10-Q 1 d10q.txt FORM 10-Q FOR PERIOD ENDED SEPTEMBER 30, 2001 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 --------------- FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 30, 2001 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: 000-29799 CROSSWORLDS SOFTWARE, INC. (Exact name of registrant as specified in its charter) Delaware 94-3240149 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 577 Airport Boulevard Burlingame, CA 94010 (Address, including zip code, of registrant's principal executive offices) (650) 685-9000 (Registrant's telephone number, including area code) 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 [_] The number of shares outstanding of the Registrant's Common Stock, par value $0.001, as of October 31, 2001 was 27,023,627. ================================================================================ CROSSWORLDS SOFTWARE, INC. AND SUBSIDIARIES TABLE OF CONTENTS

Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements: Consolidated Condensed Balance Sheets (Unaudited) as of ~~June~~September 30, 2001 and December 31, 2000 ...................................................................... 3 Consolidated Condensed Statements of Operations (Unaudited) for the three and ~~six~~nine months ended ~~June~~September 30, 2001 and 2000 .......................................... 4 Consolidated Condensed Statements of Cash Flows (Unaudited) for the ~~six~~nine months ended ~~June~~September 30, 2001 and 2000 ...................................................... 5 Notes to the Consolidated Condensed Financial Statements (Unaudited) ................... 6 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ..................................................................... 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk ........................ 2122 PART II. OTHER INFORMATION Item 1. Legal Proceedings ................................................................. 2224 Item 2. Changes in Securities and Use of Proceeds ......................................... 2224 Item 3. Defaults Upon Senior Securities ................................................... 2224 Item 4. Submission of Matters to a Vote of Security Holders ............................... 2224 Item 5. Other Information ................................................................. 2224 Item 6. Exhibits and Reports on Form 8-K .................................................. 2324 Signature ....................................................................................... 2426

2 PART I. FINANCIAL INFORMATION Item 1. Financial Statements. CROSSWORLDS SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED BALANCE SHEETS (In thousands) (Unaudited)

~~June~~September 30, December 31, 2001 2000 ------ ---- ASSETS Current assets: Cash and cash equivalents ............................... $ 22,~~645~~122 $ 22,532 Short-term investments .................................. ~~2,021~~-- 17,060 Accounts receivable, net ................................ 2112,~~867~~340 24,798 Prepaid and other current assets ........................ 5,~~615~~723 3,723 --------- ---------- Total current assets .................................. 5240,~~148~~185 68,113 Property and equipment, net ............................. 7,~~483~~816 6,310 Deposits and other assets ............................... ~~1,011~~946 1,345 --------- ---------- Total assets .......................................... $ 6048,~~642~~947 $ 75,768 ========= ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable ........................................ $ 42,~~288~~971 $ 2,970 Accrued payroll and related expenses .................... 5,~~394~~928 6,036 Accrued commissions ..................................... 2,~~485~~251 4,379 Other accrued liabilities ............................... 45,~~971~~908 5,801 Current portion of capital lease obligations ............ ~~481~~415 477 Borrowings .............................................. 21,~~404~~458 2,936 Deferred revenue ........................................ 2111,~~022~~255 30,011 --------- ---------- Total current liabilities ............................. 4130,~~045~~186 52,610 Other long-term liabilities ............................. ~~330~~911 114 Capital lease obligations, less current portion 89......... 43 325 --------- ---------- Total liabilities ..................................... 4131,~~464~~140 53,049 --------- ---------- Stockholders' equity: Common stock ............................................ 27 26 Additional paid-in capital .............................. 156,966 156,934 Deferred stock-based compensation ....................... (1,~~325~~148) (2,645) Accumulated deficit ..................................... (~~136~~138,~~490~~038) (131,596) --------- ---------- Total stockholders' equity ............................ 1917,~~178~~807 22,719 --------- ---------- Total liabilities and stockholders' equity ............ $ 6048,~~642~~947 $ 75,768 ========= ==========

The accompanying notes are an integral part of these consolidated condensed financial statements. 3 CROSSWORLDS SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF OPERATIONS (In thousands except per share amounts) (Unaudited)

Three months ended ~~Six~~Nine months ended ~~June~~September 30, ~~June~~September 30, ------------- ------------- 2001 2000 2001 2000 ------ ------ ------ ---- Revenue: Software license ...................................... $ 710,~~045~~617 $ 56,~~031~~552 $ 1626,~~115~~732 $ 814,~~214~~766 Service, maintenance and other ........................ 1311,~~099~~105 68,~~348~~503 2536,~~685~~790 1019,~~863~~366 -------- --------- --------- --------- Total revenue ....................................... 2021,~~144~~722 1115,~~379~~055 4163,~~800~~522 1934,~~077~~132 -------- --------- --------- --------- Cost of revenue: Software license and royalties ........................ ~~224~~259 ~~204~~272 ~~433~~692 ~~325~~597 Service, maintenance and other (1) .................... 76,~~361~~776 56,~~716~~879 1421,~~637~~413 1017,~~244~~123 -------- --------- --------- --------- Total cost of revenue ............................... 7,~~585~~035 57,~~920~~151 1522,~~070~~105 1017,~~569~~720 -------- --------- --------- --------- Gross profit ...................................... 1214,~~559~~687 57,~~459~~904 2641,~~730~~417 816,~~508~~412 -------- --------- --------- --------- Operating expenses: Research and development (2) .......................... 34,~~973~~272 4,~~114~~423 813,~~746~~018 712,~~889~~312 Sales and marketing (3) ............................... 7,~~335~~297 87,~~242~~976 1523,~~807~~104 1422,~~630~~606 General and administrative (4) (5) .................... 24,~~980~~531 23,~~436~~454 611,~~746~~277 58,~~089~~543 Amortization of deferred stock-based ~~compensation~~Compensation ........................................ 95177 ~~852~~633 ~~393~~570 12,~~560~~193 -------- --------- --------- --------- Total operating expenses ............................ 1416,~~383~~277 1516,~~644~~486 3147,~~692~~969 2945,~~168~~654 -------- --------- --------- --------- Operating loss .................................... (1,~~824~~590) (108,~~185~~582) (46,~~962~~552) (2029,~~660~~242) Other income (expense), net ~~.....................~~42 95723 ~~(1,029)~~110 68 (~~1,412~~689) -------- --------- --------- --------- Net loss .......................................... $ (1,~~729~~548) $(117,~~214~~859) $ (46,~~894~~442) $(2229,~~072~~931) ======== ========= ========= ========= Net loss per share: Basic and diluted ..................................... $ (0.06) $ (10.0630) $ (0.1824) $ (32.1126) Weighted average shares used in computation ........... 26,~~654~~754 1025,~~619~~849 26,~~542~~616 713,~~097~~266

(1) Excludes stock-based compensation of $39 and $100 for the three months ended September 30, 2001 and 2000, and $62 and $306 for the nine months ended September 30, 2001 and 2000, respectively. (2) Excludes stock-based compensation of $34 and $128 for the three months ended September 30, 2001 and 2000, and $152 and $495 for the nine months ended September 30, 2001 and 2000, respectively. (3) Excludes stock-based compensation of $100 and $240 for the three months ended September 30, 2001 and 2000, and $279 and $1,061 for the nine months ended September 30, 2001 and 2000, respectively. (4) Excludes stock-based compensation of $4 and $165 for the three months ended September 30, 2001 and 2000, and $77 and $331 for the nine months ended September 30, 2001 and 2000, respectively. (5) Includes special charges of $2,244 on lease loss for the three months ended September 30, 2001. 4 CROSSWORLDS SOFTWARE, INC. AND SUBSIDIARIES CONSOLIDATED CONDENSED STATEMENTS OF CASH FLOWS (In thousands) (Unaudited)

~~Six~~Nine months ended ~~June 30,~~ ----------------- ~~2001~~September ~~2000~~30, ------------- 2001 2000 ---- ---- Cash flows from operating activities: Net loss ...................................................................... $ (46,~~894~~442) $(2229,~~072~~931) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation ............................................................. 12,~~912~~821 12,~~541~~237 Amortization of warrants for financing commitment .............................................................. -- 1,406 Amortization of deferred stock-based compensation ............................................................ ~~393~~570 12,~~560~~193 Changes in operating assets and liabilities: Accounts receivable .................................................... 212,~~931~~458 (810,~~332~~077) Prepaid and other current assets ....................................... (12,~~892~~000) (~~694~~1,141) Other assets ........................................................... ~~334~~399 (1,~~489~~351) Accounts payable ....................................................... 1 1,~~318~~175 ~~649~~ Accrued payroll and related expenses ................................... (~~642~~108) 12,~~078~~584 Accrued commissions .................................................... (12,~~894~~128) ~~1,108~~672 Other accrued liabilities .............................................. ~~(913)~~65 23,~~184~~865 Deferred revenue ....................................................... (818,~~989~~756) 1115,~~628~~154 Other long-term liabilities ............................................ ~~216~~797 (9) --------- -------- Net cash used in operating activities ................................ (12,~~120~~323) (1113,~~442~~223) --------- -------- Cash flows from investing activities: Purchases of property and equipment ........................................... (34,~~081~~257) (12,~~358~~988) ~~Disposals~~Purchases of ~~property~~short-term ~~and~~investments ~~equipment~~ ............ ~~65 -- Purchases of short-term investments~~ ............................... (28,~~021~~813) -- Redemptions of short-term investments ......................................... 1725,~~060~~873 -- --------- -------- Net cash provided by (used in) ~~Investing~~investing activities... ............................................. 12,~~023~~803 (12,~~358~~988) --------- -------- Cash flows from financing activities: Repayments of capital lease obligation and ~~long-~~borrowings ~~term debt~~................................................................. (35,~~070~~670) (12,~~656~~440) Proceeds from revolving credit facility ....................................... 23,~~320~~820 -- Proceeds from issuance of common stock, net ................................... 960 53,~~395~~964 --------- -------- Net cash provided by (used in) financing activities .......................................................... ~~210~~(890) 51,~~739~~524 --------- -------- Net increase (decrease) in cash and cash equivalents ........................... ~~113~~(410) 3835,~~939~~313 Cash and cash equivalents at beginning of period ............................... 22,532 12,506 --------- -------- Cash and cash equivalents at end of period ..................................... $ 22,~~645~~122 $ 5147,~~445~~819 ========= ========

The accompanying notes are an integral part of these consolidated condensed financial statements. 5 CROSSWORLDS SOFTWARE, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED CONDENSED FINANCIAL STATEMENTS (Unaudited) (1) Basis of Presentation The accompanying unaudited consolidated condensed statements of operations for the three and nine months ended September 30, 2001 and 2000, statements of cash flows for the nine months ended September 30, 2001 and 2000, and balance sheets at September 30, 2001 and December 31, 2000 have been prepared by CrossWorlds Software, Inc. (the "Company") on the same basis as the audited consolidated financial statements and reflect all normal recurring and other adjustments which are, in the opinion of management, necessary to present fairly the financial position and the results of operations for the interim periods presented. These unaudited consolidated condensed financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company's 2000 Annual Report on Form 10-K. The results of operations for the three- and nine-month periods ended September 30, 2001 are not necessarily indicative of results for the entire fiscal year. (2) Revenue Recognition The Company recognizes revenue in accordance with the American Institute of Certified Public Accountants' ("AICPA") Statement of Position 97-2 ("SOP 97-2"), "Software Revenue Recognition." When contracts contain multiple elements, wherein vendor-specific objective evidence exists for all undelivered elements, the Company accounts for the delivered elements using the "residual method" prescribed by AICPA Statement of Position 98-9, "Software Revenue Recognition, with Respect to Certain Arrangements." The Company's software arrangements typically involve significant production, customization, or modification of the software, or services that are essential to the functionality of the software and, as a result, software license revenue for the entire arrangement is generally recognized using the percentage-of-completion method. Progress toward completion is measured by achieving certain standard and objectively verifiable milestones present in each project. In certain instances, the Company may recognize software license revenue upon delivery when persuasive evidence of an arrangement exists, the fee is fixed and determinable, acceptance is certain, collection is probable, and the Company is not involved in significant production, customization, or modification of the software or services that are essential to the functionality of the software. In the event costs to complete a contract are expected to exceed anticipated revenue, a loss is accrued. To date, no such losses have been accrued. In certain circumstances where the Company is unable to estimate the amount of effort required to customize or implement the software license, revenue is recognized using the completed contract method. To date, no amounts have been recognized under the completed contract method. Consulting and training revenue is recognized as the services are performed. Maintenance revenue from customer support and product upgrades, including maintenance bundled with original software licenses, is deferred and recognized ratably over the term of the maintenance agreement, typically twelve months. When the Company enters into software arrangements with resellers, the Company does not recognize revenue until the reseller demonstrates it has entered into an arrangement with an end user that satisfies the Company's revenue recognition criteria. When the Company's services are essential to the end user implementation of the software sold by the reseller, the software license revenue for the arrangement is recognized using the percentage-of-completion method. (3) Comprehensive Income (Loss) The Company had no material components of other comprehensive income (loss) for any of the periods presented. (4) Net Loss Per Share Basic net loss per share is computed using the weighted-average number of outstanding shares of common stock, excluding common stock subject to repurchase. Diluted net loss per share is computed using the weighted-average number of outstanding shares of common stock and, when dilutive, potential common shares from options and warrants to purchase common stock and common stock subject to repurchase using the treasury stock method, 6 and from convertible securities using the as-if converted method. All potential common shares have been excluded from the computation of diluted net loss per share for all periods presented because the effect would have been antidilutive. Diluted net loss per share does not include the effect of the following antidilutive common equivalent shares:

Three months ended ~~Six~~Nine months ended ~~June~~September 30, ~~June~~September 30, ~~-------- --------~~ 2001 2000 2001 2000 ---- ---- ---- ---- (In thousands) (In thousands) Stock options and warrants ........................... 58203 45,~~099~~592 ~~111~~142 14,~~235~~507 Common stock subject to repurchase ................... 4421 ~~101~~86 4421 ~~101~~86

The following table sets forth the computation of basic and diluted net loss per share for the periods indicated:

Three months ended ~~Six~~Nine months ended ~~June~~September 30, ~~June~~September 30, ------------- ------------- 2001 2000 2001 2000 ---- ---- ---- ---- (In thousands except (In thousands except per share amounts) per share amounts) Net loss ............................................. $ (1,~~729~~548) $ (117,~~214~~859) $ (46,~~894~~442) $ (2229,~~072~~931) Weighted average shares of common stock ~~outstanding~~Outstanding ....................................... 26,~~698~~775 1025,~~720~~935 26,~~586~~637 713,~~198~~352 Less: weighted average common shares subject to repurchase ............................. (4421) (~~101~~86) (4421) (~~101~~86) --------- --------- --------- --------- Weighted average shares used in computing basic and diluted net loss per common share ....... 26,~~654~~754 1025,~~619~~849 26,~~542~~616 713,~~097~~266 Basic and diluted net loss per share ................. $ (0.06) $ (10.0630) $ (0.1824) $ (32.1126)

(5) Supplemental Cash Flow Information

~~Six~~Nine months ended ~~June~~September 30, ------------- 2001 2000 ------ ------ (In thousands) Cash paid during the period for interest ................ $ ~~161~~175 $ ~~401~~552 Non-cash investing and financing activities: Issuance of common stock warrants for financing commitment ......................................... -- 1,406 Equipment acquired through equipment lease facility ........................................... -- 301

(6) Segment Reporting The Company is organized in a single operating segment for purposes of making operating decisions and assessing performance. The chief operating decision maker evaluates performance, makes operating decisions and 7 allocates resources based on financial data consistent with the presentation in the accompanying consolidated condensed financial statements. The following table presents geographical information about the Company's revenues:

Three months ended ~~Six~~Nine months ended ~~June~~September 30, ~~June~~September 30, ------------- ------------- In thousands 2001 2000 2001 2000 ------------ ------- ------- ------- ------- North America .............................~~.......~~ $13,~~844~~797 $7 8,~~416~~923 $2842,~~677~~475 $1221,~~700~~623 Europe ....................................~~.......~~ 7,853 6,~~184~~060 320,~~963~~753 12,~~901~~437 ~~6,377~~ Other .....................................~~.......~~ ~~116~~72 --72 ~~222~~294 --72 ------- ------- ------- ------- Total ..................................~~.......~~ $2021,~~144~~722 $1115,~~379~~055 $4163,~~800~~522 $1934,~~077~~132 ======= ======= ======= =======

The following table presents geographical information about the Company's long-lived assets (at cost):

~~June~~September 30, December 31, In thousands 2001 2000 -------------- ------------- ------------ North America ............................................... $1516,~~396~~576 $12,879 Europe ...................................................... 1,~~022~~020 1,049 ------- ------- Total .................................................... $1617,~~418~~596 $13,928 ======= =======

(7) Special Charges and Related Expenses In April 2001, the Company announced a plan to streamline operations and reduce costs. Overall expense reductions were necessary to align the Company's cost structure with changing market conditions and to create a more flexible and efficient organization. The plan resulted in a reduction in total staff of approximately 7% or 23 people throughout the organization and delay of office expansion plans. The reduction in staff was completed during the three months ended June 30, 2001. The following table summarizes the components of the special charges and other non-recurring expenses, by geographic region for the three months ended June 30, 2001 (in thousands):

Severance and Benefits Facilities Other Total -------- ---------- ----- ----- United States ............................... $252 $67 $ 3 $322 Europe ...................................... 51 17 11 79 ---- --- --- ---- Total .................................... $303 $84 $14 $401 ==== === === ====

During October 2000, the Company entered into a lease agreement for an additional 44,455 square feet of office space. The term of the 8-year lease commenced on August 15, 2001. The Company has not occupied the space, but has and continues to explore various alternatives with regards to the structure of the lease of the building, including plans to sublease the extra office space. Due to the dramatic decline in lease rates and the increase in available lease space in the San Francisco Bay Area commercial real estate market, the Company may not be able to find a suitable sub-lessee for this space or a sub-lessee willing to pay a price equal to or greater than the rates required to be paid by the Company. Accordingly, during the three months ended September 30, 2001, the Company recorded a $2.2 million charge for sublease losses over an estimated 17-month sublease period. The Company plans on fully utilizing this space after the 17-month period. Pending ongoing evaluation and market conditions, the Company may be required to record additional losses on the space in the future. (8) Recent Accounting Pronouncements In July 2001, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 141, "Business Combinations" ("SFAS 141") and Statement of Financial Accounting Standard No. 142, 8 "Goodwill and Other Intangible Assets" ("SFAS 142"). SFAS 141 provides guidance on the accounting for a business combination at the date a business combination is completed. The statement requires the use of the purchase method of accounting for all business combinations initiated after June 30, 2001, thereby eliminating use of the pooling-of-interest method. The Company is required to adopt the provisions of SFAS 141 immediately. SFAS 142 provides guidance on how to account for goodwill and intangible assets after an acquisition is completed. The most substantive change is that goodwill will no longer be amortized but instead will be tested for impairment periodically. This statement will apply to existing goodwill and intangible assets, beginning with fiscal years starting after December 15, 2001. The Company expects to adopt this statement at the beginning of fiscal 2002. As the Company has not completed any business combinations through September 30, 2001, the Company believes that these standards will not have a material impact on its consolidated financial position or operating results. The Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 143, "Accounting for Asset Retirement Obligations" ("SFAS 143"), in August 2001, and Statement of Financial Accounting Standard 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), in October 2001. SFAS 143 requires that the fair value of an asset retirement obligation be recorded as a liability in the period in which it incurs the obligation. SFAS 144 serves to clarify and further define the provisions of SFAS No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of". SFAS 144 does not apply to goodwill and other intangible assets that are not amortized. SFAS 143 is effective for fiscal years beginning after June 15, 2002 and SFAS 144 is effective for fiscal years beginning after December 15, 2001. The Company expects to adopt SFAS 144 effective January 1, 2002, and SFAS 143 effective January 1, 2003. The effect of adopting these statements is not expected to have a material effect on the Company's consolidated financial position or results of operations. (9) Subsequent Events On October 30, 2001, the Company and International Business Machines Corporation ("IBM") announced they had entered into an Agreement and Plan of Merger dated as of October 29, 2001 (the "Agreement") by and among IBM, Duke Acquisition Corporation (a wholly owned subsidiary of IBM), and the Company. Under the terms of the Agreement, each outstanding share of the Company's common stock will be converted into the right to receive $4.65 in cash, without interest. The merger has been approved by the boards of directors of both the Company and IBM and is subject to various closing conditions, including the expiration or early termination of the waiting period required under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (as amended) and approval of the Agreement by the shareholders of the Company. If the merger is completed, the Company will become a wholly owned subsidiary of IBM. The transaction is expected to close in the first quarter of 2002. On November 2, 2001, two actions, Neil Macklin vs. CrossWorlds Software, Inc. et al. and Carl Rongo vs. CrossWorlds Software, Inc. et al., were filed in the Superior Court of the State of California for the County of San Mateo. In these actions the plaintiffs named as defendants the Company and the directors of the Company. The complaint purports to assert claims on behalf of all public stockholders of CrossWorlds who are similarly situated with the plaintiff. The complaint alleges that the Company and the members of the Company's Board of Directors have breached their fiduciary duties to CrossWorlds' public stockholders, that the directors engaged in self-dealing in connection with their approval of the merger and that the directors failed to take steps to maximize the value of CrossWorlds to its public stockholders. The complaint seeks class certification and certain forms of equitable relief, including enjoining the consummation of the merger. The Company believes that the allegations are without merit and intends to vigorously contest this action. There can, however, be no assurance that the Company or the other defendants will be successful in their defense of this action. 9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. CROSSWORLDS SOFTWARE, INC. AND SUBSIDIARIES The following discussion should be read in conjunction with the unaudited consolidated condensed financial statements and the related notes that appear elsewhere in this document. This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 12E of the Securities Exchange Act of 1934. These forward-looking statements are subject to business and economic risks and uncertainties, as well as assumptions that, if they never materialize or prove incorrect, could cause the results of CrossWorlds Software, Inc. and its consolidated subsidiaries ("CrossWorlds" or the "Company") to differ materially from those expressed or implied by such forward-looking statements. Statements and information contained herein concerning markets for CrossWorlds' products and trends in financial results, and all other statements that include the word "may," "will," "should," "believe," "anticipate," "intend," "estimate," "expect," "project," "plan," "predict," "potential," "continue," "strategy" and other similar expressions constitute forward-looking statements. CrossWorlds' actual results could differ materially from those anticipated in the forward-looking statements for many reasons, including the factors and the risks to our business set forth herein and in our other Securities Exchange Commission Filings. We undertake no obligation to revise or update publicly any forward-looking statements for any reason. This quarterly report on Form 10-Q contains certain statements in connection with an announcement by International Business Machines Corporation ("IBM") and CrossWorlds that they have entered into a merger agreement contemplating a merger of a wholly-owned subsidiary of IBM with and into the Company. In connection with the merger, CrossWorlds will be filing a proxy statement with the Securities and Exchange Commission. STOCKHOLDERS OF CROSSWORLDS ARE URGED TO READ THE PROXY STATEMENT WHEN IT BECOMES AVAILABLE BECAUSE IT WILL CONTAIN IMPORTANT INFORMATION ABOUT CROSSWORLDS, THE MERGER AND RELATED MATTERS Investors and security holders can obtain free copies of the proxy statement when it becomes available by contacting Investor Relations, CrossWorlds Software, Inc., 577 Airport Boulevard, Burlingame, California 94010 (Telephone: (650) 685-9000). Investors and security holders will be able to obtain free copies of the proxy statement and other documents filed by CrossWorlds and IBM with the Securities and Exchange Commission in connection with the merger at the SEC's web site at www.sec.gov. ----------- CrossWorlds, IBM and their respective directors, executive officers and certain members of management and other employees may be deemed to be participants in the solicitation of proxies of CrossWorlds' stockholders to approve the proposed merger. Such individuals may have interests in the merger, including as a result of holding options or shares of CrossWorlds stock. A detailed list of the names, affiliations and interests of the participants in the solicitation will be contained in the proxy statement that will be filed by CrossWorlds with the SEC. Overview Business CrossWorlds provides a business integration platform both for integrating internal operations and extending these operations over the Internet. CrossWorlds' products help businesses work more efficiently with customers and suppliers through end-to-end business processes. The CrossWorlds platform enhances competitiveness and reduces information technology costs by decreasing long-term maintenance costs and enabling faster business application integration than traditional approaches. Revenues Revenues to date have been derived from the sale of our business infrastructure software, maintenance and support fees, and consulting and training services. Customers who license our software generally purchase maintenance contracts, typically covering a twelve-month period. Customers may also purchase consulting services, 10 which are customarily billed by us at a fixed daily or hourly rate plus out-of-pocket expenses. We also offer training services that are billed on a per student or per class session basis. Revenue recognition policy Our software arrangements typically involve significant customization or implementation services. As a result, software license revenue is generally recognized using the percentage-of-completion method over the project implementation cycle, which typically ranges from three to nine months. In circumstances where we are unable to estimate the amount of effort required to customize or implement the software, software license revenue is recognized using the completed contract method. To date, we have not encountered any circumstances where we have recognized revenue under the completed contract method. We have recognized upon shipment, and may in the future recognize upon shipment, revenues for projects when our services are not essential to the functionality of the software. Service revenue is recognized as the services are performed. Maintenance revenue from customer support and product upgrades, including maintenance bundled with original software licenses, is deferred and recognized ratably over the term of the maintenance agreement. When we enter into software arrangements with resellers, we do not recognize revenue until the reseller demonstrates it has an arrangement with the end user that satisfies our revenue recognition criteria. Our revenue recognition policy complies with the American Institute of Certified Public Accountants' Statement of Position 97-2, "Software Revenue Recognition" as amended. Revenue mix As a result of our revenue recognition policy, which generally requires us to defer and recognize license revenue over the software customization or implementation period, the mix of license, service and other revenue for the current quarter does not necessarily reflect the mix in sales activities for the current quarter. For example, revenues recognized during the quarter ended September 30, 2001 generally resulted from sales made during the first and second quarters of fiscal 2001. Results of Operations The following table sets forth the results of operations for the three months and nine months ended September 30, 2001 and 2000 expressed as a percentage of total revenue.

Three months ~~Six~~Nine months ended ~~June~~September 30, ended ~~June~~September 30, ------------------- ------------------- 2001 2000 2001 2000 ---- ---- ---- ---- Revenue: Software license ...................................... 3548.09% 4443.25% 3842.61% 43.13% Service, maintenance and other ........................ 6551.01 5556.85 6157.49 56.97 ----- ----- ----- ----- Total revenue ......................................... 100.0 100.0 100.0 100.0 ----- ----- ----- ----- Cost of revenue: Software license and royalties ........................ 1.12 1.8 1.01 1.7 Service, maintenance and other ........................ 3631.~~6 50.~~2 3545.17 5333.7 50.2 ----- ----- ----- ----- Total cost of revenue ................................. 3732.74 5247.05 3634.18 5551.49 ----- ----- ----- ----- Gross margin ..................................... 6267.36 4852.05 6365.92 4448.61 ----- ----- ----- ----- Operating expenses: Research and development .............................. 19.7 3629.24 20.95 4136.31 Sales and marketing .................................. 33.6 3653.40 7236.4 3766.82 ~~76.7~~ General and administrative~~............................~~ 14.~~8 21~~.~~4 16~~.~~2 26~~.~~7 Amortization of deferred stock-based Compensation~~.......................~~................~~ 020.~~5 7.5 0.9~~ 8.2 ~~--- --- --- --- Total operating expenses~~22.~~............................. 71.4 137.5 75.8 152.~~9 ~~---- ----- ---- ----- Operating loss~~17.~~.................................. (9.1) (89.5) (11.9) (108.3) Other income (expense), net................................ 0.5 (9.0) 0.2 (~~7~~.4)~~ ~~---- ------ ---- ----- Net loss~~25.~~........................................ (8.6)% (98.5)% (11.7)% (115.7)% ===== ====== ====== =======~~1

11 Amortization of deferred stock-based compensation ...................................... 0.8 4.2 0.9 6.4 ----- ------ ------ ------ Total operating expenses ............................. 74.9 109.5 75.5 133.8 ----- ------ ------ ------ Operating loss .................................. (7.3) (57.0) (10.3) (85.7) Other income (expense), net ............................... 0.2 4.8 0.2 (2.0) ----- ------ ------ ------ Net loss ........................................ (7.1)% (52.2)% (10.1)% (87.7)% ===== ====== ====== ======

Software license revenue. Total license revenue for the third quarter ended September 30, 2001 was $10.6 million, an increase of 62% over the same period in fiscal 2000. For the nine months ended September 30, 2001, license revenue was $26.7 million, an increase of 81% over the same period in fiscal 2000. The increase in license revenue resulted from progress towards project completion on increased sales to new and existing customers. Service, maintenance and other revenue. Service, maintenance and other revenue for the third quarter ended September 30, 2001 was $11.1 million, an increase of 31% over the same period in fiscal 2000. For the nine months ended September 30, 2001, service, maintenance and other revenue was $36.8 million, an increase of 90% compared to the same period in fiscal 2000. The increase was due to the increase in consulting, maintenance and maintenance renewals, and training fees associated with the increased number of licenses sold, and a larger installed license base. Cost of software license revenue and royalties. Cost of software license revenue and royalties consists of royalty payments to third parties for technology incorporated into our products. Cost of software license revenue and royalties for the three months ended September 30, 2001 was $0.3 million and 1.2% of total revenue compared to $0.3 million and 1.8% of total revenue for the same period in fiscal 2000. For the nine months ended September 30, 2001, cost of software license revenue and royalties was $0.7 million and 1.1% of total revenue compared to $0.6 million and 1.7% of total revenue for the same period in 2000. The percentage of revenue decreased year over year as a result of sales to repeat customers for which no additional royalties are due with certain third party technology vendors. Cost of service, maintenance and other revenue. Cost of service, maintenance and other revenues consists primarily of personnel, third-party consulting, and travel costs associated with implementation, support and training activities. Cost of service, maintenance and other revenue was $6.8 million and 31.2% of total revenue for the third quarter of fiscal 2001 compared to $6.9 million and 45.7% of total revenue for the same period in fiscal 2000. For the nine months ended September 30, 2001, cost of service, maintenance and other revenue was $21.4 million and 33.7% of total revenue versus $17.1 million and 50.2% of total revenue for the corresponding period in fiscal 2000. The percentage decrease year over year was due to higher revenues resulting from higher utilization of services personnel and internal resources, and rate increases for services and maintenance. Research and development expenses. Research and development expenses consist primarily of personnel and related costs incurred in the advancement and quality assurance activities related to our products. Research and development expenses were $4.3 million for the three months ended September 30, 2001, a decrease of 3% over the same period in fiscal 2000. The decrease was primarily due to a reduction in capital spending. For the nine months ended September 30, 2001, research and development expenses were $13.0 million, an increase of 6% compared to the same period in fiscal 2000. The increase was primarily due to an increase in personnel and third-party contractor costs associated with new product initiatives. Research and development expenses as a percentage of total revenue for the third quarter in fiscal 2001 were 19.7% compared to 29.4% for the same period in fiscal 2000. For the nine months ended September 30, 2001, research and development expenses as a percentage of total revenue were 20.5% versus 36.1% for the same period in fiscal 2000. The decrease as a percentage of total revenue was the result of growth in total revenue. Sales and marketing expenses. Sales and marketing expenses consist primarily of personnel and related costs of our direct sales force and marketing staff and the cost of marketing programs, including trade shows and conferences and promotional materials. Sales and marketing expenses for the third quarter of fiscal 2001 were $7.3 million, a decrease of 9% over the same period in fiscal 2000. The decrease was primarily due to lower average commission rates for 2001, offset by increased advertising costs. For the nine months ended September 30, 2001, sales and marketing expenses were $23.1 million, an increase of 2% compared to the same period in fiscal 2000. 12 The increase was primarily the result of an increase in the number of sales and marketing employees and the new branding campaign launched in the first quarter of 2001, offset by lower average commission rates. Sales and marketing expenses as a percentage of total revenue were 33.6% in the three months ended September 30, 2001 compared to 53.0% in the same period in fiscal 2000. For the nine months ended September 30, 2001, sales and marketing expenses as a percentage of total revenue were 36.4% versus 66.2% for the same period in fiscal 2000. The decline in sales and marketing expenses as a percentage of total revenue was the result of growth in total revenue. General and administrative expenses. General and administrative expenses consist primarily of personnel and related costs for general corporate functions including executive, legal, finance, human resources, facilities, and information systems as well as bad debt expense. General and administrative expenses for the third quarter of fiscal 2001 were $4.5 million, an increase of 31% over the same period in fiscal 2000. During the third quarter of 2001, the Company recorded a $2.2 million special charge for sublease losses over an estimated 17-month sublease period. Excluding the special charge, general and administrative expenses were $2.3 million, a decrease of 34% over the same period in fiscal 2000. The decrease was attributable to general cost reduction measures. For the nine months ended September 30, 2001, general and administrative expenses were $11.3 million, an increase of 32% over the same period in fiscal 2000. The increase was primarily a result of the special charge related to sublease losses during the third quarter of 2001. Excluding the special charge, general and administrative expenses were $9.0 million, an increase of 6% over the same period in fiscal 2000. The increase was attributable to increased personnel costs, professional services, insurance and other costs necessary to support a public company. General and administrative expenses as a percentage of total revenue were 20.8% in the three months ended September 30, 2001 versus 22.9% for the same period in fiscal 2000. For the nine months ended September 30, 2001, general and administrative expenses as a percentage of total revenue were 17.7% compared to 25.1% in the same period in fiscal 2000. The decline in general and administrative expenses as a percentage of total revenue was the result of growth in total revenue. Amortization of deferred stock-based compensation. Deferred stock-based compensation represents the difference between the exercise price and the deemed fair value of our common stock on the date certain stock options were granted. The difference is amortized on a straight-line basis over the vesting periods of the applicable options. Deferred stock-based compensation for the third quarter of fiscal 2001 was $0.2 million, a decrease of 72% over the same period in fiscal 2000. For the nine months ended September 30, 2001, deferred stock-based compensation was $0.6 million, a decrease of 74% compared to the same period in fiscal 2000. The decrease of this expense reflects employee attrition and no stock options being granted below fair value during 2001. Other income (expense), net. Other income and expense includes interest, foreign currency, and other miscellaneous income and expense items. Net other income for the third quarter ended September 30, 2001 was $42,000 compared to $0.7 million during the same period in 2000. The decrease was primarily due to lower interest income earned on lower cash balances. For the nine months ended September 30, 2001, net other income was $0.1 million versus net other expense of $0.7 million during the same period in fiscal 2000. The increase in net other income was primarily due to the absence of amortization of a funding commitment in 2001 that existed in the first and second quarters of fiscal 2000. Provision for income taxes. We incurred net operating losses in the three and nine months ended September 30, 2001 and 2000 and when the likelihood of realizing the benefit of the net operating loss carryforward was considered, we incurred no income taxes or benefit in these periods. Subsequent Events Proposed Sale of the Company. On October 30, 2001, the Company and International Business Machines Corporation ("IBM") announced they had entered into an Agreement and Plan of Merger dated as of October 29, 2001 (the "Agreement") by and among IBM, Duke Acquisition Corporation (a wholly owned subsidiary of IBM), and the Company. Under the terms of the Agreement, each outstanding share of the Company's common stock will be converted into the right to receive $4.65 in cash, without interest. The merger has been approved by the boards of directors of both the Company and IBM and is subject to various closing conditions, including the expiration or early termination of the waiting period required under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 13 (as amended) and approval of the Agreement by the shareholders of the Company. If the merger is completed, the Company will become a wholly owned subsidiary of IBM. The transaction is expected to close in the first quarter of 2002. Litigation. On November 2, 2001, two actions, Neil Macklin vs. CrossWorlds Software, Inc. et al. and Carl Rongo vs. CrossWorlds Software, Inc. et al., were filed in the Superior Court of the State of California for the County of San Mateo. In these actions the plaintiffs named as defendants the Company and the directors of the Company. The complaint purports to assert claims on behalf of all public stockholders of CrossWorlds who are similarly situated with the plaintiff. The complaint alleges that the Company and the members of the Company's Board of Directors have breached their fiduciary duties to CrossWorlds' public stockholders, that the directors engaged in self-dealing in connection with their approval of the merger and that the directors failed to take steps to maximize the value of CrossWorlds to its public stockholders. The complaint seeks class certification and certain forms of equitable relief, including enjoining the consummation of the merger. The Company believes that the allegations are without merit and intends to vigorously contest this action. There can, however, be no assurance that the Company or the other defendants will be successful in their defense of this action. Liquidity and Capital Resources In June 2000, we completed an initial public offering ("IPO") of 4.6 million shares of our common stock, including the exercise of 0.6 million shares of underwriters' over-allotment option, at a price of $10.00 per share. The Company also completed a sale of 0.9 million shares of its common stock in private placements concurrent with the IPO at $9.30 per share. The aggregate net proceeds realized from the IPO and private placements were approximately $49.7 million. Prior to the IPO, we had financed our operations through private sales of preferred equity securities, totaling $85.7 million and commercial bank loans and equipment leases. As of September 30, 2001, we had $22.1 million in cash and $10.0 million in working capital. Net cash used in operating activities was $12.3 million for the nine months ended September 30, 2001 and $13.2 million for the same period in fiscal 2000. Compared with the same period a year ago, the decrease in net cash used in operations primarily reflects a decrease in net loss and accounts receivable, offset by a decrease in deferred revenue. Net cash provided by investing activities was $12.8 million for the nine months ended September 30, 2001 and $3.0 million used in the corresponding period in fiscal 2000. Cash provided by investing activities in the nine months ended September 30, 2001 primarily reflect the net redemption of short-term high-grade investments previously purchased using our IPO cash proceeds. Net cash used by investing activities in the nine months ended September 30, 2000 primarily reflect the net purchase of capital equipment. In April 1999, we began leasing equipment through a $1.5 million master lease agreement with a lender. As of September 30, 2001, we have used $0.5 million of this lease line. Net cash used by financing activities was $0.9 million for the nine months ended September 30, 2001. Net cash provided by financing activities of $51.5 million for the nine months ended September 30, 2000 was primarily from the net proceeds of our initial public offering, offset by repayments of subordinated debt and equipment loans. As of September 30, 2001, outstanding borrowings including capital leases were $2.0 million, which are payable through 2003. We have a revolving line of credit that provides for borrowings of up to $10.0 million based on 65% of eligible accounts receivable. Borrowings under this line of credit accrue interest that is payable monthly at 0.5% above prime rate. As of September 30, 2001, we had borrowings of $1.5 million against this line of credit. Borrowings are secured by all of our assets, and we have agreements that require us to comply with financial covenants. As of September 30, 2001, we were in compliance with these financial covenants. We believe that our current cash and available borrowings under the existing line of credit will be sufficient to satisfy our anticipated cash needs for working capital and capital expenditures for at least the next twelve months. After that we may require additional funds to support our working capital requirements, or for other purposes. We may also seek to raise additional funds through public or private equity financings or from other sources. However, 14 there can be no assurance that we will be able to obtain adequate financing on favorable terms, if at all, at that time. Also, financing may dilute shareholder interests. A portion of our cash may be used to acquire or invest in complementary businesses, products, or technologies. We have no current plans, agreements or commitments of this nature, and we are not currently engaged in any negotiations involving a transaction of this nature. Factors That Could Affect Future Results OUR BUSINESS COULD BE HARMED IF THE ACQUISITION OF IBM IS NOT CONSUMMATED On October 30, 2001, the Company and International Business Machines Corporation ("IBM") announced they had entered into an Agreement and Plan of Merger dated as of October 29, 2001 (the "Agreement") by and among IBM, Duke Acquisition Corporation (a wholly owned subsidiary of IBM), and the Company. Under the terms of the Agreement, each outstanding share of the Company's common stock will be converted into the right to receive $4.65 in cash, without interest. The merger has been approved by the boards of directors of both the Company and IBM and is subject to various closing conditions, including the expiration or early termination of the waiting period required under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 (as amended) and approval of the Agreement by the shareholders of the Company. If the merger is completed, the Company will become a wholly owned subsidiary of IBM. Entering into the Agreement with IBM and/or a failure to consummate the merger for any reason may disrupt our relationships with our customers, partners and/or employees. Our operating results may be adversely affected by any such disruption, which could harm our business and cause our stock price to decrease. In addition, a failure to consummate the acquisition for any reason could cause our stock price to decrease. BECAUSE OF OUR LIMITED OPERATING HISTORY, IT IS DIFFICULT FOR US TO PREDICT AND PLAN FOR CHALLENGES. AS A RESULT, OUR FUTURE PERFORMANCE MAY BE HARMED. We were incorporated in March 1996 and shipped our first products in November 1997. Because our operating history is limited, our future operating results and our future stock price are difficult to predict. We may not foresee trends that may emerge and harm our business, and we cannot forecast operating expenses based on our historical results. It is also difficult to plan to meet the challenges we face in the future, specifically: . expanding our customer base; . competing effectively with: . other software vendors that offer business infrastructure products, . systems integrators that develop customized solutions, and . internal information technology departments of potential customers; and . managing expanding operations. WE HAVE A HISTORY OF LOSSES, AND WE MAY INCUR FUTURE LOSSES. We have experienced operating losses in the past, and we may incur losses in the future. Despite our history of losses, we may increase our research and development and sales and marketing expenses. If expenditures related to the expansion of our operations are not accompanied or shortly followed by significantly increased revenue, our losses could be even greater than expected until we are able to delay or reduce these expenditures. 15 BECAUSE OUR QUARTERLY REVENUE IS BASED ON OUR CUSTOMERS' IMPLEMENTATION SCHEDULES, WE MAY DISAPPOINT INVESTORS' EXPECTATIONS OR MAY NOT FULFILL THE EXPECTATIONS OF THE FINANCIAL MARKETS, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE. We generally recognize license revenue from orders on a percentage-of-completion basis as the customer reaches milestones in its project implementation using our products. We also recognize services revenue as we perform implementation services. As a consequence, the timing of our revenue depends on the continued progress of our customers' implementation cycles. Each customer has unique integration requirements and, because our products solve a complex problem, we must integrate a variety of enterprise applications in each implementation. Our product implementation schedules take up to nine months or more and span multiple quarterly periods. If we fail to achieve continued progress on anticipated implementation schedules, or our customers delay, suspend or terminate their implementation efforts, we may not recognize the expected revenue on these orders until subsequent quarters. BECAUSE OUR QUARTERLY SALES ORDERS FLUCTUATE DUE TO THE NATURE OF OUR SALES CYCLE AND SEASONALITY, WE MAY DISAPPOINT INVESTORS' EXPECTATIONS OR MAY NOT FULFILL THE EXPECTATIONS OF THE FINANCIAL MARKETS, WHICH COULD CAUSE OUR STOCK PRICE TO DECLINE. Our sales cycle varies typically from one to nine months because: . our business integration solutions are expensive, with high average selling prices, . our products solve complex problems and to generate sales we must spend significant time educating our potential customers about the uses and benefits of our products, and . some of our prospective customers evaluate our products on a trial basis before entering a sales contract. This lengthy sales cycle makes it difficult to predict the quarter in which expected orders will occur. Delays in the execution of orders could cause some or all of the new business from those orders to be shifted from the expected quarter to a subsequent quarter or quarters. Additionally, we have experienced, and expect to continue to experience, seasonality in software orders. For example, we generally have experienced higher demand for our products in the fourth quarter than the third quarter. We believe this seasonality is a result, in part, of year-end pressures influencing our customer's buying patterns, our direct sales force's efforts to meet or exceed year-end sales quotas, and the summer vacation schedules of our customers and sales force. Both our sales cycle and seasonality cause unpredictable fluctuations in our deferred revenue, which could adversely affect our quarterly operating results. BECAUSE A SUBSTANTIAL MAJORITY OF OUR REVENUE HAS BEEN DERIVED FROM A SMALL NUMBER OF SELECTED INDUSTRIES, A DECLINE IN DEMAND FOR OUR SOFTWARE IN THESE INDUSTRIES COULD HURT OUR OPERATIONS. We derive a large majority of our revenue from sales of our software and related services to customers in the complex industrial manufacturing, process manufacturing, financial services, and telecommunications industries. Any significant decline in the demand for, and market acceptance of, our software in these industries, or any failure to increase our sales to industries other than complex industrial manufacturing, process manufacturing, financial services, and telecommunications could hurt the results of our operations. We expect that sales of our software and related services to customers in the complex industrial manufacturing, process manufacturing, financial services, and telecommunications industries will continue to account for a majority of our revenue. 16 OUR REVENUE WILL LIKELY DECLINE OR FAIL TO GROW IF WE DO NOT DEVELOP AND MAINTAIN SUCCESSFUL RELATIONSHIPS WITH SYSTEMS INTEGRATORS. We engage in joint sales, marketing and/or implementation efforts with a number of large systems integrators including Deloitte Consulting, PricewaterhouseCoopers, EDS, and Accenture. In many cases, these parties have extensive relationships with our existing and potential customers and influence the decisions of these customers. We rely on these firms to: . recommend our products during the evaluation stage of the purchasing process, . provide industry expertise for developing products aimed at specific industries, . refer prospective customers to us, . provide access to customers' executive-level decision makers, and . provide implementation services for our products. If systems integrators are not appropriately trained on our products, our reputation with existing and prospective customers could be harmed. Our failure to establish or maintain these relationships could significantly harm our ability to license and successfully implement our business integration software products. Our competitors may have stronger relationships than us with some systems integrators and, as a result, those systems integrators may be more likely to work with competitors and recommend competitors' products. OUR PRODUCTS MAY NOT ACHIEVE MARKET ACCEPTANCE, WHICH COULD CAUSE OUR REVENUES TO DECLINE OR FAIL TO GROW. The market for business integration software is relatively new and rapidly evolving, and there is a variety of integration products and methods available to prospective customers. We do not know if customers in our target markets will prefer our products to other products and methods available. If we are unable to establish a sufficient base of customer references in our target markets, prospective customers may be less likely to buy our products and our ability to license our products to additional customers may be significantly reduced. THE MARKET FOR BUSINESS INTEGRATION SOLUTIONS IS COMPETITIVE AND NEW COMPETITORS MAY INCREASE COMPETITIVE PRESSURES. AS A RESULT, WE MAY LOSE SALES AND MAY BE FORCED TO LOWER OUR PRICES, WHICH WOULD CAUSE A DECLINE IN OUR REVENUE. The market for our products is intensely competitive. It is expected to become increasingly competitive as current competitors enhance and expand their product offerings and new competitors enter the market. Competition could result in: . price reductions, . reduced gross margins, and . loss of market share. Any one of these results could significantly reduce our future revenues. Our current competitors include a number of companies offering alternative business infrastructure solutions. To date, we have faced competition from: . internal information technology departments of potential customers, 17 . systems integrators and other information technology service providers, and . software vendors targeting one or more segments of our market, including Vitria Technology, Inc., webMethods, Inc., SeeBeyond Technology Corporation, IBM Corporation, and TIBCO Software, Inc. New competitors, including Oracle Corporation, BEA Systems, Inc., Hewlett-Packard Company, Sun Microsystems, Inc. and Microsoft Corporation, are emerging and may rapidly acquire significant market share. Alliances among competitors may also pose a threat. WE DEPEND ON TECHNOLOGY LICENSED TO US BY THIRD PARTIES. IF WE LOSE OUR RIGHT TO USE LICENSED TECHNOLOGY, OUR REVENUE COULD BE HARMED AND OUR COSTS COULD INCREASE. Our software products incorporate technology licensed to us by third parties, including BEA Systems, Inc., IBM Corporation, Borland Software Corporation and others, that provides important messaging, connectivity and other functionality. We depend on these third parties to deliver and support reliable products, and to enhance their products in response to industry trends and other technological changes. If we are unable to license such technology on commercially reasonable terms, it could harm our business by disrupting our operations, increasing our costs, impeding or delaying our sales and hindering our ability to support our existing customers. THE LOSS OF, OR INABILITY TO ATTRACT, SENIOR MANAGEMENT AND OTHER KEY PERSONNEL COULD HARM OUR BUSINESS AND DECREASE THE VALUE OF YOUR INVESTMENT. Our future success depends on the skills, experience and performance of our senior management team and other key personnel, and their ability to operate effectively, both individually and as a group. The intense competition for qualified personnel in our industry and geographic region could harm our ability to replace any of the members of our senior management team if we were to lose their services in the future. If we do not succeed in attracting new management and key personnel, or retaining and motivating existing management and key personnel, our business will be harmed. In addition, the services and expertise of our senior management team could be difficult to replace. OUR SUCCESS DEPENDS UPON OUR SALES, CONSULTING, BUSINESS DEVELOPMENT, MARKETING, CUSTOMER SUPPORT AND TECHNICAL PERSONNEL. IF WE FAIL TO ATTRACT AND RETAIN THESE PERSONNEL, OUR BUSINESS MAY BE UNABLE TO GROW AND REVENUES COULD DECLINE. If we fail to retain or expand our direct sales force, or our consulting, business development, marketing, customer support and technical staffs, we may not be able to increase revenue or achieve increased market acceptance of our products. To date, we have sold our products primarily through our direct sales force, have supported our customers through our consulting and customer support staff and alliance partners, and have developed and maintained our new products and product enhancements through our technical personnel. We believe that attracting and retaining these personnel may be challenging for us because: . the market for business integration software is still emerging, . we have not yet achieved broad market acceptance of our products, . the sales cycle for our product can be lengthy and, therefore, challenging for sales personnel, and . there is demand for such qualified personnel in the greater San Francisco metropolitan area. CHANGES IN OUR PERSONNEL LEVELS MAY STRAIN OUR EXISTING RESOURCES. ANY FAILURE TO MANAGE THESE CHANGES OR FUTURE SALES GROWTH EFFECTIVELY MAY CAUSE OUR REVENUES TO DECLINE OR FAIL TO GROW OR OUR OPERATING LOSSES TO INCREASE. 18 Changes in personnel levels and our future sales growth plans may strain our personnel, management systems and other resources, which could harm our business. To effectively manage and support our operations, we will be required to: . integrate, train, motivate and manage our work force, . continue to improve our operational, financial and management controls, reporting systems and procedures, and . maintain close coordination among our executive, engineering, finance, marketing, sales and operations organizations. If we fail to manage and support our operations, our business will be harmed and our operating losses could increase. OUR INTERNATIONAL OPERATIONS ARE EXPENSIVE AND CHALLENGING. IF OUR INTERNATIONAL OPERATIONS DO NOT PERFORM AS PROJECTED, OUR OPERATING LOSSES MAY INCREASE. Revenues from international sales represented 37% of total revenue for the three months ended September 30, 2001 and 34% for the nine months ended September 30, 2001. We have committed resources to the opening of international offices and the expansion of international sales and support channels in advance of revenue. We expect to incur expenses for localizing our software for foreign markets. If our international expansion strategy does not generate sufficient revenue to offset these expenditures, our operating losses may increase. IF WE FAIL TO ADAPT TO THE RAPID TECHNOLOGICAL CHANGE WHICH CHARACTERIZES OUR MARKET, WE COULD LOSE MARKET SHARE OR OUR PRODUCTS COULD BECOME OBSOLETE. The market for business integration software is characterized by: . rapid technological change, . frequent new product introductions and enhancements, . uncertain product life cycles, . changing customer requirements, and . evolving industry standards including Extensible Markup Language, or XML, Java 2 Enterprise Edition, or J2EE, and security-related standards. The introduction of products embodying new technologies and the emergence of new industry standards could make our existing products obsolete and unmarketable, which could harm our revenue. Our future success depends upon our ability to develop and introduce a variety of new products and product enhancements, in a timely fashion and at our planned release dates, to address the increasingly sophisticated needs of our customers. IF OUR PRODUCTS DO NOT WORK WITH MULTIPLE HARDWARE, SOFTWARE AND NETWORKING PLATFORMS, SOME CUSTOMERS MAY NOT BUY OUR PRODUCTS, AND OUR REVENUE MAY BE HARMED. 19 We currently serve a customer base with a wide variety of constantly changing hardware, software and networking platforms. If we are unable to provide and support our products on these multiple platforms, some prospective customers will not buy our products and our business may suffer. IF WE ARE UNABLE TO BUILD AND MAINTAIN RELATIONSHIPS WITH APPLICATION SOFTWARE VENDORS, WE COULD BE UNABLE TO CREATE, MAINTAIN AND SUPPORT OUR CONNECTIVITY PRODUCTS AND OUR REVENUE COULD BE HARMED. We have relationships with a number of application software vendors, including SAP AG, Oracle Corporation, Siebel Systems, Inc., Nortel Networks Corporation, i2 Technologies, Inc., PeopleSoft, Inc., BroadVision, Inc., Portal Software, Inc. and MetaSolv Software, Inc. and plan to establish more of these relationships in the future. These vendors provide access to their software, technical support and documentation, which enables us to develop, maintain and support connectivity solutions that are compatible with their products. If these relationships are terminated or restricted, or we are unsuccessful in establishing relationships with other vendors, our ability to develop connectivity solutions to integrate new and existing versions of these vendors' packaged enterprise applications may be harmed. THE COST AND COMPLEXITY OF IMPLEMENTING OUR PRODUCTS COULD HARM OUR REPUTATION, WHICH MAY DIMINISH OUR REVENUES. Business integration software is often implemented as part of complex, time consuming and expensive customer projects. If our customers are dissatisfied with the implementation process, our ability to license further products to these customers could be harmed, our reputation may be harmed, and these customers may be reluctant to recommend our products to prospective customers. DEFECTS IN OR SLOW PERFORMANCE OF OUR SOFTWARE PRODUCTS COULD DIMINISH DEMAND FOR OUR PRODUCTS AND CAUSE COSTLY LIABILITY, WHICH WOULD ADVERSELY AFFECT OUR OPERATING RESULTS. Our software products may contain undetected errors that cause slow performance or other defects, especially when first introduced or when new versions are released. Any such errors or defects could result in: . loss of revenue, . delay in market acceptance, . diversion of development and other resources, . distraction of management, . damage to our customer relationships or reputation, . increased service and warranty cost, and/or . costly litigation defense. In particular, legal damages sought by our customers for loss of data, lost revenue, systems costs or other harm they may suffer could be high because our software products are critical to our customers' business operations. BECAUSE OUR PRODUCTS COULD INTERFERE WITH OUR CUSTOMERS' OTHER SOFTWARE APPLICATIONS AND HARDWARE, WE MAY BE SUBJECT TO CLAIMS BY THESE CUSTOMERS, WHICH MAY BE COSTLY AND MAY NOT BE ADEQUATELY COVERED BY INSURANCE. 20 Our business integration software is integrated with our customers' other software and their networks. Customers or others may bring product liability or warranty claims based on damage to, or interference with, these networks or applications. Any of these claims could result in costly litigation and/or divert resources and management's attention. Our current insurance coverage may be insufficient to protect us from liability that may be imposed for these types of claims. OUR FAILURE TO SAFEGUARD OUR INTELLECTUAL PROPERTY COULD REDUCE OUR REVENUES, OR CAUSE US TO INCUR COSTLY LITIGATION. The value of our software products arises from the intellectual property in those products. We rely primarily on a combination of: . patents, . copyrights, . trademarks, . trade secrets, and . contractual obligations with employees and third parties to protect the proprietary aspects of our technology. The legal protection provided by these means is limited. Unauthorized parties may copy aspects of our products and obtain and use information that we believe is proprietary. Other parties may breach confidentiality agreements or other protective contracts they have made with us. The laws of many foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States. Litigation may be necessary to enforce our intellectual property rights. Intellectual property litigation has an uncertain outcome and could result in substantial costs and diversion of resources and management's attention. BECAUSE OUR MARKET IS NEW, COMPETITIVE AND DEPENDENT UPON INTELLECTUAL PROPERTY RIGHTS, WE COULD FACE COSTLY LITIGATION BROUGHT BY THIRD PARTIES FOR INFRINGEMENT OF THEIR RIGHTS. We may be subject to legal proceedings and claims for alleged infringement of third party proprietary rights, including patents, trademarks or copyrights. Any litigation could result in substantial costs and diversion of resources and management's attention. Parties making infringement claims against us may obtain judgments against us, which could prevent us from selling our products or require us to enter into royalty or license agreements which are disadvantageous to us. BECAUSE THE MARKET FOR STOCKS OF TECHNOLOGY COMPANIES HAS EXPERIENCED EXTREME PRICE AND VOLUME FLUCTUATIONS, OUR STOCK PRICE MAY BE VOLATILE, WHICH COULD HARM THE MARKET PRICE OF OUR COMMON STOCK AND LEAD TO SECURITIES LITIGATION. Many factors, including the following, could cause the market price of our common stock to fluctuate: . variations in quarterly results by us, our competitors, or other high-technology companies, . announcements of technological innovations by us or by our competitors, . introductions of new products or new pricing policies by us or by our competitors, 21 . acquisitions or strategic alliances by us or by our competitors, . departure or recruitment of key personnel, . the gain or loss of significant customers, . changes in the estimates of our operating performance or changes in recommendations by securities analysts, and . market conditions in the industry and the economy as a whole. Furthermore, the market for stocks of technology companies has experienced extreme price and volume fluctuations sometimes unrelated to these companies' operating performance. Such fluctuations could harm the market price of our common stock regardless of our actual operating performance. In the past, securities class action litigation has often been brought against a company following a period of volatility in the market price of its securities. We may in the future be the target of similar litigation. Securities litigation could result in substantial costs and divert resources and management's attention, which could harm our business. FAILURE TO RAISE ADDITIONAL CAPITAL, OR TO GENERATE THE SUBSTANTIAL CAPITAL REQUIRED TO EXPAND OUR OPERATIONS AND INVEST IN NEW PRODUCTS, COULD REDUCE OUR ABILITY TO COMPETE AND RESULT IN LOWER REVENUES. In the future, we may need to raise additional funds to: . develop or enhance our software or services, . acquire technologies or businesses, . expand operations, or . respond to competitive pressures or unexpected capital requirements. We cannot be sure that we will be able to obtain such funding, on favorable terms or at all. If we are unable to do so on a timely basis, our business could be harmed. Item 3. Quantitative and Qualitative Disclosures About Market Risk. We are exposed to a variety of risks, including changes in interest rates affecting the return on our investments and foreign currency fluctuations. We have established policies and procedures to manage our exposure to fluctuations in interest rates and foreign currency exchanges rates. Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. The majority of our investments are in cash, cash equivalents or short-term investments principally consisting of commercial paper, government bonds and money-market institutions. We place our investments with high credit quality issuers and, by policy, limit the amount of credit exposure to any one issuer. We have no investments denominated in foreign country currencies and therefore are not subject to foreign currency risk on such investments. We develop products in the United States and sell primarily in North America and Europe. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates or weak economic 22 conditions in foreign markets. Substantially all of sales are currently made in U.S. dollars; as a result, a strengthening of the dollar could make our products less competitive in foreign markets. 23 PART II. OTHER INFORMATION Item 1. Legal Proceedings. None. Item 2. Changes in Securities and Use Of Proceeds. In June 2000, the Company completed its initial public offering ("IPO") of 4.6 million shares of its common stock, including the exercise of 0.6 million shares of underwriters' over-allotment option, at a $10.00 per share pursuant to a Registration Statement on Form S-1 declared effective on June 1, 2000 by the Securities and Exchange Commission (File No. 333-96055). The Company realized aggregate net proceeds from the IPO of approximately $40.9 million. From the effective date of the registration statement through September 30, 2001, $21.4 million of the net proceeds from the offering have been used to fund working capital, general corporate purposes, sales and marketing efforts, additional research and development and capital expenditures made in the ordinary course of business. In addition, the Company applied proceeds of $8.6 million towards the purchase and installation of equipment, software and leasehold improvements. The Company may use a portion of the net proceeds to acquire or invest in complementary businesses, products and technologies. The Company has no current plans, agreements or commitments of this nature, and is not currently engaged in any negotiations involving a transaction of this nature. Pending these uses, the Company intends to invest the net proceeds in short-term, interest-bearing, investment-grade securities. Item 3. Defaults Upon Senior Securities. None. Item 4. Submission Of Matters to a Vote Of Security Holders. None. Item 5. Other Information. Amendment of Executive Management Retention Plan. On August 23, 2001, the board of directors of the Company adopted the Executive Management Retention Plan set forth in Exhibit 10.43 to this Form 10-Q (the "Retention Plan"). In connection with the Merger with IBM, the Company has agreed to amend the Retention Plan, effective upon the closing of the Merger, to provide that, except to the extent required by Section 6(c) of the Retention Plan, no Participant (as defined in the Retention Plan) shall be eligible to receive any payments under the Retention Plan unless and until such Participant is continuously employed by the Company or its successor during the 180 day period following the closing of the Merger. This amendment was entered into after the end of the quarterly period covered by this Form 10-Q and thus, the amendment is not reflected in the version of the Retention Plan filed as Exhibit 10.43. Amendment of Amoroso Secured Non-Recourse Promissory Notes. On August 23, 2001, the board of directors of the Company amended the terms of the Secured Non-Recourse Promissory Notes dated April 26, 2000 and June 7, 2000 between the Company and Alfred J. Amoroso to provide that upon a change of control, the Company's forgiveness of the loans is fully accelerated and the loans are completely forgiven, extinguishing Mr. Amoroso's obligation to repay the Company. The amendment is set forth in Exhibit 10.44 to this Form 10-Q. Item 6. Exhibits and Reports on Form 8-K. 24 (a) Exhibits: 10.42 Loan Modification Agreement, dated as of September 25, 2001, between CrossWorlds and Silicon Valley Bank. 10.43 Executive Management Retention Plan dated August 23, 2001. 10.44 Amendment To Secured Non-Recourse Promissory Notes dated November 9, 2001. (b) Reports on Form 8-K: None. 25 CROSSWORLDS SOFTWARE, INC. AND SUBSIDIARIES 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, in the city of Burlingame, state of California on November 13, 2001. CROSSWORLDS SOFTWARE, INC. (Registrant) By: /s/ JAMES W. BUDGE ------------------------------------------------ James W. Budge Chief Financial Officer (Principal Financial and Accounting Officer) 26

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