputation and ability to generate new business. On a few occasions, we have encountered scientific limitations and been unable to complete a project. In each of these cases, we have been able to successfully renegotiate the terms of the project with the particular customer. We cannot assure you that we will be able to renegotiate our customer agreements if such circumstances occur in the future. Moreover, even if we complete a project, we may not meet our customers’ expectations regarding the quality of our products and services or the timeliness of our services.
Our future success depends on our ability to continue to retain and attract qualified employees.
We believe that our future success depends upon our ability to continue to train, retain, effectively manage and attract highly skilled technical, scientific, managerial, sales and marketing personnel. We currently have limited personnel and other resources to staff and complete consulting and software deployment projects. In addition, as we grow our business, we expect an increase in the number of complex projects and large deployments of our products and services, which require a significant amount of personnel for extended periods of time. In particular, there is a limited supply of modeling and simulation personnel worldwide, and competition for these personnel from numerous companies and academic institutions may limit our ability to hire these persons on commercially reasonable terms. From time to time, we experience difficulties in locating enough highly qualified candidates in desired geographic locations, or with required scientific or industry-specific expertise. Staffing projects and deploying our products and services will become more difficult as our operations and customers become more geographically diverse. If we are not able to adequately staff and complete our projects, we may lose customers and our reputation may be harmed. Any difficulties we may have in completing customer projects may impair our ability to grow our business.
If we lose key members of our management, scientific or development staff, or our scientific advisors, our reputation may be harmed and we may lose business.
We are highly dependent on the principal members of our management, scientific and development staff. Our reputation is also based in part on our association with key scientific advisors. The loss of any of these personnel might adversely impact our reputation in the market and harm our business. Failure to attract and retain key management, scientific and technical personnel could prevent us from achieving our strategy and developing our products and services. In addition, our management team has experienced significant personnel changes over the past years and may continue to experience changes in the future. If our management team continues to experience attrition, high turnover, or does not work effectively together, it could harm our business. Additionally, we do not currently hold key-man life insurance policies on our CEO, CFO or other key contributors. The demise of any of these individuals could adversely impact our business.
Our business depends on our intellectual property rights, and if we are unable to adequately protect them, our competitive position will suffer.
Our intellectual property is important to our competitive position. We protect our proprietary information and technology through a combination of patent, trademark, trade secret and copyright law, confidentiality agreements and technical measures. We cannot assure you that the steps we have taken will prevent misappropriation of our proprietary information and technology, nor can we guarantee that we will be successful
in obtaining any patents or that the rights granted under such patents will provide a competitive advantage. Misappropriation of our intellectual property could harm our competitive position. We may also need to engage in litigation in the future to enforce or protect our intellectual property rights or to defend against claims of invalidity, and we may incur substantial costs as a result. In addition, the laws of some foreign countries provide less protection of intellectual property rights than the laws of the United States and Europe. As a result, we may have an increasingly difficult time adequately protecting our intellectual property rights as our sales in foreign countries grow.
If we become subject to infringement claims by third parties, we could incur unanticipated expense and be prevented from providing our products and services
We cannot assure you that infringement claims by third parties will not be asserted against us or, if asserted, will be unsuccessful. These claims, whether or not meritorious, could be expensive and divert management resources from operating our company. Furthermore, a party making a claim against us could secure a judgment awarding substantial damages, as well as injunctive or other equitable relief that could block our ability to provide products or services, unless we obtain a license to such technology. In addition, we cannot assure you that licenses for any intellectual property of third parties that might be required for our products or services will be available on commercially reasonable terms, or at all.
International sales of our product account for a significant portion of our revenue, which exposes us to risks inherent in international operations.
We market and sell our products and services in the United States and internationally. International sales of our products and services as a percentage of our total revenue for fiscal 2007, 2006 and 2005 were approximately 34%, 24% and 22%, respectively. We have a total of 12 employees based outside the United States who deploy our software, perform consulting services and perform research in Europe and Australia. We cannot be certain that we have fully complied with all rules and regulations in every applicable jurisdiction outside of the United States with respect to our current and previous operations outside of the United States. The failure to comply with such rules and regulations could result in penalties, monetary or otherwise, against us. Our existing marketing efforts into international markets may require significant management attention and financial resources. We cannot be certain that our existing international operations will produce desired levels of revenue. We currently have limited experience in developing localized versions of our products and services and marketing and distributing our products internationally. Our international operations also expose us to the following general risks associated with international operations:
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disruptions to commercial activities or damage to our facilities as a result of political unrest, war, terrorism, labor strikes and work stoppages;
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difficulties and costs of staffing and managing foreign operations;
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the impact of recessions or inflation in economies outside the United States;
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greater difficulty in accounts receivable collection and longer collection periods;
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reduced protection for intellectual property rights in some countries;
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potential adverse tax consequences, including higher tax rates generally in Europe;
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tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries;
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unexpected changes in regulatory requirements of foreign countries, especially those with respect to software, pharmaceutical and biotechnology companies; and
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fluctuations in the value of currencies.
To the extent that such disruptions and costs interfere with our commercial activities, our results of operations could be harmed.
Changes in government regulation could decrease the need for the products and services we provide.
Governmental agencies throughout the world, but particularly in the United States, highly regulate the drug development and approval process. A large part of our software and services business involves helping pharmaceutical and biotechnology companies through the regulatory drug approval process. Any relaxation in regulatory approval standards could eliminate or substantially reduce the need for our services, and, as a result, our business, results of operations and financial condition could be materially adversely affected. Potential regulatory changes under consideration in the United States and elsewhere include mandatory substitution of generic drugs for patented drugs, relaxation in the scope of regulatory requirements or the introduction of simplified drug approval procedures. These and other changes in regulation could have an impact on the business opportunities available to us.
While we believe we currently have adequate internal control over financial reporting, we will be required, as of March 31, 2008, to evaluate and report on the effectiveness of our internal control under Section 404 of the Sarbanes-Oxley Act of 2002 and any adverse results from the evaluation and reporting could result in a loss of investor confidence in our financial reports and have an adverse effect on our stock price.
Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, beginning with our Annual Report on Form 10-K for the fiscal year ending March 31, 2008, we will be required to furnish a report by our management on our internal control over financial reporting. Such report will contain, among other matters, an assessment of the effectiveness of our internal control over financial reporting as of the end of our fiscal year, including a statement as to whether or not our internal control over financial reporting is effective. This assessment must include disclosure of any material weaknesses in our internal control over financial reporting identified by management. PCAOB Auditing Standard No. 2 provides the professional standards and related performance guidance for independent registered public accounting firms to attest to, and report on, management’s assessment of the effectiveness of internal control over financial reporting under Section 404.
While we currently believe our internal control over financial reporting is effective, we are in the process of system and process documentation and evaluation needed to comply with Section 404, which is both costly and challenging. During this process, if our management identifies one or more material weaknesses in our internal control over financial reporting, and those weaknesses are not appropriately remediated prior to March 31, 2008, we will be unable to assert such internal control is effective. If we are unable to assert that our internal control over financial reporting is effective as of March 31, 2008 (or if our independent registered public accounting firm is unable to attest that our management’s report is fairly stated or they are unable to express an opinion on our management’s evaluation or on the effectiveness of the internal control), we could lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price, and our business and operating results could be harmed.
While we currently anticipate being able to satisfy the requirements of Section 404 in a timely fashion, we cannot be certain as to the timing of completion of our evaluation, testing and any required remediation due in large part to the fact that there is no precedent available by which to measure compliance with the new PCAOB Auditing Standard No. 2. If we are not able to comply with the requirements of Section 404 in a timely manner or if our independent registered public accounting firm is not able to complete the procedures required by PCAOB Audit Standard No. 2 to support their attestation report, we would likely lose investor confidence in the accuracy and completeness of our financial reports, which would have an adverse effect on our stock price, and our business and operating results could be harmed.
Risks Related To Our Industry
Our market may not develop as quickly as expected, and companies may enter our market, thereby increasing the amount of competition and impairing our business prospects.
Because our products and services are new and still evolving, there is significant uncertainty and risk as to the demand for, and market acceptance of, these products and services. As a result, we are not able to predict the size and growth rate of our market with any certainty. In addition, other companies, including potential strategic partners, may enter our market. Our existing customers may also elect to terminate our services and internally develop products and services similar to ours. If our market fails to develop, grows more slowly than expected, or becomes saturated with competitors, our business prospects will be impaired.
Government regulation of the pharmaceutical industry may restrict our operations or the operations of our customers and, therefore, adversely affect our business.
The pharmaceutical industry is regulated by a number of federal, state, local and international governmental entities. Although United States Food and Drug Administration or comparable international agencies do not directly regulate the majority our products and services, the use of some of our analytical software products by our customers may be regulated. We currently provide assistance to our customers in achieving compliance with these regulations. In addition, our Reporting and Analysis Services are subject to various regulatory requirements designed to ensure the quality and integrity of the data or products of these services. These regulations are governed primarily by good laboratory practice, or GLP, and good clinical practice, or GCP, guidelines mandated by the FDA. The regulatory agencies could enact new regulations or amend existing regulations with regard to these or other products that could restrict the use of our products or the business of our customers, which could harm our business.
Consolidation in the pharmaceutical industry could cause disruptions of our customer relationships, interfere with our ability to enter into new customer relationships and have a negative impact on our revenues
In recent years, the worldwide pharmaceutical industry has undergone substantial consolidation. If any of our customers consolidate with another business, they may delay or cancel projects, lay off personnel or reduce spending, any of which could cause our revenues to decrease. In addition, our ability to complete sales or implementation cycles may be impaired as these organizations undergo internal restructuring.
Reductions in the IT and/or research and development budgets of our customers may affect our sales.
Our customers include researchers at pharmaceutical and biotechnology companies, academic institutions and government and private laboratories. Fluctuations in the IT and research and development budgets of these researchers and their organizations could have a significant effect on the demand for our products. Research and development and IT budgets fluctuate due to changes in available resources, spending priorities, internal budgetary policies and the availability of grants from government agencies. Our business could be harmed by any significant decrease in research and development or IT expenditures by pharmaceutical and biotechnology companies, academic institutions or government and private laboratories.
Recent or continued withdrawals of drugs from the public market could affect pharmaceutical spending, reduce the demand for our products and have a negative impact on our revenues.
Recently, the pharmaceutical industry has experienced, and may continue to experience, forced withdrawal of certain drugs from the public market due to safety risks. Recent or future drug withdrawals could affect our ability to market and sell our products and services to companies faced with withdrawals. For example, withdrawals of drugs from the public market by our customers or potential customers may result in the reduction of current levels of spending on software solutions and strategic consulting services by these companies to minimize the impact of a potential decline in revenues. In addition, we may provide products or services to
customers with drugs in the same class as the drugs withdrawn from the market. If the demand for drugs within the class of drugs faced with recent withdrawals decreases, we may experience a decrease in demand for our products or services in that class of drugs. A decrease in demand for our products, or a decrease in IT or research and development spending by pharmaceutical companies, could prevent us from increasing or sustaining our software and strategic consulting revenues and adversely affect our revenues and results of operations.
Risks Related to Our Stock
Our common stock only trades on the Over-the-Counter Bulletin Board system, and has experienced reduced trading volumes and stock price since it began to be traded there.
On November 8, 2002 our stock was removed from trading on the Nasdaq National Market as a result of failure to meet the continuing listing requirements, and our common stock is now quoted on the Over-the-Counter Bulletin Board system. Our common stock does not experience large trading volumes. In addition, our delisting from Nasdaq has caused the loss of our exemption from the provisions of Section 2115 of the California Corporations Code, which imposes particular aspects of California corporate law on certain non-California corporations operating within California. As a result, (i) our Board of Directors is no longer classified and our stockholders elect all of our directors at each annual meeting, (ii) our stockholders are entitled to cumulative voting, and (iii) we are subject to more stringent stockholder approval requirements and more stockholder-favorable dissenters’ rights in connection with certain strategic transactions. Some of these changes may impact any possible transaction involving a change of control of Pharsight, which could negatively impact your investment. Other consequences include a reduction in analyst coverage, a lower share price as a result of lower trading volumes, and the loss of certain state securities law exemptions available to us while our securities were traded on Nasdaq, which may impact our ability to provide for future issuances of our securities, among other consequences.
Should we decide to relist our common stock on the Nasdaq, the criteria for relistment may be difficult for us to achieve.
The market price of our common stock has been lower than the required minimum bid price for relistment on Nasdaq, and the reduced trading volumes that we currently experience may prevent our stock from reaching the required minimum bid price for Nasdaq relistment. Additionally, our current stockholders’ deficit and our history of net losses may make it difficult for us to relist on Nasdaq at any point in the near future, if at all. We may be required to restructure our capital or debt structure, including our redeemable convertible preferred stock, in order to relist on Nasdaq. There is no guarantee that we would be able to effect such restructuring under terms as favorable as our current equity and debt, if at all.
The public market for our common stock may be volatile.
The market price of our common stock has been, and we expect it to continue to be, highly volatile and to fluctuate significantly in response to various factors, including:
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actual or anticipated variations in our quarterly operating results or those of our competitors;
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announcements of technological innovations or new services or products by us or our competitors;
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timeliness of our introductions of new products;
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changes in management; and
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changes in the conditions and trends in the pharmaceutical market.
For instance, during fiscal 2007 the trading price of our common stock closed as low as $1.21 and as high as $1.85 per share. We have experienced very low trading volume in our stock, and thus small purchases and sales can have a significant effect on our stock price. In addition, the stock markets have experienced extreme price and volume fluctuations, particularly in the past year, that have affected the market prices of equity securities of
many technology companies. These fluctuations have often been unrelated or disproportionate to operating performance. These broad market factors may materially affect the trading price of our common stock. General economic, political and market conditions, such as recessions and interest rate fluctuations, may also have an adverse effect on the market price of our common stock.
Insiders continue to hold a significant portion of our stock, which may negatively affect your investment.
Entities affiliated with two of our directors beneficially own or control approximately 49.5% of outstanding common stock, calculated on an as-converted basis, as of March 31, 2007. If these parties choose to act or vote together, they will have the power to control all matters requiring the approval of our stockholders, including the election of directors and the approval of significant corporate transactions. This ability may have the effect of delaying or otherwise influencing a possible change in control transaction, which may or may not be favored by our other stockholders. In addition, without the consent of these parties, we would likely be prevented from entering into transactions that could result in our stockholders receiving a premium for their stock.
The redemption of our preferred stock, or the election by the preferred stockholders to receive their dividend payments in shares instead of cash, may negatively affect our financial condition.
Our preferred stockholders have elected in the past, and may continue to elect, to receive their quarterly dividend payments in the form of Series B Preferred shares instead of cash. Beginning on June 26, 2007, the holders of our preferred stock may elect to have us redeem all or a portion of their shares of preferred stock at any time, or we may elect to redeem all of the outstanding shares of preferred stock. If we were required, or if we elected, to redeem all the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $8 million. As a result, we may need to obtain additional funds or secure additional credit facilities. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise additional funds could harm our business and financial condition. In addition, our preferred stockholders have elected in the past, and may continue to elect, to receive their quarterly dividend payments in the form of Series B Preferred shares instead of cash. We record the value of these dividend payments in the form of shares at fair market value as of the dividend payment date on our statement of operations. The fair market value is defined as the amount at which the capital stock would change hands between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither being under any compulsion to act, with equity to both. Because there is no market for such Series B Preferred shares, we perform a valuation of the fair market value of these shares. This valuation is impacted by numerous factors, including but not limited to our operations, financial conditions, future prospects and projected operations and performance of the company, as well as historical market prices and trading volume for our publicly traded securities. As such, the valuation of these dividend payments may fluctuate widely, may be greater or lesser than the stated value of the Series B Preferred shares, and may affect our ability to sustain or increase our profitability. We are unable to project with any accuracy the impact of fair market value of the Series B Preferred shares on our statement of operations.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None
ITEM 2.
ITEM 2. PROPERTIES
Our principal executive offices, totaling approximately 14,000 square feet, are located in Mountain View, California under a lease that expires in August 2010. We also lease approximately 13,000 square feet in Cary, North Carolina for a sales, development and training facility under a lease that expires in March 2011. We believe that our existing facilities are adequate for our current needs and that additional space will be available as needed.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, Pharsight may become involved in claims, legal proceedings, or state or federal government agency proceedings that arise in the ordinary course of its business. We are not currently a party to any material litigation and are currently not aware of any pending or threatened litigation that could have any material adverse effect upon our business, operating results or financial condition.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of Pharsight’s stockholders during the fourth quarter of our fiscal year ended March 31, 2007.
EXECUTIVE OFFICERS OF THE REGISTRANT
The following table provides information concerning our executive officers as of June 20, 2007:
Shawn M. O’Connor, Pharsight’s President, Chief Executive Officer and Chairman since February 2003, joined Pharsight in September 2002 as its Senior Vice President and Chief Financial Officer. Mr. O’Connor has more than 20 years of experience in high technology executive management. Prior to joining Pharsight, Mr. O’Connor was the President and Chief Operating Officer of QRS Corporation, a leading provider of business-to-business e-commerce services to the retail industry, from 1995 to 2001. Prior to QRS, he served as Chief Financial Officer of Diasonics Ultrasound, Inc., a publicly held worldwide medical equipment manufacturer, from 1987 to 1994. Mr. O’Connor began his career with the accounting firm Peat Marwick, where he served as a CPA in both San Francisco and London. Mr. O’Connor holds a B.S. from the University of California, Berkeley, in Finance & Business Administration and is a graduate of the Executive Education Program at the Stanford Graduate School of Business.
William Frederick, joined Pharsight in April, 2006. Prior to joining Pharsight, Mr. Fredrick was Vice President and Chief Financial Officer of Versata, Inc. from January 2004 to January 2005. Mr. Frederick joined Versata in December 2002 as Corporate Controller and was appointed as Vice President and Chief Financial Officer in January 2004. In February 2005, Mr. Frederick was also appointed as Versata’s interim Chief Executive Officer and President. From August 2000 through March 2002, Mr. Frederick served as Vice President, Finance at Clarent Corporation. From January 2000 through August 2000, Mr. Frederick was Corporate Controller at ACT Networks, Inc. a developer and manufacturer of broadband access equipment that was acquired by Clarent in August 2000. From May 1999 to November 1999, Mr. Frederick was the Chief Financial and Administrative Officer of IAM.com, Inc, a business-to-business web application company. From January 1998 to May 1999, Mr. Frederick was in the corporate finance department of The Disney Store division of The Walt Disney Company. Mr. Frederick holds a M.B.A degree from California State University at Long Beach and a bachelor’s degree in finance from California State University at Fullerton.
Daniel L. Weiner, Ph.D., rejoined Pharsight as Senior Vice President, Software Products in June 2004, and was recently promoted to Chief Technology Officer. Dr. Weiner worked as an independent pharmaceutical consultant before taking the position of Senior Vice President and Head of Global Clinical Development at IVAX Corporation from May 2003 to May 2004. From February 1998 until December 2002, Dr. Weiner held the
position of Senior Vice President of Software Development with Pharsight Corporation. Dr. Weiner has extensive drug development experience and has served as an expert consultant to the FDA on pharmacokinetic modeling and bioequivalence assessment. Prior to his previous tenure with Pharsight as a Senior Vice President, Dr. Weiner held several management positions including Head, Biostatistics, Merrell Dow Pharmaceuticals; Vice President, Statistical Consultants, Inc.; Vice President, Syntex Development Research; and Senior Vice President and Principal Scientist, Quintiles. Dr. Weiner graduated from the University of Kentucky with a doctoral degree in Mathematical Statistics, with emphasis on compartmental modeling, as well as an M.S. in Statistics, and a B.S. in Mathematics.
Mark Hovde joined Pharsight in April 2005 as Senior Vice President, Marketing. Mr. Hovde has more than 15 years of experience in marketing and business development for pharmaceutical software, data, and services companies. Prior to joining Pharsight, from October 2003 to April 2005, Mr. Hovde was the President and founder of Hovde Associates, LLC, a management consulting firm specializing in counsel on pharmaceutical development. Prior to this, from September 2000 to October 2003, he was the Vice President, Sales and Business Development at Fast Track Systems, Inc., a developer of software focused on improving the protocol quality and the speed of the clinical trial process. While at Fast Track, Mr. Hovde was responsible for the formation and management of the company’s sales and marketing organizations and successfully created a unique consulting services program, which was offered to the company’s major accounts. From 1989 to August 2000, Mr. Hovde was also the co-founder of DataEdge, LLC, a developer of novel informatics that help reduce the time and cost of clinical trials. At DataEdge he pioneered the PICAS and CROCAS databases, leading clinical cost benchmarking tools, which improved trial cost control. Mr. Hovde has authored several publications and presentations and holds a Bachelor of Science degree in Finance from the Wharton School of the University of Pennsylvania, where he was also named a Benjamin Franklin Scholar, and an MBA from Harvard Business School.
James D. Hayden joined Pharsight in April 2005 as Senior Vice President, Global Sales. Mr. Hayden has 15 years of experience in sales, marketing and management within the life sciences industry. From May 1998 to April 2005, Mr. Hayden held various positions with Accelrys, Inc., a leading provider of software for computation, simulation, and the management and mining of scientific data used by biologists, chemists and materials scientists. While at Accelrys, he led a sales team as National Director of Sales from 2000 to 2005 responsible for major account sales of the company’s software solutions in the Americas region. In this role, he successfully reestablished the company’s presence in a failing geographical region and also developed a variety of sales infrastructure tools that allowed the company to gauge the progress of its sales team. He also helped to successfully launch the company’s presence into the emerging nanotechnology market. From June 1991 to April 1998 he held various positions at Bio-Rad Laboratories, a developer of innovative tools and services for the clinical diagnostics and life sciences research markets including Product Support Manager and Senior Account Manager. Mr. Hayden began his career as an electrical engineer at Raytheon and holds an MBA from Rutgers University and a B.S. in Electrical Engineering from Boston University.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Our common stock is currently listed on the Over-The-Counter Bulletin Board system under the symbol “PHST.OB.” Our common stock first traded publicly on August 9, 2000, concurrent with the underwritten initial public offering of shares of our common stock, on the Nasdaq National Market and continued to be traded there until November 8, 2002.
As of June 15, 2007, there were 20,058,277 shares of common stock outstanding that were held by 98 stockholders of record. Because many of our shares of common stock are held by brokers and other institutions on behalf of stockholders, we are unable to estimate the total number of stockholders represented by these record holders.
Set forth below are the high and low closing prices for our common stock reported on the Over-The-Counter Bulletin Board system for the periods indicated:
The over-the-counter quotations reflect inter-dealer prices, without retail mark-up, markdown or commission and may not necessarily represent actual transactions.
We have never declared or paid any cash dividends on our common stock and do not anticipate paying such cash dividends on our common stock in the foreseeable future. We currently anticipate that we will retain all of our future earnings, if any, for use in the development and expansion of our business and for general corporate purposes. Any determination to pay dividends on our common stock in the future will be at the discretion of our board of directors and will depend upon our results of operation, financial condition and other factors as our board of directors, in its discretion, deems relevant. In addition, under the terms of some of our debt agreements, we are prohibited from paying dividends without the consent of the lender.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
You should read the following historical selected consolidated financial data in conjunction with the financial statements and related notes and “Item 7
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This section and other parts of this Form 10-K contain forward-looking statements that involve risks and uncertainties. Our actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in “Part I-Item 1A - Risk Factors”. The following discussion should be read in conjunction with the financial statements and notes thereto set forth under “Item 8 - Financial Statements and Supplementary Data.”
Overview
Pharsight Corporation develops and markets software and provides consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process by reducing the costs and time requirements of their drug development, and commercialization efforts. Pharsight’s proprietary software products include Trial Simulator for clinical trial simulation and computer-aided trial design; WinNonlin and WinNonMix for the statistical analysis and mathematical modeling of PK/PD data; IVIVC Toolkit for WinNonlin for the development of in vivo-in vitro correlations and the management of related datasets and workflow; WinNonlin Validation Suite for streamlined on-site validation of WinNonlin; Pharsight Knowledgebase Server (PKS), PKS Reporter and PK Automation for the storage, management, analysis, and regulatory reporting of derived data and models in data repositories; PKS Validation Suite for streamlined on-site validation of PKS; and Drug Model Explorer for dynamic visualization and communication of model-based product profiles. Our software products and our services utilize expertise in the sciences of pharmacology, drug and disease modeling, biostatistics and strategic decision-making. Our service offerings use this expertise to interpret and improve the design of scientific experiments and clinical trials, and to optimize clinical trial design and portfolio decisions. By integrating scientific, clinical, and business decision criteria into a dynamic model-based methodology, we help our customers optimize the value of their drug development programs and portfolios from discovery to post-launch marketing.
We believe the use of our software and methodology is reaching the mainstream of the drug development process, as evidenced by the FDA’s call for modeling discussions in Phase IIa meetings with sponsors, the use of modeling and simulation by the FDA to support decisions on program designs or labeling in 25% of recent new drug application reviews, and the establishment of modeling and simulation groups in most of the top pharmaceutical and biotechnology companies. Although our methodology does not displace the use of human trials in drug development, we believe our software and our methodology renders human trials more efficient and relevant. The continued growth of our customer base, the increase in the number of contracts with our customers, and the increase in our average contract values over time have shown a trend that we believe demonstrates increased acceptance of our methodology and an increased demand for its use. We believe that these trends, in addition to increasing regulatory requirements from the FDA and the FDA’s emphasis on modeling and simulation found in the Critical Path Initiative and in our Cooperative Research and Development Agreement (CRADA) with the FDA announced in June 2006, demonstrate a potential for increased revenue growth resulting from increased demand for our current products and services, as well as long-term opportunities to expand the breadth and coverage of both our consulting services and software product offerings.
For reporting purposes, we operated in two business segments during fiscal 2007: Software Products and Strategic Consulting Services. Our Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform clinical testing needed to bring drugs to market. Our Strategic Consulting Services segment consists of consulting, training and process redesign conducted by our clinical and decision scientists in the application and implementation of our core decision methodology. These segments were determined based on how management and our Chief Operating Decision Maker, or CODM, who is our Chief Executive Officer, view and evaluate our business.
We were incorporated in California in April 1995, and we reincorporated in Delaware in June 2000. In August 2000, we completed our initial public offering and our common stock began trading on the Nasdaq. In November 2002, our common stock ceased to trade on the Nasdaq and it is currently traded on the Over-The-Counter Bulletin Board system. Our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to those reports are available free of charge through our website at http://www.pharsight.com as soon as reasonably practicable after such material is electronically filed with, or furnished to, the Securities and Exchange Commission or SEC. Copies of our annual report will be made available, free of charge, upon written request to the Chief Financial Officer, c/o Pharsight Corporation, 321 E. Evelyn Ave., 3 rd Floor, Mountain View, CA 94041-1530.
Financial Highlights for Fiscal 2007
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Our revenues for fiscal 2007 were $25.1 million, a $2.4 million increase over fiscal 2006, primarily due to increases in both software license revenue and Strategic Consulting Services revenue.
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Our revenue from the Software Products segment for fiscal 2007 was $14.2 million compared with $13.4 million for fiscal 2006. License, renewal and maintenance revenue for fiscal 2007 accounted for $12.1 million, up from $10.8 million for fiscal 2006. Software services revenue accounted for $2.2 million for fiscal 2007, a decrease from $2.7 million for fiscal 2006.
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Our revenue from the Strategic Consulting Services for fiscal 2007 was approximately $10.9 million, a $1.6 million increase over $9.3 million for fiscal 2006.
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Our net income for fiscal 2007 was $1.9 million compared to $530,000 in fiscal 2006. The increase in net income was primarily resulted from our increased revenue and interest income in fiscal 2007.
Challenges and Risks
We achieved our first quarter of profitability in the fourth quarter of fiscal 2004 and had annual profitability during fiscal 2005, 2006 and 2007. Prior to that time we had incurred losses since inception. We currently have an accumulated deficit of $74.3 million. To meet increased demand for our products and services, we may be required to invest further in our operations, technology and infrastructure, which may result in our inability to sustain profitability.
We achieved positive operating cash flow in fiscal 2004 and continued to have positive operating cash flow in fiscal 2005, 2006 and 2007. Although we believe that our current cash balances are sufficient to meet our working capital needs for the next twelve months, our ability to generate positive net cash flow and sustain positive operating cash flow on a quarterly and annual basis is based on a number of factors, including some which are outside of our control, such as the state of the overall economy, the demand for our products and the length and lack of predictability of our sales cycle. In addition, beginning on June 26, 2007, the holders of our preferred stock may elect to have us convert all or a portion of their shares of preferred stock at any time, or we may elect to redeem all the outstanding shares of preferred stock. If we were required or if we elected to redeem all the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $8 million. As a result, we may need to raise additional funds or secure additional credit facilities through public or private financings or other sources. We may not be able to obtain additional funds on commercially reasonable terms, or at all. Failure to raise capital when needed could harm our business. If we raise additional funds through the issuance of equity securities, these equity securities might have rights, preferences or privileges senior to our common stock and preferred stock. In addition, the necessity of raising additional funds could force us to incur debt on terms that could restrict our ability to make capital expenditures and to incur additional indebtedness.
While we expect that the overall long-term revenue trend in our software business will continue to increase in response to customer demand, software products revenue in individual quarters may fluctuate significantly, based upon timing of completion of large software installations and related revenue recognition. Unanticipated delays in software project deployment schedules may have significant impact on the timing of revenue recognition and may have a corresponding significant impact on our net income in that quarter.
We generate a significant portion of our revenue from a limited number of clients. Although we have been diversifying our customer base, a significant portion of our revenue may continue to depend on sales to a small number of clients. In addition, the worldwide pharmaceutical industry has undergone, and may in the future undergo, substantial consolidation, which may reduce the number of our existing and potential clients. The loss of one of our large clients would hurt our business and prevent us from achieving or sustaining profitability.
Our Strategic Consulting Services customers range in size from the largest pharmaceutical companies to small biopharmaceutical companies, and the focus of our work differs depending upon the size and maturity of the customer. In our smaller and medium-sized customers, we tend to engage in discrete projects often with challenging analytic and design problems, where modeling and simulation can be particularly valuable. This kind of work may or may not lead to subsequent engagements. By contrast, at our largest customers, we tend to have ongoing relationships which are more strategic in nature, and we focus on helping improve the process by which they develop drugs, broadening and deepening the application of modeling and simulation over time, with the intent of achieving systematic, lasting performance improvement.
Our clients may also expand their internal drug development organizations to include functions and individuals that might perform services similar to those performed by our strategic consulting group. As a result, our consulting business could have difficulty sustaining its current levels of revenues, or increasing its revenues in the future. Unanticipated delays in consulting project schedules may have significant impact to the timing of revenue recognition and may have corresponding significant impact on our net income in that quarter.
The pharmaceutical industry in general has recently experienced, and may continue to experience, forced withdrawal of certain drugs from the public market due to unforeseen safety risks, more and more time-consuming safety and efficacy testing requirements in drug development, and patent expiries on significant portions of their marketed drugs. Our clients may, as a result, reduce in their current level of spending on software solutions and strategic consulting services. This could adversely affect our business and prevent us from increasing or sustaining our software and strategic consulting revenues.
Critical Accounting Policies and Estimates
We prepare our financial statements in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions upon which we rely are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The primary critical accounting policies that currently affect our financial condition and results of operations are revenue recognition and allowance for doubtful accounts, which impact revenue and operating expenses. We believe that this accounting policy is critical to fully understand and evaluate our reported financial results.
Revenue Recognition
Our revenues are derived from three primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS), (2) services related to scientific and training consulting and software deployment, and (3) strategic consulting services.
Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collection is probable, and no significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, we defer revenue
recognition until such time as all of the criteria are met. We do not currently offer, have not offered in the past, and do not expect to offer in the future, extended payment term arrangements. If we do not consider collectability to be probable, we defer recognition of revenue until the fee is collected.
Software Product Segment
We enter into arrangements for one-year software licenses (initial and renewal fees) bundled with post-contract support services, or PCS, from which we receive solely license and renewal fees. We do not have Vendor Specific Objective Evidence (“VSOE”) of fair value to allocate the fee to the separate elements, as we do not sell PCS separately. Therefore, we do not present PCS revenue separately in connection with these arrangements, and we do not believe other allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. We recognize each of the initial and renewal license fees ratably over the one-year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2. Revenues from bundled arrangements are recorded as license revenues in the statement of operations in the initial year and as renewal revenue in subsequent years.
We enter into arrangements consisting of perpetual or term-based licenses and PCS. We do not have VSOE of fair value to allocate the fee to the separate elements. We recognize revenue attributable to license and PCS ratably over the remaining period of the PCS term once the product is delivered. For financial statement presentation purposes, revenues from arrangements that include perpetual licenses are allocated among and recorded as license and maintenance revenue based upon management’s estimate of fair value and the Company’s price list. Renewals of related PCS are recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses.
We enter into arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognize revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. We currently do not have VSOE of fair value for PCS. For financial statement presentation purposes, revenues from arrangements that include perpetual and term-based licenses are allocated among and recorded as license, maintenance, renewal and service revenue based upon management’s estimate of fair value and the Company’s price list. Renewals of related PCS are recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses. The implementation/installation services revenues are recorded as services revenue in the statement of operations.
We enter into arrangements consisting of optional scientific consulting services. The optional scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, as they are not essential to the functionality of the delivered software, are described and priced separately in the arrangement and are sold separately. We recognize fees from optional scientific consulting services (equal to the amounts set forth in the contracts) as revenue as these services are provided or upon their acceptance, as applicable.
For arrangements consisting solely of services, we recognize revenue as consulting services are performed. Arrangements for consulting services may be charged at daily rates for different levels of consultants and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee contracts, with payments based on milestones or acceptance criteria, we recognize revenue using the proportional performance method-as such milestones are achieved, or if customer acceptance of the milestone’s completion is required, upon such customer acceptance, which approximates the level of services provided. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.
We have two international distributors. There is no right of return or price protection for sales to the international distributors Revenue on sales to these distributors are recognized ratably over the license term when the software is delivered to the distributors and other revenue recognition criteria are met.
Strategic Consulting Services Segment
We enter into arrangements for strategic consulting contracts, which do not fall under the scope of SOP 97-2. Arrangements for consulting services may be charged at daily rates and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee with payments based on milestones or acceptance criteria, we recognize revenue using the proportional performance method-as such milestones are achieved, or if customer acceptance is required, upon customer acceptance, which approximates the level of services provided. Management makes a number of estimates related to recognizing revenue for such contracts, as discussed above. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.
Judgments Affecting Revenue Recognition
Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter. We recognize revenue in accordance with U.S. GAAP rules that have been prescribed for the software industry. The accounting rules related to revenue recognition are complex and are affected by interpretations of the rules and an understanding of industry practices, both of which are subject to change. Consequently, the revenue recognition accounting rules require management to make significant judgments.
We do not record revenue on sales to customers whose ability to pay is in doubt at the time of sale. Rather, we recognize revenue from these customers as cash is collected. The determination of a customer’s ability to pay requires significant judgment. In this regard, management considers the international region of the customer and the financial viability of the customer in assessing a customer’s ability to pay.
We generally do not consider revenue arrangements with extended payment terms to be fixed or determinable and, accordingly, we do not generally recognize revenue on these arrangements until the customer payments become due. The determination of whether extended payment terms are fixed or determinable requires management to exercise significant judgment, including assessing such factors as the past payment history with the individual customer and evaluating the risk of concessions over an extended payment period. The determinations that we make can materially impact the timing of recognition of revenues. Our normal payment terms currently range from “net 30 days” to “net 60 days,” which are not considered by us to be extended payment terms.
The majority of our PKS software arrangements include software deployment services. We defer revenue for software deployment services, along with the associated license revenue, until the services are completed. If there is significant uncertainty about the project completion or receipt of payment for the professional services, we defer revenue until the uncertainty is sufficiently resolved.
Allowance for Doubtful Accounts
We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than the full payment on our currently outstanding receivables. We make judgments as to our ability to collect receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices and evaluation of historical trends of write-offs of accounts we deem uncollectible.
Stock-Based Compensation
Effective April 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment,” or SFAS 123R, using the modified prospective transition method. Under that transition method, compensation expense that we recognized for fiscal
2007 included: (i) compensation expense for all share-based payments granted prior to but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” or SFAS 123, and (ii) compensation expense for all share-based payments granted or modified on or after April 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123R, we recognized forfeitures as they occurred. We elected to calculate our compensation expenses by applying the Black-Scholes valuation model, applying the graded vesting expense attribution method and recognizing forfeited awards in the period that they occurred. In addition, we elected the straight-line attribution method as our accounting policy for recognizing stock-based compensation expense for all awards that are granted on or after April 1, 2006. For awards subject to graded vesting that were granted prior to the adoption of SFAS 123R, we use an accelerated expense attribution method. Results in prior periods have not been restated.
Results of Operations
The following table sets forth, for the periods given, selected consolidated financial data by reportable segment as a percentage of our revenue and the percentage of period-over-period change. The table and the discussion below should be read in connection with the consolidated financial statements and the notes thereto which appear elsewhere in this report. All percentage calculations set forth in this section have been made using figures presented in the consolidated financial statements, and not from the rounded figures referred to in the text of this management discussion and analysis.
Revenue
Comparison of Year Ended March 31, 2007 and 2006 and Comparison of Year Ended March 31, 2006 and 2005
Year Ended March 31, 2007 and 2006
Total revenue for fiscal 2007 increased to $25.1 million, compared to $22.7 million for fiscal 2006. The increase was a result of a 6% increase in the Software Products segment revenue and a 17% increase in the Strategic Consulting Services segment revenue.
Software Products Segment Revenues
License, renewal and maintenance revenues
For fiscal 2007, desktop software products revenues increased to $8.0 million from $6.8 million in fiscal 2006. The increase is mainly attributable to a $508,000 increase in our initial desktop software product revenue as we were able to successfully execute on growth initiatives and increase sales of our desktop software products and a $685,000 increase in desktop software license renewal revenue due to a continued increase in our installed base and our license renewal rate remained high at approximately 95%.
PKS software revenues increased to $3.3 million in fiscal 2007 from $2.2 million in fiscal 2006. The increase in revenue is primarily due to the growth of our customer base and increase of sales of professional services and annual maintenance contracts. We completed 5 new installation projects in fiscal 2007 as well as expansion and renewal of licenses to 19 customers.
DMX software revenues were $795,000 in fiscal 2007 compared to $1.8 million in fiscal 2006. The decrease is mainly attributable to the completion of smaller DMX development projects in fiscal 2007, compared to fiscal 2006 when one large DMX development project was completed.
Services revenues. Software services revenues were $2.2 million in fiscal 2007 compared to $2.7 million in fiscal 2006. The decrease in software services revenue was primarily due to decreased customized services associated with PKS installation, deployment and automation projects.
Strategic Consulting Services Segment Revenues
Strategic Consulting Services segment revenues were $10.9 million in fiscal 2007 compared to $9.3 million in fiscal 2006. The increase was primarily attributable to expansion in our customer base.
Year Ended March 31, 2006 and 2005
Total revenue for fiscal 2006 increased slightly to $22.7 million, compared to $22.6 million for fiscal 2005. The increase was a result of the increase in the software business segment revenue offset by a similar decrease in the Strategic Consulting Services segment revenue. The 11% increase in revenue from our software business segment from fiscal 2005 to fiscal 2006 was primarily attributable to a higher rate of renewals, completion of one PKS install base project, two automation projects, sales of three DMX contracts, and a large install base of desktop software.
Software Products Segment Revenues
License and renewal and maintenance revenues
For fiscal 2006, desktop software products revenues increased with $6.8 million from $5.9 million in fiscal 2005. The increase is mainly attributable to $763,000 increased in our initial desktop software product revenue which includes revenue of $400,000 from an initial desktop license revenue transaction with one of our major customers in the third quarter of fiscal 2006.
PKS software revenues decreased to $2.2 million in fiscal 2006 from $3.3 million in fiscal 2005. The decrease in revenue is due to larger projects closed in fiscal 2005 than in fiscal 2006. In addition, there was a change in product mix between initial PKS licenses and renewal of PKS licenses in second quarter of fiscal 2006. As PKS renewals are priced at lower rates than PKS initials, the change in product mix resulted in a decrease in PKS software product revenue. Furthermore, less PKS installation software projects were completed in the third quarter of fiscal 2006 than that in the same quarter of fiscal 2005. This resulted in less PKS license revenue recognized. In addition the average selling price for software products for which revenue was recognized during fiscal 2006 increased by 5% as compared to fiscal 2005.
DMX software revenues were $1.8 million in fiscal 2006 compared to $552,000 in fiscal 2005. The increase is mainly due to recognizing revenue on a large DMX project over the second and third quarter of fiscal 2006 as well as recognizing revenue on various smaller DMX projects completed in the fourth quarter of fiscal 2006. As a result, a full year worth of DMX software revenue was recognized throughout the fiscal year 2006, whereas only one quarter worth of revenue was recognized in fiscal 2005.
Services revenues. Software services revenues were $2.7 million in fiscal 2006 compared to $2.3 million in fiscal 2005. The increase in software services revenue was primarily attributable to increased customized services associated with PKS installation, deployment and automation projects. One PKS installation project completed in the first quarter of fiscal 2006, two PKS deployment and automation framework projects completed in each of the remaining quarters of fiscal 2006.
Strategic Consulting Segment Revenues
Strategic Consulting segment revenues were $9.3 million in fiscal 2006 compared to $10.5 million in fiscal 2005. The decrease was primarily due to the unexpected downturn of the pharmaceutical industry starting in the second quarter of fiscal 2006. During the second and third quarter we were particularly affected by the decrease spending by our largest customer. We did however see an increase in consulting revenue in the fourth quarter, compared to the third quarter, largely driven by growth from clients outside of our top two customers. However, even though we saw quarterly revenue growth of 47% in the fourth quarter, total revenue for the 2006 fiscal year was still down 12% compared to fiscal 2005.
Cost of Revenues
Year Ended March 31, 2007 and 2006
Total Cost of Revenues
Total cost of revenues remained relatively constant at $7.7 million for fiscal 2007 and fiscal 2006, respectively. Cost of revenue is comprised mainly of payroll and payroll related expenses, royalty expenses and
shipping costs. Also included in cost of revenues in fiscal 2007 is $168,000 of stock-based compensation expense related to the adoption of SFAS 123R. Cost of software revenue decreased by $406,000 in fiscal 2007, offset by an increase of $439,000 in cost of Strategic Consulting Services revenue.
Cost of Software Products Segment Revenues
Cost of license, renewal and maintenance revenues. Cost of license, renewal and maintenance revenues consists of royalty expense for third-party software included in our products, and cost of materials for both initial products and product updates provided for in our annual license agreements.
Cost of license, renewal and maintenance revenues was $287,000 for fiscal 2007 compared to $295,000 in fiscal 2006. The decrease in cost of license, renewal and maintenance revenues in fiscal 2007 in absolute dollars is primarily due to decreased cost of materials, offset by increase of payroll related expenses.
Cost of services revenues. Cost of services revenues consists of payroll and related costs, travel expenses, and facilities and overhead costs associated with our deployment services group.
Cost of services revenue was $1.1 million for fiscal 2007 compared to $1.5 million in fiscal 2006. The decrease in cost of services revenues is due to reduction of department headcount as we only had one automation project in fiscal 2007, compared to two automation projects completed in fiscal 2006.
Cost of Strategic Consulting Services Segment Revenues
Cost of services for our Strategic Consulting Services segment consists of payroll and payroll related costs, travel expenses, and facilities and overhead costs associated with our strategic consulting personnel.
Cost of services for our Strategic Consulting Services segment was $6.3 million for fiscal 2007 compared to $5.9 million in fiscal 2006. The adoption of SFAS 123R in fiscal year 2007 resulted in an expense of $148,000 stock based compensation. Additionally, employee and allocation related expenses increased by $481,000 over the prior year due to an increase in department headcount and payroll related expenses.
Year Ended March 31, 2006 and 2005
Total Cost of Revenues
Total cost of revenues decreased slightly from $7.8 million in fiscal 2005 to $7.7 million in fiscal 2006. The decrease was primarily attributable to the increased cost efficiencies in both software licenses and services
Cost of Software Products Segment Revenues
Cost of license and renewal revenues. Cost of license and renewal revenues consists of royalty expense for third-party software included in our products, and cost of materials for both initial products and product updates provided for in our annual license agreements.
Cost of license and renewal revenues was $295,000 for fiscal 2006 compared to $379,000 in fiscal 2005. The decrease in cost of license and renewal revenues in fiscal 2006 in absolute dollars is due to a decrease in royalty expense, as we currently make payments to only one vendor compared to the two vendors we paid in fiscal 2005. In addition, there was a decrease in royalty expense associated with the decrease in sales of our Trial Simulator product in the third quarter of fiscal 2006.
Cost of services revenues. Cost of service revenues consists of payroll and related costs, travel expenses, and facilities and overhead costs associated with our deployment services group.
Cost of services revenue was $1.5 million for fiscal 2006 compared to $1.6 million in fiscal 2005. The decrease in cost of services revenues is due to cost efficiencies gained in expenses related to service revenue and efficiencies gained in the utilization of our professionals’ consulting hours during fiscal 2006. We have completed more projects in fiscal 2006, one PKS install base project and two automation projects; however we were still able to keep a lower total cost of services revenue at the end of fiscal 2006 than that in fiscal 2005.
Cost of Strategic Consulting Segment Revenues
Cost of services for our Strategic Consulting segment consists of payroll and payroll related costs, travel expenses, and facilities and overhead costs associated with our strategic consulting personnel.
Cost of services for our Strategic Consulting Services segment was $5.9 million for fiscal 2006 compared to $5.8 million in fiscal 2005. The increase in cost of services for our Strategic Consulting segment in fiscal 2006 was primarily attributable to increased headcount as a result of our planned growth at the beginning of fiscal 2006, and payroll-related costs, employment fees, sign-on bonuses associated with the new headcount as well as our annual salary increases and the increase in common costs allocated to our Strategic Consulting segment. The total year to year increase in salary and related payroll expenses is $460,000 and the total year to year increase in common costs allocated to Strategic Consulting segment is $196,000.
Operating Expenses
Year Ended March 31, 2007 and 2006
Research and Development
Research and development expenses consist mainly of payroll, payroll related expenses and consulting expenses.
Software Products Segment
Research and development expenses were $4.3 million in fiscal 2007 compared to $3.5 million in fiscal 2006. The increase in research and development expenses in absolute dollars, for fiscal 2007 compared to fiscal 2006 was primarily due to an increase in third-party consulting expense of approximately $382,000 in fiscal 2007 as well as an increase of $117,000 in payroll related expenses and an increase of $189,000 in reallocation expenses of employees from other departments. The increase in third party consulting expenses and headcount is due to the company’s focus on delivering new products to the market, such as IVIVC and Autopilot.
Strategic Consulting Services Segment
The Strategic Consulting Services segment does not engage in research and development activities, nor is any such expense allocable to the segment, therefore it does not incur research and development related expenses.
Sales and Marketing
Sales and marketing expenses consist primarily of personnel costs, including salaries, commissions for sales, corporate marketing and travel related costs.
Sales and marketing expenses were $6.3 million in fiscal 2007 compared to $5.6 million in fiscal 2006. The increase in sales and marketing expense in absolute dollars in fiscal 2007 compared to fiscal 2006 was primarily the result of an increase in payroll-related expenses. In addition, there was an increase of $200,000 in sales commission resulting from increased revenue and an increase in marketing expenses related to sales conferences associated with our increased marketing efforts. Stock based compensation expense as a result of the adoption of SFAS 123R in fiscal 2007 was $315,000.
The software products and strategic consulting segments both have dedicated sales and marketing resources, as well as a shared pool of sales and marketing resources which are allocated to the segments based on each segment’s revenue as a relative percentage of total revenues. Inter-segment sales costs related to the shared pool of resources are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.
Software Products Segment
Sales and marketing expenses for the Software Products segment were $3.7 million in fiscal 2007 compared to $3.3 million in fiscal 2006. The increase in sales and marketing expense in absolute dollars in fiscal 2007 was primarily due to an increase in payroll related costs as a result of increased headcount and the stock based compensation expense associated with the adoption of SFAS 123R in fiscal 2007.
Strategic Consulting Services Segment
Sales and marketing expenses for the Strategic Consulting segment were $2.6 million in fiscal 2007 compared to $2.3 million in fiscal 2006. The increase was primarily due to the increase in payroll and payroll related costs and the allocation of stock-based compensation expenses related to the adoption of SFAS 123R in fiscal 2007.
General and Administrative
General and administrative expenses consist primarily of personnel costs of executive officers and support personnel, facilities, investor relations, insurance, legal and accounting and auditing fees. General and administrative expenses were $5.1 million in fiscal 2007 compared to $5.3 million in fiscal 2006. The decrease related to a $223,000 decrease in audit and tax fees, a $179,000 decrease in investor relations costs and a $110,000 decrease in consulting fees. These decreases were partially offset by $270,000 in stock based compensation expense as a result of the adoption of SFAS 123R in fiscal 2007 and a $190,000 increase in bonus and payroll related costs.
In addition, we evaluated the impact of the adoption of Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”) issued by the Securities and Exchange Commission (“SEC”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. Based on SAB 108, we recorded a cumulative effect adjustment of $256,000 related to the accounting for accrued expenses. We overaccrued on recurring professional services fees included in general and administrative expenses. The error arose as a result of accrual of such services ratably over the year rather than as the service was rendered. Under the rollover method of evaluating misstatements, the effect of the methodology used did not result in a material misstatement of the financial statements.
We evaluated the impact of correcting all misstatements, including both carryover and reversing effects of prior years misstatements on the current year financial statements. We determined that the effect of the errors on all prior financial statement filings were immaterial, but would be considered material to the financial statements under the methodology prescribed by SAB 108. Therefore, the Company recorded a cumulative effect adjustment to the applicable carrying values of liabilities for these previous errors as of April 1, 2006, with an offsetting adjustment to retained earnings. The amount recorded was a debit of $256,000 to accrued expenses with the offsetting credit of $256,000 to retained earnings. The error was discovered during the three months ended December 2006 and the adjustment was recorded at that time. The understatement of expense was not considered material for any other reported period and those results were therefore not restated.
Software Products Segment
General and administrative expenses for the Software Products segment were $2.8 million in fiscal 2007 compared to $3 million in fiscal 2006. The decrease was due to the above-mentioned SAB 108 adjustment and decreased allocation expenses of general and administrative costs as a result of a lower relative percentage of Software Product Segment revenues to total revenues.
Strategic Consulting Services Segment
General and administrative expenses for the Strategic Consulting Services segment remained relatively constant at $2.3 million for fiscal 2007 and fiscal 2006, respectively.
Year Ended March 31, 2006 and 2005
Research and Development
Research and development expenses consist mainly of payroll, payroll related expenses and consulting expenses.
Software Products Segment
Research and development expenses were $3.5 million in fiscal 2006 compared to $2.9 million in fiscal 2005. The increase in research and development expenses in absolute dollars, and as a percentage of revenue, for
fiscal 2006 compared to fiscal 2005 was primarily due to an increase in third-party consulting expense of approximately $134,000 in the first quarter of fiscal 2006 as well as an increase in salaries and payroll related expenses resulting from the hiring and reallocation of five employees from other departments.
Strategic Consulting Segment
The Strategic Consulting segment does not engage in research and development activities, nor is any such expense allocable to the segment, therefore it does not incur research and development related expenses.
Sales and Marketing
Sales and marketing expenses consist primarily of personnel costs, including salaries, commissions for sales, corporate marketing and travel related costs.
Total Sales and Marketing Expenses
Sales and marketing expenses were $5.6 million in fiscal 2006 compared to $4.0 million in fiscal 2005. The increase in sales and marketing expense in absolute dollars and as a percentage of revenue in the fiscal 2006 was primarily the result of an increase in payroll-related expenses related to the hiring of new executives in April 2005, near the end of first quarter of fiscal 2006, the net increase of two additional employees in the second quarter of fiscal 2006, one new employee in January 2006 and one employee transferred to the our marketing group as we increased our marketing efforts in the second quarter of fiscal 2006. In addition, there was an increase in sales commission resulting from the signing of new contracts in the third and fourth quarters of fiscal 2006 and an increase in marketing expenses related to a sales conference during the third quarter of fiscal 2006.
The software products and strategic consulting segments both have dedicated sales and marketing resources, as well as a shared pool of sales and marketing resources which are allocated to the segments based on each segment’s revenue as a relative percentage of total revenues. Inter-segment sales costs related to the shared pool of resources are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.
Software Products Segment
Sales and marketing expenses for the Software Products segment were $3.3 million in fiscal 2006 compared to $2.5 million in fiscal 2005. The increase in sales and marketing expense in absolute dollars in the fiscal 2006 was primarily due to an increase in payroll and payroll related costs, which includes employment placement fees associated with the hiring of new executives in first quarter of fiscal 2006, additional employees hired in the second quarter of fiscal 2006, a new employee hired as software trainer to service clients in the third quarter of fiscal 2006, increased commission expenses and marketing expenses related to the sales conference that took place in the third quarter of fiscal 2006. The increase in sales and marketing expenses as a percentage of revenue was also a result of higher growth in expenses relative to the growth in revenue.
Strategic Consulting Segment
Sales and marketing expenses for the Strategic Consulting segment were $2.3 million in fiscal 2006 compared to $1.5 million in fiscal 2005. The increase in absolute dollars and as a percentage of revenue was primarily due to the result of an increase in payroll and payroll related expenses of $800,000 resulted from hiring two new executives hired in the first quarter of fiscal 2006 and two new sales personnel hired in second and third quarter of fiscal 2006. The increase in expense was also due to $29,000 related to the inside sales conference that took place in the third quarter of fiscal 2006.
General and Administrative
General and administrative expenses consist primarily of personnel costs of executive officers and support personnel, facilities, investor relations, legal and accounting fees.
Total General and Administrative Expenses
General and administrative expenses were $5.3 million in fiscal 2006 compared to $4.9 million in fiscal 2005. The increase during fiscal 2006 as compared to fiscal 2005 was primarily the result of an increase of approximately $368,000 due to an increase in depreciation related expense associated with the implementation of a new ERP system, additional facility-related expenses associated with moving to new facilities, a $202,000 increase in investor relations costs and a $279,000 increase in consultant fees, offset by a decrease of approximately $140,000 in bad debt expense and a decrease of approximately $353,000 in legal fees and employee benefits. General and administrative expenses not specifically associated with corporate initiatives are allocated based on each segment’s revenues as a relative percentage of total revenues. In fiscal 2006, $19,000 of general and administrative expenses were associated with corporate initiatives and not allocated to the segments, compared to $115,000 in fiscal 2005.
Software Products Segment
General and administrative expenses for the Software Products segment were $3.0 million in fiscal 2006 compared to $2.5 million in fiscal 2005. The increase in general and administrative expense in absolute dollars in fiscal 2006 was primarily the result of an increase in professional service fees and other general business expenses, such as insurance, and an increase in the allocation of facility-related expenses. General and administrative costs for the Software Product segment also increased as the result of a higher relative percentage of Software Product segment revenues to total revenue. The increase in general and administrative expenses as a percentage of revenue was also a result of higher growth in expense relative to the growth in revenue.
Strategic Consulting Segment
General and administrative expenses for the Strategic Consulting segment were $2.2 million in fiscal 2006 compared to $2.3 million in fiscal 2005. The decrease in general and administrative expense in fiscal 2006 was primarily the result of a decrease in the allocation of general and administrative costs to the Strategic Consulting segment as the result of a lower relative percentage of Strategic Consulting segment revenues to total revenues, as well as lower professional fees related to international entities.
Other Income (Expense)
Other income, net of expense, was $372,000 in fiscal 2007 compared to $16,000 in fiscal 2006. We started to purchase short term investments in fiscal 2007. The increase in other income in fiscal 2007 was due to higher interest rates on our short term investments.
Other income, net of expense, was $16,000 in fiscal 2006 compared to other expense, net of other income of $125,000 in fiscal 2005. The increase in other income occurred primarily as a result of a higher interest income on a higher average cash balance in fiscal 2006, offset by lower interest expense due to lower outstanding balance on term loans.
Provision for Income Taxes
We recorded income tax provisions of $147,000 and $68,000 for fiscal 2007 and fiscal 2006, respectively, which were attributable to federal and state alternative minimum taxes, other state taxes and foreign income tax. The amounts provided were at rates less than the combined U.S. federal and state statutory rates due to the recognition of federal and state net operating loss carry forwards. As of March 31, 2007, we had federal and state net operating loss carryforwards of $55.5 million and $53.2 million respectively, which begin to expire in the years fiscal 2007 through 2025, if not utilized. We have recorded a valuation allowance against the entire net operating loss carry-forwards because of the uncertainty that we will be able to realize the benefit of the net operating loss carry-forwards before they expire. We have federal and state research and development tax credit carry-forwards of approximately $1.2 million and $728,000, respectively. The federal research and development credits begin to expire in fiscal 2012 through 2026, and the state credits can be carried forward indefinitely.
Under the Tax Reform Act of 1986, the amounts of and benefits from net operating loss carryforwards and credit carryforwards may be impaired or limited in certain circumstances. Events which may restrict utilization of a company’s net operating loss and credit carryforwards include, but are not limited to, certain ownership change limitations as defined in Internal Revenue Code Section 382 and similar state provisions. As a result of these ownership changes, our ability to utilize carryforwards may be restricted to an annual limitation. This annual limitation could result in the expiration of net operating loss carryforwards and credit carryforwards before utilization.
Off-Balance Sheet Arrangements
As of March 31, 2007, we did not have any off-balance sheet arrangements.
Liquidity and Capital Resources
From our inception through the initial public offering of our common stock, we funded operations through the private sale of preferred stock, with net proceeds of approximately $38 million, limited borrowings and equipment leases. In August 2000, we completed our initial public offering of 3,000,000 shares of common stock, at a price of $10.00 per share, all of which were issued and sold by us for net proceeds of $26.4 million, net of underwriting discounts and commissions of $2.1 million and expenses of $1.5 million. We paid $6.1 million to holders of our Series C preferred stock at the closing of the offering as required by the terms of the Series C preferred stock. After this payment, our net proceeds were $20.3 million. In June and September of fiscal 2003, we completed a private placement of preferred stock to several of our investors, raising additional net proceeds of $7.2 million, as further described below.
Summarized cash, working capital and cash flow information is as follows (dollars in thousands):
Cash, Cash Equivalents and Short-term Investments. As of March 31, 2007, our cash and cash equivalents consisted primarily of demand deposits and money market funds. Our short-term investments consisted primarily of corporate notes and bonds, government securities and other debt securities with an original maturity at the time of purchase of over three months. The increase in our cash, cash equivalents and short-term investments in fiscal 2007 was primarily due to $6.0 million provided by operating activities, offset by $1.7 million used in financing activities. Our working capital, defined as current assets less current liabilities, increased primarily due to an increase in cash, cash equivalents and short term investments.
Cash Flows Provided by Operating Activities. Cash flows provided by operating activities increased by $3.1 million in fiscal 2007, compared to fiscal 2006, primarily due to a $1.5 million decrease in accounts receivable associated with increased efforts in cash collection, and a $1.5 million increase in accrued compensation and deferred revenue as well as a $1.3 million increase in net income between years, partially offset by a $225,000 decrease in prepaid expenses and a $539,000 increase in accrued expenses.
Cash Flows Used for Investing Activities. Cash flows used in investing activities in fiscal 2007 was primarily related to $8.7 million in purchases of short term investments, offset by $1.9 million in proceeds from sale of short term investments.
Cash Flows Used for Financing Activities. Cash flows used in financing activities increased in fiscal 2007 compared to fiscal 2006 was primarily a result of payments against our outstanding loan facilities with Silicon Valley Bank, including the paydown of $1.0 million to our line of credit.
Credit Facilities and Loans. The Company has a credit facility with Silicon Valley Bank (the “Bank”), providing for up to $3 million in borrowings, secured against 80% of eligible accounts receivable. If the Company’s modified quick ratio is equal to 2.5:1 or greater, the Bank may include foreign accounts receivable to determine eligible receivables. However, if the modified quick ratio is less than 2.5:1, all or a portion of foreign accounts may be excluded from eligible account receivables. There was no outstanding borrowing under this facility at March 31, 2007.
The Company had a secured term loan payable over 48 months, with monthly payments that commenced in July 2002. The balance was paid off as of June 30, 2006. In February 2005, the Company secured an additional term loan for the purchase of a new financial system, which was added to the existing term loan. The $300,000 additional term loan is payable over 36 months. The balance outstanding on the additional term loan as of March 31, 2007 was $92,000. In addition, we secured an equipment credit facility through June 2006 for up to $600,000. Each advance will be payable over 36 months. As of March 31, 2007, the balance on this equipment credit facility was $300,000.
On January 2, 2007, the Company and the Bank entered into the Sixth Amendment (the “Loan Amendment”) to the Loan and Security Agreement, effective as of May 24, 2004 by and between Silicon Valley Bank and the Company, as amended (the “Loan and Security Agreement”). The Loan Amendment amends in part Section 2.4 of the Loan and Security Agreement to lower the interest rate payable at a per annum rate of 0.375% above the prime rate on the advances, and amends Section 13.1 of the Loan and Security Agreement by changing the “Revolving Maturity Date” to May 24, 2008. In addition, the Loan Amendment amends in part Section 6.7 of the Loan and Security Agreement by deleting section 6.7(iii), “Tangible Net Worth” in its entirety. Furthermore, the Loan Amendment also provides for additional representation and warranties by the Company.
The Company must maintain a minimum modified quick ratio of 2:1. Certain of our assets, excluding intellectual property, secure both facilities. We were in compliance with all financial covenants as of March 31, 2007.
Preferred Stock Financing. On June 26, 2002 and September 11, 2002, we completed private placements of our securities to certain entities affiliated with Alloy Ventures, Inc. and the Sprout Group, both of which were existing stockholders, pursuant to a Preferred Stock and Warrant Purchase Agreement (the “Purchase
Agreement”). Pursuant to the Purchase Agreement, we sold an aggregate of 1,814,662 units (each a “Unit,” and collectively the “Units”). Each Unit consisted of one share of our Series A redeemable convertible preferred stock (the “Series A Preferred”) and a warrant to purchase one share of our common stock. The purchase price for each Unit was $4.133, which is the sum of $4.008 (four times the underlying average closing price for our common stock over the five trading days prior to the initial closing (i.e., $1.002)) and $0.125 for each share of Series A Preferred and warrant, respectively. The second closing, which occurred on September 11, 2002, was subject to stockholder approval, which was obtained on September 6, 2002.
The Series A Preferred is redeemable beginning on June 26, 2007 upon the affirmative vote of at least 75% of the holders of Series A Preferred, at a price of $4.008 per share plus any unpaid dividends. Each share of Series A Preferred is convertible into four shares of our common stock at the election of the holder or upon the occurrence of certain other events. The holders of Series A Preferred are entitled to receive, but only out of legally available funds, quarterly cumulative dividends at the rate of 8% per year commencing in September 2002, which are payable in cash or shares of Series B redeemable convertible preferred stock (the “Series B Preferred” and, together with the Series A Preferred, the “Preferred Stock”), at the election of the holder. The terms of the Series B Preferred are identical to the Series A Preferred, except that the Series B Preferred is not entitled to receive the 8% dividends. In the event of any liquidation or winding up of the company, the holders of the Series A Preferred and Series B Preferred shall be entitled to receive in preference to the holders of the common stock a per share amount equal to the greater of (a) the original issue price, plus any accrued but unpaid dividends and (b) the amount that such shares would receive if converted to common stock immediately prior thereto (the “Liquidation Preference”). After the payment of the Liquidation Preference to the holders of Preferred Stock, the remaining assets shall be distributed ratably to the holders of the common stock. A merger, acquisition, sale of voting control of the Company in which our stockholders do not own a majority of the outstanding shares of the surviving corporation, or a sale of all or substantially all of our assets, shall be deemed to be a liquidation.
Our preferred stockholders have elected in the past, and may continue to elect, to receive their quarterly dividend payments in the form of Series B Preferred shares instead of cash. Beginning on June 26, 2007, the holders of our preferred stock may elect to have us redeem all or a portion of their shares of preferred stock at any time, or we may elect to redeem all of the outstanding shares of preferred stock. If we were required, or if we elected, to redeem all the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $8 million.
The holders of Series A Preferred and Series B Preferred are entitled to vote together with the common stock. Each share of Preferred Stock has a number of votes equal to the number of shares of common stock then issuable upon conversion of such share of Preferred Stock. In addition, consent of the holders of at least 75% of the then outstanding Preferred Stock is required for certain actions, including any action that amends our charter documents so as to adversely affect the Preferred.
The warrants are generally exercisable for a period of five years from issuance at an exercise price of $1.15 per share. However, the expiration date of the warrants is extended by one day for each day that a registration statement covering the resale of the shares of common stock issuable upon exercise of the warrants is not effective or otherwise suspended. The earliest maturity date as of March 31, 2007 is September 27, 2011.
During fiscal 2007, we recorded $746,000 in dividends to the Series A Preferred stockholders and we recorded an additional $48,000 in accrued dividends payable as of March 31, 2007.
Contractual Commitments. During fiscal 2007, we recorded rent expense related to operating lease arrangements of $351,000.
The following is a summary of our contractual commitments associated with our debt and lease obligations as of March 31, 2007 (in thousands):
(1) The holders of the preferred stock may elect to have us redeem the preferred stock immediately after it becomes redeemable in June 2007. However, if this does not occur then we will continue to pay dividends in the aggregate amount of approximately $582,000 per year. Further, the terms of the preferred stock provide that it will automatically convert to common stock in the event of a public offering meeting certain minimum conditions, and if this were to occur, our obligation to pay dividends or redeem the preferred stock would cease at that time. Any of these outcomes cannot be readily determined. The amounts presented in the table above reflect only our contractual obligations related to dividend payments to the holders of the preferred stock up to June 2007, at which point the stock may or may not redeem. We also refer the reader to the discussion of the redeemable convertible preferred stock in Note 7 of the Notes to Consolidated Financial Statements.
Short Term and Long Term Liquidity. We believe that the combination of our cash and cash equivalents and currently anticipated cash flow from operations should be adequate to sustain operations through the next 12 months. We are managing the business to achieve positive cash flow utilizing existing assets. Although operating expenses have increased, which is consistent with the growth of the Company over the past several fiscal years, we generated positive operating cash flow for fiscal 2007, 2006 and 2005. There is no assurance that we can continue to maintain positive cash flow. We are committed to the successful execution of our operating plan and we will take continued actions as necessary to ensure our cash resources are sufficient to fund our working capital requirements at least through fiscal 2008.
Our long-term liquidity and capital requirements will depend on numerous factors including our future revenues and expenses, growth or contraction of operations and general economic pressures. We may not be able to maintain our current market share, or continue to expand our business, without investing in our operations, technology, or product and service offerings. In order to do so, we may need to raise additional funds through public or private financings or other sources to fund our operations. However, our common stock is not listed on an exchange, and until it is listed it will be difficult for us to make sales of our equity stock. In addition, the terms of our preferred stock may prevent us from issuing additional shares of preferred stock on terms that investors would require in order to invest in our preferred stock. The necessity of raising additional funds could require us to incur debt on terms that could restrict our ability to make capital expenditures and incur additional indebtedness. As a result, we may not be able to obtain additional funds on commercially reasonable terms, or at all. In addition, beginning in June 2007, the holders of our preferred stock can force us to redeem the shares of our preferred stock, and if we were required to redeem all of the shares of preferred stock currently outstanding, this would entail a cash outlay of approximately $8 million.
Impact of Inflation
The effects of inflation and changing prices on our operations were not significant during the periods presented.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
We had cash, cash equivalents and short-term investments totaling $14.7 million at March 31, 2007. These amounts were invested primarily in money market funds and instruments, corporate notes and bonds, government securities and other debt securities with strong credit ratings. The cash, cash equivalents and short-term investments are held for working capital purposes. We do not enter into investments for trading or speculative purposes.
Our fixed-income portfolio is subject to interest rate risk. Fluctuations in the value of our investment securities caused by a change in interest rates (gains or losses on the carrying value) are recorded in other comprehensive income, and are realized only if we sell the underlying securities.
At March 31, 2007, we had cash and cash equivalents totaling $7.8 million.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Supplementary Data
The following tables set forth unaudited quarterly supplementary data for each of the years in the two-year period ended March 31, 2007.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Grant Thornton LLP, Independent Registered Public Accounting Firm
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Redeemable Convertible Preferred Stock and Stockholders’ Equity (Deficit)
Consolidated Statements of Cash Flows
Notes to the Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
Board of Directors and Shareholders
Pharsight Corporation and subsidiaries
We have audited the accompanying consolidated balance sheet of Pharsight Corporation (“the Company”) and its subsidiaries as of March 31, 2007, and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders’ equity (deficit) and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. The Company is not required to have, nor were we engaged to perform an audit of its internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pharsight Corporation. and its subsidiaries as of March 31, 2007, and the consolidated results of their operations and their cash flows for the year then ended in conformity with accounting principles generally accepted in the United States of America.
Our audit was conducted for the purpose of forming an opinion on the basic financial statements taken as a whole. Schedule II is presented for purposes of additional analysis and is not a required part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in the audit of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
As discussed in Note 2 to the consolidated financial statements, effective April 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123(R), Share-Based Payment, applying the modified prospective method.
/s/ GRANT THORNTON LLP
San Jose, CA
June 22, 2007
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Pharsight Corporation
We have audited the accompanying consolidated balance sheet of Pharsight Corporation as of March 31, 2006, and the related consolidated statements of operations, redeemable convertible preferred stock and stockholders’ equity (deficit), and cash flows for each of the two years in the period ended March 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit also 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 our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pharsight Corporation at March 31, 2006, and the consolidated results of its operations and its cash flows for each of the two years in the period ended March 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
/s/ Ernst & Young LLP
San Jose, California
May 5, 2006
PHARSIGHT CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
PHARSIGHT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
The accompanying notes are an integral part of these consolidated financial statements.
PHARSIGHT CORPORATION
CONSOLIDATED STATEMENTS OF REDEEMABLE CONVERTIBLE PREFERRED STOCK
AND STOCKHOLDERS’ EQUITY (DEFICIT)
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
PHARSIGHT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
The accompanying notes are an integral part of these consolidated financial statements.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. Description of Business
Pharsight Corporation (“Pharsight” or the “Company”) develops and markets software and provides strategic consulting services that help pharmaceutical and biotechnology companies improve the efficiency of the drug development decision making process, by reducing the costs and time requirements of their drug development, and commercialization efforts. Pharsight’s products include proprietary software for clinical trial simulation and computer-aided trial design, for the statistical analysis and mathematical modeling of data, for the development of in-vivo-in vitro correlations and the management of related datasets and workflow, for streamlined on-site validation of certain of our products, for the storage, management, and regulatory reporting of derived data and models in data repositories, and for dynamic visualization and communication of model-based product profiles. The Company’s software products and services utilize expertise in the sciences of pharmacology, drug and disease modeling, human genetics, biostatistics and strategic decision-making. Pharsight Corporation was incorporated in California in April 1995 and reincorporated in Delaware in June 2000.
Pharsight operated in two operating segments through fiscal 2007, which are also its reportable segments: Software Products and Strategic Consulting Services. These segments were determined based on how management and the Company’s Chief Operating Decision Maker, CODM, who is the Company’s chief executive officer, view and evaluate the business.
2. Summary of Significant Accounting Policies
Basis of Consolidation
The consolidated financial statements include the accounts of Pharsight and its wholly owned subsidiaries. All intercompany balances and transactions have been eliminated.
Use of Estimates
Pharsight’s financial statements are prepared in accordance with U.S. generally accepted accounting principles, or U.S. GAAP. These accounting principles require the Company to make certain estimates, judgments and assumptions. The Company believes that the estimates, judgments and assumptions upon which they rely are reasonable based upon information available to them at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, the Company’s financial statements will be affected.
Cash and Cash Equivalents
Cash equivalents consist of highly liquid investments with original maturities from the date of purchase of three months or less. Investments with an original maturity at the time of purchase of over three months are classified as short-term investments regardless of maturity date as all investments are classified as available-for-sale and can be readily liquidated to meet current operational needs. Realized gains and losses and declines in value judged to be other than temporary on available-for-sale securities are included in interest income.
Fair Value of Financial Instruments
The carrying values of Pharsight’s cash and cash equivalents, accounts receivable and payable, and accrued liabilities approximate their fair values due to their short-term nature. The fair values of notes payable are estimated based on current interest rates available to Pharsight for debt instruments with similar terms, degrees of risk, and remaining maturities. The carrying values of these obligations approximate their respective fair values.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Foreign Currency Translation
For foreign subsidiaries using the local currency as their functional currency, assets and liabilities are translated at exchange rates in effect at the balance sheet date and income and expenses are translated at average exchange rates. The effects of these translation adjustments are reported as a separate component of stockholders’ equity. Remeasurement adjustments for non-functional currency monetary assets and liabilities are included in other income (expense) in the accompanying consolidated statements of operations.
Allowance for Doubtful Accounts
We maintain an allowance for doubtful accounts at an amount estimated to be sufficient to provide adequate protection against losses resulting from collecting less than the full payment on our currently outstanding receivables. We make judgments as to our ability to collect receivables and provide allowances for the portion of receivables when collection becomes doubtful. Provisions are made based upon a specific review of all significant outstanding invoices. In determining our allowances, we analyze our historical collection experience and current economic trends. The Company reduced its allowance for doubtful accounts during the year ended March 31, 2006 by $37,000 through a reduction in general and administrative expense due to management’s change in estimate of those accounts receivable at risk of not being collected. The allowance for doubtful accounts during the year ended March 31, 2007 and March 31, 2006 was $20,000, respectively.
Property and Equipment
Property and equipment are carried at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the estimated useful lives of three to five years. Property under capital leases is amortized over the lesser of the useful lives of the assets or the lease term. Amortization expense related to these assets is included in depreciation expense.
Internal Use Software
Pharsight accounts for internal use software costs, in accordance with Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use” (“SOP 98-1”). In accordance with SOP 98-1, Pharsight capitalizes costs to develop software for internal use when preliminary development efforts are successfully completed and management has authorized and committed project funding and it is probable that the project will be completed and the software will be used as intended. Costs incurred prior to meeting these criteria, together with costs incurred for training and maintenance, are expensed. Costs incurred for upgrades and enhancements that are probable to result in additional functionality are also capitalized. All capitalized costs are included in property, plant and equipment and are amortized to expense over their expected useful lives.
Income Taxes
Pharsight accounts for income taxes under the liability method whereby deferred tax asset or liability account balances are calculated at the balance sheet date using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amounts expected to be realized.
Revenue Recognition
Our revenues are derived from three primary sources: (1) initial and renewal fees for term-based and perpetual product licenses, and post-contract customer support (PCS), (2) services related to scientific and training consulting and software deployment, and (3) strategic consulting services.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Our revenue recognition policy is in accordance with Statement of Position No. 97-2, “Software Revenue Recognition” (“SOP 97-2”), as amended. For each arrangement, we determine whether evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, collection is probable, and no significant post-delivery obligations remain unfulfilled. If any of these criteria are not met, we defer revenue recognition until such time as all of the criteria are met. We do not currently offer, have not offered in the past, and do not expect to offer in the future, extended payment term arrangements. If we do not consider collectability to be probable, we defer recognition of revenue until the fee is collected.
Software Product Services Segment
We enter into arrangements for one-year software licenses (initial and renewal fees) bundled with post-contract support services, or PCS, from which we receive solely license and renewal fees. We do not have VSOE of fair value to allocate the fee to the separate elements, as we do not sell this PCS separately. Therefore, we do not present PCS revenue separately in connection with these arrangements, and we do not believe other allocation methodologies, namely allocation based on relative costs, provide a meaningful and supportable allocation between license and PCS revenues. We recognize each of the initial and renewal license fees ratably over the one-year period of the license during which the PCS is expected to be provided as required by paragraph 12 of SOP 97-2. Revenues from bundled arrangements are recorded as license revenues in the statement of operations in the initial year and as renewal revenue in subsequent years.
We enter into arrangements consisting of perpetual or term-based licenses and PCS. We do not have VSOE of fair value to allocate the fee to the separate elements. We recognize revenue attributable to license and PCS ratably over the remaining period of the PCS term once the product is delivered. For financial statement presentation purposes, revenues from arrangements that include perpetual licenses are allocated among and recorded as license and maintenance revenue based upon management’s estimate of fair value and the Company’s price list. Renewals of related PCS are recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses.
We enter into arrangements that consist of perpetual and term-based licenses, PCS and implementation/installation services. For arrangements involving a significant amount of services related to installation and implementation of our software products, we recognize revenue for the entire arrangement ratably over the remaining period of the PCS term once the implementation and installation services are completed and accepted by the customer. We currently do not have VSOE of fair value for PCS. For financial statement presentation purposes, revenues from arrangements that include perpetual and term-based licenses are allocated among and recorded as license, maintenance, renewal and service revenue based upon management’s estimate of fair value and the Company’s price list. Renewals of related PCS are recorded as maintenance revenue for perpetual licenses and renewal revenue for term-based licenses. The implementation/installation services revenues are recorded as services revenue in the statement of operations.
We enter into arrangements consisting of optional scientific consulting services. The optional scientific consulting services meet the criteria of paragraph 65 of SOP 97-2 for separate accounting, as they are not essential to the functionality of the delivered software, are described and priced separately in the arrangement and are sold separately. We recognize fees from optional scientific consulting services (equal to the amounts set forth in the contracts) as revenue as these services are provided or upon their acceptance, as applicable.
For arrangements consisting solely of services, we recognize revenue as consulting services are performed. Arrangements for consulting services may be charged at daily rates for different levels of consultants and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee contracts, with payments based on milestones or acceptance criteria, we recognize revenue using the proportional performance method-as such
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
milestones are achieved, or if customer acceptance of the milestone’s completion is required, upon such customer acceptance, which approximates the level of services provided. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.
We have two international distributors. There is no right of return or price protection for sales to the international distributors Revenue on sales to these distributors are recognized ratably over the license term when the software is delivered to the distributors and other revenue recognition criteria are met.
Strategic Consulting Segment
We enter into arrangements for strategic consulting contracts, which do not fall under the scope of SOP 97-2. Arrangements for consulting services may be charged at daily rates and out-of-pocket expenses, or may be charged as a fixed fee. For fixed fee with payments based on milestones or acceptance criteria, we recognize revenue using the proportional performance method-as such milestones are achieved, or if customer acceptance is required, upon customer acceptance, which approximates the level of services provided. Management makes a number of estimates related to recognizing revenue for such contracts, as discussed above. A number of internal and external factors can affect our estimates, including labor rates, utilization and efficiency variances, specification and testing requirement changes, and unforeseen changes in project scope.
Judgments Affecting Revenue Recognition
Revenue results are difficult to predict, and any shortfall in revenue or delay in recognizing revenue could cause our operating results to vary significantly from quarter to quarter. We recognize revenue in accordance with U.S. GAAP rules that have been prescribed for the software industry. The accounting rules related to revenue recognition are complex and are affected by interpretations of the rules and an understanding of industry practices, both of which are subject to change. Consequently, the revenue recognition accounting rules require management to make significant judgments.
We do not record revenue on sales to customers whose ability to pay is in doubt at the time of sale. Rather, we recognize revenue from these customers as cash is collected. The determination of a customer’s ability to pay requires significant judgment. In this regard, management considers the international region of the customer and the financial viability of the customer in assessing a customer’s ability to pay.
We generally do not consider revenue arrangements with extended payment terms to be fixed or determinable and, accordingly, we do not generally recognize revenue on these arrangements until the customer payments become due. The determination of whether extended payment terms are fixed or determinable requires management to exercise significant judgment, including assessing such factors as the past payment history with the individual customer and evaluating the risk of concessions over an extended payment period. The determinations that we make can materially impact the timing of recognition of revenues. Our normal payment terms currently range from “net 30 days” to “net 60 days,” which are not considered by us to be extended payment terms.
The majority of our Pharsight Knowledgebase Server (“PKS”) software arrangements include software deployment services. We defer revenue for software deployment services, along with the associated license revenue, until the services are completed. If there is significant uncertainty about the project completion or receipt of payment for the professional services, we defer revenue until the uncertainty is sufficiently resolved.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Deferred Revenue
Deferred revenue is comprised of license fees (initial and renewal), which are recognized ratably over the one-year period of the license. In addition, deferred revenue includes services and training revenue, which will be recognized as services are performed. Deferred revenue also includes license and service fees for arrangements that include significant implementation services, which have not yet been completed. Long-term deferred revenue represents amounts received for maintenance and support services to be provided beginning in periods on or after April 1, 2007.
The principal components of deferred revenue at March 31, 2007 and 2006 were as follows (in thousands):
Shipping Costs
Shipping and handling costs are included under cost of license and renewal for all periods presented. These costs were insignificant in all periods presented.
Research and Development
Pharsight capitalizes eligible computer software development costs as products achieve technological feasibility, subject to net realizable value considerations. Pharsight has defined technological feasibility as completion of a working model. As of March 31, 2007 and 2006, there were no such internal capitalizable costs. Accordingly, Pharsight has charged all such internal costs to research and development expenses in the accompanying statements of operations as required by Statement of Financial Accounting Standards (“SFAS”) No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed”.
Advertising
Pharsight expenses the cost of advertising as incurred. These costs were insignificant in all periods presented.
Net Income (Loss) per Share
Basic net income (loss) per share attributable to common stock is computed by dividing net income or loss attributable to common stockholders for the period by the weighted-average number of shares of vested common stock (i.e. not subject to a right of repurchase) outstanding during the period.
Diluted net income (loss) per share attributable to common stockholders is computed by dividing net income attributable to common stockholders for the period by the weighted-average number of shares of vested
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
common stock outstanding and, where dilutive, weighted average number of shares of unvested common stock outstanding. Diluted net income (loss) per common share attributable to common stock also gives effect, as applicable, to the potential dilutive effect of outstanding stock options and warrants to purchase common stock using the treasury stock method, and convertible preferred stock using the as-if-converted method, as of the beginning of the period presented or the original issuance date, if later.
The following table presents the calculation of basic and diluted net income (loss) per share (in thousands, except per share data):
Common equivalent shares (on an as-converted basis) have been excluded from the computation of diluted earnings per share in 2007 and 2006 because their effects are antidilutive.
The number of potential common shares excluded from the calculation of basic net income (loss) per share attributable to common stockholders at March 31, 2007, 2006 and 2005 is detailed in the following table (in thousands):
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Stock-Based Compensation
The Company has adopted several stock plans that provide equity instruments to our employees and non-employee directors. Our plans include incentive and non-statutory stock options and restricted stock awards. Stock options generally vest ratably over a four-year period on the anniversary date of the grant, and expire ten years after the grant date. The Company also has employee stock purchase plans that allow qualified employees to purchase Company shares at 85% of the fair market value on specified dates.
Prior to April 1, 2006, we accounted for stock-based employee compensation plans under the measurement and recognition provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and related Interpretations, as permitted by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”). We generally recorded no stock-based compensation expenses during periods prior to April 1, 2006 as all stock-based grants had exercise prices equal to the fair market value of our common stock on the date of grant. We also recorded no compensation expense in connection with our employee stock purchase plans as they qualified as non-compensatory plans following the guidance provided by APB 25. In accordance with SFAS 123 and SFAS 148, “Accounting for Stock-Based Compensation-Transition and Disclosure,” we disclosed our net income or loss and net income or loss per share for the years ended March 31, 2006 and 2005 as if we had applied the fair value based method in measuring compensation expense for our stock-based compensation programs. Under SFAS 123, we elected to calculate our compensation expense by applying the Black-Scholes valuation model, applying the graded vesting expense attribution method and recognizing forfeited awards in the period that they occurred.
Effective April 1, 2006, we adopted the fair value recognition provisions of Statement of Financial Accounting Standards No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R “) using the modified prospective transition method. Under that transition method, compensation expense that we recognized for the year ended March 31, 2007 included: (a) compensation expense for all share-based payments granted prior to but not yet vested as of April 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation expense for all share-based payments granted or modified on or after April 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. Compensation expense is recognized only for those awards that are expected to vest, whereas prior to the adoption of SFAS 123R, we recognized forfeitures as they occurred. In addition, we elected the straight-line attribution method as our accounting policy for recognizing stock-based compensation expense for all awards that are granted on or after April 1, 2006. For awards subject to graded vesting that were granted prior to the adoption of SFAS 123R, we use an accelerated expense attribution method. Results in prior periods have not been restated.
We estimate the fair value of options granted using the Black-Scholes option valuation model and the assumptions shown below. We estimate the expected term of options granted based on the history of grants, exercises and post-vesting cancellations in our option database. Contractual term expirations have not been significant. We estimate the volatility of our common stock at the date of grant based on historical prices of our common stock to complete the calculation of expected volatility, consistent with SFAS 123R and SEC Staff Accounting Bulletin No. 107. Prior to the adoption of SFAS 123R, we relied exclusively on the historical prices of our common stock in the calculation of expected volatility. We base the risk-free interest rate that we use in the Black-Scholes option valuation model on the implied yield in effect at the time of option grant on U.S. Treasury zero-coupon issues with remaining terms equivalent to the expected term of our option grants. We have never paid any cash dividends on our common stock and we do not anticipate paying any cash dividends in the foreseeable future. Consequently, we use an expected dividend yield of zero in the Black-Scholes option valuation model. We use historical data to estimate pre-vesting option forfeitures and record stock-based compensation expense only for those awards that are expected to vest. For options granted before April 1, 2006, we estimated the fair value using the multiple option approach and we are amortizing the fair value on a graded vesting basis. For options granted on or after April 1, 2006, we estimate the fair value using a single option
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
approach and amortize the fair value on a straight-line basis. All options are amortized over the requisite service periods of the awards, which are generally the vesting periods. We may elect to use different assumptions under the Black-Scholes option valuation model in the future if our current experience indicates that a different measure is preferable, which could materially affect our net income or loss and net income or loss per share.
The following table presents the impact of our adoption of SFAS 123R on selected condensed consolidated statement of operations line items for the year ended March 31, 2007 (in thousands, except per share data):
As required by FAS 148, the following table illustrates the effect on net income (loss) per share if the Company had accounted for its stock option and stock purchase plans under the fair value method of accounting during fiscal 2006 and 2005 (in thousands, except per share amounts):
Valuation Assumptions for Stock Options and ESPP
The Company estimates the fair value of its options using the Black-Scholes option value model, which was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including the expected stock price volatility. The Company’s employee stock options have characteristics significantly different than those of traded options, and changes in the subjective input assumptions can materially affect the fair value estimates.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The fair value of options granted and the option component of the employee purchase plan shares were estimated at the date of grant, assuming no expected dividends, and with the following weighted average assumptions:
Stock Options
The following is a summary of stock option activity during the year ended March 31, 2007:
The weighted average remaining amortization period was 2.55 years as of March 31, 2007. The Company had 2,851,000 exercisable options and the unamortized stock compensation was $1.4 million as of March 31, 2007. Cash received from exercise of stock options in fiscal 2007 was $135,000.
Comprehensive Income
Statement of Financial Accounting Standards No. 130, “Reporting Comprehensive Income” (“SFAS 130”), requires Pharsight to display comprehensive income and its components as part of the financial statements. Comprehensive income includes certain changes in equity that are excluded from net income. Pharsight’s comprehensive income consists of net income adjusted for the effect of foreign currency translation gains or losses.
Recent Accounting Pronouncements
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), which provides interpretive guidance on the consideration of the effects of prior year misstatements in quantifying current year misstatements for the purpose of a materiality assessment. Specifically, SAB 108 articulates the SEC’s position that registrants should quantify the effects of prior period errors using both a balance sheet approach (“iron curtain method”) and an income statement approach (“rollover
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
method”) and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective as of the end of the Company’s 2007 fiscal year, allowing a one-time transitional cumulative effect adjustment to beginning retained earnings as of April 1, 2006 for errors that were not previously deemed material, but are material under the guidance in SAB 108.
The Company evaluated the impact of the adoption of SAB 108 and recorded a cumulative effect adjustment of $256,000 related to the accounting for accrued expenses. The Company was overaccrued on recurring professional services fees included in general and administrative expenses. The error arose as a result of accrual of such services ratably over the year rather than as the service was rendered. Under the rollover method of evaluating misstatements, the effect of the methodology used by the Company did not result in a material misstatement of the financial statements.
The Company evaluated the impact of correcting all misstatements, including both carryover and reversing effects of prior years misstatements on the current year financial statements. The Company determined that the effect of the errors on all prior financial statement filings were immaterial, but would be considered material to the financial statements under the methodology prescribed by SAB 108. Therefore, the Company recorded a cumulative effect adjustment to the applicable carrying values of liabilities for these previous errors as of April 1, 2006, with an offsetting adjustment to retained earnings. The amount recorded was a debit of $256,000 to accrued expenses with the offsetting credit of $256,000 to retained earnings. The error was discovered during the three months ended December 2006 and the adjustment was recorded at that time. The understatement of expense was not considered material for any other reported period and those results were therefore not restated.
In June 2006, the FASB issued FASB Interpretation No. 48 “Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109” (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with Financial Accounting Standards Board Statement No. 109, or FAS 109, “Accounting for Income Taxes”. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Earlier adoption is permitted as of the beginning of an enterprise’s fiscal year, provided the enterprise has not yet issued financial statements, including financial statements for any interim period for that fiscal year. The Company will adopt FIN 48 in the first quarter of fiscal 2008 and currently does not expect that the adoption of FIN 48 will have a material effect on its consolidated results of operations and financial condition.
In September 2006, the FASB issued SFAS 157 “Fair Value Measurements”. SFAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 applies only to other accounting pronouncements that require or permit fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company is in the process of evaluating the impact of the adoption of this statement on its consolidated financial position or results of operations.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
3. Property and Equipment
Property and equipment are stated at cost and consist of the following (in thousands):
4. Concentrations of Credit Risk
Financial instruments that potentially subject Pharsight to concentrations of credit risk consist primarily of cash and cash equivalents, and trade receivables. Pharsight generally invests its excess cash in money market funds, commercial paper, corporate notes and obligations issued by or fully collateralized by the U.S. government or federal agencies. Pharsight places its investments with high-credit quality counterparties and, by policy, limits the amount of credit exposure to any one counterparty.
Pharsight sells its products and services primarily to major pharmaceutical and biotechnology companies. Pharsight evaluates its customers’ financial condition when necessary and routinely receives a deposit for services contracts at the time of sale. Pharsight generally requires no collateral from its customers. To date, Pharsight has not experienced any significant losses with respect to these balances. For the year ended March 31, 2007, 2006 and 2005, respectively, Pharsight wrote off $0, $37,000 and $120,000 against the allowance for doubtful accounts.
The Company receives the majority of its revenue from a limited number of customers. For fiscal 2007, 2006 and 2005, sales to our top two customers accounted for 28%, 42% and 45% of total revenue, respectively and sales to our top five customers accounted for 43%, 52% and 62%. In fiscal 2007, Pfizer, our largest customer, accounted for 17% of our total revenue, and Lilly, accounted for 11% of our total revenue. In fiscal 2006, Pfizer, accounted for 25% of our total revenue, and Lilly, accounted for 17% of our total revenue. In fiscal 2005, Pfizer accounted for 25% and Lilly accounted for 20% of our total revenue.
Three customers comprised 43% of accounts receivable at March 31, 2007. Three customers comprised 47% of accounts receivable at March 31, 2006.
5. Debt
The Company has a credit facility with Silicon Valley Bank (the “Bank”), providing for up to $3 million in borrowings, secured by its accounts receivable. If the Company’s modified quick ratio (defined as cash and cash equivalents and investments plus accounts receivable, divided by total current liabilities, including all bank debt but excluding deferred revenue) is equal to 2.5:1 or greater, the Bank may include foreign accounts receivable to determine eligible receivables. However, if the modified quick ratio is less than 2.5:1, all or a portion of foreign accounts may be excluded from eligible account receivables. There was no outstanding balance at March 31, 2007.
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
The Company had a secured term loan payable over 48 months, with monthly payments that commenced in July 2002. The balance was paid off as of June 30, 2006. In February 2005, the Company secured an additional term loan for the purchase of a new financial system, which was added to the existing term loan. The $300,000 additional term loan is payable over 36 months. The balance outstanding on the additional term loan as of March 31, 2007 was $92,000. In addition, we secured an equipment credit facility through June 2006 for up to $600,000. Each advance will be payable over 36 months. As of March 31, 2007, the balance on this equipment credit facility was $300,000. The interest rate was 8.63% for both loans as of March 31, 2007.
On January 2, 2007, the Company and the Bank entered into the Sixth Amendment (the “Loan Amendment”) to the Loan and Security Agreement, effective as of May 24, 2004 by and between Silicon Valley Bank and the Company, as amended (the “Loan and Security Agreement”). The Loan Amendment amends in part Section 2.4 of the Loan and Security Agreement to lower the interest rate payable at a per annum rate of 0.375% above the prime rate on the advances, and amends Section 13.1 of the Loan and Security Agreement by changing the “Revolving Maturity Date” to May 24, 2008. In addition, the Loan Amendment amends in part Section 6.7 of the Loan and Security Agreement by deleting section 6.7(iii), “Tangible Net Worth” in its entirety. Furthermore, the Loan Amendment also provides for additional representation and warranties by the Company.
The Company must maintain a minimum modified quick ratio of 2:1. Certain of our assets, excluding intellectual property, secure both facilities. We were in compliance with all financial covenants as of March 31, 2007.
The amounts representing interest are based on year end rates. Future minimum payments under the Company’s term loans at March 31, 2007 are as follows (in thousands):
6. Commitments and Contingencies
Operating Leases
Pharsight leases its office facilities under noncancelable operating leases expiring through 2011. Minimum annual rental commitments at March 31, 2007 are as follows (in thousands):
Rent expense was $351,000, $513,000 and $595,000 for the years ended March 31, 2007, 2006, and 2005, respectively.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Contingencies
From time to time and in the ordinary course of business, the Company may be subject to various claims, charges, and litigation. In the opinion of management, final judgments from such pending claims, charges, and litigation, if any, against the Company, would not have a material adverse effect on the Company’s financial position, result of operations, or cash flows.
Guarantees
From time to time, the Company enters into certain types of contracts that contingently require it to indemnify parties against third party claims. These obligations relate to certain agreements with the Company’s officers, directors and employees, under which the Company may be required to indemnify such persons for liabilities arising out of their employment relationship. Other obligations relate to certain commercial agreements with its customers, under which the Company may be required to indemnify such parties against liabilities and damages arising out of claims of patent, copyright, trademark or trade secret infringement by its software. The terms of such obligations vary. Generally, a maximum obligation is not explicitly stated. Because the obligated amounts of these types of agreements often are not explicitly stated, the overall maximum amount of the obligations cannot be reasonably estimated. Historically, the Company has not had to make any payments for these obligations, and no liabilities have been recorded for these obligations on the Company’s balance sheets as of March 31, 2007 and 2006.
7. Preferred Stock
As of March 31, 2007 Pharsight is authorized to issue up to 5,000,000 shares of preferred stock. The Board of Directors designated 2,000,000 shares as Series A preferred stock and 1,200,000 shares as Series B preferred stock. The Board of Directors may determine the rights and preferences of the remaining 1,800,000 shares of preferred stock, subject to limitations provided pursuant to the terms of the Series A and Series B preferred stock.
Series A Redeemable Convertible Preferred Stock and Common Stock Warrants
On June 26, 2002 and September 11, 2002, the Company completed a private placement of 1,814,662 units (each a “Unit,” and, collectively, the “Units”) for an aggregate purchase price of $7.5 million to certain investors. The sale and issuance of the Units were made pursuant to a Preferred Stock and Warrant Purchase Agreement (the “Purchase Agreement”) and closed in two phases. The first phase was completed on June 26, 2002, pursuant to which the Company sold an aggregate of 761,920 Units for an aggregate purchase price of $3.15 million. The second phase was completed on September 11, 2002, pursuant to which the Company sold an aggregate of 1,052,742 Units for an aggregate purchase price of $4.35 million. Each Unit consists of one share of the Company’s Series A redeemable convertible preferred stock (the “Series A Preferred”) and a warrant to purchase one share of common stock (each a “Warrant,” and, collectively, the “Warrants”).
Dividends
The holders of the Series A Preferred are entitled to receive cumulative dividends in preference to any dividend on the common stock, payable quarterly at the rate of 8% per annum, either in cash or in shares of Series B redeemable convertible preferred stock (the “Series B Preferred” and, together with the Series A Preferred, the “Preferred Stock”) at the election of the holder. The Series B Preferred has identical rights, preferences and privileges as the Series A Preferred, except that the Series B Preferred is not entitled to the dividend payment right. During fiscal 2007, at the election of the Series A holders, the Company issued dividends of 72,568 shares of Series B Preferred Stock to Series A holders.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Conversion
The holders of the Preferred Stock have the right to convert the Preferred Stock at any time into shares of common stock. The initial conversion rate is four to one, subject to proportional adjustments for stock splits, stock dividends and recapitalizations.
The Preferred Stock shall be automatically converted into common stock, at the then applicable conversion price, (i) in the event that the holders of at least 75% of the outstanding Preferred Stock consent to such conversion or (ii) upon the closing of a firmly underwritten public offering of shares of common stock of Pharsight for a public offering price of at least $3.006 per share and with gross proceeds to the Company of not less than $40,000,000 (before deduction of underwriters commissions and expenses).
Liquidation Preference
In the event of any liquidation or winding up of Pharsight, the holders of the Preferred Stock shall be entitled to receive in preference to the holders of the common stock a per share amount equal to the greater of (a) the original issue price, plus any accrued but unpaid dividends or (b) the amount that such shares would receive if converted to common stock immediately prior thereto (the “Liquidation Preference”). After the payment of the Liquidation Preference to the holders of the Preferred Stock, the remaining assets shall be distributed ratably to the holders of the common stock. A merger, acquisition, sale of voting control of Pharsight in which the Company’s stockholders do not own a majority of the outstanding shares of the surviving corporation, or a sale of all or substantially all of the Company’s assets, shall be deemed to be a liquidation.
Voting Rights
The holders of Preferred Stock are entitled to vote together with the common stock. Each share of Preferred Stock has that number of votes equal to the number of shares of common stock then issuable upon conversion of such share of Preferred Stock. In addition, consent of the holders of at least 75% of the then outstanding Preferred Stock shall be required for certain actions, including any action that amends the Company’s charter documents so as to adversely affect the Preferred Stock.
Redemption
At the election of the holders of at least 75% of the Preferred Stock, to the extent that the Company may legally do so, the Company shall redeem the outstanding Preferred Stock after the fifth anniversary of the initial issuance of Preferred Stock. Such redemption shall be at a price of $4.008 per share plus accrued and unpaid dividends. If the holders of Preferred Stock shall not have elected to have Pharsight redeem the Preferred Stock at or after the fifth anniversary of the date of issuance, the Company shall have the option to redeem the Preferred Stock on the same terms as the optional redemption by the holders of Preferred Stock.
Registration Rights
Pursuant to the Purchase Agreement, within 55 days following the initial closing, the Company agreed to use its best efforts to prepare and file a registration statement on Form S-3 (the “Registration Statement”) for the resale of the shares of common stock issuable to the purchasers upon conversion of the Preferred Stock and exercise of the Warrants (the “Shares”), and to use commercially reasonable efforts to cause the Registration Statement to become effective within 105 days after the initial closing. In addition, in the event that the Company failed to cause the Registration Statement to be timely filed, timely declared effective, or to be kept effective (other than pursuant to the permissible suspension periods), the Company was obligated to pay to the holders of
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Preferred Stock as liquidated damages the amount of 1% per month of the aggregate purchase price for the shares remaining to be sold pursuant to the Registration Statement.
The Registration Statement covering the shares of common stock issuable upon conversion of the Series A Preferred, the shares of common stock issuable upon exercise of the Warrants sold pursuant to the Purchase Agreement and other shares of common stock held by such stockholders was declared effective on October 31, 2002. The holders of the Preferred Stock waived the right to receive liquidated damages that resulted from the delayed date of effectiveness through November 30, 2002.
The Company has not filed a Registration Statement covering the shares of Series B preferred stock to be issued as a dividend with respect to the Series A Preferred Stock, and therefore, the holders of Preferred Stock accrued additional liquidated damages following November 30, 2002. In February 2003, the holders of the Preferred Stock waived the right to receive the foregoing liquidated damages.
In May 2003, the holders of the Preferred Stock waived the requirement that the Company file a post-effective amendment on Form S-1 in the event that the Company is no longer eligible to use Form S-3. The holders of Preferred Stock also waived the right to receive liquidated damages as a result of the failure to file a post-effective amendment on Form S-1. Notwithstanding the foregoing, the holders of Preferred Stock are entitled to terminate the May 2003 waivers and, as a result, require the Company to file a post-effective amendment on Form S-1 within thirty (30) days from the Company’s receipt of such waiver termination and to cause such post-effective amendment to become effective within ninety (90) days from receipt of such waiver termination, or otherwise incur liquidated damages under the terms of the Purchase Agreement. On June 10, 2003, the Registration Statement ceased to be available for resale of the shares registered thereunder.
Warrants
The Warrants are generally exercisable for a period of five years from the date of issuance at a per share price equal to $1.15, subject to proportional adjustments for stock splits, stock dividends, recapitalizations and the like. The expiration date of the warrants is extended by one day for each day that a registration statement covering the resale of the shares of common stock issuable upon exercise of the warrants is not effective or otherwise suspended. If not exercised after expiration date, the right to purchase the common stock will terminate. The Warrants contain a cashless exercise feature. The common stock issuable upon exercise of the Warrants are entitled to the benefits and subject to the terms of the Registration Rights described above. The earliest maturity date as of March 31, 2007 is September 27, 2011
Summary of Certain Preferred Stock and Warrant Accounting
Due to the nature of the redemption features of the Series A Preferred, the Company has excluded the Series A Preferred from stockholders’ equity in its financial statements.
The amount representing the Series A Preferred with total gross proceeds of $7.5 million was discounted by a total of $2.1 million, including $1.3 million representing the value assigned to the Warrants, $585,000 representing the related beneficial conversion feature of the Series A Preferred, and $268,000 representing issuance costs. The amounts allocated in determining the discount were computed on a relative fair value basis. After reducing the proceeds by the value of the Warrants, the remaining proceeds were used to compute a discounted conversion price in accordance with EITF 00-27, “Application of EITF Issue No. 98-5, Accounting for Convertible Securities with Beneficial Conversion Features or Contingently Adjustable Conversion Ratios to Certain Convertible Instruments.” The discounted conversion price for each of the two closings was compared to
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NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
the fair market value of the Company’s common stock on June 26, 2002 (the date of issuance of the Series A Preferred) and September 6, 2002 (the date of the stockholder vote approving the second closing) that resulted in a total beneficial conversion feature of $585,000, which represents the difference between the fair market value of its common stock and the deemed conversion price.
The net discounted value for the Series A Preferred of $5.6 million was recorded as a long-term liability as of March 31, 2003 with the corresponding aggregate value of the Warrants and the beneficial conversion feature of $1.9 million ($1.3 million plus $585,000) recorded as additional-paid-in-capital within equity.
There were no deemed dividends recorded by the Company for the year ended March 31, 2007, 2006 and 2005. Deemed dividends were recorded by the Company for the year ended March 31, 2004 totaling approximately $339,000, representing accretion of the discount resulting from the value of the beneficial conversion feature. The aggregate deemed dividends recorded were charged against additional-paid-in-capital and included in the calculation of net loss applicable to common stockholders.
Dividends on the Preferred Stock, calculated at the rate of 8% per annum, were $746,000, $738,000 and $610,000 for the years ended March 31, 2007, 2006 and 2005. The dividends were charged against additional-paid-in-capital and included in the calculation of net loss applicable to common stockholders.
During the three months ended June 30, 2003, the Company recorded a $96,000 deemed dividend, for a cumulative amount of $342,000 in total deemed dividends for the Series A Preferred. During the three months ended September 30, 2003, the Company recorded a $243,000 deemed dividend, representing the balance of the $585,000 beneficial conversion feature of the Series A Preferred. The increase in the deemed dividend in the second quarter of fiscal 2004 reflected an adjustment to recognize the remaining amount of the $585,000 beneficial conversion feature. The adjustment for the beneficial conversion feature was initiated by the Company’s reevaluation of the various complex rules surrounding the accounting for the Series A Preferred and the related interpretations under EITF 00-27 for redeemable preferred stock. The amounts of deemed dividends related to the beneficial conversion feature that should have been originally recorded were $484,000 and $101,000 for the three months ended June 30, 2002 and September 30, 2002, respectively. No other amounts representing deemed dividends should have been recorded in other periods. The Company does not believe that the $96,000 and $243,000 amounts recorded as deemed dividends in the three months ended June 30, 2003 and September 30, 2003, respectively, and the $339,000 total amount recorded as deemed dividends in the year ended March 31, 2004, are material to the periods in which they should have been recorded.
The Company will recognize the remaining $1.6 million value of the warrants when and if it becomes probable the warrants will be exercised and will recognize the $268,000 of issuance costs only if it becomes probable that the Series A Preferred will be redeemed.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Series B Redeemable Convertible Preferred Stock
The following table depicts activities for Series B Preferred Stock for three years ended March 31, 2007:
The Series B Preferred has identical rights, preferences and privileges as the Series A Preferred, except that the Series B Preferred is not entitled to the dividend payment right. Due to the nature of the redemption features of the Series B Preferred, the Company has excluded the Series B Preferred from stockholders’ equity in its financial statements.
The amount of the Series B Preferred dividend was determined based on the estimated per share fair value of the Series B Preferred Stock. To record the fair value of the Series B Preferred Stock, the Company performed a valuation based on its 5-day average stock price leading up to and including the Valuation Date. Various factors including, but not limited to, deemed time to liquidity and form of dividend payment were considered in the valuation of the Series B Preferred.
8. Common Stock
Pharsight is authorized to issue up to 120,000,000 shares of common stock. At March 31, 2007, common stock was reserved for future issuance as follows (in thousands):
Warrants
No warrants have been granted during fiscal 2007, 2006 and 2005. The number of warrants outstanding was 2,091,000 for fiscal 2007, 2006 and 2005, respectively.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
9. Stock-Based Benefit Plans
Stock Option Plans
In April 2001 the Board of Directors adopted, and in May 2000 the stockholders approved, the 2000 Equity Incentive Plan (“Incentive Plan”). The Incentive Plan became effective upon Pharsight’s initial public offering in August 2000. The Incentive Plan provides for the granting of stock awards, including incentive stock options, nonstatutory stock options, stock bonuses and rights to acquire restricted stock, to Pharsight’s employees and consultants. In addition, the Incentive Plan provides for non-discretionary grants of nonstatutory stock options to Pharsight’s non-employee directors.
Under the Incentive Plan, the Board of Directors determines the term of each award and the award price. In the case of incentive stock options, the exercise price may not be less than the fair market value on the date of grant, while nonstatutory options and restricted stock awards have exercise prices of not less than 85% of fair market value on the date of grant. Stock bonuses may be granted with a zero exercise price in consideration of past services rendered. In general, stock options vest over a four-year period, 25% on the first anniversary of the grant and ratably on a monthly basis thereafter.
Non-employee directors are eligible to receive nonstatutory stock options with an exercise price equal to fair market value on the date of grant under the Incentive Plan. Each newly appointed director of Pharsight who is (i) not an employee of Pharsight, (ii) is not acting in the capacity of a consultant to Pharsight, and (iii) cannot exercise, individually or in affiliation with any entity or group of entities that exercises voting control over more than 20% of Pharsight’s voting stock (an “Independent Director”), receives a one-time grant of options to purchase 100,000 shares of common stock under the Incentive Plan, which vest monthly over a two-year period and have a maximum term of 10 years (the “Initial Grant”). A director, who was not independent when appointed who later becomes an Independent Director, will receive the Initial Grant at that time. In addition, each eligible director is also granted an option to purchase 10,000 shares of common stock on the day after each Annual Meeting of Stockholders, which vests in full on the first anniversary of the date of grant and has a maximum term of 10 years.
Pharsight has reserved 7,903,209 shares for grant under the Incentive Plan as of March 31, 2007. In 2003, the Board of Directors reduced the number of shares available for grant under the Incentive Plan to comply with certain provisions of the California Code of Regulations. Each January 1, the number of shares reserved will increase automatically by the least of (i) 5% of the total number of common shares outstanding on that date, (ii) 2,000,000 shares, (iii) such fewer number of shares as determined by the Board of Directors, or (iv) so long as Pharsight is subject to certain provisions of the California Code of Regulations, such fewer number of shares such that the Incentive Plan will be in compliance with such provisions. On January 1, 2007 and January 1, 2006, the number of shares reserved for issuance under the Incentive Plan increased by 704,822 and 785,630 shares, respectively.
In April 2001, the Board of Directors approved the UK Company Share Option Plan (“UK Plan”). The UK Plan became effective upon approval of its terms by the Inland Revenue of the United Kingdom (“Inland Revenue”). The UK Plan provides for the granting of stock options to Eligible Employees (as defined in the UK Plan). Pharsight has reserved 200,000 shares for grant under the UK Plan.
Under the UK Plan, the Board of Directors determines the term of each award and the award price (subject to the approval of Inland Revenue). The exercise price of all options may not be less than the fair market value on the date of the grant. In general, stock options vest over a four-year period, 25% on the first anniversary of the grant and ratably on a monthly basis.
Under the UK Plan, any option granted to an eligible employee shall be limited and take effect so that, immediately following such grant, the aggregate market value of all the shares which he or she may acquire upon
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
the exercise in full of all unexercised options then held by him under the UK Plan and any share option plan (other than a savings-related share option plan) approved by the Inland Revenue under Schedule 9 and adopted by the Company or any Associated Company (as defined in the Plan) of the Company, shall not exceed 30,000 English Pounds.
A summary of Pharsight’s stock option activity and related information for the three fiscal years ended March 31, 2007, is as follows (in thousands, except per share amounts):
At March 31, 2007, 2006, and 2005, there were 2,693,741, 2,946,938, and 2,819,654 shares available for future option grants, respectively.
The following table summarizes information about stock options outstanding and exercisable at March 31, 2007 (in thousands, except per share amounts):
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
As of March 31, 2006, the number of excisable stock options was 2,576,288 and weighted average excise price per share was $1.15. As of March 31, 2005, the number of excisable stock options was 2,032,600 and weighted average excise price per share were $1.32.
Employee Stock Purchase Plan
In April 2000 the Board of Directors adopted, and in May 2000 the stockholders approved, the 2000 Employee Stock Purchase Plan (“Purchase Plan”). The Purchase Plan became effective upon Pharsight’s initial public offering in August 2000.
Pharsight has reserved 600,000 shares for issuance under the Purchase Plan as of March 31, 2007. In 2003, the Board of Directors reduced the number of shares available for grant under the Purchase Plan to comply with certain provisions of the California Code of Regulations. Each January 1, the number of shares reserved will be increased automatically by the least of (i) 1.5% of the number of shares of common stock outstanding on that date, (ii) 600,000 shares, (iii) a fewer number as determined by the Board of Directors, or (iv) so long as Pharsight is subject to certain provisions of the California Code of Regulations, such fewer number of shares such that the Incentive Plan will be in compliance with such provisions. On January 1, 2007, the number of shares reserved for issuance under the Purchase Plan did not increase.
Eligible employees may purchase common stock through payroll deductions by electing to have up to 20% of their compensation withheld. Each participant is granted an option to purchase common stock on the first day of each six-month offering period and this option is automatically exercised on the last day of the offering period. The purchase price for the common stock under the Purchase Plan is 85% of the lesser of the fair market value of the common stock on the first day and the last day of the offering period. Offering periods begin on February 1 and August 1 of each year. Shares of common stock issued under the Purchase Plan totaled 45,839, 43,917 and 70,779 in fiscal 2007, fiscal 2006 and fiscal 2005, respectively.
In April 2001, the Board of Directors adopted the 2001 UK Employee Stock Purchase Plan (“UK Purchase Plan”). The UK Purchase Plan became effective immediately. Pharsight has reserved 130,000 shares for issuance under the UK Purchase Plan. Each January 1, the number of shares reserved will be increased automatically by the lesser of 1.5% of the number of shares of common stock outstanding on that date, 130,000 shares or a fewer number as determined by the Board of Directors. On January 1, 2007, 2006 and 2005, the number of shares reserved for issuance under the UK Purchase Plan did not increase.
Eligible employees may purchase common stock through payroll deductions by electing to have up to 20% of their compensation withheld. Each participant is granted an option to purchase common stock on the first day of each six-month offering period and this option is automatically exercised on the last day of the offering period. The purchase price for the common stock under the UK Purchase Plan is 85% of the lesser of the fair market value of the common stock on the first day and the last day of the offering period. Offering periods begin on February 1 and August 1 of each year. Shares of common stock issued under the Purchase Plan totaled 3,667 and 1,620 in fiscal 2007 and fiscal 2006, respectively. There were no shares of common stock issued under the UK Purchase Plan in fiscal 2005.
The weighted average grant date fair value of stock option grants, as calculated using the Black-Scholes model, was as follows:
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
10. Income Taxes
Significant components of provision for income taxes are as follows (in thousands):
The difference between the provision for income taxes and the amount computed by applying the federal statutory income tax rate of 34% to income before income taxes is as follows (in thousands):
Deferred income taxes reflect the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. Significant components of the Company’s deferred tax assets are as follows (in thousands):
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
Realization of deferred tax assets is dependent upon future earnings, if any, the timing and amount of which are uncertain. Management evaluates on a periodic basis the recoverability of deferred tax assets and the need for a valuation allowance based on all available positive and negative evidence. As a result of this review, the net deferred tax assets have been fully offset by a valuation allowance at March 31, 2007. At such time management determines it is more likely than not that the deferred tax assets are realizable, the valuation allowance will be reduced. The valuation allowance for deferred tax assets decreased by approximately $920,000 and $326,000 in the year ended March 31, 2007 and 2006, respectively.
Under the Tax Reform Act of 1986, the amounts of and benefits from net operating loss carryforwards and credit carryforwards may be impaired or limited in certain circumstances. Events which may restrict utilization of a company’s net operating loss and credit carryforwards include, but are not limited to, certain ownership change limitations as defined in IRC Section 382 and similar state provisions. This annual limitation could result in the expiration of net operating loss carryforwards and credit carryforwards before utilization.
As of March 31, 2007, the Company had net operating loss carryforwards for federal and state income tax purposes of approximately $55.5 million and $53.2 million respectively, which begin to expire in the fiscal 2007 through 2025.
We have federal and state research and development tax credit carryforwards of approximately $1.2 million and $728,000, respectively. The federal research and development credits begin to expire in fiscal 2012 through 2026, and the state credits can be carried forward indefinitely.
Utilization of the Company’s net operating loss and credits may be subject to substantial annual limitation due to the ownership change limitations provided by the Internal Revenue Code and similar state provisions. Such an annual limitation could result in the expiration of the net operating loss and credits before utilization.
11. Segment Information
Segment information is presented in accordance with SFAS 131, “Disclosures about Segments of an Enterprise and Related Information.” This standard is based on a management approach, which requires segmentation based upon the Company’s internal organization and reporting of revenue and operating income based upon internal accounting methods. The Company’s financial reporting systems present various data for management to run the business, including internal profit and loss statements prepared on a basis not consistent with accounting principles generally accepted in the United States. Not all assets are allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment and it is impracticable for the Company to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.
The Company’s Chief Operating Decision Maker (“CODM”), as defined by SFAS No. 131, is its Chief Executive Officer. The CODM allocates resources to and assesses the performance of each operating segment using information about their revenue and operating profit before interest and taxes. The Company’s segments are designed to promote alignment of strategic objectives among development, sales, marketing and services organizations; provide for more timely and rational allocation of development, sales and marketing resources within businesses; and for long-term planning efforts on key objectives and initiatives. The segments are used to allocate resources internally and provide a framework to determine management responsibility. Intersegment sales costs are estimated by management and used to compensate or charge each segment for such shared costs, and to incent shared efforts. Management will continually evaluate the alignment of sales and inter-segment commissions for segment reporting purposes, which may result in changes to segment allocations in future periods.
PHARSIGHT CORPORATION
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
As of March 31, 2007, the Company operates in two operating segments, which is also its reportable segments: Software Products and Strategic Consulting. These segments were determined based on how management and its CODM view and evaluate Pharsight’s business.
The Company’s Software Products segment consists of software products and software deployment and integration services that provide the analytical tools and conceptual framework to help clinical researchers optimize the decision-making required to perform the clinical testing needed to bring drugs to market. By applying mathematical modeling and simulation to all available information regarding the compound being tested, researchers can clarify and quantify which trial and treatment design factors will influence the success of clinical trials.
The Company’s Strategic Consulting Services segment consists of consulting, training and process redesign conducted by its clinical and decision scientists in the application and implementation of its core decision methodology. The Company’s methodology enables customers to identify which uncertainties are greatest and matter most, and then to design development programs, trial sequences, and individual trials in such a way that those trials systematically reduce the identified uncertainties, in the most rapid and cost-effective manner possible.
Summarized financial information on the Company’s reportable segments is shown in the following table (in thousands):
Corporate and reconciling amounts include adjustments to state operating income in accordance with U.S. GAAP and corporate level expenses not specifically attributed to a segment. Corporate and reconciling items to
income (loss) from operations include unallocated general and administrative expenses of $0, $19,000 and $115,000 for the fiscal years ending 2007, 2006 and 2005, respectively.
Revenues from sales to customers by major geographic area were as follows (in thousands):
All of the Pharsight’s significant long-lived assets are located within the United States.
12. 401(k) Plan
Pharsight has a 401(k) plan, which covers only US employees. Pharsight’s contributions to the plan are discretionary. Pharsight has made $29,000 in contributions to the plan in fiscal 2007.
13. Warranties
The Company generally provides a warranty for its software products and services to its customers for a period of 90 days and accounts for its warranties under the FASB’s Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies.” The Company’s software products’ media are generally warranted to be free of defects in materials and workmanship under normal use and the products are also generally warranted to substantially perform as described in accompanying Company documentation. The Company also provides for a limited performance warranty for its software products for a period of 90 days from the date of installation at the customer premises, if used as permitted under the signed agreement and in accordance with the Company documentation. The sole remedy that the Company provides is that it will, at its own expense, use commercially reasonable efforts to correct any reproducible error in the software during the warranty period, and if it determines that it is unable to correct the error, the Company will refund the license fee paid for the nonconforming component of the licensed software. The Company’s services are generally warranted to be performed in a professional manner and to materially conform to the specifications set forth in a customer’s signed contract. In the event there is a failure of such warranties, the Company generally will correct or provide a reasonable work around or replacement product. The Company has not provided for a warranty accrual in all periods presented. To date, the Company’s product warranty expense has not been significant.
The Company generally agrees to indemnify its customers against legal claims that the Company’s PKS software product infringes certain third-party intellectual property rights and accounts for its indemnification obligation under Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies”. In the event of such a claim, the Company is obligated to pay those costs and damages finally awarded against customer in any such action that are specifically attributable to such claim, or those costs and damages agreed to in a monetary settlement of such action. In addition, in the event of an infringement, the Company agrees to modify or replace the infringing product, or, if those options are not reasonably possible, in general, to refund the cost of the software paid to date upon the customer’s return of the software product. To date, the Company has not been required to make any payment resulting from infringement claims asserted against its customers. As such, the Company has not recorded a liability for infringement costs in all periods presented.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management evaluated, with the participation of our Chief Executive Officer and our Chief Financial Officer, the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Annual Report on Form 10-K. Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer have concluded that our disclosure controls and procedures are effective to ensure that information we are required to disclose in reports that we file or submit under the Exchange Act is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure, and that such information is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.
Changes in Internal Control Over Financial Reporting
There was no change in our internal control over financial reporting during the fiscal 2007 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
We are in the process of reviewing and analyzing our system of internal controls as we prepare for our first management report on internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act of 2002, which we currently expect to adopt in the fiscal year ending March 31, 2009. In this process we have identified areas of our internal controls requiring improvement, and are in the process of designing and documenting enhanced processes and controls to address these matters.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Information required under this Item concerning our directors, our code of ethics and corporate governance matters will be contained under the caption “Proposal One-Election of Directors” in our definitive Proxy Statement (the “Proxy Statement”) with respect to our 2007 Annual Meeting of Stockholders, and is incorporated by reference into this report. Information required under this Item concerning our Executive Officers is set forth in Part 1 above under the caption “Executive Officers of the Registrant” and is incorporated by reference herein. Information under this Item concerning compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” contained in our Proxy Statement.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required under this Item is incorporated by reference to the sections of the Proxy Statement entitled “Proposal One-Election of Directors-Director Compensation” and “Executive Compensation.”
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required under this Item is incorporated by reference to the sections of the Proxy Statement entitled “Share Ownership by Principal Stockholders and Management” and “Executive Compensation-Equity Compensation Plan Information.”
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR INDEPENDENCE
The information required under this Item is incorporated by reference to the sections of the Proxy Statement entitled “Certain Relationships and Related Party Transactions.” and “Proposal One-Election of Directors”.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required under this Item is incorporated by reference to the section of the Proxy Statement entitled “Proposal Three-Ratification of Appointment of Independent Registered Public Accounting Firm-Accounting Fees.”
PART IV
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES
(a) The following documents are filed as part of this Report:
1. Financial Statements
Reference is made to page 46 under “Item 8 - Financial Statements and Supplementary Data” for a list of all financial statements and schedules filed as a part of this report.
2. Financial Statement Schedules
Schedule II-Valuation and Qualifying Accounts (page 83)
3. Exhibits
See Item 15(b) below.
(b) Exhibits
The exhibits listed in the accompanying index to exhibits are filed or incorporated by reference as part of this Form 10-K.
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.
Date: June 22, 2007
PHARSIGHT CORPORATION
By:
/s/ SHAWN M. O’CONNOR
Shawn M. O’Connor
President, Chief Executive Officer and Chairman
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Shawn M. O’Connor and William Frederick, as true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for him and in his name, place and stead, in any and all capacities to sign this Annual Report on Form 10-K filed herewith and any or all amendments to said report, and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission granting unto said attorneys-in-fact and agents the full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the foregoing, as to all intents and purposes as he or she might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents or any of them, or his substitute, may lawfully 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 below.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
PHARSIGHT CORPORATION
March 31,
(Amounts in thousands)
(1) Represents amounts written-off as uncollectible
INDEX TO EXHIBITS
* Indicates management contract or compensatory plan or arrangement.