10-Q 1 p13662-10q.txt FORM 10-Q

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS NETOBJECTS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Balance Sheets (In thousands, except share data)

1 NETOBJECTS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Operations and Comprehensive Loss (In thousands, except share and per share data)

2 NETOBJECTS, INC. AND SUBSIDIARIES Unaudited Condensed Consolidated Statements of Cash Flows (in thousands)

3 NETOBJECTS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements 1. Description of the Business The Company was incorporated in Delaware on November 21, 1995 and became a majority-owned subsidiary of IBM on April 11, 1997. In fiscal 1998, the Company changed its fiscal year end from September 30 to the Saturday nearest September 30. For presentation purposes, the consolidated financial statements and notes refer to the calendar month end. On May 7, 1999, the Company completed its initial public offering. At the time, all series of convertible preferred shares outstanding were converted to common stock. On October 4, 1999 NetObjects acquired Sitematic Corporation and issued common stock that reduced IBM's ownership to less than 50%. On July 14, 2000, NetObjects acquired Rocktide Corporation and issued common stock that reduced IBM's ownership to 48%. On September 29, 2000, the Company entered into an agreement with IBIZU, Inc., a privately held company (IBIZU) pursuant to which the Company acquired a preferred equity interest in IBIZU in exchange for the transfer of certain technology rights developed by the Company. The Company accounts for this investment using the equity method of accounting. NetObjects provides software, solutions, and services that enable small businesses to build, deploy and maintain websites online, and conduct e-business. 2. Summary of Significant Accounting Policies Basis of Presentation of Interim Financial Statements The accompanying unaudited condensed consolidated financial statements of NetObjects, Inc. and subsidiaries ("the Company" or "NetObjects") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and notes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three-month period ending March 31, 2001 are not necessarily indicative of the results that may be expected for the fiscal year ending September 30, 2001. For further information, refer to the audited financial statements and footnotes thereto for the fiscal year ended September 30, 2000 included in the Company's Annual Report on Form 10-K filed December 29, 2000. Net Loss per Share Basic net loss per share is computed using the weighted average number of outstanding shares of common stock, excluding shares of common stock subject to repurchase. Diluted net loss per share is computed using the weighted-average number of shares of common stock outstanding and, when dilutive, shares of restricted common stock subject to repurchase and options and warrants to purchase common stock using the treasury stock method, and from convertible securities using the if-converted basis. In loss periods, basic and dilutive loss per share are identical since the impact of common equivalent shares is anti-dilutive. Diluted net income per share for the three-months ended March 31, 2001 includes common stock equivalents of 101,030 shares with a weighted-average exercise price of $0.50 per share. Diluted net loss per share for the six-months ended March 31, 2001, does not include the effect of warrants to purchase 336,528 shares of common stock with a weighted average exercise price of $7.70, options to purchase 9,729,017 shares of common stock with a weighted-average exercise price of $7.40 per share, or 33,262 shares of common stock issued and subject to repurchase by the Company at a weighted-average price of $0.16, because their effects are anti-dilutive. Diluted net loss per share for the three-months and six-months ended March 31, 2000, does not include the effect of warrants to purchase 336,528 shares of common stock with a weighted average exercise price of $7.70, options to purchase 6,785,305 shares of common stock with a weighted-average exercise price of $8.11 per share, or 34,607 shares of common stock issued and subject to repurchase by the Company at a weighted-average price of $0.16, because their effects are anti-dilutive. 4 NETOBJECTS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements - Continued At March 31, 2001, the Company had outstanding warrants to purchase 253,195 shares of common stock with an exercise price of $6.68, that expire in October 2003 and February 2004, respectively, and 83,333 shares of common stock with an exercise price of $10.80 and an expiration date in December 2002. All outstanding warrants as of March 31, 2001 are held by IBM. As of March 31, 2000, the Company had outstanding warrants to purchase 253,195 shares of common stock with an exercise price of $6.68, that expire on October 8, 2003 and February 18, 2004, respectively, and 83,333 shares of common stock with an exercise price of $10.80 and expiration dates between March 2000 and December 2000. Recent accounting pronouncements In December 1999, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 101, "Revenue Recognition in Financial Statements," which provides guidance related to revenue recognition based on interpretations and practices followed by the SEC and requires companies to report any changes in revenue recognition as a cumulative change in accounting principle at the time of implementation in accordance with Accounting Principles Board Opinion No. 20, "Accounting Changes." The Company anticipates that the adoption of SAB No. 101 will not have a material impact on its financial position, results of operations or cash flows. The Company will adopt SAB No. 101 in the fourth quarter of fiscal 2001. 3. Segment Information In the first quarter of 2001, the Company transitioned from a software vendor to a provider of online solutions for small business with a focus on NetObjects Fusion and NetObjects Matrix. The Company further transitioned to the new business model with the culmination of the sale of the Enterprise division to Merant Incorporated on February 18, 2001. The activity related to the Enterprise division has been recorded in the discontinued operations section of the Statement of Operations. For the fiscal year 2001, the Company's main revenue streams are from Fusion MX Sales, and Matrix and Online services. For the three month period ending March 31, 2001 Matrix and Fusion Online Revenue Services Total ------------------ --------------- ----------- Revenues: Domestic license and Online $ 598 $209 $ 807 International license 463 463 Software training 47 47 IBM license 253 34 287 ------------------ --------------- ------------ Total Revenue $1,361 $243 $1,604 ================== =============== ============ For the six month period ending March 31, 2001 Matrix and Fusion Online Revenue Services Total ------------------ --------------- ----------- Revenues: Domestic license and Online $ 796 $381 $1,177 International license 1,217 1,217 Software training 163 163 IBM license 526 34 560 ------------------ --------------- ------------ Total Revenue $2,702 $415 $3,117 ================== =============== ============ 5 NETOBJECTS, INC. AND SUBSIDIARIES Notes to Consolidated Financial Statements - Continued For the three month period ending March 31, 2000 Matrix and Fusion Online Revenue Services Total ------------------ --------------- ----------- Revenues: Domestic license and Online $1,743 $147 $1,890 International license 3,728 - 3,728 Software training - - - IBM license 2,171 - 2,171 ------------------ --------------- ------------ Total Revenue $7,642 $147 $7,789 ================== =============== ============ For the six month period ending March 31, 2000 Matrix and Fusion Online Revenue Services Total ------------------ --------------- ----------- Revenues: Revenues: Domestic license and Online $4,034 $313 $4,034 International license 5,996 - 5,996 Software training - - - IBM license 3,293 - 3,293 ------------------ --------------- ------------ Total Revenue $13,323 $313 $13,636 ================== =============== ============ 4. Discontinued Operations and Divestitures On February 18, 2001, the Company sold the Enterprise division to Merant, inorporated for approximately $18 million in cash. As a result of the divestiture, the Company recorded a pre-tax gain of $15.1 million. The NetObjects Enterprise division includes NetObjects Collage, NetObjects Authoring Server and professional services for training and support of these products. The cash obtained from the sale will be used for operating capital. 5. Deferred stock-based compensation The amortization of deferred employee stock-based compensation combined with the expense associated with stock options granted to non-employees, relates to the following items in the accompanying consolidated statements of operations and comprehensive loss (in thousands): Three months ended March 31, ---------------------------------- 2001 2000 ---------------------------------- Sales & marketing $ 33 $ 34 Research & development 7 18 General & administrative 53 92 ---------------------------------- $ 93 $ 144 ---------------------------------- Six months ended March 31, ---------------------------------- 2001 2000 ---------------------------------- Sales & marketing $ 73 $ 78 Research & development 18 35 General & administrative 118 237 ---------------------------------- $ 209 $ 350 ---------------------------------- 6 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the accompanying condensed consolidated financial statements and notes included in this report. This Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Any statements contained herein that are not statements of historical fact may be deemed to be forward-looking statements. Without limiting the foregoing, the words "believes," "anticipates," "plans," "expects," and similar expressions are intended to identify forward-looking statements. These forward-looking statements include, without limitation, statements about the market opportunity for web site building software and services, our strategy, competition and expected expense levels, and the adequacy of our available cash resources. Our actual results could differ materially from those expressed or implied by these forward-looking statements as a result of various factors, including the risk factors described in Risk Factors and elsewhere in this report. We undertake no obligation to update publicly any forward-looking statements for any reason, even if new information becomes available or other events occur in the future. Overview NetObjects has been helping small businesses transition successfully to the online world, both directly and through global customers since 1995. Our Web-site building applications have garnered over 75 awards and eleven patents; to date, we have licensed over 10 million copies of our flagship product NetObjects Fusion which has become the backbone of millions of small business websites. With the release of both FusionMX and the Matrix Platform, NetObjects will continue to transition its business model from a predominantly software license revenue model to one driven and sustained by online subscription revenue. We acquired Sitematic Corporation in October 1999 in order to offer on-line website building and hosting capabilities to small businesses. In December 1999, we combined our online resources with the Sitematic offering and launched GoBizGo.com. These combined services include website building software, e-mail list management for communicating with customers, domain name and search engine registration, auction export, relevant content information for building and maintaining an e-business online, and web hosting services. Currently, our online business has two sources of revenue: subscriptions for web-hosting services provided directly to small businesses; and fees charged to our GoBizGo business "partners" for establishing co-branded sites. In July, 2000, we acquired privately-held Rocktide, Inc. for $3.6 million in NetObjects common stock and $0.4 million in cash. Rocktide is a provider of the next generation application service provider (ASP) technology and wireless e-Services that help Web-enable businesses worldwide. This product technology was incorporated in our newly branded Matrix Platform, which was developed on October 30, 2000. The NetObjects Matrix Platform is an integrated solution using open standards to ensure seamless integration with a wide range of environments and business models. Matrix is designed specifically to help our service providers open a new and recurring revenue stream, build customer loyalty, and leverage their brand by offering a compelling suite of solutions to their small business customers. Matrix provides the most relevant, integrated suite of online applications that empower small businesses to grow their business using the power of the Internet. On March 12, 2001, we launched FusionMX, which provides both online and software solutions that enable small businesses to build, deploy and maintain Internet web sites, and applications to conduct e-business; and enable large enterprises to create corporate intranets. NetObjects Fusion MX is a key part of NetObjects' strategy to transform itself from a desktop applications company to a provider of monthly subscription-based software and online services for small businesses. The Fusion MX software is the first demonstration of the NetObjects Universal Service Delivery architecture. This core technology - a part of the NetObjects Matrix Platform - gives NetObjects an unmatched ability to integrate hosted online applications from third-party solution providers seamlessly into the Website building and maintenance experience. We recognize revenues from software license fees upon delivery of our software products to our customers, net of allowances for estimated returns and price protection, as long as we have no significant obligations remaining and we believe that collection of the resulting receivable is probable. We provide most of our distributors of software products with rights of return and record an allowance for estimated future returns based upon our historical experience with product returns by those distributors. Software license fees earned from products bundled with OEM resellers are recognized upon delivery, if the OEM vendor commits to a quantity and a fixed price with no right of return or, if the volumes are not committed, then when the OEM resellers ship the bundled products to their customers. We recognize service revenues as services are rendered, or, if applicable, using the percentage-of-completion method. We defer web-site hosting subscriptions, which typically are paid up-front, and recognize these fees as revenue ratably over the term of the contract, which ranges from one to 48 months. We defer recognition of maintenance fees, paid primarily for support and upgrades, upon receipt of payment and recognize the related revenues ratably over the term of the contract, which typically is 12 months. These payments generally are made in advance and are nonrefundable. 7 Due to the transformation of our business model, on February 18, 2001, we sold our Enterprise division, including our Collage platform to Merant Incorporated for $18 million in cash. Only $14 million was paid in cash in the quarter ended March 31, 2001 and $4 million was advanced to NetObjects in the quarter ended December 31, 2000. NetObjects Collage provides an integrated platform that combines collaboration with content management, enterprise integration, and dynamic application services. The sale of the Enterprise division is part of NetObjects' previously announced transition from a pure play software vendor to a provider of online solutions for small business with focus on NetObjects Fusion and NetObjects Matrix. Most of the employees of the Enterprise division were hired by Merant Incorporated. In addition, during the quarter ended March 31, 2001, in order to facilitate this transition in January, 2001, we reduced further the number of personnel and part-time employees by 32 and 4 respectively. Total employment was 78 people at the end of the quarter compared to 218 people at March 31, 2000. On January 10, 2001, the Company granted an aggregate amount of 3,025,600 stock options to all the employees at an option price equivalent to the market price at the close of the business day, of $0.468 per share. Executive officers of the Company received a total of 1,400,000 of these options. The initial grant of 1,512,800 stock options will vest with respect to one quarter of the shares on July 10, 2001 and the remaining shares vest in 18 equal monthly installments thereafter, subject to the optionee's continued employment with the issuer. The remaining 1,512,800 stock options will vest with respect to one quarter of the shares on September 1, 2001, and the remaining shares vests in 18 equal monthly installments thereafter, subject to the optionee's continued employment with the issuer. We have incurred substantial net losses in each fiscal period since our inception and, as of March 31, 2001, had an accumulated deficit of $118 million. Such net losses and accumulated deficit resulted primarily from the significant costs incurred in the development of our products and establishing our brand identity, marketing organization, domestic and international sales channels, and general and administrative infrastructure. Our operating expenses before goodwill amortization and other non-cash charges decreased in the first two quarters of fiscal year 2001, but we expect to continue to incur substantial losses from operations for the foreseeable future. Our future operating results must be considered in light of our limited operating history and the risks, expenses and difficulties frequently encountered by companies in early stages of development, particularly companies in rapidly evolving markets such as the market for web site building software and services. To achieve our new business objectives we will need to do the following: o Become a leading supplier of B2B online services for partners that reach small business; o Continue to develop successful new versions of our product offerings; o Continue to be a leading provider of e-business product solutions for building Web sites, and of online services for small businesses; o Respond quickly and effectively to competitive, market, and technological developments; o Control expenses; o Continue to attract, train, and retain qualified personnel in the competitive online market place: and o Maintain existing relationships and establish new relationships with leading Internet hardware, software and online companies, such as our existing OEM resellers. There can be no assurance that we will achieve or sustain profitability. Moreover, particularly as we transition to our new business model, we may be unable to adjust spending in a timely manner to compensate for both anticipated and unanticipated revenue shortfalls. Accordingly, any significant shortfall of revenues in relation to expectations would cause significant declines in our operating results. Our total revenues fluctuate from quarter to quarter due to many factors , including new product and product upgrade introductions. In addition, we attempt to limit sales of existing products during the months preceding the release of upgraded products in order to reduce returns of the older product from some of our direct and indirect channel resellers. The timing of our recognition of revenues from strategic arrangements with other companies has contributed to fluctuations in revenues from quarter to quarter. During the three months ended March 31, 2001, we had IBM revenue from software license and service revenues of $287 as compared to earned license fees and on-line service fees of $273 from IBM for the three months ended December 31, 2000. We have no ongoing commitments from IBM that will generate significant revenues for us. 8 Other factors contributing to uncertainty and fluctuations in our quarterly operating results include seasonal demand for our products and services, costs of litigation and intellectual property protection, technical difficulties with respect to the use of our products, general economic conditions and economic conditions specifically related to businesses dependent upon the Internet. The promptness with which sales and licensing data, used in recognizing product royalties, is delivered to us from third parties also may affect quarterly operating results. It often is difficult to forecast the effect these factors will have on our results of operations for any given fiscal quarter. Fluctuations in revenues from IBM, other third party distributors and other general and seasonal factors are likely to be continued for the foreseeable future. Further, we believe that period-to-period comparisons of historical operating results should not be relied upon as an indication of future performance. Our objective in implementing our new business model based on recurring subscription revenue, was to reduce those severe fluctuations that our company has experienced in the past. This will require several quarters to achieve, and in the meantime, our revenue can and will be subject to significant variations from quarter to quarter. In addition, operating results may fall below our expectations or the expectations of securities analysts or investors in some future quarter and our stock price may decline substantially. Results of Operations The following table sets forth financial data for the periods indicated as a percentage of total revenues:

9 Three Months Ended March 31, 2001 and 2000 Revenues. Total revenues from continuing operations decreased to approximately $1.6 million from approximately $7.8 million for the three months ended March 31, 2001 and 2000, respectively. The 79% decrease year-over-year was primarily due to our restructuring and substantially reduced NetObjects license fees from large OEM or enterprise licensing deals during the current quarter. IBM software license fees for the three months ended March 31, 2001 and 2000 were $0.3 million and $2.2 million, respectively. We do not anticipate that future sales to IBM will grow substantially going forward. Cost of Revenues. Our cost of software license fees includes the cost of product media, duplication, manuals, packaging materials, shipping, technology licensed to us and fees paid to third-party vendors for order fulfillment. Since October 1999, our cost of software license fees has included the cost of providing online hosting, including royalty payments. Our cost of software license fees was approximately $2.3 million for the three-months ended March 31, 2001. Excluding a one-time credit of $1.4 million, the comparable cost for the three-months ended March 31, 2000 was $1.0 million. The three-months ended March 31, 2001 contained a one-time charge of $0.9 million relating to an online services contract termination. Our cost of global service revenues of $0.5 million are directly related to the NetObjects Matrix Builder. As the rollout of the Matrix Builder continues, these costs of revenues shall increase directly related to the expected increase in global services revenue. If we expand our licenses and service agreements for Matrix Builder, we expect the cost of service revenues to increase directly as we assign personnel to these activities. Sales and Marketing. Our sales and marketing expenses consist primarily of salaries, commissions, consulting fees, tradeshow expenses, advertising, marketing materials and the cost of customer service operations. Sales and marketing expenses were approximately $2.9 million and $7.9 million for the three months ended March 31, 2001 and 2000, respectively, representing a reduction of 64% year-over-year. The decrease in sales and marketing expenses resulted from the reduction in personnel, and a reduction in discretionary spending on marketing programs. Research and Development. Our research and development expenses consist primarily of salaries and consulting fees to support product development. To date, we have expensed all research and development costs as we have incurred them because we generally establish the technological feasibility of our products upon completion of a working model. We have not yet incurred significant costs between the date of completion of a working model and the date of general release of a product. We believe that continued investment in research and development is critical to attaining our strategic objectives and, as a result, we expect research and development expenses to modestly increase in dollar amounts from current levels. Research and development expenses were $1.9 million and $2.5 million for the three months ended March 31, 2001 and 2000 due mainly to a reduction in contractor expenses. General and Administrative. Our general and administrative expenses consist primarily of salaries and fees for professional services. General and administrative expenses were $1.2 million and $1.3 million for the three months ended March 31, 2001 and 2000. During the quarter, expenses associated with divestiture of Enterprise division offset decreases associated with reductions in workforce and facilities. Amortization of intangible assets. Amortization of goodwill and other intangible assets increased to $2.4 million from $2.0 for the three months ended March 31, 2001 and 2000, respectively. The increase was predominantly attributable to the amortization of goodwill recorded in connection with the purchase of Rocktide Corporation in July, 2000. Stock-Based Compensation. For the three months ended March 31, 2001 and 2000, we incurred stock-based compensation charges of approximately $93 thousand and $144 thousand for each period, respectively. These stock-based compensation charges are being amortized on an accelerated basis over the vesting period of the options in a manner consistent with Financial Accounting Standards Board (FASB) Interpretation No. 28. Other Income (Expense). We earned interest income of $38 thousand and $277 thousand for the three months ended March 31, 2001 and 2000, respectively. Income taxes. We have had a net operating loss for each period since our inception through March 31, 2001. Our accumulated deficit through this period is approximately $118 million. We recorded an income tax provision of approximately $12 thousand in the three months ended March 31, 2001 related to income earned by our international operations. 10 Translation Adjustment. For the three months ended March 31, 2001 and 2000, we incurred a translation loss of $4k and $9k, respectively. Due to the restructuring and sale of the Enterprise division, our level of international operations has also decreased causing a decrease in the level of foreign activity. Six Months Ended March 31, 2001 and 2000 Revenues. Total revenues from continuing operations decreased to approximately $ 3.1 million from approximately $13.6 million for the six months ended March 31, 2001 and 2000, respectively. The 77% decrease year-over-year was primarily due to our restructuring and substantially reduced NetObjects license fees from large OEM or enterprise licensing deals during the current quarter. IBM software license fees for the six months ended March 31, 2001 and 2000 were $0.6 million and $3.3 million, respectively. We do not anticipate that future sales to IBM will grow substantially going forward. Cost of Revenues. Our cost of software license fees includes the cost of product media, duplication, manuals, packaging materials, shipping, technology licensed to us and fees paid to third-party vendors for order fulfillment. Since October 1999, our cost of software license fees has included the cost of providing online hosting, including royalty payments. Our cost of software license fees was approximately $4.4 million and $1.7 million for the six-months ended March 31, 2001 and 2000, respectively. Our cost of global service revenues of $0.8 million are directly related to the NetObjects Matrix Builder. As the rollout of the Matrix Builder continues, these costs of revenues shall increase directly related to the increase in global services revenue. During the six months ended March 31, 2000, there were no cost of service revenues. Sales and Marketing. Our sales and marketing expenses consist primarily of salaries, commissions, consulting fees, tradeshow expenses, advertising, marketing materials and the cost of customer service operations. Sales and marketing expenses were approximately $6.5 million and $12.6 million for the six months ended March 31, 2001 and 2000, respectively, representing a 40% year-over-year reduction. Research and Development. Our research and development expenses consist primarily of salaries and consulting fees to support product development. To date, we have expensed all research and development costs as we have incurred them because we generally establish the technological feasibility of our products upon completion of a working model. We have not yet incurred significant costs between the date of completion of a working model and the date of general release of a product. We believe that continued investment in research and development is critical to attaining our strategic objectives and, as a result, we expect research and development expenses to modestly increase in dollar amounts from current levels. Research and development expenses were $4.5 million and $5.1 million for the six months ended March 31, 2001 and 2000 respectively, representing an 11% reduction year-over-year. General and Administrative. Our general and administrative expenses consist primarily of salaries and fees for professional services. General and administrative expenses were $2.5 million and $2.7 million for the six months ended March 31, 2001 and 2000, respectively. Amortization of intangible assets. Amortization of goodwill and other intangible assets increased to $4.7 million from $4.0 for the six months ended March 31, 2001 and 2000, respectively. The increase was predominantly attributable to the amortization of goodwill recorded in connection with the purchase of Rocktide Corporation in July, 2000. Stock-Based Compensation. For the six months ended March 31, 2001 and 2000, we incurred stock-based compensation charges of approximately $209 thousand and $350 thousand for each period, respectively. These stock-based compensation charges are being amortized on an accelerated basis over the vesting period of the options in a manner consistent with FASB Interpretation No. 28. Other Income (Expense). We earned interest income of $96 thousand and $651 thousand for the six months ended March 31, 2001 and 2000, respectively. 11 Income taxes. We have had a net operating loss for each period since our inception through March 31, 2001. Our accumulated deficit through this period is approximately $118 million. We recorded an income tax provision of approximately $24 thousand in the six months ended March 31, 2001 related to income earned by our international operations. Translation Adjustment. For the six-months ended March 31, 2001 and 2000, we incurred a translation loss of $12k and $20k, respectively. Due to the restructuring and sale of the Enterprise division, our level of international operations has also decreased causing a decrease in the level of foreign activity. Liquidity and Capital Resources At March 31, 2001, NetObjects had cash and cash equivalents totaling $9.4 million, an increase of $1.0 million from September 30, 2000. Cash flows were primarily affected by losses from continuing operations, loans of $2.2 million in connection with the aborted acquisition of MyComputer.com, which we have written off and expensed completely as of March 31, 2001, and the sale of the Enterprise division. Net cash used in operating activities was $15.3 million and $15.9 million for the six months ended March 31, 2001 and 2000. For the period ended March 31, 2001, net cash used in operating activities included a decrease in accounts receivable of approximately $3.5 million, due to reduced operating revenues; terminated prepaid contract of $1.4 million and expenses of $1.4 million related to the sale of the Enterprise division. Net cash used in operating activities for the period ended March 31, 2000 included an increase in accounts receivable of $5.5 million due to slower than expected rate of collections. Net cash used in investing activities was ($1.5) million for the six months ended March 31, 2001 as compared to $6.4 million net cash provided by investing activities for the six months ended March 31, 2000. The decrease was related to the payment of cash in the Sitematic acquisition included for the six month period ending March 31, 2000. Net cash provided by financing activities was approximately $17.8 million for the six months ended March 31, 2001 as compared to $2.3 million for the six months ended March 31, 2000. Net cash provided by financing activities for the six months ended March 31, 2001 consisted primarily of the option proceeds from the sale of the Enterprise division to Merant Incorporated of $18.0 million. We anticipate a moderate decrease in our operating expenses over the next two quarters as we transition to the new business model. However, we expect our operating expenses to continue to constitute a material use of our cash resources. In addition, we may require cash resources to fund acquisitions or investments in complementary businesses, technologies or product lines. The sale of the Enterprise division created additional capital to fund future operations, however if we fail to raise additional capital to fund future operations our business, financial condition and results of operations will be materially and adversely affected, and our stock price will decline substantially. RISK FACTORS NetObjects believes that its results of operations in any quarterly period may be impacted adversely by a number of factors, including those set forth below. Readers of this report should consider these and other ordinary business risk factors in evaluating the business, financial condition, results of operations and prospects of NetObjects. Our ability to continue as a going concern is dependent on our raising additional funds. Without raising new proceeds from the sale of assets, debt or equity financing, we will not have enough cash to remain in business. For the year ended September 30, 2000, our auditors, KPMG LLP, in their independent auditors' report, have expressed "substantial doubt" as to our ability to continue as a going concern. This doubt is based on our significant operating losses since we were formed, and our insufficient funds as of September 30, 2000 to finance our operations through fiscal year 2001. As of February 18, 2001, we sold the Enterprise Division of the Company and received approximately $18 million in consideration. The proceeds of this divestiture are being utilized to fund current operations. We believe that our current cash and cash equivalents, are adequate to finance our current level of operations only for a short period. We may seek to raise additional capital to fund future operations through the sale of additional equity securities, new borrowings, some combination of debt and equity, or other available transactions. If we fail to raise additional capital to fund future operations our business, financial condition and results of operations will be materially and adversely affected. 12 We have a history of substantial losses and expect substantial losses in the future. We were incorporated in November 1995 and first recognized revenues in October 1996. As of March 31, 2001, we had an accumulated deficit of approximately $118 million. We expect to sustain significant losses for the foreseeable future, which could harm our business and decrease the market price of our stock. To achieve and sustain profitability, we must, among other things, increase substantially our revenues from our two principal products, NetObjects Fusion and NetObjects Matrix, and substantially increase our revenues from professional and online services, which have been insignificant to date. Our revenues will be substantially lower in fiscal year 2001 as we change our business model. We are changing our business model from one in which we have received large up front license fees for the distribution of large numbers of copies of NetObjects Fusion to one in which we intend to earn most of our revenues from distribution arrangements with service providers that will pay us reduced license fees and a percentage of their subscription revenues received from small business subscribers. There can be no assurance that we will generate substantial revenues under our new business model and we expect our revenues to decline substantially in the current fiscal year in comparison to our revenues in preceding fiscal years. Our online services are new and have not received a broad customer acceptance. Since inception, we have invested resources to create and enhance our online services, which we believe support and add to market acceptance of our products. With the acquisition of Sitematic Corporation, providing online services to enable small businesses to conduct e-commerce has become an integral part of our business growth strategy. Including the period during which Sitematic operated these services they have been offered to customers generally for less than 12 months. Together with our distribution partners, we must attract a substantial number of small business subscribers for these services for our online business to succeed. We may fail to attract these new customers, which would hurt our business and could cause our stock price to fall. We may not adequately adjust our operating expense to reflect the anticipated reduction in revenue. We must reduce our operating expenses relative to the anticipated revenue reduction but anticipate that these expenses will substantially exceed our revenues for at least fiscal year 2001. As a result, we expect our operating expenses, as well as planned capital expenditures, to continue to constitute a material use of our cash resources. In addition, we may require cash resources to fund acquisitions or investments in complementary businesses, technologies or product lines. Our relationship with IBM has changed substantially over time. While IBM owns a substantial percentage of our common stock and has three representatives on our board of directors, it is under no obligation to continue any business relationships with us. IBM is allowed to compete with us or act in a manner that is disadvantageous to us. Although we have contracts with IBM to bundle our products with their offerings, we have no commitments for future revenues from IBM. Revenues from IBM have been a substantial portion of our total revenues, representing approximately 18% and 19% of our total revenues for the three month period ending March 31, 2001 and the fiscal year ending September 30, 2000, respectively. Lotus also currently markets, bundles and sells our products and has created foreign language, or "localized," versions of our software, for which IBM pays us reduced royalties on products that it sells outside the U.S. Lotus' obligation to create localized versions of our software expired on December 31, 1999. We may need to incur substantial additional expense to obtain localized versions of new products or product upgrades from Lotus or other vendors if necessary to satisfy the requirements of key customers. We have a number of license and reseller agreements or arrangements with IBM many of which are subject to the terms of our 10-year license agreement that expires in April 2007. We have no future revenue commitments from IBM or Lotus. We have business conflicts with IBM. IBM has chosen in the past and is free in the future to promote and bundle competitors' products over our products. 13 Although we have been dependent on IBM, and IBM has provided substantial support to us, IBM makes independent business and product decisions that present conflicts with our business objectives. IBM controls us and is free to sell its interest in us. As of March 31, 2001 IBM owns approximately 48.0% of our common stock and holds warrants that if exercised, would increase its ownership to approximately 48.4% of our outstanding voting securities. As our largest stockholder, with three representatives on our board of directors, IBM has substantial influence over our direction and management, and may be able to prevent or cause a change in control of us and could take other actions that might be favorable to IBM and potentially harmful to us. IBM can act in ways that may be disadvantageous to us, such as competing with us, investing in our competitors and taking advantage of corporate opportunities. IBM is contractually or otherwise free to act in ways that may harm our business. Our restated certificate of incorporation contains provisions expressly acknowledging that: o IBM retains "freedom of action" to conduct its business and pursue other business opportunities, even in competition with us; o IBM has no obligation to refrain from investing in our competitors, doing business with our customers or hiring away our key personnel; o No director appointed by IBM is prohibited from taking actions or from voting on any action because of any actual or apparent conflict of interest between that director and us, and these provisions materially limit the liability of IBM and its affiliates, including IBM's representatives on our board of directors and Lotus, from conduct and actions taken by IBM or its affiliates, even if the conduct or actions are beneficial to IBM and harmful to us; and these provisions materially limit the liability of IBM and its affiliates, including IBM's representatives on our board of directors and Lotus, from conduct and actions taken by IBM or its affiliates, even if the conduct or actions are beneficial to IBM and harmful to us. Furthermore: o IBM is eligible to sell its stock subject to applicable securities laws, contractual arrangements with the underwriters and the terms of a registration rights agreement. IBM may transfer some or all of its stock, including to our competitors. Such a transfer could result in a transfer of IBM's interest in us, which could cause our revenues to decrease and our stock price to fall; and o IBM is under no obligation to inform us of any corporate opportunity and is free to avail itself of any opportunity or to transfer the opportunity to a third party. Any of IBM's rights could give rise to conflicts of interests, and we cannot be certain that any conflicts would be resolved in our favor. Any of the risks arising from our relationship with IBM could harm our business and cause our stock price to fall. IBM could obtain and use our source code if we default on our obligations under license agreements with IBM. Although our license agreements with IBM contain restrictions on IBM's use and transfer of our software and intellectual property, these restrictions are subject to exceptions. Under a software license agreement with IBM, we have placed our key source code in escrow for IBM's benefit. IBM may obtain access to the source code upon events of default related to the Company's failure to provide required maintenance and support or its bankruptcy or similar event of financial reorganization. IBM may use the source code that it obtains to create derivative works, which it will own subject to the Company's rights in the underlying software. Our licensing arrangements with IBM are not exclusive and IBM is free to enter into similar arrangements with our competitors. All of our licensing arrangements with IBM are non-exclusive. IBM has the right to cease promoting and distributing our software at any time. IBM may license its name, logo and technology to, or invest in, other Web site building companies, and it may more actively promote the services of our competitors. 14 We have many established competitors, and may be unable to compete effectively against them. The market for web site building software and services for the Internet and corporate intranets is relatively new, constantly evolving and intensely competitive. We expect competition to intensify in the future, particularly in the market for subscription based online Web site services for small business. Many of our current and potential competitors have longer operating histories, greater name recognition and significantly greater financial, technical and marketing resources, and we may be unable to compete effectively against them. We compete for small business customers with web content software makers like Adobe, Macromedia, and Microsoft and in the on-line web hosting and services with providers like Verio, Bigstep, Icat, and Yahoo Store. Microsoft's FrontPage, a web site building software product, has a dominant market share. Microsoft bundles FrontPage 2000 in several versions of the Office 2000 product suite that dominates the market for desktop business application software. For our enterprise customers, we compete in the Internet application development and services market with companies such as Interwoven and Vignette. New technologies and the expansion of existing technologies could also increase the competitive pressures on us by enabling our competitors to offer lower-cost or superior products or service. Increased competition could diminish the value of our products and services and result in reduced operating margins and loss of market share. We cannot assure you that we will be able to compete successfully against current or future competitors. We may not be able to accurately forecast revenue and adjust spending. As a result of our transition to a new business model, our business is evolving rapidly, and we have a very limited operating history, therefore, we have little experience in forecasting our revenues. Our expense levels are based in part on our expectations of future revenues, and to a large extent those expenses are fixed, particularly in the short-term. We cannot be certain that our revenue expectations will be accurate or that we will be able to adjust spending in a timely manner to compensate for any unexpected revenue shortfall. Our quarterly operating results will probably fluctuate. We believe that period-to-period comparisons of our financial results are not necessarily meaningful, and you should not rely upon them as an indication of our future performance. Going forward, our revenues from IBM, if any, are likely to become more variable. The promptness with which sales data, used for recognizing product royalties, are reported to us from third parties, including IBM, may cause annual results to be more volatile. We allow product returns and provide price protection to some purchasers and resellers of our products and our allowances for product returns may be inadequate. We have stock-balancing programs for our software products that under specified circumstances allow for the return of software by resellers. These programs also provide for price protection for our software for some of our direct and indirect channel resellers that, under specified conditions, entitle the reseller to a credit if we reduce our price to similar channel resellers. There can be no assurance that actual returns or price protection will not exceed our estimates, and our estimation policy may cause significant fluctuations. Most of our revenues have been derived from sales of a single product, and a decline in demand or the sale price of that product would harm our business and cause our stock price to fall. In the quarter ending March 31, 2001, our revenues were derived entirely from the sales of NetObjects Fusion software. On February 18, 2001 we sold the Enterprise Division to Merant Incorporated for approximately $18 million in cash. About 68% of our revenues from software license fees in fiscal 2000 were derived from NetObjects Fusion, and we expect that this single product will continue to account for the majority of our total revenues in the near-term. To remain competitive, software products typically require frequent updates that add new features. There can be no assurance that we will succeed in creating and selling updated or new versions of NetObjects Fusion. A decline in demand for, or in the average selling price of, NetObjects Fusion, whether as a result of new product introductions or price competition from competitors, technological change or otherwise, would hurt our business or cause our stock price to fall. We may not be able to expand our distribution channels or sales force. We need to maintain our third-party distribution channel because our direct sales to third parties would be insufficient to support our operating base. While we derive some of our revenues from selling our products directly to third parties, most of our revenues are derived from the sale of our products through third-party distributors and OEM resellers. We need to develop third party relationships for promoting our on-line offerings. A substantial portion of our revenues from NetObjects Fusion comes from arrangements with a limited number of customers. There can be no assurance that third parties will be 15 willing or able to carry our products in the future. If third parties were to reduce or cease carrying our products, our direct sales to third parties would be insufficient to support our operating expense base. We need to maintain and establish new bundling arrangements because we may be less successful at selling our products on a stand-alone basis. We believe that products that are not sold in a "suite" containing software products or components that perform different functions are less likely to be commercially successful. For example, NetObjects Fusion 5.0 includes free web site hosting services. IBM also bundles our products with some of its software products, such as the bundling of NetObjects Fusion with WebSphere Studio and NetObjects Fusion with Lotus Designer Studio and Lotus SmartSuite. NetObjects Fusion is also bundled with Novell's NetWare for Small Business. We cannot be assured of maintaining or obtaining suitable product or component bundling arrangements with third parties. Failure to maintain or conclude suitable software product bundling arrangements could hurt our business, cause our revenues to decrease and our stock price to fall. Our products may contain defects that could subject us to liability in excess of insurance limitations. Our software products are complex and may contain undetected errors or result in system failures. Despite extensive testing, errors could occur in any of our current or future product offerings after commencement of commercial shipments. Any errors could result in loss of or delay in revenues, loss of market share, failure to achieve market acceptance, diversion of development resources, and injury to our reputation or damage to our efforts to build brand awareness. We cannot be certain that the contractual limitations of liability will be enforceable, or that our insurance coverage will continue to be available on reasonable terms or will be available in amounts to cover one or more large claims, or that the insurer will not disclaim coverage as to any future claim. The successful assertion of one or more large claims that exceed available insurance coverage or changes in our insurance policies, including premium increases or the imposition of large deductible or co-insurance requirements, could cause our revenues to decrease and our stock price to fall. If we fail to respond adequately to rapid technological changes, our existing products and services will become obsolete or unmarketable. The market for our products is marked by rapid technological change, which leads to frequent new product introductions and enhancements, uncertain product life cycles, changes in customer demands and evolving industry standards. New web site building products and services based on new technologies or new industry standards could render our existing products obsolete and unmarketable. We believe that to succeed, we must enhance our current products and develop new products on a timely basis to keep pace with technological developments and to satisfy the increasingly sophisticated requirements of our customers. Our product and software development efforts are inherently difficult to manage and keep on schedule, so development delays may increase our costs. On occasion, we have experienced software development delays and related cost overruns, which to date have not materially affected our business, and we cannot be certain that we will not encounter these problems in the future. Any delays in developing and releasing enhanced or new products could cause our revenues to decrease. In addition, we cannot be certain that we will successfully develop and market new products or product enhancements that respond to technological change, evolving industry standards or customer requirements, or that any product innovations will achieve the market penetration or price stability necessary for profitability. The loss of our key personnel, or failure to hire additional personnel, could harm our business because we would lose experienced personnel and new skilled personnel are in short supply and command high salaries. We depend on the continued service of our key personnel, and we expect that we will need to hire additional personnel in all areas. The competition for personnel throughout our industry is intense, particularly in the San Francisco Bay Area, where our headquarters are located. We have experienced difficulties in attracting new personnel, and all of our personnel, including our management, may terminate their employment at any time for any reason. Currently, we are dependent upon the services of Samir Arora, our President, Chief Executive Officer, Chairman of the Board and one of our founders. The loss of Mr. Arora's services would materially impede the operation and growth of our business at this time. We do not maintain key person life insurance for any of our personnel. Furthermore, our failure to attract new personnel or retain and motivate our current personnel could hurt our business. 16 A third party could be prevented from acquiring our shares of stock at a premium to the market price because of our anti-takeover provisions. As of March 31, 2001 IBM owns approximately 48.0% of our outstanding stock and holds warrants that if exercised, would increase its ownership to approximately 48.4% of our outstanding voting securities. That ownership interest and provisions of our restated certificate of incorporation, bylaws, a voting agreement between us and IBM and Delaware law could make it more difficult for a third party to acquire us, even if a change in control would result in the purchase of your shares of common stock at a premium to the market price. If we fail to adequately protect our intellectual property rights or face a claim of intellectual property infringement by a third party, we could lose our intellectual property rights or be liable for significant damages. Trademarks and other proprietary rights are important to our success and our competitive position. We seek to protect our trademarks and other proprietary rights, but our actions may be inadequate to prevent misappropriation or infringement of our technology, trademarks and other proprietary rights or to prevent others from claiming violations of their trademarks and other proprietary rights. Although we have obtained federal registration of the trademark NetObjects Fusion, we know that other businesses use the word "Fusion" in their marks alone or in combination with other works. We do not believe that we will be able to prevent others from using the word "Fusion" for competing goods and services. For example, Allaire Corporation markets its application development and server software for web development, including applications for e-commerce, under the federally registered trademark "ColdFusion." Under an agreement with Allaire Corporation, we have agreed that neither company will identify its products and services with the single word "Fusion," unless otherwise agreed as in the case of our co-bundled product "Fusion2Fusion." Business customers may confuse our products and services with similarly named brands, which could dilute our brand names or limit our ability to build market share. To license many of our products, we rely in part on "shrink-wrap" and "clickwrap" licenses that are not signed by the end user and, therefore may be unenforceable under the laws of certain jurisdictions. In addition, we may license content from third parties. We could become subject to infringement actions based upon these third-party licenses, and we could be required to obtain licenses from other third parties to continue offering our products. We cannot be certain that we will be able to avoid significant expenditures to protect our intellectual property rights, to defend against third-party infringement or other claims or to license content from third parties alleging that our products infringe their intellectual property rights. Incurring significant expenditures to protect our intellectual property rights or to defend against claims or to license content could decrease our revenues and cause our stock price to fall. Since we are no longer a majority-owned subsidiary of IBM, we no longer enjoy cross-licensing protection that we received as an IBM subsidiary. We may face material litigation risk associated with patent infringement claims that IBM's patent cross-licensees could not assert against us while we were an IBM subsidiary. Our international operations continue to expand and may not be successful. International sales represented approximately 29% of our total revenues in the quarter ended March 31, 2001 and approximately 50% of our total revenues in the quarter ended December 31, 2000. International sales represented approximately 39% and 44% of our total revenues for the six-month periods ended March 31, 2001 and 2000, respectively. We intend to expand the scope of our international operations and currently have a subsidiary in the United Kingdom. Our continued growth and profitability will require continued expansion of our international operations, particularly in Europe. Our international operations are, and any expanded international operations will be, subject to a variety of risks associated with conducting business internationally that could materially adversely affect our business, including the following: o difficulties in staffing and managing international operations; o lower gross margins than in the United States; o slower adoption of the Internet; o longer payment cycles; o fluctuations in currency exchange rates; o seasonal reductions in business activity during the summer months in Europe and other parts of the world; o recessionary environments in foreign economies; and 17 o increases in tariffs, duties, price controls or other restrictions on foreign currencies or trade barriers imposed by foreign countries. Furthermore, the laws of foreign countries may provide little or no protection of our intellectual property rights. If Internet and intranet usage does not continue to grow, we will not be successful. Sales of our products and services depend in large part on the emergence of the Internet as a viable commercial marketplace with a strong and reliable infrastructure and on the growth of corporate intranets. Critical issues concerning use of the Internet and intranets, including security, reliability, cost, ease of use and quality of service, remain unresolved and may inhibit the growth of, and the degree to which business is conducted over, the Internet and intranets. Failure of the Internet and intranets to develop into viable commercial mediums would harm our business and cause our revenues to decrease and our stock price to fall. Due to our small size, limited operations and the difficulty of hiring personnel in our industry, any future acquisitions could strain our managerial, operational and financial resources. In the future we may make acquisitions of, or large investments in, businesses that offer products, services and technologies that we believe would help us better provide e-business web site and intranet site building software and services to businesses. Any future acquisitions or investments would present risks such as difficulty in combining the technology, operations or workforce of the acquired business with our own, disruption of our ongoing businesses and difficulty in realizing the anticipated financial or strategic benefits of the transaction. To make these acquisitions or large investments we might use cash, common stock or a combination of cash and common stock. If we use common stock, these acquisitions could further dilute existing stockholders. Amortization of goodwill or other intangible assets resulting from acquisitions, as in the case of our Sitematic and Rocktide acquisitions, could materially impair our operating results and financial condition. Furthermore, there can be no assurance that we would be able to obtain acquisition financing, or that any acquisition, if consummated, would be smoothly integrated into our business. If we make acquisitions or large investments and are unable to surmount these risks, our business could be harmed, our revenues could decrease and our stock price could fall. We may become subject to burdensome government regulation and legal uncertainties in areas including network security, encryption and privacy, among others, because we conduct electronic commerce and provide information and services over the Internet. We are not currently subject to direct regulation by any governmental agency, other than laws and regulations generally applicable to businesses, although specific U.S. export controls and import controls of other countries, including controls on the use of encryption technologies, may apply to our products. Due to the increasing popularity and use of the Internet, it is possible that a number of laws and regulations may be adopted in the United States and abroad with particular applicability to the Internet. It is possible that governments will enact legislation that may apply to us in areas such as network security, encryption, the use of key escrow, data and privacy protection, electronic authentication or "digital" signatures, illegal and harmful content, access charges and retransmission activities. Moreover, the applicability to the Internet of existing laws governing issues such as property ownership, content, taxation, defamation and personal privacy is uncertain. Any new legislation or regulation or governmental enforcement of existing regulations may limit the growth of the Internet, increase our cost of doing business or increase our legal exposure, any of which could cause our revenues to decrease and our stock price to fall. A governmental body could impose sales and other taxes on the sale of our products, license of our technology or provision of services, which would harm our financial condition. We currently do not collect sales or similar taxes with respect to the sale of products, license of technology or provision of services in states and countries other than states in which we have offices. In October 1998, the Internet Tax Freedom Act, or ITFA, was signed into law. Among other things, the ITFA imposes a three-year moratorium on discriminatory taxes on e-commerce. Nonetheless, foreign countries, or, following the moratorium, one or more states, may seek to impose sales or other tax obligations on companies that engage in on-line commerce within their jurisdictions. A successful assertion by one or more states or any foreign country that we should collect sales or other taxes on the sale of products, license of technology or provision of services or remit payment of sales or other taxes for prior periods, could hurt our business. 18 Our stock price might have wide fluctuations, and Internet-related stocks have been particularly volatile. The market price of our common stock is highly volatile and subject to wide fluctuations. Recently, the stock market has experienced significant price and volume fluctuations and the market prices of securities of technology companies, particularly Internet-related companies, have been highly volatile. Market fluctuations, as well as general political and economic conditions, such as recession or interest rate or currency rate fluctuations, could adversely affect the market price of our common stock. 19 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Our exposure to market risks for changes in interest rates relates primarily to investments in debt securities issued by U.S. government agencies and corporate debt securities. We place our investments with high quality credit issuers and, by policy, limit the amount of the credit exposure to any one issuer. We manage interest rate risk by limiting investments to debt securities of relatively short maturities. In addition, we maintain sufficient cash and cash equivalents so that we can hold investments to maturity. As of March 31, 2001, we had cash and cash equivalents of $9.4 million, including approximately $4.5 million in money market funds with maturities of less than 90 days. Based upon our balance of cash and cash equivalents at March 31, 2001, a decrease in interest rates of 0.5% would not cause a material decrease in our annual interest income. Our general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with a maturity of three months or less at the date of purchase are considered to be cash equivalents; investments with maturities greater than three months are considered to be short-term investments. Our investment policy limits purchases of debt securities to maturities of three months or less. To date, we have not purchased or sold forward contracts to hedge foreign currency exposure, since the relative amounts of international revenue generated have not been large enough to make hedging cost-effective. 20 PART II: OTHER INFORMATION ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) None (b) On March 6, 2001, we filed a report of Form 8-K with respect to the sale of the Company's Enterprise division to Merant Incorporated. SIGNATURES 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. NETOBJECTS, INC. Date: May 15, 2001 /s/ Samir Arora ---------------------------------------------- Samir Arora Chairman of the Board, Chief Executive Officer and President (Duly Authorized Officer) /s/ Ernie Cicogna ----------------------------------------- Ernie Cicogna Senior Vice President, Finance (Principal Accounting Officer) 21

NETOBJECTS INC 10-Q