10-Q 1 f72710e10-q.txt FORM 10-Q 1 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 MARCH 31, 2001 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Commission File Number 000-31011 TALARIAN CORPORATION -------------------- (Exact Name as Registrant specified in its charter) DELAWARE 33-0323810 -------- ---------- (State or other jurisdiction of (I.R.S. Employer Identification Number) incorporation or organization) 333 DISTEL CIRCLE LOS ALTOS, CALIFORNIA 94022 (Address of principal executive offices) (650) 965-8050 -------------- (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 past 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 $.001 per share, as of April 15, 2001, was 19,113,199. 2 TALARIAN CORPORATION QUARTERLY REPORT ON FORM 10-Q QUARTER ENDED MARCH 31, 2001 TABLE OF CONTENTS

3 TALARIAN CORPORATION AND SUBSIDIARY CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS) (UNAUDITED)

The accompanying notes are an integral part of the condensed consolidated financial statements. 3 4 TALARIAN CORPORATION AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT PER SHARE DATA) (UNAUDITED)

The accompanying notes are an integral part of the condensed consolidated financial statements. 4 5 TALARIAN CORPORATION AND SUBSIDIARY CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED)

The accompanying notes are an integral part of the condensed consolidated financial statements. 5 6 TALARIAN CORPORATION AND SUBSIDIARY NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) NOTE 1 BASIS OF PRESENTATION The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly they do not include all information and footnotes necessary for a complete presentation of the financial statements in conformity with accounting principles generally accepted in the United States of America. In the opinion of management, the accompanying unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for the fair presentation of the Company's financial position as of March 31, 2001, and the results of its operations and cash flows for the interim periods ended March 31, 2001 and 2000. These financial statements should be read in conjunction with the Company's audited financial statements as of September 30, 2000 and 1999 and for each of the years in the three-year period ended September 30, 2000, including notes thereto, included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission on December 27, 2000. The condensed consolidated balance sheet at September 30, 2000 has been derived from the audited financial statements as of that date. The results of operations for the interim periods ended March 31, 2001 and 2000 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending September 30, 2001. NOTE 2 COMPREHENSIVE INCOME (LOSS) The Company had no material components of other comprehensive income (loss) for any of the periods presented. NOTE 3 CASH AND CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS Cash and cash equivalents consist of cash and highly liquid investments with remaining maturities of less than 90 days at the date of purchase. The Company is exposed to credit risk in the event of default by the financial institutions or the issuers of these investments to the extent of the amounts recorded on the balance sheet in excess of amounts that are insured by the Federal Deposit Insurance Corporation. As of March 31, 2001 and September 30, 2000, cash equivalents consisted of money market accounts. The Company classifies its investments in debt securities as available-for-sale and as such these are classified as short-term investments. Available-for-sale securities are carried at fair market value, which approximates amortized cost. Any unrealized gains or losses are recorded as a component of other comprehensive income (loss). 6 7 NOTE 4 NET LOSS PER SHARE ATTRIBUTABLE TO COMMON STOCKHOLDERS Basic net loss per share attributable to common stockholders is computed using the weighted-average number of outstanding shares of common stock excluding shares of restricted stock subject to repurchase. Diluted net loss per share attributable to common stockholders is computed using the weighted-average number of shares of common stock outstanding and, when dilutive, potential shares of restricted common stock subject to repurchase and common stock from exercise of options, using the treasury stock method, and from convertible securities on an "as if converted" basis. The following potential shares of common stock have been excluded from the computation of diluted net loss per share attributable to common stockholders for all periods presented because the effect would have been antidilutive:

The weighted-average exercise price of stock options outstanding was $3.95 and $1.92 for the three months ended March 31, 2001 and 2000, respectively. The weighted-average purchase price of restricted stock subject to repurchase was $0.41 for the six months ended March 31, 2001. The weighted-average exercise price of outstanding warrants to purchase common stock was $0.90 and $0.71 for the six months ended March 31, 2001 and 2000, respectively. In July 2000, all outstanding shares of the Company's convertible preferred stock were automatically converted into common stock upon completion of the Company's initial public offering. NOTE 5 RECENT ACCOUNTING PRONOUNCEMENTS In September 2000, FASB issued SFAS No. 140, "Accounting for the Transfers and Servicing of Financial Assets and Extinguishments of Liabilities". SFAS No. 140 is effective for transfers occurring after March 31, 2001 and for disclosures relating to the securitization transactions and collateral for fiscal years ending after December 15, 2000. The Company does not expect the adoption of SFAS No. 140 to have a material impact on its financial position or results of operations. NOTE 6 BALANCE SHEET COMPONENTS Intangible Assets In September 1999, the Company completed the acquisition of certain assets of GlobalCast Communications, Inc. for total consideration of approximately $3.6 million. Approximately $2.9 million of the purchase price was allocated to intangible assets, which included $2.7 million in goodwill and $0.2 million of developed technology. On March 13, 2000, the Company acquired WhiteBarn, Inc. for total consideration of approximately $4.9 million. Approximately $4.4 million of the purchase price was allocated to intangible assets including goodwill. The goodwill and intangible assets acquired in connection with the acquisitions of GlobalCast and WhiteBarn are being amortized on a straight-line basis over their estimated useful lives of between two and four years. Pro forma revenue, net loss attributable to common stockholders and basic and diluted net loss per share attributable to common stockholders for the six months ended March 31, 2001 and 2000 with respect to the WhiteBarn acquisition is presented below. The pro forma financial information presents the combined results of operations of the Company and WhiteBarn as if the acquisition had occurred on October 1, 1999 after giving effect 7 8 to certain adjustments including amortization of goodwill and other intangibles, the elimination of non-recurring items and related income tax effects. The pro forma financial information does not necessarily reflect the consolidated results of operations that would have occurred had the Company and WhiteBarn constituted a single entity during these periods (in thousands):

NOTE 7 SEGMENT INFORMATION The Company has adopted SFAS No. 131, "Disclosures About Segments of an Enterprise and Related Information". SFAS No. 131 establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers. The method for determining what information to report is based on the way that management organizes segments within the Company for making operating decisions and assessments of financial performance. The Company's chief operating decision maker is considered to be the Company's Chief Executive Officer (CEO). The CEO reviews financial information presented on a consolidated basis for purposes of making operating decisions and assessing financial performance. The consolidated financial information reviewed by the CEO is identical to the information presented in the accompanying consolidated statements of operations. The Company has determined that it operates in a single operating segment: real-time infrastructure software. The Company maintains significant operations in the United States, with direct sales and marketing offices located in the United Kingdom, Germany and Japan. The Company does not measure performance of net revenue by geographical area, and accordingly no analysis has been provided. There were no significant assets maintained by the Company outside the United States for March 31, 2001 or 2000. Revenue from sales made to customers outside the United States aggregated 12% and 15% for the six months ended March 31, 2001 and 2000, respectively. Customers were primarily concentrated in the United Kingdom, France and Germany. Significant customer information is as follows:

8 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q contains 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. These statements can generally be identified by words such as "may", "might", "should", "expects", "plans", "anticipates", "believes", "estimates", or "predicts", and includes statements relating to the Company's plans to increase the size of its product and services offerings , and the Company's expectations regarding future financial results, expense levels, and size of our customer base. These forward-looking statements involve risks and uncertainties that may cause actual results to differ materially from the forward-looking statements. These risks and uncertainties include, but are not limited to, those discussed under "Factors That May Affect Operating Results", below, and other risks discussed in our filings with the Securities and Exchange Commission. We do not assume any obligation to update any such forward-looking statements. OVERVIEW We develop and market infrastructure software products that allow our customers to distribute and share information in real time within and across organizations. Our products enable distributed computer applications to communicate quickly, reliably, and securely across virtually any type of network, including the Internet. We were incorporated in November 1988. From inception through 1996, we derived a substantial portion of our revenue from a suite of software products used primarily in connection with mission-critical command and control operations in industries such as aerospace. In 1997, leveraging our technology developed for mission-critical command and control operations, we refocused our business strategy to provide infrastructure software for applications relying heavily upon the use of real-time, distributed systems. Our operating activities during 1997 and 1998 related primarily to developing our SmartSockets messaging infrastructure product line and directing our sales and marketing efforts to increase market awareness of our SmartSockets product in industries such as finance, telecommunications and computer hardware and services. In 1999, we launched MQexpress (now known as SmartMQ), a message queuing product that provides complementary storage, backup, and audit capabilities to SmartSockets. We also added Internet-related applications and industries, such as business-to-business e-commerce, to our sales and marketing focus and began a concerted effort to market our product to third-party partners such as original equipment manufacturers and value-added resellers. Additionally in 1999, we began incorporating reliable multicast capabilities into our SmartSockets product line. As part of our overall multicast initiative, we acquired substantially all of the assets of GlobalCast Communications, Inc. in September 1999, and acquired WhiteBarn, Inc. in March 2000. Later in 2000 we launched a suite of reliable multicast products called SmartMulticast. SmartMulticast includes SmartPGM, our implementation of a real time reliable multicast protocol known as Pragmatic General Multicast (PGM) and SmartTransfer, which simplifies the setup and management of file transfers from a single sender to multiple receivers over an IP multicast and PGM capable network. In 2000 we also launched two products as add-on modules to SmartSockets, SmartSocket SSL, which provides private, secure connections between SmartSockets processes, and RT Gateway, which extends the message functionality of SmartSockets. Our revenue consists principally of license fees generated from our SmartSockets and SmartMulticast product lines and, to a lesser extent, revenue from maintenance, support, and professional services related to our product lines. We license our products to end users to deploy in their networks and, to a lesser extent, to software applications providers to embed in their products. For end users, we typically ship products with a shrink-wrap license agreement and recognize revenue from software license fees upon delivery of the software to the customer, provided that the fees are fixed and determinable and that collection is probable. Increasingly, we are entering into signed license agreements with our end-user customers. All of our original equipment manufacturer and value-added reseller customers enter into signed agreements with us. For customers using a signed license agreement, revenue is recognized after delivery of the software to the customer, for a fixed and determinable fee, for which collection is considered probable and we have received the signed agreement. We recognize software license revenue ratably over the term of the license if the license requires us to deliver unspecified additional software products during its term. Payments received in advance of revenue recognition are recorded as deferred revenue. As of March 31, 2001, we had $4.5 million of deferred revenue. Of this amount, $1.4 million was classified as long-term deferred revenue, 9 10 relating primarily to software licenses that require us to deliver software over an extended period and, to a lesser extent, to maintenance and support agreements that have a term in excess of one year. Maintenance and support revenue consists of fees for providing software updates and technical support for software products. Revenue from maintenance and support fees is recognized ratably over the period of the maintenance and support agreement, typically twelve months. Payments for maintenance and support are typically paid in advance and are nonrefundable. Professional services revenue consists of fees for services, including product and application development, implementation and installation of software products, integration of software, on-site support, consulting and training. Revenue from professional services is generally recognized as the services are performed. We market our products primarily through our direct sales force and, to a lesser extent, through indirect channels. Recently, we have begun to derive increasing amounts of revenue through indirect channel relationships with distributors, original equipment manufacturers, value-added resellers, and systems integrators. Our third-party relationships have typically been with companies that embed our product within their product, for which we receive a license fee and, in some cases, future royalties based on our reseller's product revenue. During 1998, we expanded our international presence by opening a sales and support office in London, England, and we opened sales offices in Japan and Germany in 2000 and 2001, respectively. Currently, our international revenue is primarily generated through distributors. We plan to aggressively expand our sales force and the market awareness of our company and our products. As a result, we expect to incur substantial expenditures related to programs designed to achieve those goals. In September 1999, we acquired substantially all of the assets of GlobalCast, a provider of reliable multicast technology, for common stock with an aggregate value of $3.6 million. The acquisition was accounted for using the purchase method of accounting in accordance with Accounting Principles Board Opinion No. 16, and $300,000 of the purchase price was allocated to in-process research and development and expensed at the time of the acquisition. Also, in connection with the GlobalCast acquisition, we recorded intangible assets of $2.9 million, which we are amortizing over a three to four year period. In March 2000, we acquired WhiteBarn, a professional services and software development company focused on reliable multicast and network protocols with cash, stock and options to purchase our common stock that had an aggregate value of $4.9 million. The transaction was accounted for as a purchase. In this acquisition, the acquired technology included existing technology, but not in-process research and development. In connection with the WhiteBarn acquisition, we recorded intangible assets of $4.4 million, which we are amortizing over a two to three year period. We have a limited operating history since the implementation of our current business strategy. We believe our success is dependent upon our ability to rapidly expand our customer base and enhance our technology. Over the past 12 months we have invested substantial resources in our sales and marketing and research and development activities. While we generally expect to maintain, but not further increase such levels of expenditures, we expect to incur operating losses for the foreseeable future. In connection with the granting of stock options to our employees through March 31, 2001, we recorded deferred stock compensation totaling approximately $22.1 million. This amount represents the difference between the exercise price and the deemed fair value of our common stock for accounting purposes on the date these stock options were granted. This amount is included as a component of stockholders' equity and is being amortized on an accelerated basis by charges to operations over the vesting period of the options consistent with the method described in Financial Accounting Standards Board Interpretation No. 28. The stock options, or restricted stock purchased pursuant to these options, generally vest at a rate of 12.5% upon the six-month anniversary of the option grant date and 2.083% each month thereafter for the next 42 months. Amortization of the March 31, 2001 balance of deferred stock compensation will result in charges to operations of $2.7 million, $3.2 million, $1.2 million and $117,000 for the six months ended September 30, 2001, and for fiscal years 2002, 2003, and the nine months ended June 30, 2004. We have recorded no provision for federal or state income taxes for any period since our inception as we have incurred losses in each period. As of September 30, 2000, we had net operating loss carryforwards for federal income tax purposes of approximately $7.2 million and for California income tax purposes of approximately $2.4 10 11 million, available to offset income in future years. The federal net operating loss carryforwards expire from 2007 through 2020. The California net operating loss carryforwards expire from 2001 through 2005. RESULTS OF OPERATIONS The following table sets forth the results of operations for the three months ended March 31, 2001 and 2000 expressed as a percentage of total revenue.

REVENUE Total revenue increased by $489,000, or 13%, to $4.1 million for the three months ended March 31, 2001, from $3.6 million for the three months ended March 31, 2000. Total revenue increased $1.1 million, or 17%, to $7.5 million for the six months ended March 31, 2001, from $6.4 million for the six months ended March 31, 2000. Licenses and associated maintenance revenue represented 83% of total revenue for both the three and six months ended March 31, 2001 and 83% and 86% of total revenue for the three and six months ended March 31, 2000. The increase in total revenue for the three and six-month periods was due to increases in all three of our revenue components, but primarily due to increases in software licenses and associated maintenance revenue. One customer accounted for more than 10% of our total revenue in the three and six months ended March 31, 2001. Two customers each accounted for more than 10% of our total revenue in the three months ended March 31, 2000. No customer accounted for more than 10% of our total revenue in the six months ended March 31, 2000. During the three months ended March 31, 2001, international revenue decreased by $56,000, or 19%, to $236,000, from $292,000 in the three months ended March 31, 2000. In the six months ended March 31, 2001, international revenue decreased by $4,000 to $849,000, from $853,000 in the six months ended March 31, 2000. International 11 12 revenue was 6% and 8% of our total revenue in the three months ended March 31, 2001 and 2000, respectively, and 11% and 13% of our total revenue in the six months ended March 31, 2001 and 2000, respectively. License. License revenue increased by $237,000 or 11%, to $2.5 million in the three months ended March 31, 2001, from $2.3 million in the three months ended March 31, 2000. License revenue increased by $430,000 or 11%, to $4.5 million in the six months ended March 31, 2001, from $4.1 million for the six months ended March 31, 2000. The increase in license revenue was due to an increase in the number of SmartMulticast software licenses to new and existing customers, which was partially offset by a decrease in other license revenue. We started shipping our stand-alone SmartMulticast products shortly after the acquisition of WhiteBarn in March 2000. As a percentage of total revenue, license revenue represented 60% and 62% in the three months ended March 31, 2001 and 2000, respectively, and 60% and 63% in the six months ended March 31, 2001 and 2000, respectively. Maintenance. Maintenance revenue increased by $178,000, or 24%, to $929,000 in the three months ended March 31, 2001, from $751,000 for the three months ended March 31, 2000. Maintenance revenue increased by $298,000, or 20% to $1.8 million in the six months ended March 31, 2001, from $1.5 million for the six months ended March 31, 2000. The increase in maintenance revenue was due to growth associated with license agreements entered into in earlier periods. As a percentage of total revenue, maintenance revenue represented 23% and 21% in the three months ended March 31, 2001 and 2000, respectively, and 23% in both six months ended March 31, 2001 and 2000. Professional services. Professional services revenue increased by $74,000, or 12%, to $706,000 in the three months ended March 31, 2001, from $632,000 in the three months ended March 31, 2000. Professional services increased by $383,000, or 44%, to $1.3 million for the six months ended March 31, 2001, from $879,000 for the six months ended March 31, 2000, respectively. These increases are primarily a result of new customers obtained through our acquisition of WhiteBarn in March 2000. As a percentage of total revenue, professional services revenue represented 17% in both three months ended March 31, 2001 and 2000, and 17% and 14% in the six months ended March 31, 2001 and 2000, respectively. COST OF REVENUE In the three months ended March 31, 2001, cost of revenue increased by $353,000, or 50%, to $1.1 million, from $704,000 for the three months ended March 31, 2000. Cost of revenue increased by $862,000, or 78%, to $2.0 million for the six months ended March 31, 2001, from $1.1 million for six months ended March 31, 2000. The increase in cost of revenue was attributable to increased costs related to our growing maintenance and professional services departments, much of which resulted from personnel acquired in connection with our acquisition of WhiteBarn. As a percentage of total revenue, cost of revenue represented 26% and 20% in the three months ended March 31, 2001 and 2000, respectively, and represented 27% and 18% in the six months ended March 31, 2001 and 2000, respectively. The increase in cost of revenue as a percentage of total revenue was the result of the increase in costs associated with personnel responsible for delivering the additional professional services revenue, which typically has a lower gross margin than other types of revenue, as well as personnel increases associated with customer support to provide increased support capabilities across a wider cross section of product lines. Licenses. Cost of license revenue includes royalties due for technology licensed from third parties, product packaging, manuals and documentation, and software media. In the three months ended March 31, 2001, cost of license revenue decreased by $101,000, or 99%, to $1,000 from $102,000 for the three months ended March 31, 2000. Cost of license revenue decreased by $143,000, or 88%, to $19,000 for the six months ended March 31, 2001, from $162,000 for six months ended March 31, 2000. The decrease in cost of license revenue was attributable to a decrease in license revenue from royalty-bearing products. We anticipate that the cost of license revenue will increase in absolute dollars and as a percentage of license revenue due to an expected increase use of third-party software incorporated into our product line. As a percentage of license revenue, cost of license revenue represented 0% and 5% in the three months ended March 31, 2001 and 2000, and represented 0% and 4% in the six months ended March 31, 2001 and 2000, respectively. Maintenance. Cost of maintenance revenue consists of compensation and related expenses for our technical support organization. Cost of maintenance revenue increased by $183,000, or 106%, to $355,000 for the three months ended March 31, 2001, from $172,000 for the three months ended March 31, 2000. In the six months ended March 31, 2001, cost of maintenance revenue increased by $375,000, or 107%, to $724,000, from $349,000 for the six months ended March 31, 2000. The increase in cost of maintenance revenue was due to increased personnel and contractors hired in order to provide increased support capabilities to our growing installed base of customers across 12 13 a broader product line. As a percentage of maintenance revenue, cost of maintenance revenue represented 38% and 23% in the three months ended March 31, 2001 and 2000, respectively, and represented 41% and 24% in the six months ended March 31, 2001 and 2000. We anticipate that our cost of maintenance revenue will continue to grow in absolute dollars, albeit at a slower pace, as we expand our customer base and provide increasing levels of support for our customers and as we increase the number of products for which we provide support. Professional services. Cost of professional services revenue consists of compensation and related overhead expense for personnel and third-party contractors we use in performing consulting, implementation and training services for our customers. Cost of professional services revenue increased by $280,000, or 134%, to $489,000 for the three months ended March 31, 2001, from $209,000 for the three months ended March 31, 2000. In the six months ended March 31, 2001, cost of professional services increased $429,000, or 145%, to $725,000, from $296,000 for the six months ended March 31, 2000. A portion of the dollar increase in cost of professional services revenue for the three months ended March 31, 2001, was a result of personnel acquired in the acquisition of WhiteBarn. The remainder of the increase in cost of professional services revenue was a result of additional personnel deployed on our professional services engagements. As a percentage of professional services revenue, cost of professional services revenue represented 69% and 33% in the three months ended March 31, 2001 and 2000, respectively, and represented 57% and 34% in the six months ended March 31, 2001 and 2000. The increase in the cost of professional services revenue as a percentage of professional services revenue was a result of increasing the management and other infrastructure associated with delivering our professional services. Provided our revenue from professional services continues to grow, we anticipate that the cost of professional services revenue will also continue to increase in terms of absolute dollars as we continue to expand our service offerings and increase the overall infrastructure related to our professional services organization. Amortization of deferred stock compensation. Amortization of deferred stock compensation in cost of revenue decreased by $9,000, to $212,000 for the three months ended March 31, 2001, from $221,000 for the three months ended March 31, 2000. In the six months ended March 31, 2001, amortization of deferred stock compensation in cost of revenue increased by $201,000 to $500,000, from $299,000 for the six months ended March 31, 2000. OPERATING EXPENSES Sales and marketing. Sales and marketing expenses include costs of sales and marketing personnel and related overhead, commissions, field office expenses, advertising and promotion expenses, travel and entertainment expenses and other selling and marketing costs. Sales and marketing expenses increased by $1.5 million, or 76%, to $3.5 million for the three months ended March 31, 2001, from $2.0 million for the three months ended March 31, 2000. For the six months ended March 31, 2001, sales and marketing expenses increased by $3.6 million, or 104%, to $7.0 million, from $3.4 million for the six months ended March 31, 2000. The increase in sales and marketing expenses was due to substantial expansion of our sales and marketing department personnel and locations and, to a lesser extent, increased promotional programs. As a percentage of total revenue, sales and marketing expenses represented 84% and 55% in the three months ended March 31, 2001 and 2000, respectively, and represented 92% and 53% in the six months ended March 31, 2001 and 2000, respectively. We plan to closely monitor our spending in sales and marketing in the coming months to better align such spending with anticipated revenue. As a result, we expect sales and marketing expenses to remain relatively flat, with perhaps a slight increase, on an absolute basis. Research and development. Research and development expenses consist of costs of research and development personnel and associated overhead, and costs of short-term independent contractors required in connection with development of new products, enhancements to existing products, technical documentation, and quality assurance. Costs incurred in research and development are expensed as incurred until technological feasibility is established. We believe that under our current engineering processes, the establishment of technological feasibility and general release substantially coincide. As a result, no software development costs have been capitalized to date. Research and development expenses increased by $1.5 million, or 144%, to $2.6 million for the three months ended March 31, 2001, from $1.1 million for the three months ended March 31, 2000. For the six months ended March 31, 2001, research and development expenses increased by $3.5 million, or 185%, to $5.4 million, from $1.9 million for the six months ended March 31, 2000. A portion of the increase for the three months ended March 31, 2001, was a result of personnel acquired in the acquisition of WhiteBarn. The remainder of the increase in research and development expenses was due to an increase in personnel and consultants in our software development, quality assurance, and documentation departments. As a percentage of total revenue, research and development expenses represented 64% and 30% in the three months ended March 31, 2001 and 2000, respectively; compared with 72% and 30% in the six months ended March 31, 2001 and 2000, respectively. We believe that our product development activities are important to attaining our strategic objectives. We expect to maintain current levels of investment in research and development on an absolute basis. 13 14 General and administrative. General and administrative expenses include personnel costs for finance, administration, information systems and general management, as well as professional fees, legal expenses, bad debt expense and other general corporate expenses. General and administrative expenses increased by $633,000, or 131%, to $1.1 million for the three months ended March 31, 2001, from $482,000 in the three months ended March 31, 2000. For the six months ended March 31, 2001, general and administrative expenses increased by $1.1 million, or 111%, to $2.1 million, from $1.0 million in the six months ended March 31, 2000. Approximately $60,000 and $186,000 of the increases in the three and six months ended March 31, 2001, respectively, were attributable to increases in our reserve for uncollectable accounts receivable. The accounts receivable reserve was increased due to current economic conditions. The remainder of the increase in general and administrative expenses was due to increased personnel expenses in finance and administration and in information systems as well as increases in professional fees associated with additional requirements of being a public company. As a percentage of total revenue, general and administrative expenses represented 27% and 13% in the three months ended March 31, 2001 and 2000, respectively; compared with 28% and 15% in the six months ended March 31, 2001 and 2000, respectively. We expect general and administrative expenses to remain relatively flat on an absolute basis. Amortization of deferred stock compensation. During the three months ended March 31, 2001, we recorded $1.6 million of amortization of deferred stock compensation in operating expenses, representing $617,000 of additional sales and marketing expenses, $568,000 of additional research and development expenses and $428,000 of additional general and administrative expenses. During the six months ended March 31, 2001, we recorded $3.6 million of amortization of deferred stock compensation in operating expenses, representing $1.4 million of additional sales and marketing expenses, $1.3 million of additional research and development expenses and $900,000 of additional general and administrative expenses. During the three and six months ended March 31, 2000, we recorded $2.7 million and $4.2 million, respectively, of amortization of deferred stock compensation. Amortization of goodwill and intangible assets. Amortization of goodwill and intangible assets was $608,000 and $314,000 for the three months ended March 31, 2001 and 2000, respectively. For the six months ended March 31, 2001 and 2000, amortization of goodwill and intangible assets was $1.2 million and $553,000, respectively. This amount represents the amortization of goodwill and other intangible assets acquired in connection with our acquisition of GlobalCast in September 1999 and WhiteBarn in March 2000. INTEREST INCOME AND OTHER, NET Interest income and other, net consists of interest income, net of interest expense, and losses on foreign currency transactions. Interest income and other, net resulted in income of $928,000 and $2.0 million for the three and six months ended March 31, 2001, respectively, compared to income of $55,000 and $30,000 for the three and six months ended March 31, 2000. The resulting change was attributable to higher interest income and lower interest expense in the more recent periods following our private equity funding in February 2000 and our initial public offering in July 2000. Our average cash reserves in interest-bearing accounts were thus significantly higher, and the outstanding balance on our line of credit was lower, during the three and six months ended March 31, 2001 than in the same periods in the prior year. LIQUIDITY AND CAPITAL RESOURCES Prior to our initial public offering we funded our operations through private sales of redeemable convertible preferred stock, internal operations, and, to a lesser extent, through our credit facilities. In February 2000, we raised $9.9 million through a private sale of redeemable convertible preferred stock. On July 20, 2000, we completed an initial public offering of 4.2 million shares of our common stock at $16.00 per share. Net proceeds from this offering were $60 million, net of underwriters' commissions and offering expenses. Net cash used in operating activities was $8.2 million for the six months ended March 31, 2001. Net cash used in operating activities was $881,000 for the six months ended March 31, 2000. For the six months ended March 31, 2001, substantially all of net cash used in operating activities was attributable to our net loss of $11.7 million, which included $5.3 million in non-cash charges, an increase in accounts receivable of $1.3 million, and a reduction in other accrued expenses of $935,000. For the six months ended March 31, 2000, net cash used in operating activities was primarily due to our net loss of $5.7 million, which included $5.2 million in non cash charges, and an increase in the accounts receivable of $1.0 million, offset in part by an increase in deferred revenue of $254,000 and increases in other current liabilities. 14 15 Net cash provided by investing activities was $7.7 million for the six months ended March 31, 2001 and net cash used in investing activities was $9.2 million for the six months ended March 31, 2000. For the six months ended March 31, 2001, net cash provided by investing activities was primarily related to the sale of short-term securities, partially offset by purchases of property and equipment. For the six months ended March 31, 2000, net cash used in investing activities represented purchases of short-term investments totaling $8.0 million, the acquisition of WhiteBarn, and purchases of property and equipment. Net cash provided by financing activities was $195,000 for the six months ended March 31, 2001 and $10.4 million for the six months ended March 31, 2000. For the six months ended March 31, 2001, net cash provided by financing activities was mainly related to the sale of common stock through employee stock options. For the six months ended March 31, 2000, net cash provided by financing activities was primarily attributable to the sale of preferred stock and to a lesser extent, the sale of common stock through the exercise of employee stock options. As of March 31, 2001, we had approximately $58.4 million in cash, cash equivalents, and short-term investments, and working capital of $57.7 million. Our commitments consist primarily of amounts due under our operating leases. As of that date, we also had a line of credit under which we could borrow up to $2.0 million with a revolving maturity date of February 22, 2002, at an interest rate of prime plus 0.25%. Any borrowing will be collateralized by accounts receivable and other assets of ours. We have no borrowings under this line of credit and are in compliance with all required financial ratios and covenants. We have no material commitments for capital expenditures; however, we expect that both capital expenditures and operating lease commitments will increase to the extent we expand our operations and personnel worldwide. For the next twelve months, we expect our capital expenditures to be approximately $2.5 million. We may use cash resources to fund acquisitions or investments in complementary businesses or technologies. We believe that our current cash, cash equivalents, and short-term investments will be sufficient to meet our working capital and operating resource requirements for at least the next 12 months. FACTORS THAT MAY AFFECT OPERATING RESULTS The Company's future operating results may differ materially from the results discussed in, or implied by, forward-looking statements made by the Company. Factors that may cause such differences include, but are not limited to, those discussed below and elsewhere in this Report. WE HAVE A HISTORY OF LOSSES, WE EXPECT FUTURE LOSSES, AND WE MAY NEVER ACHIEVE OR MAINTAIN PROFITABILITY. We have a history of losses, we expect future losses, and we do not expect to achieve profitability in the near future. We incurred net losses of $1.7 million in fiscal 1998, $3.5 million in fiscal 1999, and $15.0 million in fiscal 2000. As of March 31, 2001, we had an accumulated deficit of approximately $36.5 million. We cannot assure you that our revenue will grow or that we will achieve or maintain profitability in the future. While we intend to maintain controls on expenses at approximately current levels, it may be necessary to increase our future product development, sales and marketing, and administrative expenses. In any event, we will need to increase our revenue substantially to achieve and maintain profitability, which we may not be able to do. OUR BUSINESS IS DIFFICULT TO EVALUATE BECAUSE WE HAVE A LIMITED OPERATING HISTORY SINCE THE IMPLEMENTATION OF OUR CURRENT BUSINESS STRATEGY. Prior to 1997, we derived a substantial majority of our revenue from a suite of software products used primarily in connection with mission-critical command and control operations in industries such as aerospace. In 1997, we re-focused our business strategy on providing infrastructure software for applications relying heavily upon the use of real-time, distributed systems. In addition, through our acquisition of substantially all the assets of GlobalCast Communications, Inc. in 1999 and our acquisition of WhiteBarn, Inc. in 2000, we added reliable multicast capabilities to our product line. We also expanded our business strategy in 1999 to include providing software infrastructure products to the market for Internet-related applications. We have recently placed increased focus on our SmartMulticast related line of products. We have only a limited operating history with a significant portion of our current product line and business strategy, which makes it difficult to evaluate our business. If our current product line and business strategy is not successful, our revenue is unlikely to grow significantly, if at all. 15 16 OUR OPERATING RESULTS ARE DIFFICULT TO PREDICT IN ADVANCE AND MAY FLUCTUATE SIGNIFICANTLY, AND A FAILURE TO MEET THE REVENUE EXPECTATIONS OF SECURITIES ANALYSTS OR INVESTORS MIGHT RESULT IN A DECLINE IN OUR STOCK PRICE. Our future operating results may vary significantly. If our operating results are below the expectations of securities analysts or investors, our stock price is likely to decline. Our revenue and operating results depend upon the volume and timing of customer orders and payments and the date of product delivery. Historically, we have had little backlog and our revenue in any quarter has been substantially dependent upon orders booked in that quarter. In addition, more than 50% of our license revenue in a given quarter has often been recorded in the third month of that quarter, with a concentration of this revenue in the last two weeks of the third month. Furthermore, more than 50% of our license revenue for a given quarter has often been derived from fewer than ten customers. For example, in the quarter ended March 31, 2001, 6 customers represented more than 50% of our revenue. We expect these trends to continue and, therefore, any failure or delay in the closing of orders could have a material adverse effect on our quarterly operating results. Additionally, since our operating expenses are based on anticipated revenue and because a high percentage of these expenses are relatively fixed, a shortfall in anticipated revenue could have a significant negative impact on our operating results. Other factors that may cause our revenue or operating results to fall short of expectations include: - the uncertainty of current economic conditions and their affect on customer purchase decisions; - the amount and timing of sales and marketing expenses and other operating costs and capital expenditures relating to our business; - changes in prices of, and the adoption of different pricing strategies for, our products and those of our competitors; - changes in the demand for our products due to the announcement or introduction of new or enhanced products or services by us or our competitors; - the capital and expense budgeting decisions of our customers; - changes in the demand for our products due to the fact that many of our future customers are expected to be concentrated in early-stage industries, such as the Internet industry, and these customers are often capital constrained and have rapidly changing needs; and - the impact of possible acquisitions both on our operations and on our reported operating results due to associated accounting charges. VARIATIONS IN THE TIME IT TAKES US TO SELL OUR PRODUCTS MAY CAUSE FLUCTUATIONS IN OUR OPERATING RESULTS. Variations in the length of our sales cycles could cause our revenue to fluctuate widely from period to period. The period between our initial contact with a customer and the time when we recognize revenue from that customer varies widely in length. Our sales cycles typically range from three to nine months. For larger opportunities with new customers, these cycles can be longer. Additionally, due to the mission-critical nature of many deployments of our products, our customers may take a long time to evaluate our products, and many individuals may be involved in the evaluation process. In addition, many of our customers purchase our real-time infrastructure software as part of a large-scale information technology project, which includes the purchase of many products from a number of vendors. Changes in the scheduling of these projects, or delays or problems caused by other vendors or their products, may cause unexpected delays in our sales cycles. THE REAL-TIME INFRASTRUCTURE SOFTWARE PRODUCTS MARKET IS IN AN EARLY STAGE OF DEVELOPMENT, AND THESE PRODUCTS, INCLUDING OUR SMARTSOCKETS AND SMARTMULTICAST SOFTWARE AND RELATED PRODUCTS, MAY NOT ACHIEVE MARKET ACCEPTANCE. The market for real-time infrastructure software products is relatively new and rapidly evolving, and there are a variety of infrastructure methods available. We do not know if customers in our target markets will widely adopt 16 17 and deploy real-time infrastructure software products such as our SmartSockets and SmartMulticast software and related products. If real-time infrastructure software products are not widely adopted by customers in our target markets, our revenue will not increase substantially, if at all. THE SUBSTANTIAL EXPENDITURES REQUIRED TO EDUCATE PROSPECTIVE CUSTOMERS AND DEVELOP MARKET ACCEPTANCE FOR OUR PRODUCTS MAY NEVER BE OFFSET BY FUTURE REVENUE. Due to the evolving nature of our market, we may have to devote substantial resources to educate prospective customers about the benefits of infrastructure software in general and our SmartSockets and SmartMulticast software and related products in particular. Our efforts to educate potential customers may not result in our products achieving market acceptance. In addition, many of these prospective customers have made significant investments in internally developed or custom systems and may incur significant costs in switching to third-party products such as ours. Our target customers may not choose our products for technical, cost, support, or other reasons. If the market for our products fails to grow or grows more slowly than we anticipate, these substantial expenditures may not be offset by incremental revenue. WE DERIVE MORE THAN 80% OF OUR TOTAL REVENUE FROM OUR SMARTSOCKETS PRODUCT LINE AND IF DEMAND FOR SMARTSOCKETS DECREASES OR DOES NOT INCREASE, OUR TOTAL REVENUE WILL NOT INCREASE AND MAY DECREASE. We currently derive more than 80% of our total revenue from licensing our SmartSockets software product line and providing related consulting and maintenance services. We expect to continue to derive a substantial portion of our revenue from these sources for the foreseeable future. Accordingly, our future operating results will depend on the demand for SmartSockets by future customers. If our competitors release products that are superior to SmartSockets in performance or price, SmartSockets is not widely accepted by the market, or we fail to enhance SmartSockets and introduce new versions in a timely manner, demand for this product may decrease or fail to increase. A decline in demand for SmartSockets or a failure of demand to increase, as a result of competition, technological change or other factors, would significantly and adversely affect our business, financial condition and operating results. IF WE DO NOT KEEP PACE WITH TECHNOLOGICAL CHANGE OR INDUSTRY STANDARDS, OUR PRODUCTS MAY NOT BE COMPETITIVE AND OUR REVENUE AND OPERATING RESULTS MAY SUFFER. Our industry is characterized by rapid technological change, frequent new product introductions and enhancements, and evolving customer demands and industry standards. Our products may not be competitive if we fail to introduce new products or product enhancements that meet new customer demands, support new standards, or integrate with new or upgraded versions of packaged applications. The development of new products is complex, and there can be no assurance that we will be able to complete development in a timely manner, or at all. There are currently no widely accepted standards in various technical areas of importance to us, including the areas of reliable multicast and business-quality messaging. There can be no assurance that the proposed standards we support will prevail or be widely adopted. We believe that we will need to continue to enhance our products and develop new products to keep pace with competitive and technological developments and evolving industry standards, and our failure to do so on a timely basis, or to achieve market acceptance for our products, would harm our revenue and operating results. FAILURE TO DEVELOP AND MAINTAIN KEY STRATEGIC RELATIONSHIPS COULD CAUSE US TO LOSE MARKET OPPORTUNITIES AND LIMIT OUR GROWTH. We believe that our success in penetrating our target markets depends in part upon our ability to develop and maintain strategic relationships with key original equipment manufacturers, systems integrators, distributors, and independent software vendors. Relationships with these parties are also important because they often influence a customer's decision on which infrastructure software will be used for a project. We believe these relationships will introduce our products to potential customers and provide us with insights into new technologies to which we may not otherwise have access. For example, a system integrator that is responsible for reengineering a network may be heavily involved in analyzing and ultimately selecting the infrastructure software to be used in the network. To date, we have informal working relationships with several system integrators, and formal agreements with only a limited number of system integrators. Some of our competitors have developed more strategic relationships than we have. We cannot be certain that we will be able to establish relationships with additional companies on a timely basis, or at all, or that these companies will devote adequate resources to embedding, promoting or selling our products. Potential conflicts between our direct sales force and third-party reselling efforts could also limit our 17 18 ability to develop additional key strategic relationships. If we fail to develop these strategic relationships, or if any of our current relationships with these types of organizations is terminated, we might lose important revenue opportunities and our growth might be limited. COMPETITION IN THE REAL-TIME INFRASTRUCTURE SOFTWARE MARKET IS INTENSE; MANY OF OUR COMPETITORS AND POTENTIAL COMPETITORS ARE MUCH LARGER THAN WE ARE AND HAVE SIGNIFICANTLY GREATER RESOURCES; WE MAY NOT BE ABLE TO COMPETE EFFECTIVELY. The market for our products is intensely competitive, relatively new, rapidly evolving and subject to rapid technological change. We believe that competition will become more intense in the future and may cause price reductions, reduced gross margins, and loss of market share, any one of which could significantly reduce our future revenue. We most often compete against Tibco Software, a provider of infrastructure software products and services. Other current and potential competitors include: EAI Vendors. We currently face competition from various enterprise application integration, or EAI, vendors that offer some of the features of our products in their technology. These EAI vendors include webMethods and Vitria. Infrastructure Software Providers. We face potential competition from various infrastructure software providers including IBM, Microsoft, and BEA. Currently, their products do not generally offer the performance and scalability of our infrastructure software and therefore do not directly compete with our products. In the future, infrastructure software providers may add functionality to their products that would enable them to compete directly with us. Operating System Software Vendors. Vendors of widely used operating system software, including Microsoft and Sun Microsystems, may integrate real-time infrastructure functionality into future versions of their operating system software or introduce directly competing infrastructure functionality. Microsoft has announced its intention to introduce products that may compete with some aspects of our product. If Microsoft or other vendors are able to incorporate infrastructure functionality successfully into future versions of their operating system software or introduce competing products, we may not be able to compete effectively and may not be able to obtain or may lose market share. IT Departments. We currently face competition from the information technology departments of potential customers which have developed or may develop systems that provide for some or all of the functionality of our SmartSockets and SmartMulticast software and related products. It is often difficult for us to sell our products to a potential customer that has already invested heavily in a system that our products are intended to replace. Many of our current and potential competitors have longer operating histories, significantly greater financial, technical, product development, and marketing resources, greater name recognition, and larger customer bases than we do. Historically, our expenditures on research and development have been limited due to resource constraints, and we will need to substantially increase our investment in research and development in the future. Our competitors may be able to develop products comparable or superior to those we offer, adapt more quickly than we do to new technologies, evolving industry trends or customer requirements, or devote greater resources to the development, promotion and sale of their products than we do. Many of our competitors also have well-established relationships with our existing and prospective customers as well as companies that have significant influence in the industry. For example, Tibco has a strategic relationship with Cisco Systems. Negotiating and maintaining favorable customer and strategic relationships is critical to our business, and our competitors may be able to negotiate strategic relationships on more favorable terms than we are able to negotiate. Furthermore, a number of these competitors may merge or form strategic relationships that would enable them to offer, or bring to market earlier, products or services that are superior to our own in terms of features, quality, pricing or other factors. We expect additional competition from other established and emerging companies. The industry in which we compete is rapidly evolving. We may not be able to compete effectively against current and potential competitors, especially those with significantly greater resources. 18 19 SOME OF OUR COMPETITORS HAVE SIGNIFICANTLY BROADER PRODUCT OFFERINGS, AND WE MAY NEED TO PARTNER WITH THIRD PARTIES TO PROVIDE A BROADER RANGE OF PRODUCTS AND SERVICES. Our customers often purchase our real-time infrastructure software as part of a large-scale information technology project requiring many products from many vendors. Many of our competitors offer extended product lines, and some customers may prefer to purchase products from vendors that are able to offer broader functionality than can be provided by our products alone as part of the customers' overall information technology project. For example, some of our competitors offer a larger number of "adaptors" that facilitate connecting their products with third-party applications, and some competitors have products that contain a software feature, known as "business logic," that facilitates the routing and delivery of information in a different manner than is used by our products. In order to compete more effectively, we may need to expand the breadth of our product offerings by partnering with companies offering complementary products. We may not be able to enter into relationships of this type, on reasonable terms or at all, and our failure to do so could adversely affect our ability to sell our products and services. IF WE FAIL TO PENETRATE KEY TARGET MARKETS, SUCH AS THE BUSINESS-TO-BUSINESS E-COMMERCE MARKET, OR IF THESE MARKETS FAIL TO GROW AS ANTICIPATED, OUR REVENUE GROWTH WILL BE IMPAIRED. We have recently devoted substantial resources to penetrating new target markets, including the market for Internet infrastructure software. If we fail to address the needs of these new markets, our revenue growth will be impaired. Historically, we have directed our sales and marketing efforts toward companies in the financial services, telecommunications and aerospace industries. To date, less than 10% of our revenue had been derived from customers in the Internet infrastructure market. This market is new and rapidly changing. Customers in this market and other potential new markets are likely to have different requirements than our current customers, and may require us to change our product design or features, sales methods, support capabilities or pricing policies. The costs of addressing these requirements, as well as the failure to do so, could be substantial and could adversely affect our operating results. Furthermore, because we have expended and will continue to allocate substantial resources toward providing Internet-based products and services, the growth of our business depends on the increased acceptance and use of the Internet as a medium for conducting e-commerce and demand for our products in Internet-based applications. The rapid growth of the Internet as a means for conducting business is a recent occurrence and may not continue at historical rates. If the use of the Internet and e-commerce does not grow as anticipated, the Internet infrastructure market may not offer the revenue opportunity we currently perceive. WE PLAN TO EXPAND OUR INTERNATIONAL OPERATIONS, AND THE SUCCESS OF OUR INTERNATIONAL EXPANSION IS SUBJECT TO SIGNIFICANT UNCERTAINTIES. Revenue from the sale of our products and services outside the United States accounted for 11% and 15% of our total revenue in the first six months of fiscal 2001 and in fiscal 2000, respectively. We believe that we must expand our international sales and distribution operations to be successful. In attempting to conduct and expand business internationally, we are exposed to various risks that could adversely affect our international operations and, consequently, our operating results, including: - difficulties and costs of staffing and managing international operations; - fluctuations in currency exchange rates; - unexpected changes in regulatory requirements, including imposition of currency exchange controls, applicable to our business or to the Internet; - difficulties and additional costs of tailoring our products to meet the demands of foreign markets; - political and economic instability; and - potentially reduced protection for intellectual property rights. 19 20 WE HAVE MADE AND MAY CONTINUE TO MAKE ACQUISITIONS, WHICH COULD PUT A STRAIN ON OUR RESOURCES, CAUSE DILUTION TO OUR STOCKHOLDERS, AND ADVERSELY AFFECT OUR FINANCIAL RESULTS. We have made and may continue to make acquisitions of other companies in order to expand our business and services. For example, in September 1999 we acquired the assets of GlobalCast, a provider of reliable multicast products and services. In addition, in March 2000, we acquired WhiteBarn, a provider of reliable multicast-related consulting services and developer of multicast technology. Integrating newly acquired organizations and technologies into our company could be expensive and time-consuming and may strain our resources. We may not be successful in integrating acquired businesses or technologies and may not achieve anticipated revenue and cost benefits. In addition, future acquisitions could result in potentially dilutive issuances of equity securities or the incurrence of debt, contingent liabilities or amortization expenses related to goodwill and other intangible assets, any of which could adversely affect our balance sheet or operating results. For example, in connection with the acquisition of substantially all of the assets of GlobalCast, we recorded approximately $2.7 million in goodwill and other intangibles, which will be amortized over a period of three to four years and, in connection with the acquisition of WhiteBarn, we recorded approximately $4.4 million in goodwill and other intangibles, which will be amortized over a period of two to three years. However, new FASB guidelines relating to accounting for goodwill could make our future acquisition-related charges less predictable in any given reporting period. On February 14, 2001, the FASB issued a limited revision of its Exposure Draft, "Business Combinations and Intangible Assets" that establishes a new standard for accounting for goodwill acquired in a business combination. It would continue to require recognition of goodwill as an asset but would not permit amortization of goodwill as currently required by APB Opinion No. 17, Intangible Assets. Under the proposed statement, goodwill would be separately tested for impairment using a fair-value-based approach when an event occurs indicating the potential for impairment. Any required goodwill impairment charges would be presented as a separate line item within the operating section of the income statement. The shift from an amortization approach to an impairment approach would apply to previously recorded goodwill as well as goodwill arising from acquisitions completed after the application of the new standard. If the standard is adopted as described above, our goodwill amortization charges would cease. However, it is possible that in the future, we would incur less frequent, but larger, impairment charges related to the goodwill already recorded as well as goodwill arising out of potential future acquisitions. Additionally, we cannot make any assurances that we will be able to identify future suitable acquisition candidates or, if we are able to identify suitable candidates, that we will be able to make these acquisitions on commercially reasonable terms or at all. THE GOODWILL AND OTHER INTANGIBLE ASSETS WE RECORDED AS A RESULT OF OUR ACQUISITIONS MAY BECOME IMPAIRED. We have acquired two companies since we were incorporated: GlobalCast Communications in September 1999, and WhiteBarn in March 2000, both of which were accounted for as purchase business combinations. In conjunction with these acquisitions, we recorded $7.1 million in goodwill and other intangible assets. As of March 31, 2001, our stock price had declined significantly since the respective valuation dates of the shares issued in connection with each acquisition. Subsequent to March 31, 2001, our stock price has continued to decline. Due to these changes, along with changes in the markets in which we compete and the United States and global economy, we have begun a process to determine whether the respective fair values of our goodwill and other intangible assets may be less than their respective carrying values. This process will include a detailed analysis of estimated cash flows that we expect to generate from future operations for purposes of determining whether an impairment of goodwill and other intangible assets has occurred. If, as a result of our detailed analysis and investigation, we determine that there has been an impairment of goodwill and other intangibles assets, the carrying value of these assets will be written down to their fair values as a charge against our operating results in the period that the determination is made. A significant impairment would harm our financial position and operating results if and when it is recorded. THE RAPID GROWTH OF OUR OPERATIONS COULD STRAIN OUR RESOURCES AND CAUSE OUR BUSINESS TO SUFFER. Our ability to successfully offer products and services and implement our business plan in a rapidly evolving market requires an effective planning and management process. Over the past 12 months, we have increased our headcount substantially. This growth may place a significant strain on our management systems, infrastructure, and other resources. We expect that we will need to continue to improve our financial and managerial controls, reporting systems and procedures. We will also need to expand, train, and manage our workforce worldwide. Furthermore, 20 21 we expect that we will be required to manage an increasing number of relationships with various customers and other third parties. If we do not manage our growth efficiently and effectively, it could adversely affect our business, operating results and financial condition. THE LOSS OF KEY MANAGEMENT PERSONNEL, ON WHOSE KNOWLEDGE, LEADERSHIP, AND TECHNICAL EXPERTISE WE RELY, WOULD ADVERSELY AFFECT OUR ABILITY TO EXECUTE OUR BUSINESS PLAN. Our success depends heavily upon the continued contributions of our key management personnel, whose knowledge, leadership, and technical expertise would be difficult to replace. In particular, we rely upon the leadership of Paul A. Larson, our President and Chief Executive Officer, and Thomas J. Laffey, our Chief Technical Officer. If we were to lose the services of any of our key personnel, the ability to execute our business plan would be adversely affected. All of our executive officers and key personnel are employees at-will. We have no employment contracts and maintain no key person insurance other than a very limited amount on Thomas J. Laffey and Paul A. Larson. IF WE ARE UNABLE TO HIRE, TRAIN, AND RETAIN SALES, MARKETING, ENGINEERING AND FINANCE PERSONNEL, OUR GROWTH WILL BE IMPAIRED. In order to grow our business successfully and maintain a high level of quality and service, we will need to recruit, retain, and motivate additional highly skilled sales, marketing, and engineering and finance personnel. If we are not able to hire, train, and retain a sufficient number of qualified employees, our growth will be impaired. In addition, as a company focused on the development of complex software products, we will need to recruit, retain and motivate software developers and engineers, systems architects and project managers of various experience levels in order to keep pace with technological change and develop products that meet the needs of rapidly evolving markets. Competition for skilled employees, particularly in the San Francisco Bay Area, is intense. We may have even greater difficulty recruiting potential employees now that we have completed our initial public offering if they perceive the equity component of our compensation package to be less valuable than prior to our initial public offering. Furthermore, new employees require training, take time to achieve full productivity, and, in light of the high rate of turnover for these employees, may be difficult to retain. OUR SOFTWARE PRODUCTS MAY HAVE UNKNOWN DEFECTS, WHICH COULD HARM OUR REPUTATION, DECREASE MARKET ACCEPTANCE OF OUR PRODUCTS, CAUSE US TO LOSE CUSTOMERS AND REVENUE, AND RESULT IN LIABILITY TO US. Our products were created using highly complex software, both internally developed and licensed from third parties. Highly complex software may contain errors or defects, particularly when first introduced or when new versions or enhancements are released. We may not discover software defects that affect our current or future products or enhancements until after they are sold. Any interruptions caused by unknown defects in our products could cause substantial damage to our customers' businesses and could damage our reputation, cause our customers to initiate product liability suits against us, increase our product development costs, divert our product development resources, cause us to lose revenue or delay market acceptance of our products. WE COULD RECEIVE NEGATIVE PUBLICITY AND SUFFER INJURY TO OUR REPUTATION IF WELL-KNOWN CUSTOMERS SUFFER SERVICE INTERRUPTIONS. Many of our customers, including financial exchanges, telecommunications companies and large-scale e-businesses, rely upon our infrastructure software to provide widely used and highly publicized services. If any of these customers were to suffer a service interruption, we could receive negative publicity and suffer injury to our reputation even if these interruptions were wholly unrelated to the performance of our products. The degree of this injury could be grossly disproportionate to the actual contribution of our products to the service interruption. OUR CUSTOMERS WILL NOT BE ABLE TO REALIZE THE FULL EFFICIENCY BENEFITS OF OUR INFRASTRUCTURE SOFTWARE UNLESS THE INTERNET IS ENHANCED TO ALLOW MULTICAST. As the volume of data transmitted across networks, particularly the Internet, increases, it may be increasingly important for infrastructure software to make efficient use of available network bandwidth. One of the potential competitive advantages of our infrastructure software is that it enables more efficient use of available network bandwidth. Our software achieves this benefit through an efficient implementation of publish-subscribe architecture and is capable of even greater efficiency using multicast technology. However, our customers will not be able to 21 22 realize the full efficiency benefits of our multicast capabilities over the Internet unless the Internet is enhanced to allow multicast. There can be no assurance that it will be. OUR PRODUCTS MAY INFRINGE THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, WHICH MAY CAUSE US TO BECOME SUBJECT TO EXPENSIVE LITIGATION, CAUSE US TO INCUR SUBSTANTIAL DAMAGES OR LICENSE FEES, OR PREVENT US FROM SELLING OUR PRODUCTS. We cannot be certain that our products do not and will not infringe issued patents or other intellectual property rights of others. Historically, patent applications in the United States have not been publicly disclosed until the patent is issued, and we may not be aware of filed patent applications that relate to our products or technology. If patents later issue on these applications, we may be liable for infringement. We may also be subject to legal proceedings and claims in the ordinary course of our business, including claims of alleged infringement of the patents, trademarks and other intellectual property rights of third parties by us or our licensees in connection with their use of our products. Intellectual property litigation is expensive and time-consuming, and could divert our management's attention away from operating our business. If we discovered that our products infringe the intellectual property rights of others, we would need to obtain licenses from these parties or substantially reengineer our products in order to avoid infringement. We might not be able to obtain the necessary licenses on acceptable terms or at all, or to reengineer our products successfully. Moreover, if we are sued for infringement and lose the suit, we could be required to pay substantial damages or enjoined from licensing or using the infringing products or technology. Any of the foregoing could cause us to incur significant costs and prevent us from selling our products. OUR INTELLECTUAL PROPERTY COULD BE USED BY OTHERS WITHOUT OUR CONSENT. We rely primarily on a combination of copyrights, trademarks, trade secret laws, and contractual obligations with employees and third parties to protect our proprietary rights. We do not currently own any issued patents, and other protection of our intellectual property will not prevent third parties from independently developing technology that is similar to or competes with our own. Moreover, despite our efforts to protect our proprietary rights, unauthorized parties may copy aspects of our products and obtain and use information that we regard as proprietary. In addition, other parties may breach confidentiality agreements or other protective contracts into which we have entered, and we may not be able to enforce our rights in the event of these breaches. Furthermore, we expect that we will increase our international operations in the future, and the laws of many foreign countries do not protect our intellectual property rights to the same extent as the laws of the United States. OUR STOCK PRICE AND THOSE OF OTHER TECHNOLOGY COMPANIES HAVE EXPERIENCED EXTREME PRICE AND VOLUME FLUCTUATIONS, AND ACCORDINGLY OUR STOCK PRICE MAY BE VOLATILE, WHICH COULD ADVERSELY AFFECT YOUR INVESTMENT. The trading price of our common stock has fluctuated significantly since our initial public offering in July 2000 and is significantly below the original offering price of $16 per share. An active public market for our common stock may not be sustained in the future. Many factors could cause the market price of our common stock to rise and fall, including: - variations in our quarterly results; - announcements of technological innovations by us or by our competitors; - introductions of new products or new pricing policies by us or by our competitors; - acquisitions or strategic alliances by us or by our competitors; - recruitment or departure of key personnel; - the gain or loss of significant orders or 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. 22 23 In addition, stocks of technology and Internet-related companies have experienced extreme price and volume fluctuations that often have been unrelated or disproportionate to these companies' operating performance. Public announcements by companies in our industry concerning, among other things, their performance, accounting practices or legal problems could cause fluctuations in the market for stocks of these companies. These fluctuations could lower 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 management's attention and resources, which could harm our operating results and our business. OUR OFFICERS, DIRECTORS, AND AFFILIATED ENTITIES OWN A LARGE PERCENTAGE OF OUR COMPANY AND COULD SIGNIFICANTLY INFLUENCE THE OUTCOME OF ACTIONS IN WAYS THAT COULD ADVERSELY IMPACT OUR STOCK PRICE. As of March 31, 2001, our executive officers, directors, entities affiliated with them and other five percent stockholders, in the aggregate, beneficially owned approximately 46% of our outstanding common stock. These stockholders, acting together, would be able to significantly influence all matters requiring approval by our stockholders, including the election of directors. These actions might be taken even if they are opposed by other stockholders. This concentration of ownership may also have the effect of delaying or preventing a change of control of our company, which could have a material adverse effect on our stock price. SUBSTANTIAL FUTURE SALES OF OUR COMMON STOCK COULD ADVERSELY AFFECT MARKET PRICES FOR OUR COMMON STOCK. The market price of our common stock could decline as a result of sales of a large number of shares of our common stock in the market or the perception that these sales could occur. As of April 15, 2001, we had outstanding [18,969,149] shares of common stock. Of these shares, the 4,200,000 shares sold in our initial public offering are freely tradeable except for any shares purchased by our "affiliates" as defined in Rule 144 under the Securities Act of 1933. 14,755,880 of the remaining shares of common stock held by our stockholders prior to our initial public offering were subject to 180-day "lock-up" agreements with the underwriters or with us. The 180-day lock-up period ended on January 16, 2001, and pursuant to Rule 144, 12,283,383 of these shares were immediately subject to sale in the public market without registration subject to volume limitations. The remaining shares held by our existing stockholders will become available for sale pursuant to Rule 144 at varying times. Stockholders owning 9,193,831 shares are entitled, pursuant to contractual provisions providing for registration rights, to require us to register our securities owned by them for public sale. In addition, as of March 31, 2001, we had 3,055,661 shares issuable under outstanding options and warrants, 728,217 of which were exercisable. On July 21, 2000, we filed a registration statement to register for resale, subject to the terms of the lock-up agreements, shares issuable upon the exercise of outstanding stock options and shares reserved for future issuance under our stock option and stock purchase plans. OUR CERTIFICATE OF INCORPORATION, BYLAWS AND DELAWARE LAW CONTAIN PROVISIONS THAT COULD DISCOURAGE OR PREVENT A TAKEOVER, EVEN IF AN ACQUISITION WOULD BE BENEFICIAL TO OUR STOCKHOLDERS. Provisions of our Amended and Restated Certificate of Incorporation and Bylaws, as well as provisions of Delaware law, could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include: - establishing a classified board of directors requiring that not all members of the board may be elected at one time; - providing that directors may only be removed "for cause" and only with the approval of 66 2/3% of our stockholders; - authorizing the issuance of "blank check" preferred stock that could be issued by our board of directors to increase the number of outstanding shares and thwart a takeover attempt; - limiting the ability of our stockholders to call special meetings of stockholders; - prohibiting stockholder action by written consent, which requires all stockholder actions to be taken at a meeting of our stockholders; 23 24 - eliminating cumulative voting in the election of directors; and - establishing advance notice requirements for nominations, election to the board of directors or for proposing matters that can be acted upon by stockholders at stockholder meetings. In addition, Section 203 of the Delaware General Corporation Law and the terms of our stock option plans may discourage, delay, or prevent a change in control. 24 25 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK The following discusses our exposure to market risk related to changes in interest rates, equity prices and foreign currency exchange rates. This discussion contains forward-looking statements that are subject to risks and uncertainties. Actual results could vary materially as a result of a number of factors including those set forth in the section entitled "Factors That May Affect Operating Results". Foreign Currency Exchange Rate 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 future product license and services revenue may also be derived 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 various currencies in relation to the U.S. dollar. Furthermore, to the extent that we engage in international sales denominated in U.S. dollars, an increase in the value of the U.S. dollar relative to foreign currencies could make our products less competitive in international markets. 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. Interest Rate Risk As of March 31, 2001, we had cash and highly liquid short-term investments totaling $58.4 million. Declines in interest rates will reduce our interest income from our short-term investments. Based upon our balance of cash and short-term investments at March 31, 2001, a decrease in interest rates of 0.5% would cause a corresponding decrease in our annual interest income of $292,000. As of March 31, 2001, we did not have any short-term or long-term debt outstanding. 25 26 PART II: OTHER INFORMATION ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS Our Registration Statement on Form S-1 (File No. 333-34694) related to our initial public offering was declared effective by the SEC on July 20, 2000. A total of 4,200,000 shares of our common stock was registered with the SEC with an aggregate registered offering price of $67.2 million, all of which shares were registered on our behalf. The offering commenced on July 21, 2000 and all shares of common stock being offered were sold for the aggregate registered offering price through a syndicate of underwriters managed by Lehman Brothers, Inc., SG Cowen Securities Corporation, Wit SoundView Corporation and Fidelity Capital Markets, a division of National Financial Services Corporation. We paid to the underwriters underwriting discounts and commissions totaling $4.7 million in connection with the offering. In addition, we incurred additional expenses of approximately $2.5 million in connection with the offering, which when added to the underwriting discounts and commissions paid by us amounts to total estimated expenses of $7.2 million. Thus, the net offering proceeds to us (after deducting underwriting discounts and commissions and offering expenses) were approximately $60 million. From the effective date of the registration statement through March 31, 2001, the proceeds from the offering have been used to fund $8.8 million of working capital and general corporate needs. In addition, we applied $35.2 million of the proceeds towards short-term investments, and $1.5 million of the proceeds towards purchase and installation of machinery and equipment. The remaining proceeds are held in cash and cash equivalents. No offering expenses were paid directly or indirectly to any of our directors or officers (or their associates), or persons owning ten percent (10%) or more of any class of our equity securities or to any other affiliates. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the Company's annual meeting of stockholders held on March 16, 2001 the following matters were approved by the stockholders. The total number of shares of common stock outstanding and entitled to vote at the meeting was 18,969,149.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K A. Exhibits None. B. Reports on Form 8-K None. 26 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. TALARIAN CORPORATION DATE: May 15, 2001 SIGNATURE: /s/ Paul A. Larson ------------------- ------------------ Paul A. Larson President and Chief Executive Officer (Duly Authorized Officer) DATE: May 15, 2001 SIGNATURE: /s/ Michael A. Morgan ------------------- --------------------- Michael A. Morgan Vice President, Finance and Administration and Chief Financial Officer (Principal Financial and Accounting Officer) 27

TALARIAN CORP 10-Q