10-Q 1 q3.txt FORM 10-Q 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, 2002 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: 000-31139 RESONATE INC. (Exact name of registrant as specified in its charter) DELAWARE 94-3228496 (State of incorporation) (I.R.S. Employer Identification No.) 385 MOFFETT PARK DRIVE SUNNYVALE, CALIFORNIA 94089 (Address of principal executive offices) (408) 548-5500 (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 as of October 31, 2002 was 27,289,431. RESONATE INC. INDEX

2 PART I: FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS RESONATE INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands) (unaudited)

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements. 3 RESONATE INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (in thousands, except per share amounts) (unaudited)

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements. 4 RESONATE INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (in thousands) (unaudited)

The accompanying notes are an integral part of these Condensed Consolidated Financial Statements. 5 RESONATE INC. NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited) NOTE 1. BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In our opinion, the accompanying unaudited condensed consolidated financial statements contain all adjustments (all of which are normal and recurring in nature) necessary to present fairly our financial position, results of operations and cash flows of Resonate Inc. and our subsidiaries. The results of operations for the interim periods presented are not necessarily indicative of the results that may be expected for any future interim periods or for the full year. These condensed consolidated financial statements and notes thereto should be read in conjunction with the financial statements and the notes to the financial statements contained in our Annual Report on Form 10-K filed with the Securities and Exchange Commission. NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. REVENUE RECOGNITION We derive revenue from licenses of our software and delivery of related services, which include maintenance fees and professional services. Revenue is recognized when there is persuasive evidence of an arrangement for a fixed and determinable fee that is probable of collection and when delivery has occurred. We generally recognize revenue under the residual method as prescribed by AICPA's Statement of Position No. 97-2 "Software Revenue Recognition" and Statement of Position No. 98-9 "Modification of SOP No. 97-2, Software Revenue Recognition, With Respect to Certain Transactions" whereby revenue is allocated to each undelivered element based upon the fair value of each element when sold separately and the residual amount is then allocated to the delivered element. The fair value of maintenance service is determined by the renewal rate stated in the license agreement or, if not stated, the renewal rates generally charged to customers on similar transactions. Product revenue from existing reseller arrangements is recognized when reported by the reseller upon re-licensing of our software to end-users. Our agreements with our customers and resellers do not contain product return rights. For arrangements with extended payment terms (i.e., greater than 60 days), revenue is recognized at the earlier of when the payment becomes due and payable or when the cash is received. We also derive revenue from providing access to our products for a specified period of time. Revenue is recognized on such arrangements as the license fees become due and payable. Prepaid amounts are recorded as deferred revenue and are recognized as revenue over the term of the arrangement. Revenue recognized under such arrangements for the three months and nine months ended September 30, 2002 and 2001 was not significant. 6 Fees from maintenance agreements, which include services such as technical product support and unspecified product upgrades, are recognized ratably over the term of the agreement, generally one year. Professional services primarily consist of software installation and integration, consulting and training. Professional services revenue is recognized as such services are performed. CASH, CASH EQUIVALENTS AND INVESTMENTS We consider all highly liquid investments purchased with a maturity of three months or less at the date of acquisition to be cash equivalents; those with original maturities greater than three months and current maturities less than twelve months from the balance sheet date are considered short-term investments, and those with maturities greater than twelve months from the balance sheet date are considered long-term investments. Short-term investments are classified as available-for-sale securities and are carried at cost, which approximates fair value. Our investment portfolio consists of both fixed and variable rate financial instruments, including commercial paper, money market funds, government agency securities and highly rated corporate bonds and notes. CONCENTRATION OF CREDIT RISK Financial instruments that potentially subject us to a concentration of credit risk consist of cash equivalents, short-term investments and accounts receivable. We limit our exposure to credit loss by placing our cash, cash equivalents and short-term investments with major financial institutions. Our accounts receivable are derived from revenue earned from customers located primarily in the U.S., and to a lesser extent, Canada, Europe and Asia. We perform ongoing credit evaluations of our customers' financial condition and, generally, require no collateral from our customers. We maintain an allowance for doubtful accounts receivable based upon the expected collectibility of accounts receivable. Two customers accounted for 17% and 13% of our total recognized revenue during the three months ended September 30, 2002 and one customer accounted for 15% of our total revenue during the three months ended September 30, 2001. No customer accounted for more than 10% of our total revenue during the nine months ended September 30, 2002 and 2001. At September 30, 2002, one customer accounted for 13% of total accounts receivable. At December 31, 2001, two customers accounted for 11% and 17% of total accounts receivable. NET LOSS PER SHARE Basic net loss per share is computed by dividing the net loss by the weighted average number of shares of common stock outstanding during the period excluding shares of common stock subject to repurchase. Our diluted net loss per share is the same as basic net loss per share because the calculation of diluted net loss per share excludes potential shares of common stock since their effect is antidilutive. The following table sets forth the computation of basic and diluted net loss per share available to common stockholders for the periods indicated (in thousands, except per share amounts): 7

The following table sets forth the weighted average potential shares of common stock that are not included in the basic and diluted net loss per share available to common stockholders calculation above because to do so would be antidilutive (in thousands):

SEGMENT INFORMATION During the periods presented, we operated in a single business segment. We sell our products, solutions and services through direct and indirect channels primarily in North America, Europe and Asia Pacific. For geographic reporting, revenues are attributed to the geographic location in which the customer is located. Identifiable long-lived assets for all foreign locations were insignificant for all periods presented. The following table sets forth our revenue by geographic area for the periods indicated (in thousands):

RECLASSIFICATION Certain reclassifications have been made to prior period financial statements to conform to the current year presentation with no effect on previously reported net loss or accumulated deficit. RECENT ACCOUNTING PRONOUNCEMENTS During April 2002, the Financial Accounting Standards Board, or FASB, issued Emerging Issues Task Force Issue No. 01-14, or EITF 01-14, Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses 8 Incurred. EITF 01-14 provisions require companies to characterize reimbursements received for out-of-pocket expenses as revenue in the statement of operations. We have historically accounted for such reimbursements as a reduction to the cost of service revenue in our financial statements to offset the related costs incurred. The provisions of this EITF are required to be applied to fiscal years beginning after December 15, 2001, although early adoption is permitted. The adoption of the EITF in the third quarter of 2002 did not have a material impact on our financial statements. NOTE 3. LITIGATION On September 12, 2000, we filed a complaint for patent infringement against Alteon Web Systems, Inc. in the United States District Court, Northern District of California for permanent injunctive relief and damages. We believe Alteon infringes United States Letters Patent No. 5,774,660, titled "World-Wide Web Server With Delayed Resource-Binding For Resource-Based Load Balancing On A Distributed Resource Multi-Node Network," which was issued to us on June 30, 1998. Alteon served its answer to our complaint in October 2000, in which Alteon denied our allegations and counterclaimed that our patent is invalid. In October 2000, Alteon was acquired by Nortel Networks Corporation. In November 2001, the Court issued a claim construction ruling that we believe prevents us from prevailing in the case. In December 2001, we entered into a stipulated judgment of non-infringement and, in January 2002, filed a notice of appeal. The appeal is currently pending. In December 2001, a putative securities class action lawsuit was filed in the United States District Court for the Southern District of New York against us, certain investment bank underwriters for our initial public offering ("IPO"), and various of our officers and directors. The lawsuit, captioned In re Resonate Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-11245, generally alleges undisclosed and improper practices by the underwriters concerning the allocation of our IPO shares, in violation of federal securities laws, and seeks unspecified damages on behalf of persons who purchased our stock during the period from August 2, 2000 to December 6, 2000. The Court has appointed a lead plaintiff in this litigation. On April 19, 2002, plaintiffs filed an amended complaint. Other actions have been filed making similar allegations regarding the IPOs of more than 300 other companies. All of these have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92. Defendants in these cases have filed omnibus motions to dismiss on common pleading issues. Oral argument on the omnibus motions to dismiss are scheduled for October 29, 2002. Our officers and directors have been dismissed without prejudice in this litigation. We believe we have meritorious defenses to the claims against us and will defend ourselves vigorously. In January 2002, we received a Demand for Arbitration from the individual who transferred the domain name "resonate.com" to the Company in 1998. The Demand for Arbitration alleges, among other things, that we breached our obligations pursuant to our agreement with the individual by providing her with "restricted stock" rather than stock that was not encumbered with any restrictions. As a consequence, this individual alleges that she was unable to sell her Resonate stock when it was trading at its highest price, and that she is entitled to damages or, alternatively, to the return of her domain name and additional payments by us for our prior use of the domain name. This dispute is currently pending before the American Arbitration Association and a hearing date has been set for January 2003. Although there can be no assurances that we will prevail in the arbitration, we believe that we have meritorious defenses to the claims asserted against us in the Demand for Arbitration and intend to defend this action vigorously. We are also involved in disputes in the normal course of business. We do not believe that the outcome of any of these disputes will have a material effect on our business, financial condition or results of operations. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The discussion in this quarterly report on Form 10-Q contains forward-looking statements that involve risks and uncertainties. The statements contained in this report that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements regarding our expectations, beliefs, intentions or strategies regarding the future. These forward-looking statements are typically denoted in this report by the phrases "anticipates," "believes," "expects," "plans," and similar phrases. All forward-looking statements included in this report are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Our actual results could differ materially from those described in our forward-looking statements. Factors that could cause or contribute to such differences are discussed in this item under the heading "Risk Factors" on page 16 of this report and the risks discussed in our other Securities and Exchange Commission filings. The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our condensed consolidated financial statements and the notes thereto included under Item 1 beginning on page 3 of this report, the section entitled "Risk Factors" on page 16 in this report and our Annual Report on Form 10-K filed on March 28, 2002 with the Securities and Exchange Commission. OVERVIEW We develop and market software solutions for enterprises that wish to guarantee end-user response time and service levels of business-critical applications while cutting operating costs. Resonate Commander Solutions significantly reduces problem resolution time while it simultaneously ensures transaction completion by routing end-users around problems. Resonate was founded in July 1995 and began substantive operations in April 1996. From April 1996 through the first quarter of 1997, we primarily engaged in research activities, developing our products and building our business infrastructure. We began shipping our first software product, Resonate Central Dispatch, and first generated revenue from software license fees and implementation and consulting fees, in the first quarter of 1997. We released our Resonate Global Dispatch software product in the first quarter of 1998 and our Commander software product in the third quarter of 1999. In the fourth quarter of 2001, we released our Resonate Commander Solutions. We market and sell our software products through our direct sales force and indirect channels. Our indirect channels consist of server systems vendors, independent software vendors, value-added resellers, and system integrators. Our current relationships with these system integrators typically are structured as non-exclusive co-marketing and resale arrangements. In addition, we have entered into a limited number of reseller arrangements in which our products are embedded in the reseller's products, for which we receive a royalty from the reseller. We derived revenue of $47,000 from these reseller arrangements for the three months ended September 30, 2002 compared to $265,000 for the three months ended September 30, 2001. We derived revenue of $206,000 from these reseller arrangements for the nine months ended September 30, 2002 compared to $897,000 for the nine months ended September 30, 2001. The decreases are primarily attributable to having fewer arrangements with these system integrators and resellers. CRITICAL ACCOUNTING POLICIES REVENUE RECOGNITION. We derive revenue from licenses of our software and delivery of related services, which include maintenance fees and professional services. Revenue is recognized when there is persuasive evidence of an arrangement for a fixed and determinable fee that is probable of collection and when delivery has occurred. We generally recognize revenue under the residual method as prescribed by AICPA's Statement of Position No. 97-2 "Software Revenue Recognition" and Statement of Position No. 98-9 "Modification of SOP No. 97-2 with Respect to Certain Transactions" whereby revenue is allocated to each undelivered element based upon the fair value of each element when sold separately and the residual amount is then allocated to the delivered element. 10 The fair value of maintenance service is determined by the renewal rate stated in the license agreement or, if not stated, the renewal rates generally charged to customers on similar transactions. Product revenue from existing reseller arrangements is recognized when reported by the reseller upon re-licensing of our software to end-users. Our agreements with our customers and resellers do not contain product return rights. For arrangements with extended payment terms (i.e., greater than 60 days), revenue is recognized at the earlier of when the payment becomes due and payable or when the cash is received. We also derive revenue from providing access to our products for a specified period of time. Revenue is recognized on such arrangements as the license fees become due and payable. Prepaid amounts are recorded as deferred revenue and are recognized as revenue over the term of the arrangement. Revenue recognized under such arrangements for the three months and nine months ended September 30, 2002 and 2001 was not significant. Fees from maintenance agreements, which include services such as technical product support and unspecified product upgrades, are recognized ratably over the term of the agreement, generally one year. Professional services primarily consist of software installation and integration, consulting and training. Professional services revenue is recognized as such services are performed. ESTIMATING VALUATION ALLOWANCES. The preparation of financial statements requires our management to make estimates and assumptions that affect the reported amount of assets and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reported period. Our management must make estimates of the uncollectibility of our accounts receivable. Management specifically analyzes accounts receivable and analyzes historical bad debts, customer creditworthiness, current economic trends and changes in customer payment terms, if any, when evaluating the adequacy of the allowance for doubtful accounts. Our accounts receivable balance at September 30, 2002 was $1.8 million, net of allowance for doubtful accounts of $400,000. Similarly, our management must assess the likelihood that our deferred tax assets will be recovered from future taxable income; and to the extent we believe that recovery is not likely, we have established valuation allowances against the deferred taxes. We have provided a full valuation allowance for our deferred tax assets since the realization of these future benefits cannot be sufficiently assured. 11 RESULTS OF OPERATIONS The following table sets forth financial data as a percentage of total revenue.

REVENUE Our total revenue was $2.5 million for the three months ended September 30, 2002 and $3.7 million for the three months ended September 30, 2001. Our total revenue was $8.8 million for the nine months ended September 30, 2002 and $10.5 million for the three months ended September 30, 2001. Total revenue was comprised of sales of software products and solutions and related service fees from implementation, consulting, training and support. The decrease in our revenue was primarily due to a slowdown in the global economy, particularly in the technology sector, resulting in delays or cancellations in anticipated sales to new and existing customers. The decrease in our revenue was also attributed in part to our transition from selling primarily traffic management products to selling solutions more focused on active service level management. Since our active service level management solutions are more expensive and provide a much wider range of functions than traffic management products, the sales cycle has been longer as more senior level participation from customers is generally required before a purchase is made. Product revenue was $1.2 million, or 48.8% of total revenue, for the three months ended September 30, 2002 and $2.0 million, or 54.5% of total revenue, for the three months ended September 30, 2001. Services revenue was $1.3 million, or 51.2% of total revenue, for the three months ended September 30, 2002 and $1.7 million, or 45.5% of total revenue, for the three months ended September 30, 2001. Product revenue was $4.6 million, or 52.2% of total revenue, for the nine months ended September 30, 2002 and $5.5 million, or 52.7% of total revenue, for the nine months ended September 30, 2001. Services revenue was $4.2 million, or 47.8% of total revenue, for the nine months ended September 30, 2002 and $4.9 million, or 47.3% of total revenue, for the nine months ended September 30, 2001. Our revenue mix may vary from quarter to quarter depending primarily on new sales of products and services to new and existing customers. Services 12 revenue declined primarily due to lower maintenance revenue since we have fewer customers to date in 2002 than in 2001. We believe our revenue mix will consist of 55-65% product revenue and 35-45% services revenue. SBC Online accounted for 17% and Deluxe Corporation accounted for 13% of our total recognized revenue during the three months ended September 30, 2002. One customer, Eastman Chemical, accounted for 15% of our total recognized revenue during the three months ended September 30, 2002. No customer accounted for more than 10% of our total revenue during the nine months ended September 30, 2002 and 2001. COST OF REVENUE Cost of revenue was $532,000 for the three months ended September 30, 2002 and $725,000 for the three months ended September 30, 2001, excluding stock-based compensation charges of $99,000 for the three months ended September 30, 2002 and $103,000 for the three months ended September 30, 2001. Cost of revenue was $1.8 million for the nine months ended September 30, 2002 and $2.7 million for the nine months ended September 30, 2001, excluding stock-based compensation charges of $299,000 for the nine months ended September 30, 2002 and $402,000 for the nine months ended September 30, 2001. The decrease in our cost of revenue is primarily attributed to a decrease in our personnel-related expenses for our professional services organization. Our professional services headcount decreased from 14 at September 30, 2001 to 10 at September 30, 2002. Our cost of product revenue includes expenses incurred to manufacture, package and distribute software products and solutions and related documentation. Our cost of services revenue includes salaries and related expenses for our implementation, consulting support, and training organizations and an allocation of facilities and communications expenses. We believe that our cost of revenue, excluding stock-based compensation charges, will be 17-20% of total revenue for the quarter ended December 31, 2002, as we expect our existing professional services organization to continue to support new and existing customers while continuing to monitor our spending closely. We expect cost of services revenue as a percentage of services revenue to vary from period to period depending on the mix of services we provide and the overall utilization rates of our professional services staff. OPERATING EXPENSES Research and Development Research and development expenses were $2.5 million for the three months ended September 30, 2002 and $3.5 million for the three months ended September 30, 2001, excluding stock-based compensation charges of $47,000 for the three months ended September 30, 2002 and $166,000 for the three months ended September 30, 2001. Research and development expenses were $8.1 million for the nine months ended September 30, 2002 and $10.5 million for the nine months ended September 30, 2001, excluding stock-based compensation charges of $(97,000) for the nine months ended September 30, 2002 and $289,000 for the nine months ended September 30, 2001. Substantially all of the decrease in research and development expenses was related to a decrease in the number of software engineers and other technical staff as well as related consulting expenses and other employee expenses, including recruiting fees. Research and development personnel decreased from 73 at September 30, 2001 to 50 at September 30, 2002. We believe that research and development expenses, in absolute dollars, excluding stock-based compensation charges, will remain consistent in the quarter ended December 31, 2002 relative to the levels of the quarter ended September 30, 2002. We expect to continue to develop new products and product enhancements with the investments we have made to date in the research and development infrastructure while monitoring our spending closely. Research and development expenses as a percentage of total revenue may fluctuate from period to period. Sales and Marketing Sales and marketing expenses were $2.7 million for the three months ended September 30, 2002 and $4.4 million for the three months ended September 30, 2001, excluding stock-based compensation charges of $80,000 for the three months 13 ended September 30, 2002 and $(61,000) for the three months ended September 30, 2001. Sales and marketing expenses were $9.5 million for the nine months ended September 30, 2002 and $16.1 million for the nine months ended September 30, 2001, excluding stock-based compensation charges of $(21,000) for the nine months ended September 30, 2002 and $(470,000) for the nine months ended September 30, 2001. The decrease in sales and marketing expenses is attributed primarily to a decrease in sales and marketing personnel. Sales and marketing personnel decreased from 69 at September 30, 2001 to 39 at September 30, 2002. Personnel related expenses such as salaries, recruiting fees, facilities expenses, travel and entertainment, phone charges and marketing programs represented approximately 81% of the decrease in sales and marketing expenses from the nine months ended September 30, 2001 to the nine months ended September 30, 2002. We believe that sales and marketing expenses, in absolute dollars, excluding stock-based compensation charges, will increase in the quarter ended December 31, 2002 from the levels of the quarter ended September 30, 2002 as commission expenses are seasonally higher and tradeshow activities increase. We expect to continue to focus our sales and marketing efforts on increasing market penetration into the enterprise directly and through partnerships while monitoring our spending closely. Sales and marketing expenses may fluctuate as a percentage of total revenue from period to period. General and Administrative General and administrative expenses were $1.1 million for the three months ended September 30, 2002 and $1.7 million for the three months ended September 30, 2001, excluding stock-based compensation charges of $(695,000) for the three months ended September 30, 2002 and $216,000 for the three months ended September 30, 2001. General and administrative expenses were $3.4 million for the nine months ended September 30, 2002 and $6.3 million for the nine months ended September 30, 2001, excluding stock-based compensation charges of $(666,000) for the nine months ended September 30, 2002 and $(101,000) for the nine months ended September 30, 2001. The decreases in general and administrative expenses are primarily attributable to higher costs relating to the transition of our chief executive officer in February 2001, higher bad debt expenses incurred during the three and nine months ended September 30, 2001, reduced accounting and legal fees incurred during the three and nine month periods ended September 30, 2002 and an overall reduction in general and administrative personnel. General and administrative personnel decreased from 29 at September 30, 2001 to 19 at September 30, 2002. We believe that general and administrative expenses, in absolute dollars, excluding stock-based compensation charges, will be consistent in the quarter ended December 31, 2002 relative to the levels of the quarter ended September 30, 2002 or slightly higher. General and administrative expenses may fluctuate as a percentage of total revenue from period to period. Stock-Based Compensation Stock-based compensation consisted of amortization of unearned stock-based compensation in connection with certain stock option grants to employees at exercise prices below the deemed fair market value of our common stock. Of the total unearned stock-based compensation, $(469,000) was amortized in the three months ended September 30, 2002 compared to $424,000 amortized in the three months ended September 30, 2001 and $(484,000) was amortized in the nine months ended September 30, 2002 compared to $120,000 amortized in the nine months ended September 30, 2001. The fluctuations are attributed primarily to options cancelled in connection with terminated employees. The remaining unearned stock-based compensation is expected to be amortized as follows: $231,000 in the remaining three months of 2002, $416,000 in 2003 and $6,000 in 2004. INTEREST AND OTHER INCOME For the three months ended September 30, 2002, we had interest and other income of approximately $375,000 compared to $1.0 million for the three months ended September 30, 2001. For the nine months ended September 30, 2002, we had interest and other income of approximately $1.3 million compared to $3.6 million for the nine months ended September 30, 2001. The decrease in interest and other 14 income resulted from a lower interest rate environment and lower average cash and investment balances compared to 2001. INTEREST AND OTHER EXPENSES For the three months ended September 30, 2002, we had interest and other expenses of approximately $210,000 compared to $220,000 for the three months ended September 30, 2001. For the nine months ended September 30, 2002, we had interest and other expenses of approximately $457,000 compared to $588,000 for the nine months ended September 30, 2001. The decrease in interest and other expenses is attributed to paying down of our outstanding debt, as well as paying off of our capital lease obligations in 2002. Interest and other expenses consist primarily of interest incurred on our outstanding debt and capital lease obligations. LIQUIDITY AND CAPITAL RESOURCES We funded our operations through September 30, 2002 primarily with proceeds from previous private placements and public offering of equity securities and to a lesser extent, through revenue, subordinated debt and lines of credit. As of September 30, 2002, our principal sources of liquidity included $67.8 million of cash, cash equivalents and investments. Net cash used in operating activities during the nine months ended September 30, 2002 was $13.2 million and was primarily attributable to a net loss of $12.7 million. Cash provided by operating activities resulted from a decrease in accounts receivable of $887,000, decrease in other assets of $150,000 and add backs for non-cash items including depreciation and amortization of $2.1 million, provision for doubtful accounts of $13,000 and loss on sale of property and equipment of $60,000. Cash provided by operating activities was offset by an increase in prepaid expenses and other assets of $231,000 and decreases in accounts payable of $1.2 million, accrued liabilities of $1.0 million and deferred revenue of $693,000. The decreases in accounts payable and accrued liabilities were attributed primarily to cost-cutting efforts and reduced headcount. The decreases in accounts receivable and deferred revenue were attributed primarily to lower than expected sales generated during the quarter ended September 30, 2002. Net cash provided by investing activities during the nine months ended September 30, 2002 was $15.7 million and resulted primarily from the sale of property and equipment of $39,000 and the sale and maturities of short-term investments of $69.4 million, offset by purchases of $53.3 million in investments and purchases of property and equipment of $416,000. The increase in net cash provided by investing activities resulted primarily from the increased conversion of short-term investments to cash used to support our operations. Net cash used in financing activities totaled $906,000 resulting from repayments of debt and capital lease obligations of $1.8 million, offset by proceeds from the issuance of common stock in connection with the exercise of stock options and purchase of common stock through our employee stock purchase plan of $443,000 and payment of notes receivable of $457,000. We believe that our current cash balances and cash flow from operations will be sufficient to meet our working capital and capital expenditure requirements for at least the next twelve months. RECENT ACCOUNTING PRONOUNCEMENTS During April 2002, the FASB issued EITF 01-14, Income Statement Characterization of Reimbursements Received for Out-of-Pocket Expenses Incurred. EITF 01-14 provisions require companies to characterize reimbursements received for out-of-pocket expenses as revenue in the statement of operations. We have historically accounted for such reimbursements as a reduction to the cost of service revenue in our financial statements to offset the related costs incurred. The provisions of this EITF are required to be applied to fiscal years 15 beginning after December 15, 2001, although early adoption is permitted. The adoption of the EITF in the third quarter of 2002 did not have a material impact on our financial statements. RISK FACTORS This report contains forward-looking statements within the meaning of the Securities Litigation Reform Act of 1995 that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of certain factors, including those set forth in the following risk factors and other factors discussed elsewhere in this report. These risk factors should be considered carefully in evaluating our business and us. WE HAVE A HISTORY OF LOSSES, EXPECT TO CONTINUE TO INCUR SIGNIFICANT OPERATING EXPENSES AND LOSSES IN THE FUTURE, AND MAY NEVER ACHIEVE OR SUSTAIN PROFITABILITY. We have experienced operating losses in each quarterly and annual period since our inception in 1995, and we expect to continue to incur significant operating expenses and losses for the foreseeable future. We cannot predict when we will be profitable, if at all. We may never achieve future revenue growth or achieve or sustain profitability. If we do achieve profitability in any period, we cannot be certain that we will sustain or increase such profitability on a quarterly or annual basis. If we continue to incur net losses and never attain profitability, our stock price will suffer. We will need to generate significant additional revenue to achieve and maintain profitability in the future. Moreover, failure to achieve and sustain significant increases in our quarterly net sales could cause us to further reduce our operating expenses, which would adversely impact our ability to operate and grow our business. OUR REVENUES MAY BE HARMED IF GENERAL ECONOMIC CONDITIONS CONTINUE TO WORSEN OR DO NOT IMPROVE. Our revenues are dependent on the health of the economy and the growth of our customers and potential future customers. If the growth of the economy remains stagnant or declines, our customers may continue to reduce their spending on the active service level management solutions we offer or defer purchases of our products and solutions until general economic conditions improve. If that happens, our revenues could suffer and our stock price may decline. Further, if global economic conditions worsen, we may experience a material adverse impact on our business, operating results and financial condition. Our software products, solutions and services are designed for customers that use the Internet and Internet-based technologies to conduct business. Many companies that may require our solutions are continuing to experience a general slowdown in business and are re-evaluating the cost of using the Internet and Internet-based technologies to conduct business as well as the necessity to make significant capital investments for their infrastructures. Economic slowdowns may also adversely affect the ability of some of our customers to fulfill their payment obligations to us in a timely manner. To the extent we are required to write off additional accounts receivable, sales cycles lengthen or customers cancel orders, our results of operations will be harmed. IF THE MARKET FOR ACTIVE SERVICE LEVEL MANAGEMENT DOES NOT GROW, OUR ABILITY TO SELL OUR PRODUCTS AND SOLUTIONS AND GROW OUR BUSINESS WILL BE HARMED. Our future success depends on widespread commercial acceptance of our products and solutions. The market for active service level management solutions is relatively new and rapidly evolving. If we are unable to educate our potential customers, and the market in general, about the advantages of our software-based active service level management solutions over their existing system and network management products, our ability to sell our products and solutions will be severely limited. Rather than utilizing comprehensive active service level management solutions, most corporations manage their applications and services by adding servers and interconnecting a variety of single function management tools. In addition, our competitors offer a wide variety of products 16 that purport to serve the needs addressed by our products and solutions. Our ability to increase revenue in the future depends on the extent to which our potential customers recognize the value of our integrated active service level management solutions. The acceptance of our products and services may also be hindered by: - The reluctance of our prospective customers to replace or supplement their current management products, which may be supplied by more established vendors, with our products and solutions - The emergence of new technologies or industry standards, which could cause our products and solutions to be less competitive or become obsolete In addition, because the market for active service level management solutions is still in an early stage of development, we cannot accurately assess the size of the market, and we have limited insight into trends that may emerge and affect our business. For example, we may have difficulty in predicting customer needs, developing products and solutions that could address those needs and establishing a distribution strategy for these products and solutions. IF OUR RESONATE COMMANDER SOLUTIONS, RESONATE CENTRAL DISPATCH AND RESONATE GLOBAL DISPATCH OR OTHER NEW PRODUCTS AND SOLUTIONS, PRODUCT ENHANCEMENTS OR SERVICES FAIL TO ACHIEVE CUSTOMER ACCEPTANCE, OUR GROWTH AND REVENUE WILL BE LIMITED. Our industry is characterized by rapid technological change, frequent new product and solution introductions and enhancements, changes in customer demands and evolving industry standards. Our existing products and solutions will be rendered less competitive or obsolete if we fail to introduce new products, solutions or product enhancements that anticipate the features and functionality that customers demand or ensure that they interoperate with current and emerging networking technologies. The success of our products and solutions will depend on factors including: - Their ability to meet customer needs and expectations regarding features and performance - Our ability to accurately anticipate industry trends and changes in technology standards - Timely completion and introduction of new product designs and features - Our ability to provide timely and responsive maintenance and support to our customers who purchase products and services Further, because the market is new for products and solutions that facilitate the efficient processing of data and transactions across computer networks, potential customers in this market may be confused or uncertain about the relative merits of these products and solutions or which products and solutions to adopt, if any. Confusion and uncertainty in the marketplace may inhibit customers from purchasing our products and solutions, which could limit our revenue growth. OUR QUARTERLY OPERATING RESULTS MAY FLUCTUATE SIGNIFICANTLY, AND MAY BE SUBJECT TO SEASONALITY, WHICH MAY CAUSE OUR STOCK PRICE TO FALL. Our quarterly operating results have varied significantly in the past and are likely to vary significantly in the future, which makes it difficult for us to predict our future operating results. Factors that could cause our operating results to fluctuate include: - General economic conditions specific to the active service level management industry or generally relating to information technology spending - Changes in the mix of products, solutions and services we sell 17 - The timing of the development and release of enhanced versions of Resonate Commander Solutions, Command Modules, Resonate Central Dispatch and Resonate Global Dispatch, as well as future product enhancements and new products - Deferrals of customer orders in anticipation of product enhancements or new products and solutions - Announcement or market acceptance of new products or product enhancements offered by our competitors - Acceptance of our Resonate Commander Solutions - The mix of channels through which we sell our products and solutions - The timing and number of orders from companies who sell our products and solutions through our indirect distribution channel - The size and timing of large transactions may yield revenue fluctuations that are inconsistent with prior or subsequent periods - Deferrals or cancellations of orders resulting from uncertain domestic and international political, economic and social environments Because of these and possibly other factors, we believe that period-to-period comparisons of our results of operations are not meaningful and should not be relied upon as an indicator of our future performance. Our operating results have been below analysts' expectations in the past and will likely also be below the expectations of public market analysts and investors in some future quarter or quarters. If this occurs, the price of our common stock will probably decline. A delay in anticipated sales beyond the end of a particular quarter may harm our results of operations for that quarter. We have experienced this type of delay in the past. Furthermore, we base our decisions regarding our operating expenses on anticipated revenue trends. Consequently, if revenue levels fall below our expectations and the expectations of public market analysts and investors, we may suffer unexpected losses because only a small portion of our expenses varies with our revenue. We expect to experience seasonality in the sales of our software products and solutions. For example, we expect that sales may decline during summer months, particularly in Europe, thereby adversely affecting sales during our third quarter. We also anticipate that sales may be lower in our first calendar quarter due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers. These seasonal variations in our sales may lead to fluctuations in our quarterly operating results. Furthermore, it is difficult for us to evaluate the degree to which this seasonality may affect our business because the recent general economic slowdown may have largely overshadowed the seasonality impact experienced in prior periods. OUR ABILITY TO GROW OUR BUSINESS DEPENDS UPON INCREASED DEMAND FOR OUR PRODUCTS AND SOLUTIONS FROM CORPORATE ENTERPRISES AND THE EXTENT TO WHICH OUR PRODUCTS AND SOLUTIONS CAN ACCOMMODATE THE NEEDS OF CORPORATE ENTERPRISES. We cannot assure you that corporate enterprises, which typically operate in complicated information technology environments, will widely adopt active service level management solutions to facilitate their system management needs. Our ability to grow our business will depend upon the extent to which corporate enterprises adopt active service level management solutions. Moreover, if corporate enterprises require significantly different product features from active service level management solutions, whether as a result of choosing to outsource some or all of their applications to application service providers or otherwise, we will be required to enhance or modify our products and solutions. 18 As a result, we could incur delays in introducing enhanced or modified versions of our products and solutions, delays in capturing enterprise customers and significant expenses. Any of these alternatives will limit our ability to grow our business and could result in higher net losses. OUR SALES CYCLE IS LENGTHY AND UNPREDICTABLE, INVOLVING SIGNIFICANT EXPENSE AND EFFORT BY US IN ADVANCE OF PRODUCT ORDERS, AND MAY CAUSE OUR OPERATING RESULTS TO FLUCTUATE, WHICH COULD RESULT IN VOLATILITY IN OUR STOCK PRICE. The typical sales cycle of our active service level management products and solutions can be lengthy and unpredictable and involves significant capital investment decisions by prospective customers, as well as education of potential customers regarding the benefits of our software-based solutions. The sales cycle for our products and solutions has ranged from one to three months for sales to smaller customers to up to one year or more for sales to large, established enterprises. As we increasingly target enterprise customers, we expect our average sales cycle to lengthen. Since enterprise customers are generally larger, significant purchases require more levels of approval, which increases the sales cycle for our products and solutions. If sales forecasted from specific customers for a particular quarter are not realized in that quarter, we may be unable to compensate for the revenue shortfall causing our operating results to vary significantly from quarter to quarter. A significant variation in our quarterly results could result in volatility in our stock price. Customers frequently begin by evaluating our products and solutions on a limited basis before deciding to purchase them. Generally, customers consider a wide range of issues before committing to purchase our products and solutions, including benefits, ability to operate with their networking equipment and product reliability. While potential customers are evaluating a purchase of our products and solutions, we may incur substantial sales and marketing expenses and expend significant management effort. The result of making these expenditures with no corresponding revenue in any given quarter could further exacerbate quarterly fluctuations in our financial performance and our stock price volatility. WE DERIVE SUBSTANTIALLY ALL OF OUR REVENUE THROUGH THE SALE OF UPFRONT LICENSES OF OUR SOFTWARE PRODUCTS AND SOLUTIONS, AND ALTERNATIVE BUSINESS MODELS EMPLOYED BY OUR COMPETITORS COULD ERODE OUR PRODUCT PRICING. Alternative methods of delivering the capabilities of our software products and solutions have been developed by our competitors. Such methods may substantially erode the price which we can charge for our products and solutions. These alternative methods may include bundling these capabilities through a subscription model, among other possible methods. Some of our competitors currently offer some capabilities of our software products and solutions through a subscription model. We compete in the traffic management market against vendors of hardware products. As the prices of the hardware products are reduced over time, the prices for our software products and solutions could become less competitive, and the ensuing competition could also erode the price we can charge for our products and solutions. OUR MARKETS ARE HIGHLY COMPETITIVE, OUR CUSTOMERS MAY CHOOSE TO PURCHASE OUR COMPETITORS' PRODUCTS, AND WE CANNOT ASSURE YOU THAT WE WILL BE ABLE TO COMPETE EFFECTIVELY. Our markets are new, rapidly evolving and highly competitive, and we expect competition to persist and intensify in the future. Although our Resonate Commander Solutions has features and capabilities that no individual competitor offers, principal competitors are the systems and network management product providers including Tivoli Systems, BMC Software, Mercury Interactive, Micromuse, Precise Software, Dirig Software, Wily Technology and others. We cannot assure you that potential customers will choose our product over those of our competitors. As these providers enhance their products and solutions to target the needs and requirements of Internet deployed applications, potential customers may choose their products over ours. In addition, many of our competitors in the systems and network management market are larger companies with greater financial and technical resources and more established brand recognition. We may lose potential customers to our competitors if customers prefer to make significant infrastructure purchases with larger vendors rather than a smaller company like ours. 19 Our principal competitors for our Resonate Central Dispatch and Resonate Global Dispatch products include Cisco Systems, F5 Networks, Foundry Networks, Nortel Networks and other server load balancing and traffic management product suppliers. We expect to continue to face additional competition as new participants enter the service level management market. In addition, companies with greater resources and more established brand recognition and sales channels may form alliances or acquire competing traffic management solutions and emerge as significant competitors. Potential competitors have bundled their products and incorporated a load balancing or traffic management capability into their existing products in a manner that discourages users from purchasing our products. Our competitors have also significantly reduced their prices and have forced us to match their price reductions in order to remain competitive in some cases. Further price reductions could significantly lower our revenue and increase our operating losses. Our competitors may respond more quickly to emerging technologies than we do. We may lose customers to competitors if we are not able to respond to requests for additional features in a timely fashion. We may not be able to maintain or improve our competitive position against current or potential competitors, especially those with greater resources. IF WE DO NOT DEVELOP OUR DIRECT AND INDIRECT SALES CHANNELS EFFECTIVELY, OUR ABILITY TO SUSTAIN OR INCREASE OUR SALES WILL BE HARMED. In order to increase the sales of our products, solutions and services, we need to develop our direct and indirect sales channels effectively. If we are unable to develop both our direct and indirect sales channels effectively, our ability to increase revenue could be seriously harmed. In North America, we currently sell our products and solutions directly and indirectly through companies with whom we have established sales channel relationships. Outside North America, we derive a significant portion of our revenue through our indirect sales channels. Our sales and distribution strategy depends principally on: - Developing our direct sales organization by providing adequate training and technical marketing materials - Developing our indirect sales and distribution channels by establishing relationships with leading server system vendors, independent software vendors, value-added resellers and systems integrators If we fail to develop and maintain relationships with significant server system vendors, independent software vendors, value-added resellers and systems integrators, or if these third parties are not successful in their sales efforts or if we fail to develop our direct sales organization effectively, sales of our products, solutions and services may decrease or fail to increase. OUR BUSINESS IN INTERNATIONAL MARKETS MAY NOT SUCCEED AND WILL EXPOSE US TO RISKS ASSOCIATED WITH INTERNATIONAL OPERATIONS AND RESULT IN HIGHER PERSONNEL COSTS. Outside of North America, we have only limited experience in marketing, selling and supporting our products and solutions internationally. Prior to 1998, we had no revenue from sales to customers located outside North America. Sales to customers located outside North America represented 8% of our total revenue for the three months ended September 30, 2002 and 7% of our total revenue for the three months ended September 30, 2001. Sales to customers located outside North America represented 6% of our total revenue for the nine months ended September 30, 2002 and 9% of our total revenue for the nine months ended September 30, 2001. In order to increase our international sales, we intend to develop our relationships with third parties who sell our products and solutions internationally. Our investment in developing our international sales efforts 20 may not result in an increase in our revenue. We may not be able to achieve positive operating margins for international sales in the near future. Our efforts to increase our international sales could also be affected by a number of risks and uncertainties, including: - The difficulties and significant costs of establishing and maintaining relationships with third parties who understand our products and can effectively sell to potential international customers - Unexpected changes in regulatory requirements - Legal uncertainties regarding liability, export and import restrictions, tariffs and other trade barriers - Reduced protection of intellectual property in other countries - Longer collection cycles and increased difficulty in collecting delinquent or unpaid accounts - Fluctuations in the value of the U.S. dollar relative to other currencies - Potentially adverse tax consequences - Political and economic instability Any of these factors could impair our ability to operate effectively in international markets and generate significant revenue. OUR INTELLECTUAL PROPERTY COULD BE USED BY OTHERS WITHOUT OUR CONSENT BECAUSE PROTECTION OF OUR INTELLECTUAL PROPERTY IS LIMITED. We rely on a combination of patent, copyright, trademark and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality agreements with our employees and consultants and confidentiality and/or license agreements with our corporate partners, and control access to and distribution of our software, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. In addition, other parties may breach confidentiality agreements or other protective contracts we have entered into, and we may not be able to enforce our rights in the event of these breaches. Any actions taken by us to enforce our intellectual property rights could result in significant expense to us and the diversion of management time and other resources. In September 2000, we filed a lawsuit for patent infringement against Alteon Websystems, which has since been acquired by Nortel Networks. This action has required us to expend significant financial resources to protect our intellectual property, and has consumed valuable management time. In November 2001, the United States District Court, Northern District of California, issued a claim construction ruling that we believe prevents us from prevailing in the case. The case is currently on appeal. We will continue to expend financial resources as the case proceeds. Monitoring use of our products and solutions is difficult and we cannot be certain that the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. 21 WE DEPEND ON OUR KEY PERSONNEL AND LOSS OF ANY KEY PERSONNEL MAY HARM OUR BUSINESS AND RESULTS OF OPERATIONS. Our success depends to a significant degree upon the continued contributions of our key management, product development, sales and marketing and finance personnel, many of whom would be difficult to replace. If we were to lose the services of key personnel, we may not be able to successfully execute our new product strategies, sales and marketing initiatives and financial business models. In particular, we rely on our President and Chief Executive Officer, Peter Watkins. If we were to lose the services of Mr. Watkins, our business and results of operations could be harmed. Other than Mr. Watkins, we do not maintain employment agreements for any of our key personnel. We do not maintain key person life insurance for any of our personnel. IF WE CONTINUE TO USE SUBSTANTIAL AMOUNTS OF CASH, WE MAY NOT BE ABLE TO RAISE ADDITIONAL FUNDS TO FUND OUR OPERATIONS AND MEET OUR FUTURE CAPITAL REQUIREMENTS. Because our business operations currently use more cash than we generate, the cash used each quarter substantially reduces the cash available to fund our operations and future capital requirements. If we need additional cash to fund our operations or capital requirements, we may need to issue additional debt, convertible debt or equity securities. In addition, the current unfavorable market for equity or debt financing makes it increasingly difficult to raise additional funding. If we do not achieve positive cash flow from our operations and future financing is not available, or is not available on acceptable terms, we may not be able to fund our continuing operations. THE DEVELOPMENT OF NEW OPERATING SYSTEMS, THE EMERGENCE OF NEW NETWORK STANDARDS OR THE DISCONTINUATION OF SUPPORT FOR A GIVEN STANDARD COULD CAUSE OUR PRODUCTS TO BECOME OBSOLETE, LESS COMPETITIVE OR REQUIRE US TO REDESIGN OUR PRODUCTS. The products we currently offer operate on Solaris, Windows NT, Windows 2000, AIX, Linux and HP-UX operating systems, and features of our products are dependent upon application and network monitoring standards used by a customer. If new operating systems are developed or new network monitoring standards emerge, our failure to modify our products in a timely or cost effective manner could limit our potential customer base, which would adversely affect our ability to increase our revenue. Furthermore, we will need to modify our products or develop new versions of our products as new versions of operating systems are developed. Similarly, if we decide to discontinue support of a given standard, those customers or potential customers who utilize that standard may be unable or unwilling to buy our solutions. If we fail to continue to develop new products to respond to changes in computer networks and operating systems, or if we discontinue support of an operating system, our ability to grow our business will suffer. UNDETECTED SOFTWARE ERRORS IN OUR PRODUCTS COULD HARM OUR REPUTATION AND CAUSE US TO INCUR SIGNIFICANT WARRANTY AND REPAIR COSTS. Software products frequently contain undetected errors when first introduced or as new versions are released. We have experienced these errors in the past in connection with new products and product upgrades. We expect that these errors will be found from time to time in new or enhanced products after commencement of commercial shipments. These problems may cause us to incur significant warranty and repair costs, divert the attention of our engineering personnel from our product development efforts and cause significant customer relations problems. BECAUSE OUR PRODUCTS COULD INTERFERE WITH THE OPERATIONS OF OUR CUSTOMERS' OTHER SOFTWARE APPLICATIONS, WE MAY BE SUBJECT TO POTENTIAL PRODUCT LIABILITY AND WARRANTY CLAIMS BY THESE CUSTOMERS, WHICH MAY BE COSTLY AND MAY NOT BE ADEQUATELY COVERED BY INSURANCE. Our products are integrated with our customers' networks and software applications. The sale and support of our products may entail the risk of product liability or warranty claims. Any of these claims, even if not meritorious, could result in costly litigation or divert management's attention and resources. Although we carry general liability insurance, our current 22 insurance coverage would likely be insufficient to protect us from all the liability that may be imposed under these types of claims. A material product liability claim may seriously harm our results of operations. OUR PRODUCTS MAY INFRINGE THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, AND RESULTING CLAIMS AGAINST US COULD BE COSTLY AND REQUIRE US TO ENTER INTO DISADVANTAGEOUS LICENSE AND ROYALTY ARRANGEMENTS. Our industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement and the violation of other intellectual property rights. We may be subject to legal proceedings and claims for alleged infringement by us or our licensees of third party proprietary rights, such as patents, trademarks or copyrights, from time to time in the ordinary course of business. Any claims relating to the infringement of third party proprietary rights, even if not meritorious, could result in costly litigation, divert management's attention and resources, or require us to enter into royalty or license agreements that are not advantageous to us. In addition, parties making these claims may be able to obtain an injunction, which could prevent us from selling our products and solutions in the United States or abroad. Any of these results could harm our business. We may increasingly be subject to infringement claims as the number of products and competitors in our industry grows and functionalities of products overlap. Former employers of our current and future employees may assert that our employees have improperly disclosed confidential or proprietary information to us. OUR PRODUCTS INCORPORATE THE JAVA RUN TIME ENVIRONMENT, WHICH WE LICENSE FROM SUN MICROSYSTEMS, AND OUR PRODUCT SHIPMENTS COULD BE DELAYED IF THAT SOFTWARE IS NO LONGER AVAILABLE TO US. Our products incorporate the Java run time environment, which we license from Sun Microsystems. This third party software may not continue to be available to us on commercially reasonable terms. If we cannot maintain our license to Sun's Java run time environment, shipments of our products could be delayed until we could develop or license software to replace the functionality provided by this license and integrate that software into our products. Delays in product shipments could harm our revenue. A DISASTER COULD SEVERELY DAMAGE OUR OPERATIONS BECAUSE WE DO NOT HAVE A SEPARATE GEOGRAPHICALLY LOCATED BACKUP SYSTEM. All of our primary computer systems are located in our principal headquarters in Sunnyvale, California. Sunnyvale exists on or near a known earthquake fault zone. Although our facility which hosts our computer systems is designed to be fault tolerant, the system is vulnerable to damage from fire, floods, earthquakes, power loss, telecommunications failures, acts of terrorism and similar events. Although we maintain general business insurance against fires, floods and some general business interruptions, there can be no assurance that the amount of coverage will be adequate in any particular case. OUR EXECUTIVE OFFICERS, DIRECTORS AND 5% STOCKHOLDERS AND THEIR AFFILIATES ARE ABLE TO EXERCISE SIGNIFICANT CONTROL OVER ALL MATTERS REQUIRING STOCKHOLDER APPROVAL. As of October 31, 2002, our executive officers, directors and 5% stockholders and their affiliates beneficially own, in the aggregate, approximately 56.6% of our outstanding common stock. As a result, these stockholders are able to exercise significant control over all matters requiring stockholder approval, including the election of directors and approval of significant corporate transactions, which may have the effect of delaying or preventing a third party from acquiring control over us even if our other stockholders believe that it is desirable. WE ARE AT RISK OF SECURITIES CLASS ACTION LITIGATION DUE TO OUR STOCK PRICE VOLATILITY. The market price of our common stock has fluctuated and may continue to fluctuate significantly in response to a number of factors such as changes in accounting rules and regulations, market trends, recommendations from analysts and company performance, some of which are beyond our control. In the past, securities class action litigation has often been brought against a company following periods of volatility in the market price of its securities. We may, in the future, be the target of similar litigation. Regardless of its outcome, 23 securities litigation may result in substantial costs and divert management's attention and resources, which could harm our business and results of operations. In December 2001, a putative securities class action lawsuit was filed in the United States District Court for the Southern District of New York against us, certain investment bank underwriters for our initial public offering, and various of our officers and directors. The lawsuit, captioned In re Resonate Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-11245, generally alleges undisclosed and improper practices by the underwriters concerning the allocation of our IPO shares, in violation of federal securities laws, and seeks unspecified damages on behalf of persons who purchased our stock during the period from August 2, 2000 to December 6, 2000. The Court has appointed a lead plaintiff in this litigation. On April 19, 2002, plaintiffs filed an amended complaint. Other actions have been filed making similar allegations regarding the IPOs of more than 300 other companies. All of these have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92. Defendants in these cases have filed omnibus motions to dismiss on common pleading issues. Oral argument on the omnibus motions to dismiss are scheduled for October 29, 2002. Our officers and directors have been dismissed without prejudice in this litigation. We believe we have meritorious defenses to the claims against us and will defend ourselves vigorously. A SALE OF A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK MAY CAUSE OUR STOCK PRICE TO DECLINE. If our stockholders sell substantial amounts of our common stock, including shares issued upon the exercise of outstanding options, the market price of our common stock may fall. In addition, such sales could create the perception to the public of difficulties or problems with our products and solutions. As a result, these sales might also make it more difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate. WE MAY ENGAGE IN FUTURE ACQUISITIONS THAT DILUTE OUR STOCKHOLDERS, CAUSE US TO INCUR DEBT OR ASSUME CONTINGENT LIABILITIES. We may acquire businesses, products or technologies that we believe may complement our current product offerings, augment our market coverage or enhance our technical capabilities, or that may otherwise offer growth opportunities. While we have no current agreements with respect to any acquisitions, we may acquire businesses, products or technologies in the future. We may not be able to successfully integrate any businesses, products, technologies, or personnel that we might acquire in the future, and our failure to do so could harm our business. Furthermore, we may issue equity securities to pay for any future acquisitions which could be dilutive to our existing stockholders. WE HAVE BROAD DISCRETION TO USE THE PROCEEDS FROM OUR INITIAL PUBLIC OFFERING AND MAY NOT USE THE PROCEEDS EFFECTIVELY. The net proceeds from our initial public offering, which closed in August 2000, were not allocated for specific uses other than working capital and general corporate purposes. Thus, our management has broad discretion over how these proceeds are used and could spend most of these proceeds in ways with which our stockholders may not agree. As of September 30, 2002, we have used approximately $20.2 million of the proceeds from our initial public offering, of which $1.6 million was used to repurchase our common stock and $18.6 million was used for working capital purposes. PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW MAY DELAY OR PREVENT AN ACQUISITION OF OUR COMPANY. Our certificate of incorporation and bylaws contain provisions which could make it harder for a third party to acquire us without the consent of our board of directors. For example, if a potential acquirer were to make a hostile bid for us, the acquirer would not be able to call a special meeting of stockholders to remove members of our board of directors or act by written consent without a meeting. In addition, our directors have staggered terms, which makes it difficult to remove all of our directors at once. The acquirer would also be required to provide advance notice of its proposal to remove directors at an 24 annual meeting. The acquirer also will not be able to cumulate votes at a meeting, which will require the acquirer to hold more shares to gain representation on our board of directors than if cumulative voting were permitted. Our board of directors also has the ability to issue preferred stock which would significantly dilute the ownership of a hostile acquirer. In addition, Section 203 of the Delaware General Corporation Law limits business combination transactions with 15% stockholders that have not been approved by the board of directors. These provisions and other similar provisions make it more difficult for a third party to acquire us without negotiation. These provisions may apply even if the offer may be considered beneficial to some stockholders. Our board of directors could choose not to negotiate with an acquirer that it does not feel is in the strategic interests of Resonate. If the acquirer was discouraged from offering to acquire us or prevented from successfully completing a hostile acquisition by the anti-takeover measures, our stockholders could lose the opportunity to sell their shares at a favorable price. Item 3. Quantitative and Qualitative Disclosures About Market Risk. To date, all of our recognized revenue has been denominated in U.S. dollars and primarily from customers in the United States, and our exposure to foreign currency exchange rate changes has been immaterial. We expect, however, that an increasing percentage of our future product and services revenue may come from international markets and may be denominated in the currency of the applicable market. As a result, our operating results may become subject to significant fluctuations based upon changes in the exchange rates of some currencies in relation to the U.S. dollar. Although we will continue to monitor our exposure to currency fluctuations, and when appropriate, may use financial hedging techniques in the future to minimize the effect of these fluctuations, we cannot assure you that exchange rate fluctuations will not adversely affect our financial results in the future. We maintain an investment portfolio of various issuers, types and maturities. Our investment portfolio consists of both fixed and variable rate financial instruments. We purchase only high-grade investments rated A or above with original maturities of no more than thirteen months. These securities are classified as available-for-sale, and consequently, are recorded on the balance sheet at fair value. The average original maturity of investments in our portfolio was approximately 357 days and the average remaining maturity of investments in our portfolio was approximately 210 days as of September 30, 2002. At any time, a sharp rise in interest rates could seriously harm the fair value of our investment portfolio. Conversely, declines in interest rates could seriously decrease the interest income from our investment portfolio. Currently, we do not hedge these interest rate exposures. As of September 30, 2002, we had total short-term debt outstanding of $1.0 million, which bears interest at rates that are tied to the prime rate. Therefore, we are subject to exposure to interest rate risk for these borrowings based on fluctuations in the prime rate. Based upon the outstanding indebtedness under these arrangements, an increase in the prime rate of 0.5% would cause a corresponding increase in our annual interest expense of approximately $5,000. ITEM 4. CONTROLS AND PROCEDURES a) EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES. Within the 90 days prior to the date of this quarterly report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures pursuant to Exchange Act Rule 240.13a-14. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our current disclosure controls and procedures are effective in timely alerting them to material information relating to us and our subsidiaries required to be included in our periodic SEC filings. 25 b) CHANGES IN INTERNAL CONTROLS. There have been no significant changes in our internal controls or in other factors that could significantly affect internal controls subsequent to the date we carried out this evaluation. PART II: OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS On September 12, 2000, we filed a complaint for patent infringement against Alteon Web Systems, Inc. in the United States District Court, Northern District of California for permanent injunctive relief and damages. We believe Alteon infringes United States Letters Patent No. 5,774,660, titled "World-Wide Web Server With Delayed Resource-Binding For Resource-Based Load Balancing On A Distributed Resource Multi-Node Network," which was issued to us on September 30, 1998. Alteon served its answer to our complaint in October 2000, in which Alteon denied our allegations and counterclaimed that our patent is invalid. In October 2000, Alteon was acquired by Nortel Networks Corporation. In November 2001, the Court issued a claim construction ruling that we believe prevents us from prevailing in the case. In December 2001, we entered into a stipulated judgment of non-infringement and, in January 2002, filed a notice of appeal. The appeal is currently pending. In December 2001, a putative securities class action lawsuit was filed in the United States District Court for the Southern District of New York against us, certain investment bank underwriters for our initial public offering, and various of our officers and directors. The lawsuit, captioned In re Resonate Inc. Initial Public Offering Securities Litigation, Civil Action No. 01-CV-11245, generally alleges undisclosed and improper practices by the underwriters concerning the allocation of our IPO shares, in violation of federal securities laws, and seeks unspecified damages on behalf of persons who purchased our stock during the period from August 2, 2000 to December 6, 2000. The Court has appointed a lead plaintiff in this litigation. On April 19, 2002, plaintiffs filed an amended complaint. Other actions have been filed making similar allegations regarding the IPOs of more than 300 other companies. All of these have been coordinated for pretrial purposes as In re Initial Public Offering Securities Litigation, Civil Action No. 21-MC-92. Defendants in these cases have filed omnibus motions to dismiss on common pleading issues. Oral argument on the omnibus motions to dismiss are scheduled for October 29, 2002. Our officers and directors have been dismissed without prejudice in this litigation. We believe we have meritorious defenses to the claims against us and will defend ourselves vigorously. In January 2002, we received a Demand for Arbitration from the individual who transferred the domain name "resonate.com" to the Company in 1998. The Demand for Arbitration alleges, among other things, that we breached our obligations pursuant to our agreement with the individual by providing her with "restricted stock" rather than stock that was not encumbered with any restrictions. As a consequence, this individual alleges that she was unable to sell her Resonate stock when it was trading at its highest price, and that she is entitled to damages or, alternatively, to the return of her domain name and additional payments by us for our prior use of the domain name. This dispute is currently pending before the American Arbitration Association and a hearing date has been set for January 2003. Although there can be no assurances that we will prevail in the arbitration, we believe that we have meritorious defenses to the claims asserted against us in the Demand for Arbitration and intend to defend this action vigorously. We are also involved in disputes in the ordinary course of business. We do not believe that the outcome of any of these disputes will have a material effect on our business, financial condition or results of operations. ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS The net proceeds from our initial public offering, which closed in August 2000, were not allocated for specific uses other than working capital and general corporate purposes. As of September 30, 2002, of the proceeds from our initial public offering in August 2000, we used $1.6 million for the repurchase of 700,000 shares of our common stock and $18.6 million for working capital purposes. 26 ITEM 3. DEFAULTS UPON SENIOR SECURITIES None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS Our annual meeting of stockholders was held on August 29, 2002 in Sunnyvale, California. Of the 27,170,405 shares outstanding as of the record date, 21,429,665 shares were present or represented by proxy at the meeting. The following matters were submitted to a vote of security holders: (1) To elect the following to serve as directors of the company: Votes For Votes Abstaining ------------- ---------------- Russell Siegelman 21,390,801 38,864 David Murphy 21,391,101 38,564 (2) To ratify the company's appointment of PricewaterhouseCoopers LLP as independent accountants for the company for the fiscal year ending December 31, 2002: Votes for: 21,428,760 Votes against: 283 Votes abstaining: 622 ITEM 5. OTHER INFORMATION Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits 3.1 (1) Restated Certificate of Incorporation of the registrant. 3.2 (2) Bylaws of the registrant, as amended on January 24, 2002. 4.1 (1) Form of specimen certificate for registrant's common stock. 99.1 CEO and CFO Certification ------------------------- (1) Incorporated by reference to the registrant's registration statement on Form S-1 (File No. 333-31730), declared effective August 2, 2000. (2) Incorporated by reference to the registrant's annual report on Form 10-K (File No. 000-31139) filed with the Securities and Exchange Commission on March 28, 2002. (b) Reports on Form 8-K We did not file any reports on Form 8-K during the three months ended September 30, 2002. 27 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. RESONATE INC. Date: November 14, 2002 /s/Peter R. Watkins --------------------------------- Peter R. Watkins Chairman, President and Chief Executive Officer /s/Richard Hornstein --------------------------------- Richard Hornstein Vice President, Chief Financial Officer and General Counsel 28 CERTIFICATIONS I, Peter R. Watkins, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Resonate Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 /s/ Peter R. Watkins ------------------------------ Peter R. Watkins Chairman, President and Chief Executive Officer 29 I, Richard Hornstein, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Resonate Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: (a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; (b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and (c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): (a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and (b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 14, 2002 /s/ Richard Hornstein ------------------------------------------- Richard Hornstein Vice President, Chief Financial Officer and General Counsel 30 INDEX TO EXHIBITS Exhibit Number Description ------ ------------------------ 3.1 (1) Restated Certificate of Incorporation of the registrant. 3.2 (2) Bylaws of the registrant, as amended on January 24, 2002. 4.1 (1) Form of specimen certificate for registrant's common stock. 99.1 CEO and CFO Certification ------------------------- (1) Incorporated by reference to the registrant's registration statement on Form S-1 (File No. 333-31730), declared effective August 2, 2000. (2) Incorporated by reference to the registrant's annual report on Form 10-K (File No. 000-31139) filed with the Securities and Exchange Commission on March 28, 2002. 31

RESONATE INC 10-Q