10-Q 1 a10-q.txt QUARTERLY REPORT ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ---------------------- FORM 10-Q (MARK ONE) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2000 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from _____ to _____ Commission file number: 0-26613 ------------------------------- BLUESTONE SOFTWARE, INC. (Exact name of registrant as specified in its charter) DELAWARE 22-2964141 (State or other jurisdiction (I.R.S. Employer of incorporation or organization) Identification No.) 300 STEVENS DRIVE PHILADELPHIA, PENNSYLVANIA 19113 (Address of principal executive offices, including zip code) (610) 915-5000 (Registrant's telephone number, including area code) 1000 BRIGGS ROAD MOUNT LAUREL, NJ 08054 (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes /X/ No / / As of July 31, 2000, there were 20,775,296 shares of the registrant's common stock outstanding. ================================================================================ INDEX PART I. FINANCIAL INFORMATION Item 1. FINANCIAL STATEMENTS. Balance sheets as of June 30, 2000 (unaudited) and December 31, 1999. Statements of operations (unaudited) for the three and six months ended June 30, 2000 and 1999. Statements of cash flows (unaudited) for the six months ended June 30, 2000 and 1999. Notes to financial statements. Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. Item 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK. PART II. OTHER INFORMATION Item 1. LEGAL PROCEEDINGS. Item 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. Item 3. DEFAULTS UPON SENIOR SECURITIES. Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Item 5. OTHER INFORMATION. Item 6. EXHIBITS AND REPORTS ON FORM 8-K. SIGNATURE 2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS BLUESTONE SOFTWARE, INC. BALANCE SHEETS (in thousands) JUNE 30, DECEMBER 31, 2000 1999 --------- --------- (unaudited) ASSETS Current assets: Cash and cash equivalents .................. $ 145,289 $ 66,160 Marketable securities ...................... 55,997 -- Accounts receivable, net ................... 9,451 4,079 Prepaid expenses and other ................. 1,985 1,043 Total current assets ......................... 212,722 71,282 Property and equipment, net .................. 3,130 2,495 Other assets ................................. 1,176 363 --------- --------- $ 217,028 $ 74,140 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT) Current liabilities: Current portion of long-term debt ......... $ 3 $ 429 Accounts payable .......................... 2,346 2,259 Accrued expenses .......................... 4,869 3,083 Deferred revenues ......................... 3,702 1,966 Total current liabilities .................... 10,920 7,737 --------- --------- Long-term debt ............................... -- 439 Stockholders' equity (deficit): Common stock .............................. 20 18 Common stock warrants ..................... 1,205 1,205 Deferred stock-based compensation ......... (964) (1,133) Additional paid-in capital ................ 249,864 100,790 Accumulated deficit ....................... (44,017) (34,916) --------- --------- Total stockholders' equity (deficit) ......... 206,108 65,964 --------- --------- $ 217,028 $ 74,140 ========= ========= The accompanying notes are an integral part of these statements. 3 BLUESTONE SOFTWARE, INC. STATEMENTS OF OPERATIONS (in thousands, except per share data) (unaudited)

The accompanying notes are an integral part of these statements. 4 BLUESTONE SOFTWARE, INC. STATEMENTS OF CASH FLOWS (in thousands) (unaudited)

The accompanying notes are an integral part of these statements. 5 BLUESTONE SOFTWARE, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1. BASIS OF PRESENTATION The accompanying unaudited financial statements have been prepared by the Company and, in the opinion of management, include all adjustments (consisting of normal recurring adjustments) necessary for the fair presentation of results for the interim periods presented. These financial statements and notes included herein should be read in conjunction with the Company's audited financial statements and notes for the year ended December 31, 1999 included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the entire year ending December 31, 2000. NOTE 2. NET LOSS PER SHARE The Company follows SFAS No. 128, "Earnings Per Share," which requires a dual presentation of "basic" and "diluted" earnings per share ("EPS") on the face of the statements of operations. Basic EPS is computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding for the period. Diluted EPS includes the dilutive effect, if any, from the potential exercise or conversion of securities like stock options, which would result in the issuance of additional shares of common stock. For the six months ended June 30, 1999 and 2000, diluted EPS is equal to basic EPS as all common stock equivalents were anti-dilutive for all periods presented. NOTE 3. ACCRUED EXPENSES Accrued expenses at June 30, 2000 includes $1.4 million in accrued wages and $301,000 in accrued payroll taxes. Accrued expenses at December 31, 1999 includes $892,000 in accrued wages and $628,000 in accrued payroll taxes. NOTE 4. PUBLIC OFFERING On February 22, 2000, the Company completed a public offering of 3,500,000 shares of its common stock. Of the 3,500,000 total shares offered, 1,750,000 shares were offered by the Company and 1,750,000 shares were offered by certain selling stockholders. The Company received proceeds of $146.0 million, net of underwriting discounts and offering expenses. NOTE 5. RECENT PRONOUNCEMENTS In June 1997, the Financial Accounting Standards Board issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information." SFAS No.131 applies to all public companies and is effective for fiscal years beginning after December 15, 1997. SFAS No. 131 requires that business segment financial information be reported in the financial statements utilizing the management approach. The management approach is defined as the manner in which management organizes the segments within the enterprise for making operating decisions and assessing performance. Management believes the Company operates in one business segment, therefore, the adoption of SFAS No. 131 had no impact on the financial statements. In March 1998, the American Institute of Certified Public Accountants ("AICPA") issued Statement of Position ("SOP") 98-1, "Accounting for the Costs of Computer Software Developed or Obtained for Internal Use." The Company adopted SOP 98-1 in January 1999. The adoption had no material effect on the Company's financial position or results of operations. NOTE 6. SUBSEQUENT EVENT On July 3, 2000, the Company acquired all of the outstanding share capital of Arjuna Solutions Limited, a U.K. limited company based in Newcastle and London, England. Arjuna Solutions is a leading center of expertise in standards-based, distributed transactional and workflow software, and the developers of a 100% Pure Java 6 transactioning system. Initial acquisition consideration consisted of $3.3 million and 277,803 shares of common stock. Additional consideration is payable upon the completion by Arjuna Solutions of certain products on or before February 1, 2001 and will consist of $375,000 and 82,725 shares of common stock. The acquisition is being accounted for as a purchase. ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with our audited Financial Statements and Notes thereto for the year ended December 31, 1999 included in our Annual Report on Form 10-K that was filed with the Securities and Exchange Commission on February 15, 2000. The information in this discussion contains forward-looking statements. Forward-looking statements involve known and unknown risks, uncertainties and other factors which may cause our actual results, performance or achievements or industry results to be materially different from any future results, performance or achievements expressed or implied by these forward-looking statements. Such factors include those described in "Risk Factors." The forward-looking statements included in this report may prove to be inaccurate. In light of the significant uncertainties inherent in these forward-looking statements, you should not consider this information to be a guarantee by us or any other person that our objectives and plans will be achieved. OVERVIEW We are a leading provider of software for enterprise interaction management, which enables businesses to extend information over the World Wide Web in a controlled manner and to support high volumes of users and interactions. Our flagship product, Sapphire/Web, which has evolved into our Total-e-Server product, is a framework for JAVA Web application servers and is currently in Release 7.1. In 1998, we decided to focus on internally developed software products and curtail the licensing and services related to third party products. Beginning in March 1998, we increased our sales and marketing efforts and hired new management. We hired a significant number of sales personnel throughout the country in order to develop a nationwide presence and generate increased revenue. The positioning and feature set of the Sapphire/Web product was shifted from a low-cost development tool to an enterprise-wide software solution for Internet applications. For the year ended December 31, 1998, the Sapphire/Web products and related services generated approximately $7.0 million in revenues, while third party products and related services contributed approximately $1.1 million. In January 1999, we released Bluestone XML-Server, which represented a new generation of specialized Web application server focused on Internet commerce. In December 1999, we released Bluestone Total-e-Business, an e-business platform that provides the infrastructure, integration, content management, personalization and e-commerce components that companies utilize to conduct their businesses on the Internet. In June 2000, we released our Total-e-B2B, Total-e-B2C, Total-e-Wireless and Total-e-Global products that are based on our Total-e-Business platform. We generate revenue from two principal sources: license fees for our software products and professional services and support revenue derived from consulting, training and maintenance services related to our software products. During the three months ended June 30, 2000 two of our customers individually accounted for greater than 10% of our total revenues. During the six months ended June 30, 2000, one customer accounted for greater than 10% of our total revenues. Our top 10 customers represented 55.3% of total revenues during the three months ended June 30, 2000 and 55.1% of total revenues during the six months ended June 30, 2000. In the future, we expect to continue to have individual customers account for a significant portion of our revenues during a given period. SOFTWARE LICENSE FEES. Typically, our end-user customers pay an up-front, one-time fee for a perpetual license of our software. The amount of the fee is generally based on the number of developer seats and server interactions. Pricing models based on enterprise-wide deployment or the number of processors are also available. We also sell annual and multi-year licenses to independent software vendors that allow for the integration of our products into their software. We generally require a written license contract that typically provides for payment within 30-90 days of contract signing. Certain multi-year license contracts contain payment terms that extend beyond one year. Pursuant to the American Institute of Certified Public Accountants' Statement of Position 97-2, any amounts due under contract beyond one year are not deemed to be fixed or determinable and therefore are deferred and recognized as revenue when the payments become due. 7 Prior to 1998, software licenses were principally the result of direct sales to end-users. Beginning in 1998, we began to focus on channel sales and marketing. This has resulted in significant sales of products through independent software vendors, resellers and systems integrators. We believe that these alliances have increased our exposure in the marketplace. Furthermore, we have experienced, and expect to continue to experience, significant variation in the size of individual licensing transactions, ranging from small sales of perpetual developer licenses to large, multi-year licensing arrangements with independent software vendors. We generally recognize license fee revenue when a formal agreement exists, delivery of the product has occurred, no production, modification, customization or implementation obligations remain, the license fee is deemed fixed or determinable and collectibility is probable. Revenue from arrangements with distributors and resellers is not recognized until our product is delivered to the end-user. SERVICES REVENUE. Services revenue consists principally of revenue derived from consulting services provided to customers during implementation and integration of our software products, training of customers' employees and fees for ongoing maintenance, which consists of customer technical support services and unspecified product upgrades/enhancements on a when-and-if-available basis. Consulting and training services are typically delivered on a time and material basis. We recognize services revenue as the services are performed. Maintenance revenue is generally invoiced in advance and is recognized ratably over the term of the maintenance agreement, which is generally 12 months. COST OF SOFTWARE LICENSE FEES. Cost of software license fees consists primarily of the costs associated with the purchase of product CDs and related documentation and duplication costs. Cost of licenses also includes the cost of third-party software products embedded in our product offerings. COST OF SERVICES. Cost of services consist primarily of salary and benefit costs of our consulting, support and training organizations, as well as the costs of outside consultants engaged to meet customer demand, and are expensed when incurred. SALES AND MARKETING. We license our products primarily through our indirect channels and direct sales force. Sales and marketing expenses consist primarily of personnel costs, commissions to employees, office facilities, travel and promotional events such as trade shows, advertising and public relations programs. PRODUCT DEVELOPMENT. We maintain an in-house development staff to enhance our existing products and to develop new ones. Product development expenditures are generally charged to operations as incurred. Statement of Financial Accounting Standards No. 86 requires the capitalization of certain software development costs subsequent to the establishment of technological feasibility. We establish technological feasibility upon the completion of a working model. To date, we have expensed all software development costs due to the minimal level of development costs incurred subsequent to the establishment of technological feasibility. GENERAL AND ADMINISTRATIVE. General and administrative expenses include our personnel and other costs of our corporate, finance, human resources and information services activities. STOCK-BASED COMPENSATION. The amount by which the fair market value of our common stock exceeded the exercise price of stock options on the date of grant is recorded as deferred compensation and is amortized to stock-based compensation expense as the options vest. THREE MONTHS ENDED JUNE 30, 2000 COMPARED TO THREE MONTHS ENDED JUNE 30, 1999 SOFTWARE LICENSE FEES License fees were $7.2 million and $2.5 million for the three months ended June 30, 2000 and 1999, respectively. This increase of 191.0% was primarily due to an increased presence in the market, as well as an increase in the number of licenses with independent software vendors, which has increased the amount of license revenue per customer during the second quarter of 2000 versus the same period in 1999. 8 SERVICES REVENUE Services revenue was $2.2 million and $845,000 for the three months ended June 30, 2000 and 1999, respectively, an increase of 159.5%. Services revenue increased between the two periods primarily due to two large consulting engagements that were performed and concluded during the second quarter of 2000. GROSS MARGIN-LICENSE FEES Our license fee gross margin decreased to 95.9% for the three months ended June 30, 2000 from 96.0% for the same period in 1999. This change was not material. GROSS MARGIN-SERVICES REVENUE Our services gross margin improved to (20.1)% for the three months ended June 30, 2000 from (33.6)% for the same period in 1999. Our services gross margin remained negative in 2000 primarily due to the hiring and training of additional internal personnel and external consultants to support our growing installed base of customers and anticipated increases in future revenues, as well as the training of our existing internal and external consultants on our Total-e-Business products. Based on our current business plan, we believe that our services gross margin will remain negative for the next two quarters as we continue to add additional personnel. We anticipate that our services gross margin will improve and will be approaching a breakeven point towards the end of the fourth quarter of 2000. SALES AND MARKETING Sales and marketing expenses were $9.7 million and $3.4 million for the three months ended June 30, 2000 and 1999, respectively, an increase of 190.1%. Of this increase, $2.2 million was due to increases in payroll and related costs, $301,000 in recruiting costs and $624,000 in travel and entertainment costs as a result of the growth in the number of sales personnel, $676,000 in office and occupancy expense due to the expansion of our sales offices throughout the United States and Europe, $1.2 million was due to increased trade show, direct mail, advertising and public relations expenses, and $592,000 was due to increased commissions expense as a result of higher sales volume. We also incurred increases in variable marketing expenses due to increased printing and collateral and professional fees. We intend to continue to increase our spending on sales and marketing because we believe that our sales and marketing efforts are essential for us to increase our market position and our product acceptance. The average number of sales and marketing employees for the three months ended June 30, 2000 was 119 compared to 64 for the three months ended June 30, 1999. These costs as a percentage of revenue were 103.9% and 101.4% for the three months ended June 30, 2000 and 1999, respectively. PRODUCT DEVELOPMENT Product development expenses were $2.2 million and $964,000 for the three months ended June 30, 2000 and 1999, respectively, an increase of 133.2%. These increases were associated with the development and enhancement of our Bluestone Total-e-Business products and were due to an increase in payroll and related costs of $751,000 and an increase in sub-contract expense of $249,000 related to outside consultants involved in development projects. Average development headcount for the three months ended June 30, 2000 and 1999 was 55 and 29, respectively. We believe that our continued increases in product development investment are essential for us to maintain our market and technological competitiveness. These costs as a percentage of revenue were 24.0% and 29.1% for the three months ended June 30, 2000 and 1999, respectively. GENERAL AND ADMINISTRATIVE General and administrative expenses were $1.8 million and $1.5 million for the three months ended June 30, 2000 and 1999, respectively, an increase of 23.5%. Of this increase $135,000 was due to increases in our insurance costs related to new directors and officers insurance, $108,000 was due to increases in public reporting costs and $49,000 was due to increase in sub-contracting expenses for temporary employees. General and administrative expenses as a percentage of revenue were 19.6% and 44.9% for the three months ended June 30, 2000 and 1999, respectively. We expect that our general administrative expenses will continue to increase as we continue to expand geographically and add personnel and administrative resources to support the growth of our business. 9 AMORTIZATION OF STOCK-BASED COMPENSATION Amortization of stock-based compensation was $85,000 and $112,000 for the three months ended June 30, 2000 and 1999, respectively. Deferred compensation of $1.4 million arose due to the issuance of stock options at exercise prices below the fair market value of our common stock for accounting purposes related to the hiring of key employees and directors during the second quarter of 1999. Deferred compensation is included as a component of stockholders' equity and is being amortized by charges to operations over the vesting periods of the options. As of June 30, 2000, we had an aggregate of $964,000 of deferred compensation to be amortized through June 30, 2003. INTEREST INCOME (EXPENSE), NET Net interest income was $3.1 million for the three months ended June 30, 2000 and net interest expense was $1.1 million for the three months ended June 30, 1999. The additional interest income was due to interest earned on a higher cash balance during the second quarter of 2000 as compared to the second quarter of 1999 resulting from $54.8 million of net proceeds generated from our initial public offering of common stock in September 1999 and $146.0 million of net proceeds generated from our follow-on public offering in February 2000. SIX MONTHS ENDED JUNE 30, 2000 COMPARED TO SIX MONTHS ENDED JUNE 30, 1999 SOFTWARE LICENSE FEES License fees were $12.2 million and $4.7 million for the six months ended June 30, 2000 and 1999, respectively. This increase of 157.9% was primarily due to an increased presence in the market, as well as an increase in the number of licenses with independent software vendors, which has increased the amount of license revenue per customer during the first six months of 2000 versus the same period in 1999. SERVICES REVENUE Services revenue was $4.5 million and $1.9 million for the six months ended June 30, 2000 and 1999, respectively, an increase of 139.2%. Services revenue increased between the two periods primarily due to two large consulting engagements performed during the first six months of 2000, as well as an increase in maintenance revenues due to a larger base of installed software. GROSS MARGIN-LICENSE FEES Our license fee gross margin decreased to 95.9% for the six months ended June 30, 2000 from 96.7% for the same period in 1999. This decrease was primarily due to an increase in the cost of third-party software products embedded in our product offerings. GROSS MARGIN-SERVICES REVENUE Our services gross margin improved to (20.9)% for the six months ended June 30, 2000 from (32.3)% for the same period in 1999. Our services gross margin remained negative in 2000 primarily due to the hiring and training of additional internal personnel and external consultants to support our growing installed base of customers and anticipated increases in future revenues, as well as the training of our existing internal and external consultants on our Total-e-Business products. Based on our current business plan, we believe that our gross services margin will remain negative for the next two quarters as we continue to add additional personnel. We anticipate that our services gross margin will improve and will be approaching a breakeven point towards the end of the fourth quarter of 2000. SALES AND MARKETING Sales and marketing expenses were $17.2 million and $6.2 million for the six months ended June 30, 2000 and 1999, respectively, an increase of 177.6%. Of this increase, $3.5 million was due to increases in payroll and related costs, $550,000 in recruiting costs and $983,000 in travel and entertainment costs as a result of the growth in the number of sales personnel, $1.1 million in office and occupancy expense due to the expansion of our sales 10 offices throughout the U.S. and Europe, $989,000 in sub-contractor's expense for the use of outside consultants, $1.9 million was due to increased trade show, direct mail, advertising and public relations expenses, and $1 million was due to increased commissions expense as a result of higher sales volume. We also incurred increases in variable marketing expenses due to increased printing and collateral and professional fees in order to increase market awareness and gain market acceptance of our products. We intend to continue to increase our spending on sales and marketing because we believe that our sales and marketing efforts are essential for us to increase our market position and our product acceptance. The average number of sales and marketing employees for the six months ended June 30, 2000 was 114 compared to 65 for the six months ended June 30, 1999. These costs as a percentage of revenue were 103.1% and 93.8% for the six months ended June 30, 2000 and 1999, respectively. PRODUCT DEVELOPMENT Product development expenses were $3.9 million and $1.9 million for the six months ended June 30, 2000 and 1999, respectively, an increase of 106.2%. These increases were associated with the development and enhancement of our Bluestone Total-e-Business products and were due to an increase in payroll and related costs of $1.3 million and an increase in sub-contractor expense of $312,000 related to outside consultants involved in development projects. Average development headcount for the six months ended June 30, 2000 and 1999 was 50 and 28, respectively. We believe that our continued product development investment is essential for us to maintain our market and technological competitiveness. These costs as a percentage of revenue were 23.1% and 28.4% for the six months ended June 30, 2000 and 1999, respectively. GENERAL AND ADMINISTRATIVE General and administrative expenses were $3.5 million and $2.1 million for the six months ended June 30, 2000 and 1999, respectively, an increase of 63.9%. This increase was primarily due to payroll and related costs resulting from the addition of personnel to support the growth of our business as well as increased expenses for recruiting, travel, professional fees and insurance. The average number of general and administrative employees for the six months ended June 30, 2000 was 40 compared to 29 for the six months ended June 30, 1999. General and administrative expenses as a percentage of revenue were 20.9% and 32.2% for the six months ended June 30, 2000 and 1999, respectively. AMORTIZATION OF STOCK-BASED COMPENSATION Amortization of stock-based compensation was $170,000 and $112,000 for the six months ended June 30, 2000 and 1999, respectively. Deferred compensation of $1.4 million arose due to the issuance of stock options at exercise prices below the fair market value of our common stock for accounting purposes related to the hiring of key employees and directors during the second quarter of 1999. Deferred compensation is included as a component of stockholders' equity and is being amortized by charges to operations over the vesting periods of the options. As of June 30, 2000, we had an aggregate of $964,000 of deferred compensation to be amortized through June 30, 2003. INTEREST INCOME (EXPENSE), NET Net interest income was $4.8 million for the six months ended June 30, 2000 and net interest expense was $1.1 million for the six months ended June 30, 1999. The net interest income was due to interest earned on a higher cash balance during the first six months of 2000 as compared to the first six months of 1999 resulting from $54.8 million of net proceeds generated from our initial public offering of common stock in September 1999 and $146.0 million of net proceeds generated from our follow-on public offering in February 2000. LIQUIDITY AND CAPITAL RESOURCES In February 2000, we completed our secondary public offering of shares of our common stock. Of the 3,500,000 total shares offered, 1,750,000 shares were offered by the Company and 1,750,000 shares were offered by certain selling stockholders. We realized net proceeds from the offering of $145.8 million. In September 1999, we completed our initial public offering of 4,000,000 shares of our common stock, realizing net proceeds of $54.8 million. Prior to these offerings, we financed our operations and met our capital expenditure requirements primarily through sales of preferred stock, bank loans, equipment loans and funds generated from operations. From April 11 1997 through May 1999, we raised approximately $41.6 million of venture capital funding in order to expand the sales and marketing and product development efforts of the business. As of June 30, 2000 our primary sources of liquidity consisted of cash, cash equivalents and short term marketable securities totaling approximately $201.3 million and available borrowings under our two revolving lines of credit which are secured by substantially all of our assets. As of June 30, 2000, we had a total of $2.0 million of available borrowings under both the $3.0 million and $500,000 revolving lines of credit. We did not have an outstanding balance on either line of credit. The reduced borrowing availability is due to several outstanding letters of credit. Borrowings under the $3.0 million revolving line of credit are subject to a borrowing base of 80% of eligible domestic accounts receivable and borrowings under the $500,000 revolving line of credit are subject to a borrowing base of 90% of eligible foreign accounts receivable. Interest is payable monthly at a rate of prime plus .5% on both lines of credit. Net cash used in operating activities was $11.9 and $4.7 million for the six months ended June 30, 2000 and 1999, respectively. The cash used in operating activities in the first six months of 2000 was attributable primarily to net losses of $9.1 million, offset by certain non-cash items and changes in operating assets and liabilities. The cash used in operating activities for the six months ended June 30, 1999 was attributable primarily to net losses of $7.5 million offset by certain non-cash items and increases in working capital items. Net cash used in investing activities was $57.1 million and $164,000 for the six months ended June 30, 2000 and 1999, respectively. The cash used in investing activities for the six months ended June 30, 2000 related primarily to the purchase of short term marketable securities, as well as the purchase of fixed assets of $1.1 million. The cash used in investing activities for the six months ended June 30, 1999 related to purchases of computers and software for internal use. Net cash provided by financing activities was $148.2 million for the six months ended June 30, 2000. During the six months ended June 30, 2000, net proceeds of $145.8 million was provided from the public offering of shares of our common stock. Additionally, we received proceeds of $3.2 million from the exercise of common stock options and made repayments of $865,000 of long-term debt. Net cash provided by financing activities for the six months ended June 30, 1999 was $22.9 million. This was primarily due to the sale of 9,191,176 shares of series C preferred stock for net proceeds of $23.1 million, $1.35 million of which was comprised of the conversion of bridge financing incurred earlier in 1999. We anticipate that we will continue to expand our operations throughout the U.S. and internationally within the next 12 months and, therefore, we expect to continue to incur additional increases in our sales and marketing, product development and general and administrative expenditures to support our growth. These expenditures will use large amounts of cash. However, we believe that our existing capital resources are sufficient to meet our capital requirements for at least the next 12 months. On July 3, 2000, the Company acquired all of the outstanding share capital of Arjuna Solutions Limited, a U.K. limited company based in Newcastle and London, England. Initial acquisition consideration consisted of $3.3 million and 277,803 shares of common stock. Additional consideration is payable upon the completion by Arjuna Solutions of certain products on or before February 1, 2001 and will consist of $375,000 and 82,725 shares of common stock. The acquisition is being accounted for as a purchase. RISK FACTORS THIS SECTION HIGHLIGHTS SPECIFIC RISKS WITH RESPECT TO AN INVESTMENT IN OUR BUSINESS. INVESTING IN OUR COMMON STOCK INVOLVES A HIGH DEGREE OF RISK. WE ALSO CAUTION YOU THAT THIS REPORT INCLUDES FORWARD-LOOKING STATEMENTS THAT ARE BASED ON MANAGEMENT'S BELIEFS AND ASSUMPTIONS AND ON INFORMATION CURRENTLY AVAILABLE TO MANAGEMENT. 12 WE HAVE HAD RECENT LOSSES AND MAY INCUR FUTURE LOSSES THAT MAY DEPRESS OUR STOCK PRICE. We have incurred significant net losses since 1996, including losses of approximately $11.6 million and $15.1 million for the years ended December 31, 1998 and 1999, respectively and $9.1 million for the six months ended June 30, 2000. Our losses have resulted in an accumulated deficit of approximately $44.0 million as of June 30, 2000. Any significant shortfall of revenues in relation to our expectations or any material delay of customer orders would have an immediate adverse effect on our business, operating results and financial condition. Additionally, our planned acceleration of expenditures may have an adverse effect on our operating results. We may not be profitable in any future period and our net losses may increase in the next several quarters. Our future operating results will depend on many factors, including: - the overall growth rate for the markets in which we compete; - the level of market acceptance of, and demand for, our software products; - the level of product and price competition; - our ability to establish strategic marketing relationships, develop and market new and enhanced products, and control costs; - our ability to expand our direct sales force and indirect distribution channels; - our ability to integrate acquired businesses and product lines; - our ability to develop and maintain awareness of our brands; and - our ability to attract, train and retain consulting, technical and other key personnel. LACK OF GROWTH OR DECLINE IN INTERNET USAGE OR THE LACK OF ACCEPTANCE OF COMMERCE CONDUCTED VIA THE INTERNET COULD BE DETRIMENTAL TO OUR FUTURE OPERATING RESULTS. Our products enhance companies' ability to transact business and conduct operations utilizing the Internet. Therefore, our future sales and any future profits are substantially dependent upon the widespread acceptance and use of the Internet as an effective medium of commerce by consumers and businesses. Rapid growth in the use of the Internet and other online services is a recent development and we are unsure whether that acceptance and use will continue to develop or that a sufficiently broad base of consumers will adopt and continue to use the Internet and other online services as a medium of commerce. To be successful, we must rely on consumers and businesses, who have historically used traditional means of commerce to purchase products, accepting and utilizing new ways of conducting business and exchanging information over the Internet. In addition, the Internet may not be accepted as a viable commercial marketplace for a number of reasons, including potentially inadequate development of the necessary network infrastructure or delayed development of enabling technologies and Web performance improvements. If the Internet continues to experience significant growth in the number of users, frequency of use or an increase in bandwidth requirements, the Internet's infrastructure may not be able to support the demands placed upon it. In addition, the Internet could lose its viability due to delays in the development or adoption of new standards and protocols required to handle increased levels of Internet activity, or due to increased governmental regulation. If Congress, or other governing bodies both within and outside the United States, decides to alter materially the current approach to, and level of, regulation of the Internet, we may need to adapt our technology. Any required adaptation could cause us to spend significant amounts of time and money. If use of the Internet does not continue to grow or grows more slowly than expected, if the infrastructure for the Internet does not effectively support growth that may occur, if government regulations change, or if the Internet does not become a viable commercial marketplace, our business could suffer. 13 WE DEPEND ON OUR SOFTWARE PRODUCTS AND IF THE MARKET FOR THESE PRODUCTS DOES NOT CONTINUE TO GROW, OUR BUSINESS COULD BE MATERIALLY ADVERSELY AFFECTED. Software license revenues from our software products were $11.7 million or 74% of total revenues in 1999 and $12.2 million or 73.2% of total revenues in the first six months of 2000. We expect to continue to be dependent upon our software products in the future, and any factor adversely affecting the market for Web application server and e-business platform software in general, or our software in particular, would adversely affect our ability to generate revenues. The market for Web application server and e-business platform software is competitive, highly fragmented and characterized by rapid technological change. Our future financial performance will depend in large part on the successful development, introduction and customer acceptance of our new products and product enhancements in a timely and cost effective manner. We expect to continue to commit significant resources to market and further develop our software products and enhance the brand awareness of our products. The market for our software may not continue to grow or may grow at a slower rate than we expect. Furthermore, the market may not accept our products. If this market fails to grow or grows more slowly than we anticipate, or if the market fails to accept our products, our business could suffer. IF THE MARKET'S ACCEPTANCE AND ADOPTION OF JAVA AND XML SERVER TECHNOLOGIES DOES NOT CONTINUE, OUR FUTURE RESULTS MAY SUFFER. Our Total-e-Server product is 100% Pure JAVA. JAVA is a programming language developed by Sun Microsystems. Therefore, the continued acceptance of our products in the marketplace depends on JAVA's acceptance as a standard programming language. If Sun Microsystems were to make significant changes to the JAVA language or fail to correct defects and limitations in its products, our ability to continue to improve and ship our products could be impaired. In the future, our customers may also require the ability to deploy our products on platforms for which technically acceptable JAVA implementations either do not exist or are not available on commercially reasonable terms. In January 1999, we introduced a product based on a document format for the Web called XML, or extensible mark-up language. We cannot be sure that XML technology will be adopted as a standard, that XML-based products will achieve broad market acceptance, that our XML products will be accepted or that other superior technologies will not be developed. The failure of XML technology to become a standard or the failure of our XML products to achieve broad acceptance could adversely affect our ability to generate revenues. The XML server technology is one of several competing technologies used in information exchange and Internet commerce. We intend to continue to invest substantial resources in our XML products. INTENSE COMPETITION AND INCREASING CONSOLIDATION IN OUR INDUSTRY COULD CREATE STRONGER COMPETITORS AND HARM OUR BUSINESS. The market for our products is intensely competitive, highly fragmented, characterized by rapid technological change and significantly affected by new product introductions. Acquisitions of several of our competitors by large software companies and other market activities of industry participants have increased the competition in our market. Our competitors consist of a number of private and public companies including, among others: BEA Systems which acquired WebLogic; IBM; Microsoft; Oracle; and Sun Microsystems, which acquired NetDynamics and the rights to Netscape's Application Server. In addition, we face competition from in-house software developers who may develop some or all of the functionality that our products provide. Many of our competitors have longer operating histories, significantly greater financial, technical, marketing and other resources, greater name recognition, a broader range of products to offer and a larger installed base of customers than us, any of which could provide them with a significant competitive advantage. We expect to face increased competition in the future from our current competitors. In addition, new competitors, or alliances among existing and future competitors, may emerge and rapidly gain significant market share. We also may face increased competition from existing large business application software vendors that may broaden their product offerings to include Web application server software. Their significant installed customer bases and abilities to offer a broad solution and price these new products as incremental add-ons to existing systems could provide them with a significant competitive advantage. 14 OUR CUSTOMERS ARE CONCENTRATED AND THE LOSS OF ONE OF OUR LARGEST CUSTOMERS COULD CAUSE OUR REVENUES TO DROP QUICKLY AND UNEXPECTEDLY. Our top ten customers for the year ended December 31, 1999 and the six months ended June 30, 2000 in the aggregate accounted for approximately 56% and 55.1%, respectively, of our revenues. One customer accounted for more than 10% of our revenues for the year ended December 31, 1999 and one customer accounted for more than 10% of our revenues for the six months ended June 30, 2000. We expect that a small number of customers will continue to account for a substantial portion of revenues in any given quarter in the foreseeable future, although it is unusual for the same customer to account for a substantial amount of revenues in each of several quarters. As a result, our inability to secure major customers during a given period or the loss of any one major customer could cause our revenues to drop quickly and unexpectedly. IF WE FAIL TO DEVELOP NEW PRODUCTS AND SERVICES IN THE FACE OF OUR INDUSTRY'S RAPIDLY EVOLVING TECHNOLOGY, OUR FUTURE RESULTS MAY BE ADVERSELY AFFECTED. Due to the recent emergence of the Internet and the Web as a forum for conducting business, the market for Web application server systems and e-business platforms in which we participate is subject to rapid technological change, changing customer needs, frequent new product introductions and evolving industry standards that may render existing products and services obsolete. Our growth and future operating results will depend in part upon our ability to enhance existing applications and develop and introduce new applications or components that: - meet or exceed technological advances in the marketplace; - meet changing customer requirements; - achieve market acceptance; - integrate successfully with third party software; and - respond to competitive products. Our product development and testing efforts have required, and are expected to continue to require, substantial investment. We may not possess sufficient resources to continue to make the necessary investments in technology. In addition, we may not successfully identify new software opportunities and develop and bring new software to market in a timely and efficient manner. If we are unable, for technological or other reasons, to develop and introduce new and enhanced software in a timely manner, we may lose existing customers and fail to attract new customers, resulting in a decline in revenues. OUR STOCK PRICE MAY FLUCTUATE WIDELY. Prior to our initial public offering in September 1999, there was no public market for our common stock. Since then, the market price of our common stock has fluctuated, and it may continue to fluctuate substantially, due to: - quarterly fluctuations in operating results; - announcements of new products or product enhancements by us or our competitors; - technological innovations by us or our competitors; - general market conditions or market conditions specific to our or our customers' industries; and - changes in earnings estimates or recommendations by analysts. Stock prices of Internet-related companies have been highly volatile. Our current stock price may not be indicative of the price that will prevail in the trading market. In the past, following periods of volatility in the market 15 price of a company's securities, securities class action litigation has at times been instituted against that company. If we become subject to securities litigation, we could incur substantial costs and experience a diversion of management's attention and resources. THE UNPREDICTABILITY OF OUR QUARTERLY OPERATING RESULTS MAY ADVERSELY AFFECT THE TRADING PRICE OF OUR COMMON STOCK. Quarterly fluctuations in operating results may be caused by: - changes in the growth rate of Internet usage; - fluctuations in the demand for our products and services; - the level of product and price competition in our markets; - the timing and market acceptance of new product introductions and upgrades by us or our competitors; - our success in expanding our customer support and marketing and sales organizations; - the size and timing of individual transactions; - delays in, or cancellations of, customer implementations; - customers' budget constraints; - the level of sales and marketing, product development and general and administrative expenditures; - our ability to control costs; and - general economic conditions. Many of these factors are not in our control. In addition, we also experience seasonality which causes us to typically recognize a disproportionately greater amount of our revenues for any fiscal year in our fourth quarter and a disproportionately lesser amount in our first quarter, due largely to sales force quota practices in the software industry and to customer budgeting processes. OUR FAILURE TO SUCCESSFULLY INTEGRATE FUTURE ACQUISITIONS COULD ADVERSELY AFFECT OUR BUSINESS. We intend to acquire complementary product lines, technologies and businesses as part of our growth strategy. Although we may make such acquisitions, we may not be able to successfully integrate them with our business in a timely manner. Our failure to successfully address the risks associated with such acquisitions, if consummated, could have a material adverse effect on our business and our ability to develop and market products. The success of any acquisitions will depend on our ability to: - successfully integrate and manage the acquired operations; - retain the key employees of the acquisition targets; - develop, integrate and market products and product enhancements based on the acquired products and technologies; and - control costs and expenses, as well as demands on our management, associated with the potential acquisitions. If we are not able to successfully integrate acquired product lines, technologies or businesses with our business, we may incur substantial costs and delays or other operational, technical or financial problems. In 16 addition, our failure to successfully integrate acquisitions may divert management's attention from our existing business and may damage our relationships with key clients and employees. To finance future acquisitions, we may issue equity securities that could be dilutive to our stockholders. We may also incur debt and additional amortization expenses related to goodwill and other intangible assets as a result of future acquisitions. The interest expense related to this debt and additional amortization expense may significantly reduce our profitability and could have a material adverse effect on our business, financial condition and operating results. WE NEED TO MANAGE OUR GROWTH EFFECTIVELY OR WE MAY NOT SUCCEED. We are a growing company. Our ability to manage our growth will depend in large part on our ability to improve and expand our operational, sales and marketing capabilities which may require significant additional expenditures, to develop the management skills of our managers and supervisors, many of whom have been employed by us for a relatively short time, and to train, motivate and manage both our existing employees and the additional employees that may be required. Additionally, we may not adequately anticipate all of the demands that growth may impose on our systems, procedures and structure. Any failure to adequately anticipate and respond to these demands or manage our growth effectively would have a material adverse effect on our future prospects. THE DEVELOPMENT OF INTERNATIONAL OPERATIONS WILL CAUSE US TO FACE ADDITIONAL RISKS. In the first quarter of 2000, we established a U.K. subsidiary and opened a branch office in London, England. In July 2000 we acquired Arjuna Solutions Limited, a U.K. limited company. We expect to continue to expand our international operations and international sales and marketing efforts and anticipate opening a regional sales and support offices in Asia Pacific by year end. We have limited experience in marketing, selling and distributing our products and services internationally. International operations, including operations in those regions that we are targeting, are subject to the following risks: - recessions in foreign economies; - political and economic instability; - fluctuations in currency exchange rates; - difficulties and costs of staffing and managing foreign operations; - potentially adverse tax consequences; - reduced protection for intellectual property rights in some countries; and - changes in regulatory requirements. OUR FAILURE TO MAINTAIN ONGOING SALES THROUGH A LIMITED NUMBER OF INDIRECT CHANNELS MAY RESULT IN LOWER REVENUES. We derive a significant portion of our license revenues through a limited number of independent software vendors, systems integrators, distributors and resellers. Although we intend to increase our marketing and direct sales efforts, we expect that a limited number of these indirect channels will continue to account for a significant portion of our revenues in any given quarter in the foreseeable future. To be successful, we must continue to foster and maintain our existing indirect channels, as well as develop new relationships. The loss of, or reduction in orders through, existing indirect channels or the failure to develop new indirect channel relationships could cause our revenues to decline and have a material adverse effect on our business. 17 IF WE LOSE OUR KEY PERSONNEL, OR FAIL TO ATTRACT AND RETAIN ADDITIONAL PERSONNEL, THE SUCCESS AND GROWTH OF OUR BUSINESS MAY SUFFER. A significant portion of our senior management team has been in place for a relatively short period of time. Our success will depend to a significant extent on their ability to gain the trust and confidence of our other employees and to work effectively as a team. Our future success will also depend significantly on our ability to attract, integrate, motivate and retain additional highly skilled technical, managerial, sales, marketing, and services personnel. Competition for skilled personnel is intense, and we may not be successful in attracting, motivating and retaining the personnel required to grow and operate profitably. Failure to attract, integrate, motivate and retain highly skilled personnel could adversely affect our business, especially our ability to develop new products and enhance existing products. THE LENGTHY AND VARIABLE SALES CYCLES OF OUR SOFTWARE PRODUCTS COULD CAUSE SIGNIFICANT FLUCTUATION IN OUR QUARTERLY RESULTS. Our software products are generally used for mission-critical or enterprise-wide purposes and involve a significant commitment of resources by our customers. A customer's decision to license our software generally involves the evaluation of the available alternatives by a significant number of personnel in various functional and geographic areas, each often having specific and conflicting requirements. Accordingly, we typically must expend substantial resources educating prospective customers about the value of our software solutions. For these reasons, the length of time between the date of initial contact with the potential customer and the execution of a software license agreement typically ranges from three to six months, and is subject to delays over which we have little or no control. As a result, our ability to forecast the timing and amount of specific sales is limited and the delay or failure to complete one or more large license transactions could cause our operating results to vary significantly from quarter to quarter. THE FAILURE TO IMPLEMENT SUCCESSFULLY OUR SOFTWARE PRODUCTS COULD RESULT IN DISSATISFIED CUSTOMERS AND DECREASED SALES. Implementation of our software products often involves a significant commitment of financial and other resources by our customers. The customer's implementation cycle can be lengthy due to the size and complexity of their systems and operations. In addition, our customers rely heavily on third party systems integrators to assist them with the installation of our software. Our failure or the failure of our alliance partners, our customers or our third party integrators to implement successfully our software could result in dissatisfied customers which could adversely affect our reputation. WE MAY REQUIRE FUTURE ADDITIONAL FUNDING TO STAY IN BUSINESS. Over time, we may require additional financing for our operations. Additionally, we periodically review other companies' product lines and technologies for potential acquisition. Any material acquisitions or joint ventures could require additional financing. This additional financing may not be available to us on a timely basis if at all, or, if available, on terms acceptable to us. Moreover, additional financing may cause dilution to existing stockholders. CAPACITY RESTRICTIONS COULD REDUCE THE DEMAND AND UTILITY OF OUR PRODUCTS. Concurrency restrictions can limit Internet deployment and use capacity. The boundaries of our Total-e-Server software, Bluestone XML server and Bluestone Total-e-Business capacity, in terms of numbers of concurrent users or interactions, are unknown because, to date, no customer or testing environment has reached these boundaries. These boundaries may, at some future time, be reached and, when reached, may be insufficient to enable our customers to achieve their desired levels of information deployment and exchange. We may lose customers or fail to gain new customers if any of our products' capacity boundary limits the ability of our customers to achieve expected levels of information deployment and exchange or Internet commerce transactions. 18 OUR LIMITED ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS COULD IMPAIR OUR ABILITY TO COMPETE EFFECTIVELY. Our success and ability to compete are substantially dependent on our internally developed technologies and trademarks, which we protect through a combination of copyright, trademark and trade secret laws, confidentiality procedures and contractual provisions. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult and, though we are unable to determine the extent to which piracy of our software products exists, we expect software piracy to be a problem. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as the laws of the United States. Furthermore, our competitors may independently develop technology similar to ours. The number of intellectual property claims in our industry may increase as the number of competing products grows and the functionality of products in different industry segments overlaps. Although we are not aware that any of our products infringe upon the proprietary rights of third parties, there can be no assurance that third parties will not claim infringement by us with respect to current or future products. Any of these claims, with or without merit, could be time consuming to address, result in costly litigation, cause product shipment delays or require us to enter into royalty or license agreements. These royalty or license agreements might not be available on terms acceptable to us or at all, which could have a material adverse effect on our business. OUR FAILURE TO OBTAIN OR MAINTAIN THIRD PARTY LICENSES COULD HARM OUR BUSINESS. We have in the past resold, and may in the future resell, under license, certain third party software that enables our software to interact with other software systems or databases. In addition, we license certain software technology used to develop our software. The loss or inability to maintain any of these software licenses could result in delays or reductions in product shipments until equivalent software could be identified and licensed or compiled, which could adversely affect our business. WE MAY BE SUBJECT TO FUTURE PRODUCT LIABILITY CLAIMS AND OUR PRODUCTS' REPUTATIONS MAY SUFFER. Many of our installations involve projects that are critical to the operations of our customers' businesses and provide benefits that may be difficult to quantify. Any failure in a customer's system could result in a claim for substantial damages against us, regardless of our responsibility for the failure. Although our license agreements with our customers typically contain provisions designed to limit contractually our liability for damages arising from negligent acts, errors, mistakes or omissions, it is possible that these provisions will not be enforceable in certain instances or would otherwise not protect us from liability for damages. Although we maintain general liability insurance coverage, this coverage may not continue to be available on reasonable terms or at all, or may be insufficient to cover one or more large claims. We have entered into and plan to continue to enter into agreements with strategic alliance partners whereby we license our software products for integration with the alliance partners' software. If an alliance partner's software fails to meet customer expectations or causes a failure in its customer's systems, the reputation of our software products could be materially and adversely affected even if our software products performed in accordance with their functional specifications. OUR EXECUTIVE OFFICERS AND DIRECTORS AND THEIR AFFILIATES OWN A LARGE PERCENTAGE OF OUR VOTING STOCK AND WILL HAVE THE ABILITY TO MAKE DECISIONS THAT COULD ADVERSELY AFFECT OUR STOCK PRICE. Currently, our executive officers, directors and their affiliates own approximately 34% of the outstanding shares of common stock. As a result, these stockholders are able to control all matters requiring stockholder approval and, thereby, our management and affairs. Matters that require stockholder approval include: - election of directors; - approval of mergers or consolidations; and 19 - sale of all or substantially all of our assets. This concentration of ownership may delay, deter or prevent acts that would result in a change of control of Bluestone, which in turn could reduce the market price of our common stock. OUR CHARTER AND BYLAWS AND DELAWARE LAW CONTAIN PROVISIONS THAT COULD DISCOURAGE A TAKEOVER EVEN IF BENEFICIAL TO STOCKHOLDERS. Our charter and our bylaws, in conjunction with Delaware law, contain provisions that could make it more difficult for a third party to obtain control of Bluestone even if doing so would be beneficial to stockholders. For example, our charter provides for a classified board of directors and restricts the ability of stockholders to call a special meeting. Our bylaws allow the board of directors to expand its size and fill any vacancies without stockholder approval. FUTURE SALES OF OUR COMMON STOCK MAY DEPRESS OUR STOCK PRICE. The market price of our common stock could decline as a result of sales by our existing stockholders or the perception that those sales may occur. These sales could also make it more difficult for us to raise funds through equity offerings in the future at a time and at a price that we think is appropriate. The holders of a significant amount of our common stock, as well as the holders of outstanding warrants, are entitled to registration rights with respect to their common stock or the common stock underlying their convertible securities. If these holders, by exercising their registration rights, cause a large number of securities to be registered and sold in the public market, these sales could have an adverse effect on the market price for our common stock. If we were to include, in a registration statement initiated by us, shares held by these holders pursuant to the exercise of their registration rights, these sales may have an adverse effect on our ability to raise needed capital. YEAR 2000 PROBLEMS MAY DISRUPT OUR BUSINESS. We have not experienced any material internal Year 2000 problems to date. While our software products are not time/date sensitive, many of the third party software applications run by our customers are time/date sensitive. We have not been advised and are not otherwise aware of any material Year 2000 problems experienced by our customers to date. We have, however, in the past resold third party software that may not be Year 2000 compliant. While we have not been made aware of any material Year 2000 problems relating to the hardware and software used by our customers in connection with our products to date, these problems may exist. Should any of these problems develop, they may have a material adverse effect on our business, operating results and financial condition. In addition, we utilize software, computer technology and other services internally developed and provided by third party vendors that may have Year 2000 issues. Although we have not experienced any of these problems to date, the failure of our internal computing systems or of systems provided by third party vendors to be Year 2000 compliant could materially adversely affect our business. Our costs related to Year 2000 compliance, which thus far have not been material could ultimately be significant if Year 2000 problems surface. In the event that we experience disruptions as a result of any Year 2000 problems, our business could be seriously harmed. Additionally our insurance coverage may not cover or be adequate to offset these and other business risks related to the Year 2000. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Until the first quarter of 2000, we developed our products in the U.S. and have sold them primarily in North America. As a result, our financial results have not been affected by factors such as changes in foreign currency exchange rates or weak economic conditions in foreign markets. In the first six months of 2000, we established a U.K. subsidiary, opened a branch office in London, England and generated an immaterial amount of revenue from that office, which was denominated in U.S. dollars. In the future, we expect to increase operations in that office and our international operations in general which could increase our exposure to these factors. 20 Our future interest income will be sensitive to changes in the general level of U.S. interest rates. However, we plan to invest our excess cash in short-term, investment-grade, interest-bearing securities and we have concluded that there is no material market risk exposure relating to these investments. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS None. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. (d) Use of Proceeds On September 23, 1999, the Securities and Exchange Commission declared effective our registration statement on Form S-1 (File No. 333-82213) relating to our initial public offering of our common stock. We received net proceeds of approximately $54.8 million after deducting underwriting discounts and offering expenses. Although we cannot distinguish the net proceeds from our initial public offering from the net proceeds from our prior financing activities, other cash on hand at September 30, 1999 or the net proceeds of $145.8 million from our follow-on public offering in February 2000, we used $16.2 million in cash for operating activities since September 30, 1999 (approximately the date of the closing of our initial public offering) and believe that approximately 69% of such amount was used for sales and marketing activities, 16% was used for product development and 15% was used for general corporate purposes. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. On April 20, 2000, we conducted our annual meeting of stockholders during which the following items were voted upon: 1. Election of the Class I directors. 2. The approval of our 2000 Employee Stock Purchase Plan. 3. The ratification of the appointment of Arthur Andersen LLP as our independent accountants for 2000. The following nominees for Class I directors were re-elected, receiving the number of votes set opposite their names: NAME FOR WITHHELD P. Kevin Kilroy 16,266,983 154,362 Paul E. Blondin 16,272,239 149,106 Mel Baiada, Gregory Case, Andrew Filipowski and William Hulley constitute Class II and III directors whose terms continued after the annual meeting. Our 2000 Employee Stock Purchase Plan was approved by the following votes: 16,085,142 FOR 185,863 AGAINST 11,377 ABSTAIN 21 Ratification of the appointment of Arthur Andersen LLP as our independent accountants for 2000 was approved by the following votes: 16,256,317 FOR 17,005 AGAINST 9,136 ABSTAIN ITEM 5. OTHER INFORMATION. None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits: 10.1 Amendment to Sublease agreement between Bluestone Software, Inc. (as "Sublandlord") and Bluestone Consulting, Inc. (as "Subtenant") dated May 1, 2000. 10.2 2000 Employee Stock Purchase Plan (incorporated herein by reference to Appendix B contained in Bluestone's proxy statement filed on March 24, 2000). 27.1 Financial Data Schedule (in electronic format only). (b) Reports on Form 8-K: None. 22 SIGNATURE Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. BLUESTONE SOFTWARE, INC. Dated: August 14, 2000 By: /s/ S. Craig Huke ---------------------------- S. Craig Huke Executive Vice President and Chief Financial Officer 23

BLUESTONE SOFTWARE INC 10-Q