<PAGE> 1
3,500,000 SHARES
[VISUAL NETWORKS LOGO]
COMMON STOCK
(PAR VALUE $.01 PER SHARE)
------------------------
All of the shares of Common Stock offered hereby are being sold by the
Company. Prior to this offering, there has been no public market for the Common
Stock. For factors considered in determining the initial public offering price,
see "Underwriting".
SEE "RISK FACTORS" BEGINNING ON PAGE 5 FOR CERTAIN CONSIDERATIONS RELEVANT
TO AN INVESTMENT IN THE COMMON STOCK.
The Common Stock has been approved for quotation on the Nasdaq National
Market under the symbol "VNWK".
------------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS
THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES
COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS.
ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
<TABLE>
<CAPTION>
INITIAL
PUBLIC
OFFERING UNDERWRITING PROCEEDS TO
PRICE DISCOUNT(1) COMPANY(2)
------------ ----------- ------------
<S> <C> <C> <C>
Per Share........................................... $12.50 $0.875 $11.625
Total (3)........................................... $43,750,000 $3,062,500 $40,687,500
</TABLE>
- ---------------
(1) The Company has agreed to indemnify the Underwriters against certain
liabilities, including liabilities under the Securities Act of 1933. See
"Underwriting".
(2) Before deducting estimated expenses of $750,000 payable by the Company.
(3) The Company has granted the Underwriters an option for 30 days to purchase
up to an additional 525,000 shares at the initial offering price per share,
less the underwriting discount, solely to cover over-allotments. If such
option is exercised in full, the total initial public offering price,
underwriting discount and proceeds to Company will be $50,312,500,
$3,521,875 and $46,790,625, respectively. See "Underwriting".
------------------------
The shares are offered severally by the Underwriters, as specified herein,
subject to receipt and acceptance by them and subject to their right to reject
any order in whole or in part. It is expected that certificates for the shares
will be ready for delivery in New York, New York, on or about February 11, 1998,
against payment therefor in immediately available funds.
GOLDMAN, SACHS & CO.
DEUTSCHE MORGAN GRENFELL
WESSELS, ARNOLD & HENDERSON
------------------------
The date of this Prospectus is February 5, 1998.
<PAGE> 2
[Communications Antenna.] [Photo of central office.]
HOW CAN WAN SERVICE PROVIDERS COST-EFFECTIVELY MEET
THE SERVICE LEVELS THAT SUBSCRIBERS DEMAND FOR
MISSION-CRITICAL COMPUTING APPLICATIONS?
[Photo of network support center.] [Photo of optical cables.]
[Visual Networks logo.]
The Company intends to furnish to its stockholders annual reports containing
audited financial statements and quarterly reports containing unaudited interim
financial information for the first three quarters of each fiscal year of the
Company.
------------------------
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK,
INCLUDING OVER-ALLOTMENT, STABILIZING AND SHORT-COVERING TRANSACTIONS IN SUCH
SECURITIES, AND THE IMPOSITION OF A PENALTY BID, IN CONNECTION WITH THE
OFFERING. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING."
------------------------
Visual Networks and Visual UpTime are registered trademarks of the Company.
This Prospectus contains other product names, trade names and trademarks of the
Company and of other organizations.
<PAGE> 3
VISUAL UPTIME, A WAN SERVICE LEVEL MANAGEMENT SYSTEM
Visual UpTime combines WAN access functionality with innovative software for
performance monitoring, troubleshooting and planning. These capabilities enable
WAN service providers to achieve the service levels required by their customers
and to lower the costs associated with statistically multiplexed services. The
system supports Frame Relay and IP/Internet Services.
Improving the service levels achievable with statistically multiplexed services
such as Frame Relay and IP/Internet results in:
- - Increased subscriber confidence in using such services for both host-centric
and distributed mission-critical computing applications.
- - Increased scaleability of service provider deployment models and achievable
economies of scale for the business (when the system is used as part of
network infrastructure).
<TABLE>
<CAPTION>
[Photo of ACE]
Instrumented WAN Access for
[Visual Networks logo.] [Photo of Troubleshooting every circuit.
[Photo of Monitoring screen.] screen.] [Photo of Planning screen.]
<S> <C> <C>
Monitoring: Troubleshooting: Planning:
Gain early insight into Rapidly and cost-effectively Accurately plan and engineer
performance degradation. provision WAN services and the network.
solve service level problems.
</TABLE>
[Graphic of globe depicting a Frame Relay and IP network across North America,
Europe, Asia and with Visual UpTime system comprised of "instrumented" WAN
access equipment and centralized system manager.]
<PAGE> 4
PROSPECTUS SUMMARY
The following summary is qualified in its entirety by the more detailed
information and Financial Statements and Notes thereto appearing elsewhere in
this Prospectus. Certain terms used in this Prospectus are defined in the
Glossary. Unless otherwise indicated, all information in this Prospectus assumes
no exercise of the over-allotment option granted to the Underwriters and the
conversion of the Company's convertible preferred stock (the "Convertible
Preferred Stock") into 10,605,735 shares of Common Stock upon the closing of the
offering. See "Description of Capital Stock" and "Underwriting".
THE COMPANY
Visual Networks, Inc. ("Visual" or the "Company") designs, manufactures and
sells wide-area-network ("WAN") service level management systems for
statistically multiplexed technologies such as Frame Relay and IP/Internet. The
Company's Visual UpTime system combines WAN access functionality with innovative
software for performance monitoring, troubleshooting and network planning.
Visual UpTime provides instrumentation for network performance measurement and
analysis that allows WAN service providers ("providers") to achieve the service
levels required by their customers ("subscribers") and to lower operating costs
associated with statistically multiplexed services. The availability of
performance monitoring and troubleshooting instrumentation also allows
subscribers to verify the service levels being supplied by their WAN provider
and monitor traffic traversing the WAN, a requirement for many subscribers
wishing to use statistically multiplexed services to carry mission-critical data
traffic. The Company believes Visual UpTime systems are deployed in
configurations managing as few as 3 circuits and as many as 1,000 circuits. The
system is currently designed to scale up to 3,000 circuits on a single managed
network.
The Company believes it is a worldwide leader in field deployment of WAN
service level management systems. The Company introduced Visual UpTime in the
summer of 1995 and has since shipped systems configured for deployment on over
17,000 WAN circuits in over 300 subscriber Frame Relay networks, including those
of ABN-AMRO Bank, Cargill, Inc., Delta Air Lines, Inc., EDS Electronic Commerce
Division ("EDS"), Federal Express Corporation ("FedEx"), Household
International, Inc., Marriott International, Inc. ("Marriott"), Reynolds Metals,
Inc. ("Reynolds")and Waste Management, Inc. For the year ended December 31,
1997, the Company had revenue of approximately $23.7 million.
Vertical Systems Group ("Vertical Systems"), a leading WAN industry
analyst, estimates that approximately 920,000 Frame Relay circuits will be
installed worldwide over the next three years. To take advantage of this
projected growth in the Frame Relay market, the Company has developed
relationships with major Frame Relay service providers such as AT&T Corp.
("AT&T"), Sprint/United Management Company ("Sprint"), MCI Telecommunications
Corp. ("MCI"), Ameritech Corp. ("Ameritech") and BellAtlantic Network
Integration, Inc. ("BellAtlantic"). The percentage of revenue attributable to
sales to providers, which either resell or lease the systems to subscribers,
increased from approximately 30% in the first quarter of 1997, to approximately
52% in the fourth quarter of 1997, with Sprint and AT&T accounting for 31% and
7%, respectively, of revenue for the year ended December 31, 1997.
The Company was incorporated in Maryland in August 1993 under the name
Avail Networks, Inc. and reincorporated in Delaware in December 1994 as Visual
Networks, Inc. The Company's principal executive offices are located at 2092
Gaither Road, Rockville, Maryland 20850, and its telephone number is (301)
296-2300.
3
<PAGE> 5
THE OFFERING
<TABLE>
<S> <C>
Common Stock offered by the Company............................ 3,500,000 shares
Common Stock to be outstanding after the offering.............. 17,061,439 shares(1)
Use of proceeds................................................ General corporate purposes.
See "Use of Proceeds".
Proposed Nasdaq National Market symbol......................... VNWK
</TABLE>
- ---------------
(1) Excludes 1,840,501 shares of Common Stock issuable upon exercise of options
outstanding at December 31, 1997, at a weighted average exercise price of
$2.18 per share. See "Capitalization" and "Management -- Stock Plans".
SUMMARY FINANCIAL INFORMATION
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
FOR THE PERIOD
FROM INCEPTION
(AUGUST 12, 1993) YEAR ENDED DECEMBER 31,
THROUGH --------------------------------------
DECEMBER 31, 1993 1994 1995 1996 1997
----------------- ----- ------- ------- -------
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue............................... $ -- $ -- $ 250 $ 6,335 $23,651
Gross profit.......................... -- -- 206 3,785 16,035
Loss from operations.................. (5) (222) (1,831) (7,058) (200)
Net loss.............................. $ (5) $(222) $(1,791) $(6,983) $ (152)
=============== ====== ======== ======== ========
Pro forma basic and diluted net loss
per common share(1)................. $ (0.01)
========
Pro forma weighted average common
shares outstanding(1)............... 14,223
========
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1997
--------------------------
PRO FORMA
ACTUAL AS ADJUSTED(2)
-------- --------------
<S> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents......................................... $ 8,693 $ 48,631
Working capital................................................... 2,037 41,975
Total assets...................................................... 16,366 56,304
Redeemable convertible preferred stock............................ 14,855 --
Total stockholders' equity........................................ (11,567) 43,226
</TABLE>
- ---------------
(1) See Notes 1, 4 and 5 of Notes to Financial Statements included elsewhere in
this Prospectus.
(2) As adjusted to reflect the conversion upon the closing of the offering of
all outstanding shares of Convertible Preferred Stock into 10,605,735
shares of Common Stock, the sale of Common Stock offered by the Company
hereby and the application of the estimated net proceeds therefrom.
4
<PAGE> 6
RISK FACTORS
In addition to the other information in this Prospectus, prospective
investors should consider carefully the following risk factors in evaluating the
Company and its business before purchasing Common Stock in the offering.
IMPLEMENTATION OF PROVIDER DEPLOYMENT MODEL; LENGTHY SALES CYCLE
To date, substantially all of the Company's sales of its products have been
attributable to sales to subscribers, and the Company expects that such sales
will continue to account for a significant portion of its revenue through at
least mid-1999. The Company is currently implementing a sales and marketing
strategy whereby sales of Visual UpTime will be made directly to providers,
which will deploy the systems as part of their network infrastructure ("provider
deployment model"). The Company anticipates that a significant portion of its
future revenue will be attributable to sales of Visual UpTime to these
providers. The Company's future performance will therefore be substantially
dependent on incorporation of Visual UpTime by providers into their service
offerings to subscribers. Providers have not typically offered solutions that
enable the subscriber to measure and test the WAN service levels offered by the
provider, and the Company could encounter resistance on the part of some
providers to offering these solutions. There can be no assurance that the
Company will be successful in persuading providers to adopt the provider
deployment model. The Company believes the success or failure of the provider
deployment model, and the timing of success, if achieved, will depend on a
number of factors over which the Company may have little or no control,
including: provider and subscriber acceptance of and satisfaction with the
Company's systems; the realization of operating cost efficiencies for providers
when service level management systems are deployed and the ability of the
Company to demonstrate such operational benefits; generation of demand for these
systems from subscribers and support for the systems within the providers' sales
forces; competitive dynamics between WAN service providers and the development
of the WAN services market overall; successful development by the Company of
systems and products which address the requirements for systems deployed as part
of a provider's infrastructure; the timing and successful completion of
integration development work by providers to incorporate the Company's service
level management functionality into their operational support systems; and the
absence of new technologies which make the Company's products and systems
obsolete before they can achieve broad acceptance. The failure of the Company's
products to become an accepted part of the providers' service offerings or a
slower than expected increase in the volume of sales by the Company to providers
would have a material adverse effect upon the Company's business, financial
condition and results of operations.
The Company expects that the provider deployment model will be
characterized by a lengthy sales cycle. The Company expects that sales of Visual
UpTime will require a substantial commitment of capital from providers, with the
attendant delays frequently associated with providers' internal procedures to
approve large capital expenditures and lengthy decision-making processes. The
sales cycle can also be expected to be subject to a number of significant risks,
including providers' budgetary constraints and technology assessment and other
internal acceptance reviews over which the Company has little or no control.
Sales of Visual UpTime generally involve significant testing by and education of
both providers and subscribers as well as a substantial commitment of the
Company's sales and marketing resources. As a result, the Company may expend
significant resources pursuing potential sales that will not be consummated.
Even if the provider deployment model is implemented, curtailment or termination
of provider purchasing programs, decreases in provider capital budgets or
reduction in the purchasing priority assigned to products such as Visual UpTime,
particularly if significant and unanticipated by the Company, could have a
material adverse effect on the Company's business, financial condition and
results of operations.
DEPENDENCE ON MAJOR CUSTOMERS
The Company is dependent on a small number of customers for a substantial
portion of its revenue. For the year ended December 31, 1996, sales of products
or services to Hewlett-Packard Company ("HP") and Sprint accounted for 13% and
10%, respectively, of the Company's revenue.
5
<PAGE> 7
For the year ended December 31, 1997, sales of products or services to Sprint,
FedEx and AT&T accounted for 31%, 11% and 7%, respectively, of the Company's
revenue, substantially all of which was attributable to sales to subscribers. If
the Company's evolution to the provider deployment model is successful, the
Company's customer base will consist predominantly of large public network
service providers. There are only a small number of these providers, and the
substantial capital requirements involved in the establishment of public
networks significantly limit additional entrants into this market. In addition,
the number of these providers may decrease if and as providers merge or acquire
one another. Accordingly, the loss of any provider customer, or the reduction,
delay or cancellation of orders or a delay in shipment of the Company's products
to any provider customer, could materially and adversely affect the Company's
business, financial condition and results of operations.
The Company's anticipated dependence on sizable orders from a limited
number of providers will make the relationship between the Company and each
provider critically important to the Company's business. As relationships evolve
over time, adjustments to product specifications, forecasts and delivery
timetables may be required in response to provider demands and expectations.
Further, because none of the Company's agreements contain minimum purchase
requirements, there can be no assurance the issuance of a purchase order will
result in significant repeat business. The inability of the Company to manage
its provider relationships successfully would have a material adverse effect on
the Company's business, financial condition and results of operations.
RISKS ASSOCIATED WITH RAPID TECHNOLOGICAL CHANGE; EMERGING SERVICES MARKET; NEW
PRODUCTS
Visual UpTime is the Company's only product and is focused on service level
management for WANs that utilize statistically multiplexed technologies.
Accordingly, the Company's future financial performance will depend in large
part on continued growth in the number of enterprises adopting solutions based
on Frame Relay, Asynchronous Transfer Mode ("ATM") and IP/Internet services. The
market for these services is characterized by rapid changes, including
continuing advances in technology, frequent new product introductions, changes
in customer requirements and preferences and changes in industry standards. The
introduction of new technologies or advances in techniques for statistically
multiplexed WAN services or the integration of WAN service level management
functionality into other network hardware components could render Visual UpTime
obsolete or unmarketable. Further, the Company will be required to make
enhancements and refinements to the product for wide scale implementation
through the provider deployment model. There can be no assurance that (i) Visual
UpTime will continue to compete successfully; (ii) the Company's future product
offerings will keep pace with the technological changes implemented by its
competitors; (iii) the Company's products will satisfy evolving industry
standards or preferences of existing or prospective customers; or (iv) the
Company will be successful in developing and marketing products for any future
technology. Failure to develop and introduce new products and product
enhancements in a timely fashion could have a material adverse effect on the
Company's business, financial condition and results of operations.
Because Visual UpTime is deployed predominantly on Frame Relay networks,
the Company's near-term success will depend on the continued market acceptance
of Frame Relay technology as a preferred networking solution. The failure of
Frame Relay-based services to maintain widespread market acceptance would have a
material adverse effect on the Company's business, financial condition and
results of operations. The Company is currently devoting significant resources
toward the development of additional products, including those based on ATM
technologies. There can be no assurance that the Company will complete
successfully the development of these or any future products in a timely
fashion, that the Company will successfully manage the transition from existing
products, that the Company's future products will achieve market acceptance, or
if market acceptance is achieved, that the Company will be able to maintain such
acceptance for a significant period of time. Any inability of the Company to
develop products on a timely basis that address changing customer needs and
technologies may result in a loss of market share to competitors or
6
<PAGE> 8
may require the Company to substantially increase development expenditures. Such
an increase in research and development expenditures may have a material effect
on the Company's business, financial condition and results of operations. There
also can be no assurance that products or technologies developed by others will
not adversely affect the Company's competitive position or render its products
or technologies noncompetitive or obsolete.
Products as complex as those offered by the Company may contain undetected
errors or failures when first introduced or as new versions are released. There
can be no assurance that, despite testing by the Company and by current and
potential customers, errors will not be found in new products after commencement
of commercial shipments. The occurrence of such errors could result in the loss
of or delay in market acceptance of the Company's products, diversion of
development resources, damage to the Company's reputation or increases in
service or warranty costs, any of which could have a material adverse effect
upon the Company's business, financial condition and results of operations.
INTENSE AND EVOLVING COMPETITION
The WAN equipment market is highly competitive. The Company faces
competition from participants in three distinct market segments: the WAN access
equipment market, the network test and analysis market and the market for
telecommunications support systems. Companies participating in these market
segments which compete or can be expected to compete with the Company include
ADC Telecommunications, Inc. ("ADC"), Adtran, Inc. ("Adtran"), Digital Link
Corp. ("Digital Link"), NetScout Systems, Inc. ("NetScout"), Network Associates,
Inc. ("Network Associates"), Paradyne Corporation ("Paradyne"), Sync Research,
Inc. ("Sync"), Hewlett-Packard Company ("HP") and Concord Communications, Inc.
("Concord").
The Company expects that it may experience price competition from products
and services that provide a portion of the functionality provided by Visual
UpTime. In particular, as prices for network equipment components such as data
service units/channel service units ("DSU/CSUs") decrease, customers may decide
to purchase these less expensive products even though they lack certain features
offered by the Company's products. The Company expects that, in some cases,
participants with strong capabilities in these various segments may partner with
each other to offer products that supply functionality approaching that provided
by Visual UpTime. The Company is aware of such an arrangement between Digital
Link and NetScout, who jointly offer a WAN service level product.
Many of the Company's current and possible competitors have greater
financial, technical, marketing and other resources than the Company, and some
have well established relationships with current and potential customers of the
Company. As a result, these competitors may be able to respond to new or
emerging technologies and changes in customer requirements more effectively than
the Company, or devote greater resources than the Company to the development,
promotion and sale of products. Increased competition may result in price
reductions, reduced profitability and loss of market share, any of which would
have a material adverse effect on the Company's business, financial condition
and results of operations.
POTENTIAL FLUCTUATIONS IN QUARTERLY OPERATING RESULTS
The Company's revenue and operating results may vary significantly from
quarter to quarter and from year to year as a result of a number of factors,
including the size and timing of orders, product mix and shipment of systems.
The timing of order placement, size of orders, satisfaction of contractual
customer acceptance criteria, as well as order delays or deferrals and shipment
delays and deferrals, may cause material fluctuations in revenue. Operating
results may also fluctuate on a quarterly basis based upon factors such as the
continued acceptance of Frame Relay-based products, demand for the Company's
current and future product offerings, the introduction of product enhancements
by the Company or its competitors, market acceptance of new products
7
<PAGE> 9
offered by the Company or its competitors and the size, timing, cancellation or
delay of customer orders, including cancellation or delay in anticipation of new
product offerings. The Company's quarterly operating results are also affected
by the budgeting cycles of customers, the relative percentages of products sold
through the Company's direct and indirect sales channels, product pricing and
competitive conditions in the industry. Any unfavorable changes in these or
other factors could have a material adverse effect on the Company's business,
financial condition and results of operations. Accordingly, the Company believes
that period-to-period comparisons of its results of operations may not be
meaningful and should not be relied upon as an indication of future performance.
Furthermore, there can be no assurance that the Company will be able to sustain
profitability on a quarterly or annual basis. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations".
HISTORY OF LOSSES AND ACCUMULATED DEFICIT
The Company was organized in 1993 and introduced Visual UpTime in mid-1995.
Accordingly, the Company has only a limited operating history upon which an
evaluation of the Company, its product and prospects can be based. As of
December 31, 1997, the Company had an accumulated deficit of approximately $11.9
million. The Company incurred losses from operations for the years ended
December 31, 1995, 1996 and 1997, of approximately $1.8 million, $7.1 million
and $0.2 million, respectively. These losses resulted primarily from
expenditures associated with the development and marketing of the Company's
products. While the Company reported net income for the three month periods
ended June 30, 1997, September 30, 1997 and December 31, 1997, there can be no
assurance that the Company will sustain or again achieve profitability. See
"Selected Financial Data" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations".
There can be no assurance that the Company's revenue will grow or be
sustained in future periods. Although the Company has recently experienced an
increase in revenue from providers, such growth should not be considered
indicative of future revenue growth, if any, or of future operating results. The
Company's revenue in any period depends primarily on the volume and timing of
orders received during the period, which are difficult to predict. The Company's
expense levels are based, in part, on its expectation of future revenue. If
revenue levels are below expectations due to delays associated with customers'
decision-making processes or for any other reason, operating results are likely
to be materially and adversely affected. Net income may be affected
disproportionately by a reduction in revenue because a large portion of the
Company's expenses are fixed and cannot be easily reduced without adversely
affecting the Company's business. In addition, the Company currently intends to
increase its funding of research and product development, increase its sales and
marketing and customer support operations and expand distribution channels. To
the extent such expenses precede or are not promptly followed by increased
revenue, the Company's business, financial condition and results of operations
could be materially and adversely affected. For the foregoing reasons, there can
be no assurance that the Company will be profitable in any future period, and
recent operating results should not be considered indicative of future financial
performance. See "Selected Financial Data" and "Management's Discussion and
Analysis of Financial Condition and Results of Operations".
DEPENDENCE ON SOLE AND LIMITED SOURCE SUPPLIERS AND FLUCTUATIONS IN COMPONENT
PRICING
Certain key components used in the manufacture of Visual UpTime are
currently purchased only from sole, single or limited sources. At present,
sole-source components, where the Company has identified no other supplier for
the components, include T-1 framers, certain semiconductors, embedded
communications processors and line interface components. While alternative
suppliers have been identified for certain key components, those alternative
sources have not been qualified by the Company. The qualification process could
be lengthy and no assurance can be given that any additional sources would
become available to the Company on a timely basis, or, if such sources
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<PAGE> 10
were to become available, that the Company would not experience a degradation in
the quality of components provided by such new suppliers. The Company generally
does not have long-term agreements with its suppliers that guarantee the
continuity of supply for sole, single or limited source components or that
provide protection against sudden increases in component prices. The Company has
from time to time experienced minor delays in the receipt of key components, and
any future difficulty in obtaining sufficient and timely delivery of them could
result in delays or reductions in product shipments, which, in turn, could have
a material adverse effect on the Company's business, financial condition and
results of operations. In the event any significant supplier becomes unable or
unwilling to continue to supply required components for the Company's products,
the Company would have to identify and qualify acceptable replacements. In
addition, although the Company's sole or limited source suppliers are all based
in the United States, some of them may manufacture components, or acquire
components from, outside of the United States. If events in a country where a
key component is produced reduce or eliminate the supply of such component, and
the Company's supplier is unable to obtain the component from another country,
the Company would have to identify and qualify acceptable replacements. Any
interruption in the supply of required or key components, or the inability of
the Company to procure these components from alternate sources at acceptable
prices and within a reasonable time, could have a material adverse effect upon
the Company's business, financial condition and results of operations. In the
event of significant increases in the cost of components, the Company would be
forced either to increase the price of its products or accept lower profit
margins. In particular, certain of Visual UpTime's key components, including
dynamic random access memories ("DRAMs") and embedded communications processors,
are subject to fluctuations in pricing. An increase in prices for the Company's
products resulting from such component price fluctuations would make the
Company's products less competitive with products which do not incorporate such
components. Lower margins or less competitive product pricing could have a
material adverse effect on the Company's business, financial condition and
results of operations.
MANAGEMENT OF CHANGE AND EXPANSION
Since its inception, the Company has experienced rapid and significant
growth, including a significant increase in its number of employees. This growth
and changes in the Company's operations have placed significant demands on the
Company's administrative, operational, technical and financial resources. To
compete effectively, and to manage future growth, if any, the Company must
continue to strengthen its operational, financial and management information
reporting systems, controls and procedures on a timely basis and expand, train
and manage its work force. There can be no assurance that the Company will be
able to take such actions successfully. The failure of the Company's management
team to effectively manage growth could have a material adverse effect on the
Company's business, financial condition and results of operations.
DEPENDENCE ON KEY PERSONNEL
The Company's success depends to a significant degree upon the continuing
contributions of its key management and technical employees, particularly Scott
E. Stouffer, Chairman, President and Chief Executive Officer. The loss of the
services of any key employee would adversely affect the Company's business,
financial condition and results of operations. The Company maintains, and is the
beneficiary under, $2.0 million of key person life insurance on Mr. Stouffer.
The Company believes that its future success will depend in large part upon its
ability to attract and retain highly-skilled managerial, sales, marketing,
customer support and product development personnel. The Company requires sales
consultants and product development personnel who are highly technically trained
in the field of telecommunications, and the competition for such individuals is
intense. The Company has at times experienced, and continues to experience,
difficulty in recruiting qualified personnel. There can be no assurance that the
Company will be successful in retaining its key employees or that it can attract
or retain additional skilled personnel as required. Failure to attract
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<PAGE> 11
and retain key personnel would have a material adverse effect on the Company's
business, financial condition and results of operations.
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
As the number of products in the network management industry increases and
the functionality of these products further overlaps, companies may increasingly
become subject to claims of infringement or misappropriation of the intellectual
property or proprietary rights of others. There can be no assurance that third
parties will not assert infringement or misappropriation claims against the
Company in the future with respect to current or future products, or that any
such assertion will not require the Company to enter into royalty arrangements
or litigation that would be costly to the Company. Any claims or litigation,
with or without merit, could result in a diversion of management's attention and
the Company's financial resources, which could have a material adverse effect on
the Company's business, financial condition and results of operations. Adverse
determinations in such claims or litigation could also have a material adverse
effect on the Company's business, financial condition and results of operations.
While the Company believes that its success will depend principally upon
its ability to develop and effectively market products that meet the
requirements of customers for service level management functionality, its
ability to compete is also dependent in part upon its proprietary technology and
rights. The Company holds one patent and also relies on copyright and trade
secret laws, trademarks, confidentiality procedures and contractual provisions
to protect its proprietary software, documentation and other proprietary
information. There can be no assurance that the confidentiality agreements and
other methods on which the Company relies to protect its trade secrets and
proprietary information and rights will be adequate to prevent competitors from
developing similar technology. Moreover, in the absence of patent protection,
the Company's business may be adversely affected by competitors that develop
functionally equivalent technology. Furthermore, the Company may be subject to
additional risk as it enters into transactions in countries where intellectual
property laws are not well developed or enforced effectively. Legal protection
of the Company's rights may be ineffective in such countries, and technology
developed or used in such countries may not be protectable in jurisdictions
where protection is ordinarily available. Litigation to defend and enforce the
Company's intellectual property rights, regardless of the final outcome of such
litigation, could result in substantial costs and diversion of resources and
could have a material adverse effect on the Company's business, financial
condition and results of operations. There can also be no assurance that the
Company's trade secrets or non-disclosure agreements will provide meaningful
protection of the Company's proprietary information. The Company's inability to
protect its proprietary rights would have a material adverse effect on the
Company's business, financial condition and results of operations.
CONTROL BY DIRECTORS AND OFFICERS
The Company's officers, directors and their affiliates will, in the
aggregate, beneficially own approximately 51.0% of the Company's outstanding
Common Stock after the offering. As a result, these stockholders, if acting
together, would be able effectively to control substantially all matters
requiring approval by the stockholders of the Company, including the election of
directors. This ability may have the effect of delaying or preventing a change
in control of the Company, or causing a change in control of the company which
may not be favored by the Company's other stockholders. See "Management" and
"Principal Stockholders".
NO PRIOR PUBLIC MARKET; VOLATILITY OF STOCK PRICE
Prior to the offering, there has been no public market for the Common Stock
of the Company. The initial public offering price has been determined through
negotiations among the Company and the Representatives of the Underwriters. See
"Underwriting" for a discussion of the factors considered in determining the
initial public offering price. There can be no assurance that an active
10
<PAGE> 12
public market will develop or be sustained after the offering or that the market
price of the Common Stock will not decline below the public offering price.
Future announcements concerning the Company or its competitors, quarterly
fluctuations in operating results, announcements of technological innovations,
the introduction of new products or changes in product pricing policies by the
Company or its competitors, proprietary rights or changes in earnings estimates
by analysts could cause the market price of the Common Stock to fluctuate
substantially. In addition, stock prices for many technology companies fluctuate
widely for reasons which may be unrelated to operating results. Such
fluctuations in the Company's market price of the Common Stock may affect the
visibility and credibility of the Company in its markets. Although the Company
has no current plans for acquisitions, fluctuations in the market price could
affect the Company's ability to use stock for acquisitions. These fluctuations,
as well as general economic, political and market conditions such as recessions,
international instabilities or military conflicts, may materially and adversely
affect the market price of the Common Stock.
IMMEDIATE AND SUBSTANTIAL DILUTION
Purchasers of the Common Stock offered hereby will suffer immediate and
substantial dilution of $9.97 per share in the net tangible book value of the
Common Stock from the initial public offering price. To the extent outstanding
options to purchase the Company's Common Stock are exercised, there will be
further dilution. See "Dilution".
BENEFITS OF THE OFFERING TO EXISTING STOCKHOLDERS
After the offering, it is expected that a public market will exist for the
Common Stock. There will be a substantial increase in the market value of the
shares of Common Stock held by management and existing stockholders over their
original purchase price. As of December 31, 1997, the directors, officers, key
employees and 5% stockholders of the Company held an aggregate of 10.9 million
shares of Common Stock having an aggregate original purchase price of
approximately $9.8 million and a market value of $136.0 million. As of December
31, 1997, the stockholders held an aggregate of 13.6 million shares of Common
Stock having an aggregate original purchase price of $12.5 million and a market
value of $169.5 million. See "Dilution," "Management" and "Principal
Stockholders".
ANTITAKEOVER CONSIDERATIONS
Following the offering, the Company's Board of Directors will have the
authority to issue up to 5,000,000 shares of preferred stock ("Preferred Stock")
and to determine the price, rights, preferences, privileges and restrictions,
including voting rights, of those shares without any further vote or action by
the stockholders. The rights of the holders of Common Stock will be subject to,
and may be adversely affected by, the rights of the holders of any Preferred
Stock that may be issued in the future. See "Description of Capital
Stock -- Preferred Stock". The issuance of Preferred Stock could have the effect
of making it more difficult for a third party to acquire a majority of the
outstanding voting stock of the Company. Furthermore, certain provisions of the
Company's Certificate of Incorporation and Bylaws and of Delaware law could
delay or make more difficult a merger, tender offer or proxy contest involving
the Company. The Company is subject to the anti-takeover provisions of Section
203 of the Delaware General Corporation Law. In general, the statute prohibits a
publicly held Delaware corporation from engaging in a "business combination"
with an "interested stockholder" for a period of three years after the date of
the transaction in which the person became an interested stockholder, unless the
business combination is approved in a prescribed manner.
The Company's Certificate of Incorporation contains other provisions that
may have the effect of delaying or preventing a change in control of the
Company, including a classified Board of
11
<PAGE> 13
Directors and a limitation on stockholder action by written consent. See
"Description of Capital Stock -- Delaware Law and Certain Charter Provisions".
In addition, the Company's credit facility with Silicon Valley Bank prohibits
the Company from engaging in a merger with or being acquired by another entity
without the Bank's consent.
DISCRETIONARY USE OF PROCEEDS
The net proceeds to the Company from the offering, estimated at $39.9
million, will be used for general corporate purposes and have not been
designated for any particular purpose. Accordingly, the Company will have broad
discretion as to the application of such proceeds. See "Use of Proceeds".
SHARES ELIGIBLE FOR FUTURE SALE
Sales of a substantial number of shares of Common Stock after the offering
could adversely affect the market price for the Common Stock and could impair
the Company's ability to raise capital through the sale of equity securities.
The 3,500,000 shares of Common Stock offered hereby will be freely tradable
without restriction in the public market as of the date of this Prospectus
except as described in "Underwriting". Approximately 3,437,864 shares will be
eligible for immediate sale in the public market pursuant to Rule 144(k) under
the Securities Act of 1933, as amended (the "Securities Act"), all of which are
subject to lock-up agreements. Within 90 days after the date of this Prospectus,
approximately 10,095,575 shares will become eligible for sale in the public
market, subject in some cases to the volume and other restrictions of Rule 144.
Of these shares, 10,065,950 shares are subject to lock-up agreements. Shares
covered by these lock-up agreements are subject to restrictions on resale in the
public market for a period of 180 days following the date of this Prospectus,
subject to release, at the discretion of the Representatives of the
Underwriters. Upon the expiration of the lock-up period, approximately
14,073,454 shares, which includes options exercisable for approximately 541,640
shares, will become eligible for sale in the public market subject in some cases
to the volume and other restrictions of Rule 144. The holders of 10,605,735
shares of Common Stock are entitled to certain registration rights with respect
to such shares under the Securities Act. In addition, the Company intends to
file a registration statement under the Securities Act promptly following the
effective date of this Registration Statement to register all of the shares of
Common Stock issued or reserved for issuance upon the exercise of options issued
or that may be issued under the Company's 1994 Stock Option Plan, 1997 Omnibus
Stock Plan and the 1997 Directors' Stock Option Plan. As of December 31, 1997,
there were outstanding options for the purchase of 1,840,501 shares, of which
options for approximately 334,814 shares were vested. See "Management -- Stock
Plans", "Underwriting" and "Shares Eligible for Future Sale".
12
<PAGE> 14
USE OF PROCEEDS
The principal purposes of the offering are to increase the Company's
working capital and equity base, create a public market for the Company's Common
Stock, facilitate future access to public capital markets and provide increased
visibility and credibility for the Company in its marketplace. The net proceeds
to the Company from the sale of the 3,500,000 shares of Common Stock offered by
the Company hereby are estimated to be $39.9 million ($46.0 million if the
Underwriters' over-allotment option is exercised in full).
The Company has no current plans for the net proceeds of the offering. The
Company intends to add the net proceeds from the offering to working capital,
where such proceeds will be available to support general corporate purposes
which are expected to include capital equipment expenditures to support selling
and marketing, manufacturing and product development activities. A portion of
the proceeds may also be used to acquire or invest in complementary businesses
or products or to obtain the right to use complementary technologies. From time
to time, in the ordinary course of business, the Company evaluates potential
acquisitions of such businesses, products or technologies. However, the Company
has no present understandings, commitments or agreements with respect to any
material acquisition of other businesses, products or technologies. Pending use
of the net proceeds for any purposes, the Company intends to invest such funds
in short-term, interest-bearing, investment grade obligations.
DIVIDEND POLICY
The Company has never paid or declared any cash dividends on its Common
Stock. It is the present policy of the Company to retain earnings to finance the
growth and development of the business and, therefore, the Company does not
anticipate declaring or paying cash dividends on its Common Stock in the
foreseeable future. In addition, the Company's credit facility with Silicon
Valley Bank prohibits the Company from paying cash dividends without the Bank's
consent. See Note 2 of Notes to Financial Statements.
13
<PAGE> 15
CAPITALIZATION
The following table sets forth the capitalization of the Company as of
December 31, 1997, (i) on an actual basis and (ii) as adjusted to reflect the
conversion of all outstanding shares of Convertible Preferred Stock into
10,605,735 shares of Common Stock upon the closing of the offering and the sale
of 3,500,000 shares of Common Stock offered by the Company hereby and the
application of the estimated net proceeds therefrom. This table should be read
in conjunction with the Company's Financial Statements and Notes thereto
appearing elsewhere in this Prospectus.
<TABLE>
<CAPTION>
DECEMBER 31, 1997
-----------------------
ACTUAL AS ADJUSTED
-------- -----------
(IN THOUSANDS)
<S> <C> <C>
Long-term debt....................................................... $ 256 $ 256
Redeemable convertible cumulative preferred stock, $.01 par value;
7,229,438 shares authorized, 7,228,473 shares issued and
outstanding (actual); no shares issued and outstanding (as
adjusted) (1)...................................................... 14,855 --
Stockholders' equity (deficit):
Preferred stock, $.01 par value; 5,000,000 shares authorized, no
shares issued and outstanding (actual and as adjusted) (1)..... -- --
Series A convertible cumulative preferred stock, $.01 par value;
347,070 shares authorized, 347,070 shares issued and
outstanding (actual); no shares issued and outstanding (as
adjusted) (1).................................................. 3 --
Common Stock, $.01 par value; 50,000,000 shares authorized,
2,955,704 shares issued and outstanding (actual); 17,061,439
shares issued and outstanding (as adjusted) (2)................ 29 170
Deferred compensation........................................... (247) (247)
Additional paid-in capital...................................... 528 55,183
Accumulated deficit............................................. (11,880) (11,880)
-------- ----------
Total stockholders' equity (deficit)................................. (11,567) 43,226
-------- ----------
Total capitalization................................................. $ 3,544 $ 43,482
========= ==========
</TABLE>
- ---------------
(1) See Note 3 of Notes to Financial Statements.
(2) Excludes 3,275,000 shares of Common Stock reserved for issuance under the
Company's 1994 Stock Option Plan, 1997 Omnibus Stock Plan and 1997
Directors' Stock Option Plan, under which options to purchase 1,840,501
shares at a weighted average exercise price of $2.18 were outstanding as of
December 31, 1997. See "Management -- Stock Plans" and Note 5 of Notes to
Financial Statements.
14
<PAGE> 16
DILUTION
The pro forma net tangible book value of the Company as of December 31,
1997, was approximately $3.3 million, or approximately $0.24 per share of Common
Stock. Pro forma net tangible book value per share represents the amount of the
Company's pro forma stockholders' equity, less intangible assets, divided by
13,561,439 pro forma shares of Common Stock outstanding as of December 31, 1997.
The preceding pro forma information gives effect to the conversion of the
Company's Convertible Preferred Stock into 10,605,735 shares of Common Stock.
After giving effect to the sale by the Company of 3,500,000 shares of Common
Stock offered hereby and receipt of the estimated net proceeds therefrom, the
pro forma adjusted net tangible book value of the Company as of December 31,
1997 would have been approximately $43.2 million, or $2.53 per share. This
represents an immediate increase in such net tangible book value of $2.29 per
share to existing stockholders and an immediate dilution of $9.97 per share to
new investors. The following table illustrates this per share dilution:
<TABLE>
<S> <C> <C>
Initial public offering price........................................... $ 12.50
-------
Pro forma net tangible book value per share as of December 31, 1997... $ 0.24
Increase per share of Common Stock attributable to the offering....... 2.29
------
Pro forma net tangible book value per share after the offering.......... 2.53
-------
Net tangible book value dilution per share to new investors............. $ 9.97
=======
</TABLE>
The following table summarizes on a pro forma basis as of December 31,
1997, the total number of shares of Common Stock purchased from the Company, the
total consideration paid to the Company and the average price per share paid by
existing stockholders and the new investors:
<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION AVERAGE
--------------------- ---------------------- PRICE PER
NUMBER PERCENT AMOUNT PERCENT SHARE
---------- ------- ----------- ------- ---------
<S> <C> <C> <C> <C> <C>
Existing stockholders(1)........ 13,561,439 79.5% $12,484,143 22.2% $ 0.92
New investors................... 3,500,000 20.5 43,750,000 77.8 12.50
---------- ------ ----------- ------
Total........................... 17,061,439 100.0% $56,234,143 100.0%
========== ====== =========== ======
</TABLE>
- ---------------
(1) Excludes 3,275,000 shares of Common Stock reserved for issuance under the
Company's 1994 Stock Option Plan, 1997 Omnibus Stock Plan and 1997
Directors' Stock Option Plan under which options to purchase 1,840,501
shares at a weighted average exercise price of $2.18 were outstanding as of
December 31, 1997. See "Management -- Stock Plans" and Note 5 of Notes to
Financial Statements.
15
<PAGE> 17
SELECTED FINANCIAL DATA
The selected financial data below should be read in conjunction with
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and the financial statements, notes thereto and other financial
information included elsewhere in this Prospectus. The selected financial data
as of and for the years ended December 31, 1995, 1996 and 1997, are derived from
financial statements of the Company which have been audited by Arthur Andersen
LLP, independent public accountants. See "Experts". The selected financial data
for the period from inception to December 31, 1993 and for the year ended
December 31, 1994 are derived from audited financial statements not included in
this Prospectus.
<TABLE>
<CAPTION>
FOR THE PERIOD
FROM
INCEPTION
(AUGUST 12, 1993) YEAR ENDED DECEMBER 31,
THROUGH -------------------------------------------
DECEMBER 31, 1993 1994 1995 1996 1997
----------------- ------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue....................................... $ -- $ -- $ 250 $ 6,335 $23,651
Cost of goods sold............................ -- -- 44 2,550 7,616
------- ------- ------- ------- -------
Gross profit................................ -- -- 206 3,785 16,035
------- ------- ------- ------- -------
Operating expenses:
Research and development.................... -- 163 994 2,988 4,253
Sales and marketing......................... -- -- 700 6,386 9,696
General and administrative.................. (5) 59 343 1,469 2,286
------- ------- ------- ------- -------
Total operating expenses.................. (5) 222 2,037 10,843 16,235
------- ------- ------- ------- -------
Loss from operations.......................... (5) (222) (1,831) (7,058) (200)
Interest income, net.......................... -- -- 40 75 48
------- ------- ------- ------- -------
Net loss...................................... $ (5) $ (222) $(1,791) $(6,983) $ (152)
======= ======= ======= ======= =======
Pro forma basic and diluted net loss per
common share (1)............................ $ (0.01)
=======
Pro forma weighted average common shares
outstanding (1)............................. 14,223
=======
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------------------
1993 1994 1995 1996 1997
-------- -------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents..................... $ 1 $ 1,137 $ 993 $ 3,404 $ 8,693
Working capital............................... -- 1,063 1,151 2,494 2,037
Total assets.................................. 1 1,167 1,728 7,249 16,366
Long-term debt, net of current portion........ 6 -- 81 28 256
Redeemable convertible preferred stock........ -- 1,170 3,385 13,398 14,855
Stockholders' equity (deficit)................ (5) (83) (2,124) (10,119) (11,567)
</TABLE>
- ---------------
(1) For an explanation of the determination of the number of shares used in
computing pro forma per share amounts, see Note 1 of Notes to Financial
Statements.
16
<PAGE> 18
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following discussion of the financial condition and results of
operations of the Company should be read in conjunction with the Company's
financial statements, the related notes thereto, and other financial information
included elsewhere in this Prospectus.
OVERVIEW
The Company was incorporated in Maryland in August 1993 as Avail Networks,
Inc. and reincorporated in Delaware in December 1994 as Visual Networks, Inc.
From incorporation through December 1994, the Company's principal objective was
to secure sufficient equity financing to enable the Company to accelerate
product development efforts. The Company secured its initial round of equity
financing in December 1994.
During 1995 and 1996, the Company devoted substantial resources to
developing Visual UpTime for Frame Relay deployment and to developing sales and
marketing functions and general and administrative infrastructure. Visual UpTime
was first shipped in mid-1995. The Company began generating significant revenue
from sales of Visual UpTime during 1996.
During 1995 and 1996, most of the Company's sales were to subscribers. In
August 1996, the Company entered into a master reseller agreement with Sprint,
resulting in the Company's products shipping through Sprint to subscribers.
During 1997, the Company began expanding its sales force and distribution
capabilities in order to sell Visual UpTime directly to providers for deployment
of the system as part of their network infrastructure.
The Company realizes revenue from sales of hardware, from the licensing of
related software and from maintenance contracts. The Company generally
recognizes revenue upon shipment or delivery of the product and passage of title
to the customer. Where the agreements provide for evaluation or customer
acceptance, the Company recognizes revenue upon the completion of the evaluation
process and acceptance of the product by the customer. Maintenance contracts
call for the Company to provide technical support and software updates to
customers. The Company recognizes maintenance revenue, including maintenance
revenue that is bundled with product sales, ratably over the contract period,
which currently ranges from one to three years.
The Company currently contracts with third parties for board assembly and
has a manufacturing operation that performs final assembly, testing and shipping
of its product at its facility in Rockville, Maryland. The Company anticipates
maintaining a portion of its internal manufacturing function for the foreseeable
future, but is exploring opportunities with contract manufacturers to have its
products assembled, tested and shipped at a third-party location.
17
<PAGE> 19
RESULTS OF OPERATIONS
The following table presents for the periods indicated certain statement of
operations data as a percentage of the Company's revenue:
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
---------------------------
1995 1996 1997
------ ------ -----
<S> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenue................................................. 100.0% 100.0% 100.0%
Cost of goods sold...................................... 17.6 40.3 32.2
------ ------ ------
Gross profit.......................................... 82.4 59.7 67.8
------ ------ ------
Operating expenses:
Research and development.............................. 397.6 47.1 18.0
Sales and marketing................................... 280.0 100.8 41.0
General and administrative............................ 137.2 23.2 9.6
------ ------ ------
Total operating expenses........................... 814.8 171.1 68.6
------ ------ ------
Loss from operations.................................... (732.4) (111.4) (0.8)
Interest income, net.................................... 16.0 1.2 0.2
------ ------ ------
Net loss................................................ (716.4)% (110.2)% (0.6)%
====== ====== ======
</TABLE>
YEAR ENDED DECEMBER 31, 1996 COMPARED WITH YEAR ENDED DECEMBER 31, 1995
REVENUE. The Company recognized $6.3 million in revenue for the year ended
December 31, 1996, as compared to $0.3 million for the year ended December 31,
1995, an increase of $6.0 million. The increase was due primarily to the initial
acceptance of Visual UpTime by subscribers.
GROSS PROFIT. Cost of goods sold consists of component costs, direct
compensation costs, warranty and other contractual obligations, royalties,
license fees and overhead expenses related to manufacturing operations. Gross
profit was $3.8 million for the year ended December 31, 1996, as compared to
$0.2 million for the year ended December 31, 1995, an increase of $3.6 million.
Gross margin was 59.7% for the year ended December 31, 1996.
RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense
consists of compensation for research and development staff, depreciation of
test and development equipment, certain software development costs and costs of
prototype materials. The Company expenses research and development costs as
incurred. Research and development expense was $3.0 million for the year ended
December 31, 1996, as compared to $1.0 million for the year ended December 31,
1995, an increase of $2.0 million. The increase in research and development
expense was due primarily to increased staffing levels and, to a lesser extent,
purchases of materials used in the development of new or enhanced products.
Research and development expense was 47.1% of revenue for the year ended
December 31, 1996.
SALES AND MARKETING EXPENSE. Sales and marketing expense consists of
compensation for the sales and marketing staff, commissions, pre-sales support,
travel and entertainment expense, trade shows and other marketing programs.
Sales and marketing expense was $6.4 million for the year ended December 31,
1996, as compared to $0.7 million for the year ended December 31, 1995, an
increase of $5.7 million. The increase in sales and marketing expense was due
primarily to increased staffing levels. Sales and marketing expense was 100.8%
of revenue for the year ended December 31, 1996.
GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense
consists of finance, administration and general management activities. General
and administrative expense was $1.5 million for the year ended December 31,
1996, as compared to $0.3 million for the year ended
18
<PAGE> 20
December 31, 1995, an increase of $1.2 million. The increase in general and
administrative expense was due primarily to increased staffing levels and the
development of infrastructure to support the anticipated revenue growth. General
and administrative expense was 23.2% of revenue for the year ended December 31,
1996.
OPERATING LOSS. The Company's operating loss was $7.1 million for the year
ended December 31, 1996, as compared to an operating loss of $1.8 million for
the year ended December 31, 1995, an increase of $5.3 million. This increase was
due primarily to increased operating expenses which offset the revenue and gross
profit increases described above.
YEAR ENDED DECEMBER 31, 1997 COMPARED WITH YEAR ENDED DECEMBER 31, 1996
REVENUE. The Company recognized $23.7 million in revenue for the year
ended December 31, 1997, as compared to $6.3 million for the year ended December
31, 1996, an increase of $17.4 million. The increase was due primarily to
acceptance of Visual UpTime in the Frame Relay market and to sales resulting
from the reseller agreement signed with Sprint in August 1996. Revenue from this
reseller agreement accounted for approximately 31% of revenue for the year ended
December 31, 1997.
GROSS PROFIT. Gross profit was $16.0 million for the year ended December
31, 1997, as compared to $3.8 million for the year ended December 31, 1996, an
increase of $12.2 million. Gross margin was 67.8% for the year ended December
31, 1997, as compared to 59.7% for the year ended December 31, 1996. The
increase in gross margin percentage was due primarily to product cost
reductions. The Company's future gross margins may be affected by the product
mix of sales and the allocation of sales among its various sales channels. The
Company's future gross margins also may be adversely affected by a number of
factors, including competitive pricing, manufacturing volumes and increases in
component costs.
RESEARCH AND DEVELOPMENT EXPENSE. Research and development expense was
$4.3 million for the year ended December 31, 1997, as compared to $3.0 million
for the year ended December 31, 1996, an increase of $1.3 million. The increase
in research and development expense was due primarily to increased staffing
levels and, to a lesser extent, purchases of materials used in the development
of new or enhanced products. Research and development expense was 18.0% of
revenue for the year ended December 31, 1997. The Company expects that research
and development expenditures will increase in absolute dollars, and may decrease
as a percentage of revenue, during 1998 and thereafter. This increase in
absolute dollars will support continued development of new and enhanced products
and the exploration of new or complementary technologies.
SALES AND MARKETING EXPENSE. Sales and marketing expense was $9.7 million
for the year ended December 31, 1997, as compared to $6.4 million for the year
ended December 31, 1996, an increase of $3.3 million. The increase in sales and
marketing expense was due primarily to increased staffing levels. Sales and
marketing expense was 41.0% of revenue for the year ended December 31, 1997. The
Company expects that sales and marketing expenditures will increase in absolute
dollars, and may decrease as a percentage of revenue, during 1998 and
thereafter. This increase in absolute dollars is expected to be incurred as
additional personnel are hired, field offices are opened and promotional
expenditures increase to allow the Company to increase its market penetration
and to pursue new market opportunities.
GENERAL AND ADMINISTRATIVE EXPENSE. General and administrative expense was
$2.3 million for the year ended December 31, 1997, as compared to $1.5 million
for the year ended December 31, 1996, an increase of $0.8 million. The increase
in general and administrative expense was due primarily to increased staffing
levels. General and administrative expense was 9.6% of revenue for the year
ended December 31, 1997. The Company expects that general and administrative
expenditures will increase in absolute dollars, and may decrease as a percentage
of revenue, during 1998 and thereafter. This increase in absolute dollars is
expected to be required for the expansion
19
<PAGE> 21
of the Company's administrative staff and internal systems to support expanding
operations and operating as a public company.
OPERATING LOSS. The Company's operating loss was $0.2 million for the year
ended December 31, 1997, as compared to an operating loss of $7.1 million for
the year ended December 31, 1996, a decrease of $6.9 million. This decrease was
due primarily to the revenue and gross profit increases described above.
The Company has recorded a valuation allowance to offset the Company's net
deferred tax assets, including the possible future benefit from realization of
tax operating loss carryforwards. The recording of such valuation allowance was
based upon management's determination that realization of the net deferred tax
assets was not "more likely than not" (as defined in Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes").
SELECTED QUARTERLY RESULTS OF OPERATIONS
The following tables present statement of operations data in dollars and as
a percentage of the Company's revenue. This quarterly information is unaudited
but has been prepared on a basis consistent with the Company's audited financial
statements presented elsewhere herein, and in the Company's opinion, includes
all adjustments (consisting only of normal recurring adjustments), necessary for
a fair presentation of the information for the quarters presented. The results
of operations for any quarter are not necessarily indicative of results that may
be expected for any subsequent periods. See "Risk Factors -- Potential
Fluctuations in Quarterly Operating Results".
<TABLE>
<CAPTION>
QUARTER ENDED
----------------------------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
--------- --------- --------- --------- --------- --------- --------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF
OPERATIONS DATA:
Revenue........... $ 433 $ 1,556 $ 1,955 $ 2,391 $ 3,079 $ 5,428 $ 7,017 $ 8,127
Cost of goods
sold............. 182 643 789 936 1,051 1,797 2,211 2,557
-------- -------- -------- -------- -------- -------- -------- --------
Gross profit..... 251 913 1,166 1,455 2,028 3,631 4,806 5,570
-------- -------- -------- -------- -------- -------- -------- --------
Operating
expenses:
Research and
development.... 564 617 894 913 880 937 1,133 1,303
Sales and
marketing...... 744 1,452 2,064 2,126 2,063 2,137 2,551 2,945
General and
administrative... 238 246 356 629 483 545 588 670
-------- -------- -------- -------- -------- -------- -------- --------
Total operating
expenses..... 1,546 2,315 3,314 3,668 3,426 3,619 4,272 4,918
-------- -------- -------- -------- -------- -------- -------- --------
Income (loss) from
operations....... (1,295) (1,402) (2,148) (2,213) (1,398) 12 534 652
Interest income,
net.............. 27 20 5 23 8 1 2 37
-------- -------- -------- -------- -------- -------- -------- --------
Net income
(loss)........... $(1,268) $(1,382) $(2,143) $(2,190) $(1,390) $ 13 $ 536 $ 689
======== ======== ======== ======== ======== ======== ======== ========
</TABLE>
<TABLE>
<CAPTION>
QUARTER ENDED
----------------------------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
--------- --------- --------- --------- --------- --------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
STATEMENT OF
OPERATIONS DATA:
Revenue........... 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Cost of good
sold............. 42.0 41.3 40.4 39.1 34.1 33.1 31.5 31.5
-------- -------- -------- -------- -------- -------- -------- --------
Gross profit..... 58.0 58.7 59.6 60.9 65.9 66.9 68.5 68.5
-------- -------- -------- -------- -------- -------- -------- --------
Operating
expenses:
Research and
development.... 130.2 39.7 45.7 38.2 28.6 17.3 16.1 16.0
Sales and
marketing...... 171.8 93.3 105.6 88.9 67.0 39.4 36.4 36.2
General and
administrative... 55.0 15.8 18.2 26.4 15.7 10.0 8.4 8.3
-------- -------- -------- -------- -------- -------- -------- --------
Total operating
expenses..... 357.0 148.8 169.5 153.5 111.3 66.7 60.9 60.5
-------- -------- -------- -------- -------- -------- -------- --------
Income (loss) from
operations....... (299.0) (90.1) (109.9) (92.6) (45.4) 0.2 7.6 8.0
Interest income,
net.............. 6.2 1.3 0.3 1.0 0.3 0.0 0.0 0.5
-------- -------- -------- -------- -------- -------- -------- --------
Net income
(loss)........... (292.8)% (88.8)% (109.6)% (91.6)% (45.1)% 0.2% 7.6% 8.5%
======== ======== ======== ======== ======== ======== ======== ========
</TABLE>
20
<PAGE> 22
THREE MONTHS ENDED MARCH 31, 1997, JUNE 30, 1997, SEPTEMBER 30, 1997 AND
DECEMBER 31, 1997
Revenue has increased in each of the last four quarters from $3.1 million
for the three months ended March 31, 1997 to $5.4 million, $7.0 million and $8.1
million for the three months ended June 30, 1997, September 30, 1997 and
December 31, 1997, respectively. These increases were due primarily to the
acceptance of Visual UpTime in the Frame Relay market and increases in sales to
subscribers by Sprint and other providers. The Company's sales strategy is to
focus on selling Visual UpTime to providers for deployment as part of their core
network infrastructure. There can be no assurance that the Company will be
successful in executing this provider deployment sales model and the impact of
this sales model, if successfully implemented, on the Company's future growth is
uncertain. See "Business -- Sales, Marketing and Support".
Gross margins increased in the first three quarters of 1997 from 65.9% in
the three months ended March 31, 1997 to 66.9% and 68.5% in the three months
ended June 30, 1997 and September 30, 1997, respectively and continued at 68.5%
during the three months ended December 31, 1997. The increases were due
primarily to product cost reductions. The Company's future gross margins may be
affected by the product mix of sales and the allocation of sales among its
various sales channels. The Company's future gross margins also may be adversely
affected by a number of factors, including competitive pricing, manufacturing
volumes and increases in component costs.
The Company's operating expenses have increased in each of the last four
quarters, from $3.4 million in the three month period ended March 31, 1997 to
$3.6 million, $4.3 million and $4.9 million in the three month periods ended
June 30, 1997, September 30, 1997, and December 31, 1997, respectively. The
increases were due primarily to increased staffing in sales and marketing and to
a lesser extent increases in research and development and administrative
personnel. The Company expects that operating expenses will continue to increase
in 1998 as the Company attempts to increase its market penetration, develops new
and enhanced products, and increases administrative staff and the systems
required to support the Company's expanding operations. Operating expenses as a
percentage of revenue have declined from 111.3% of revenue for the three months
ended March 31, 1997 to 66.7%, 60.9% and 60.5% of revenues for the three month
periods ended June 30, 1997, September 30, 1997, and December 31, 1997,
respectively. The Company expects that operating expenses as a percentage of
revenue will continue to decrease as, and if, its revenue increases.
The Company's quarterly revenue and operating results may vary
significantly as a result of a number of factors, including the size and timing
of orders, product mix and shipment of systems. Operating results may also
fluctuate on a quarterly basis based upon factors such as the continued
acceptance of Frame Relay-based products, demand for the Company's current and
future product offerings, the introduction of product enhancements by the
Company or its competitors and market acceptance of new products offered by the
Company or its competitors. The Company's quarterly operating results are also
affected by the budgeting cycles of customers, the relative percentages of
products sold through the Company's direct and indirect sales channels, product
pricing and competitive conditions in the industry. Any unfavorable changes in
these or other factors could have a material adverse effect on the Company's
business, financial condition and results of operations. Accordingly, the
Company believes that period-to-period comparisons of its results of operations
may not be meaningful and should not be relied upon as an indication of future
performance. Furthermore, there can be no assurance that the Company will be
able to sustain profitability on a quarterly or annual basis.
LIQUIDITY AND CAPITAL RESOURCES
The Company, since inception, has financed its operations and capital
expenditures through the sale of Convertible Preferred Stock, for aggregate
proceeds, net of issuance costs, of approxi-
21
<PAGE> 23
mately $12.1 million, and through capital lease and other debt financing. Cash
used in operating activities was approximately $2.0 million in 1995 and $6.6
million in 1996. During 1997, the Company's operating activities provided net
cash of approximately $6.8 million, primarily due to improved collections from
customers. Capital expenditures were approximately $0.2 million in 1995, $0.8
million in 1996 and $1.2 million for 1997. Any delay in these expenditures could
have a material adverse effect on the Company's business, financial condition
and results of operations.
The Company requires substantial working capital to fund its business,
particularly to finance inventories, accounts receivable, research and
development and capital expenditures. The Company currently has no commitments
for capital expenditures and capital expenditures for 1998 are not expected to
exceed $2.5 million. The Company's future capital requirements will depend on
many factors, including the rate of revenue growth, if any, the timing and
extent of spending to support product development efforts and expansion of sales
and marketing, the timing of introductions of new products and enhancements to
existing products and market acceptance of the Company's products. There can be
no assurance that additional equity or debt financing, if required, will be
available on acceptable terms, if at all.
The Company's principal source of liquidity consists of $8.7 million in
cash and cash equivalents and a bank credit facility. The credit facility
includes a revolving line of credit providing for borrowings up to the lesser of
$7.0 million or 75% of eligible accounts receivable (as defined in the credit
facility). The agreement entitles Silicon Valley Bank to a security interest in
the Company's assets. The agreement contains restrictive financial covenants,
including, but not limited to, restrictions related to liquidity, profitability,
net worth, and indebtedness, as well as restrictions related to acquisitions,
dispositions of assets, distributions and investments. Interest is payable
monthly at the prime rate plus 0.5%. As of December 31, 1997, there were no
borrowings outstanding under the bank credit facility.
Although all of the Company's product sales to date have been made to
customers in the United States and Canada, the Company intends to increase its
sales efforts in foreign markets. The Company plans to sell its products to
foreign customers at prices denominated in U.S. dollars. However, if the Company
commences selling material volumes of product to such customers at prices not
denominated in U.S. dollars, the Company intends to adopt a strategy to hedge
against fluctuations in foreign currency.
The Company believes that the net proceeds from the offering and cash
generated from operations, together with existing sources of liquidity will be
sufficient to meet its capital expenditures and working capital for the next 18
to 24 months. The Company may consider from time to time various financing
alternatives and may seek to raise additional capital through equity or debt
financing or to enter into strategic arrangements. There can be no assurance,
however, that any such financing alternatives will be available on terms
acceptable to the Company, if at all.
NEW ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board issued Statements of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" and No.
131, "Disclosures about Segments of an Enterprise and Related Information."
These statements become effective for the Company's 1998 financial statements.
The Company is evaluating these statements to determine the impact on its
reporting and disclosure requirements.
22
<PAGE> 24
BUSINESS
OVERVIEW
The Company designs, manufactures and sells WAN service level management
systems for statistically multiplexed technologies such as Frame Relay and
IP/Internet. The Company's Visual UpTime system combines WAN access
functionality with innovative software for performance monitoring,
troubleshooting and network planning. Visual UpTime provides instrumentation for
network performance measurement and analysis that allows providers to achieve
the service levels required by their subscribers and to lower operating costs
associated with statistically multiplexed services. The availability of
performance monitoring and troubleshooting instrumentation also allows
subscribers to verify the service levels being supplied by their WAN provider
and monitor traffic traversing the WAN, a requirement for many subscribers
wishing to use statistically multiplexed services to carry mission-critical data
traffic. The Company believes Visual UpTime systems are deployed in
configurations managing as few as 3 circuits and as many as 1,000 circuits. The
system is currently designed to scale up to 3,000 circuits on a single managed
network.
The Company believes it is a worldwide leader in field deployment of WAN
service level management systems. The Company introduced Visual UpTime in the
summer of 1995 and has since shipped systems configured for deployment on over
17,000 WAN circuits in over 300 subscriber Frame Relay networks, including those
of ABN-AMRO Bank, Cargill, Inc., Delta Air Lines, Inc., EDS, FedEx, Household
International, Inc., Marriott, Reynolds and Waste Management, Inc. For the year
ended December 31, 1997, the Company had revenue of approximately $23.7 million.
Vertical Systems estimates that approximately 920,000 Frame Relay circuits
will be installed worldwide over the next three years. To take advantage of this
projected growth in the Frame Relay market, the Company has developed
relationships with major Frame Relay service providers such as AT&T, Sprint,
MCI, Ameritech and BellAtlantic. The percentage of revenue attributable to sales
to providers, which either resell or lease the systems to subscribers, increased
from approximately 30% in the first quarter of 1997, to approximately 52% in the
fourth quarter of 1997, with Sprint and AT&T accounting for 31% and 7%,
respectively, of revenue for the year ended December 31, 1997.
INDUSTRY BACKGROUND
WAN SERVICES MARKET
The WAN services market has grown rapidly with the increase in computing
and the associated data traffic volumes carried over WANs. WAN services are used
to interconnect the computing facilities of geographically dispersed sites
within an enterprise or to connect the computing facilities of one enterprise to
another. The Company believes WAN data traffic volumes will continue to expand
rapidly due to three key trends driving telecommunications markets worldwide:
- Proliferation of distributed computing applications such as electronic
mail, electronic transaction processing, enterprise resource planning and
inter-enterprise information transfer based on Web technologies;
- Deregulation of the telecommunications services industry, which has
intensified competition and resulted in decreasing prices of WAN
services; and
- The continued deployment of high capacity fiber-optic networks and the
emergence of high-bandwidth network access technologies that increase the
ability to transfer large volumes of electronic information.
Vertical Systems, a leading independent WAN industry analyst, forecasts
that WAN traffic on leased-line, Frame Relay and ATM services in the U.S. market
will triple from 1996 to 2000, and projects the U.S. market for these services
will exceed $13 billion in 1997 and grow to $19.5 billion in
23
<PAGE> 25
2000. Vertical Systems estimates that the non-U.S. market for these services is
expected to exceed $13 billion in 1997.
WAN NETWORK DEPLOYMENT
A typical WAN deployment to support distributed computing environments
includes various types of customer premise equipment ("CPE") owned by the
subscriber, deployed at the subscriber's sites and interconnected by the WAN
service. The points at which the subscriber CPE connects to the WAN service are
known as service demarcations ("demarcs"). The subscribers are responsible for
network performance on the subscriber side of the demarcs, while providers are
responsible for network performance on the provider side of the demarcs.
TYPICAL WAN DEPLOYMENT
[WAN DEPLOYMENT CHART]
The equipment used for Frame Relay, ATM and IP/Internet services comprises
both the access equipment located at the subscriber premises and the switches
located at the provider's central office. Access equipment includes devices such
as DSU/CSUs, FRADs (frame relay access devices), frame relay cards for routers
and ATM access multiplexers. Vertical Systems projects that the markets for this
equipment will grow significantly in parallel with the projected growth in the
underlying service markets. The market for Frame Relay, ATM and IP/Internet
access equipment is projected to grow from $353 million in 1996 to $1.4 billion
in 2000.
WAN NETWORK ARCHITECTURES
WAN services are provided through two network architectures, time division
multiplexing ("TDM") and statistical multiplexing. TDM services, such as
leased-line and ISDN, rely on architectures which provide dedicated circuits
between computing facilities and provide fixed bandwidth regardless of traffic
flow. Unless information is continuously transmitted, the dedicated bandwidth is
often idle, resulting in the inefficient use of expensive bandwidth. The use of
dedicated bandwidth does, however, provide guaranteed throughput and fixed
delay, ensuring high quality of service for all network traffic. Consequently,
TDM services are suitable for the large installed base of mainframe computing
environments running mission-critical, host-centric applications where the
24
<PAGE> 26
variability in traffic volume is low and the traffic volume is relatively
predictable. By contrast, statistical multiplexing technologies and their
derivative services, such as Frame Relay, ATM, IP/Internet, X.25 and Switched
Multimegabit Data Services ("SMDS"), are based on the concept of shared
bandwidth which is dynamically allocated in real time according to prevailing
traffic patterns. As a result of this shared bandwidth, WANs based on these
services can be up to 50% less expensive than WANs based on leased-line services
for distributed computing applications. Because bandwidth in the WAN is shared
among multiple subscribers, however, these services are generally characterized
by "best efforts" throughput and variable delay, often resulting in lower
quality of service more suitable for non-mission-critical distributed computing
applications where the traffic is highly variable and unpredictable.
WAN services are undergoing a significant shift from TDM architectures to
statistically multiplexed architectures. Vertical Systems estimates that
worldwide revenues for Frame Relay service, the most widely used service, will
have grown at a compound annual growth rate of 117% between 1995 and 1997 and
will grow at a compound annual growth rate of 41% through the year 2000. The
worldwide number of installed Frame Relay circuits is projected to grow from
approximately 580,000 in 1997 to more than 1.5 million in 2000. ATM services are
less widely offered today but also are projected to experience rapid growth.
Accordingly, the U.S. market for Frame Relay and ATM services is expected to
shift from 12% of WAN bandwidth in 1996 to nearly 40% in 2000 (with the majority
of growth attributed to Frame Relay services) while the U.S. market for
leased-line services is expected to decrease from approximately 88% of WAN
bandwidth to 60% from 1996 to 2000.
The growth of statistically multiplexed services has resulted in increased
focus by subscribers on WAN service levels, defined by parameters such as
service availability, throughput and delay. Subscribers have historically been
able to tolerate the lower reliability and quality of service of statistically
multiplexed services because most of the distributed computing applications
supported by these services, including E-mail and file transfer, were not
mission-critical. Today, however, the importance of distributed computing
applications is increasing as enterprises implement newer mission-critical
applications for enterprise resource planning, transaction processing, work
group collaboration, remote telecommuting, sales force automation and electronic
order entry. Subscribers, therefore, are demanding that their providers offer,
achieve and, increasingly, guarantee higher service levels.
The proliferation of statistically multiplexed services has also resulted
in increased administrative costs for subscribers as more network managers
manage multiple networks consisting of leased-line services supporting
mission-critical legacy applications and Frame Relay services supporting
recently-deployed, distributed computing applications. The high cost of
administering multiple networks coupled with the attractive pricing of Frame
Relay services is driving the need for subscribers to consolidate their
applications onto a single Frame Relay WAN. The migration of mainframe computing
environments running mission-critical host-centric applications onto lower cost
statistically multiplexed services has highlighted the need to provide higher
service levels with such services. This migration and the proliferation of
distributed computing applications have also generated subscriber demand for
providers to offer multiple classes of service levels. Multiple service levels
enable subscribers to deploy statistically multiplexed WANs that have service
characteristics commensurate with the performance requirements of their
differing computing applications, thereby optimizing price and performance.
Subscriber demand for multiple, guaranteed and verified WAN service levels
presents challenges to providers, which must be able to offer profitably these
service levels.
The WAN services segment of deregulated telecommunications markets is
intensely competitive and price sensitive, and cost leadership tends to drive
competitive strategies. Providers can only achieve cost leadership if they can
realize economies of scale. They must also avoid a costly dependence on highly
skilled personnel for service provisioning and maintenance, a dependence that
has historically existed for statistically multiplexed services. Therefore,
providers face the challenge of increasing the manageability of statistically
multiplexed services while simultaneously
25
<PAGE> 27
developing service deployment and operational models that can satisfy rapid
growth requirements and achieve economies of scale.
PROBLEMS MANAGING FRAME RELAY, ATM AND IP/INTERNET SERVICES
In leased-line environments, the performance, quality and maintainability
of the service are independent of the volume and type of traffic running over
the service. Accordingly, the diagnostic and measurement capabilities required
to sufficiently maintain these services are fairly simplistic and are focused
largely on physical transmission characteristics such as bit error rates or line
coding violations. These capabilities are widely available within the providers'
facilities and work in conjunction with simple DSU/CSUs deployed by the
subscribers. By contrast, the performance, quality and maintainability of
statistically multiplexed services are highly dependent on the volume and type
of traffic running over the service. This extensive interplay between the
subscriber application traffic and the provider service dictates the need for
sophisticated diagnostic and measurement capabilities which not only analyze
physical transmission characteristics but can also analyze the traffic itself.
Historically, this level of measurement and analysis capability has generally
required the use of expensive portable protocol analyzers, and therefore has not
been cost effective to deploy on a continuous basis at the demarc. This
inability to measure service performance and quality has created difficulties
for both subscribers and providers including the following:
SUSPECT SERVICE LEVELS INHIBIT SUBSCRIBER ACCEPTANCE OF
SERVICE. Subscribers generally view statistically multiplexed services as
offering deficient service levels and are therefore reluctant to run
mission-critical applications across statistically multiplexed WANs. As the
demand for higher service levels and multiple service levels has increased,
subscribers and providers need a mechanism to measure, verify and improve
service levels at the demarc.
OPERATIONAL COST MODELS ARE NOT SCALEABLE. The inability to
cost-effectively measure performance at the demarc, and thereby demonstrate to
subscribers the WAN service level being provided, results in providers requiring
many highly skilled personnel to provision and operate statistically multiplexed
services. This cost is exacerbated by the gap between the demand for and supply
of such personnel. The implication of this model is that operating costs are
driven up and providers' WAN service businesses are not scaleable to the levels
required to generate the economies of scale necessary for cost leadership. The
specific areas of concern are:
- INEFFICIENT SERVICE PROVISIONING. It is difficult for the provider to
ascertain if the WAN service is properly deployed until the subscriber's
network has been connected to the service and the subscriber's
applications are operational. This often results in multiple dispatches
of personnel to the subscriber site and extensive interaction with the
subscriber for its equipment and applications to be configured properly
for the WAN service. At the same time, the provider is typically
restricted from billing the subscriber for the service until the
subscriber's applications are working properly over the WAN service.
- EXTENSIVE TROUBLESHOOTING AND HIGH MAINTENANCE. When the subscriber
applications experience degraded performance, subscribers generally
assume there is a problem with the WAN service supplied by the provider.
It can often take days, weeks or even months to diagnose the causes of
degraded performance and require highly skilled personnel with
sophisticated instrumentation and diagnostic tools. Although these
degraded performance conditions are frequently caused by faulty or
misconfigured subscriber equipment or applications, the provider is
forced to expend significant time and effort without reimbursement to
help the subscriber diagnose the problem.
- INACCURATE NETWORK ENGINEERING AND PLANNING. The shared bandwidth nature
of these WAN services coupled with subscriber demand for many classes of
service levels increases the importance of accurate network planning and
design to ensure that the network architecture is optimized for
performance and cost. If the network is engineered with excess capacity,
it may improve the performance of subscriber applications, but it will
tend to negate the
26
<PAGE> 28
inherent bandwidth efficiencies of statistically multiplexed
technologies. By contrast, if the network is designed with inadequate
capacity, performance will suffer. Successful network engineering and
planning is dependent on accurate historical usage information which,
because of the inability of traditional equipment to measure traffic at
the demarc, is difficult to ascertain for these services.
The Company believes that the potential subscriber demand for statistically
multiplexed services has been constrained by the inability to manage and verify
service levels. Additionally, the Company believes that it will be difficult for
providers to meet the increasing demand for statistically multiplexed services
without systems for managing service levels because the labor-intensity of
provisioning and maintaining the service inhibits the providers' ability to
scale these WAN services profitably. As the providers' focus shifts to
profitability, the growth in Frame Relay, ATM and IP/Internet services will
depend, in part, on the ability of providers to implement systems that can
manage service levels, lower operational costs and increase scaleability.
THE VISUAL NETWORKS SOLUTION
The Company's Visual UpTime offering is a leading Frame Relay and
IP/Internet WAN service level management system that combines WAN access
functionality with planning, monitoring and troubleshooting capabilities and
enables the implementation of required service levels while simultaneously
decreasing the costs and complexity of achieving such levels. Visual UpTime
deploys instrumentation for measurement and analysis at the demarc and provides
innovative software applications that address the historical problems of
managing service levels.
INCREASED CONFIDENCE IN SERVICE LEVELS. By instrumenting the demarc,
Visual UpTime enables providers and subscribers to accurately measure, report on
and improve service levels. These abilities serve to clarify the relationship
between subscriber and provider, resulting in increased subscriber confidence in
running critical computing applications on statistically multiplexed services.
INCREASED SCALEABILITY AND LOWER COSTS OF PROVIDERS' OPERATIONAL
MODEL. Visual UpTime can reduce the labor-intensive nature of deploying
statistically multiplexed services, decreasing providers' costs and increasing
their ability to generate revenues:
- RAPID AND COST-EFFECTIVE SERVICE PROVISIONING. Visual UpTime allows the
provider to verify that its service is properly provisioned without
waiting for the subscriber network or applications to be connected and
configured. This tends to reduce customer support costs during initiation
of service. Additionally, it positions the provider to begin billing for
the service earlier than was previously possible.
- REDUCED NEED FOR TROUBLESHOOTING. Visual UpTime reduces the need for
providers to perform troubleshooting by continuously monitoring the
service performance at the demarc and proactively alerting the provider
and subscriber to anomalous performance characteristics. Such early
warnings allow the network operator to take corrective action before the
performance of any computing application on the network is impaired.
Furthermore, since many of the anomalous characteristics are
subscriber-related, the subscriber is more likely to take corrective
action without involving the provider. The net result of this early
warning system is that fewer maintenance personnel are required to solve
fewer problems, thereby increasing provider efficiency and subscriber
satisfaction.
- MORE RAPID BUT LESS COSTLY TROUBLESHOOTING. Because Visual UpTime
provides information which enables isolation of problems between provider
network and subscriber equipment and applications, the provider can more
quickly diagnose the cause of faulty or degraded performance. With Visual
UpTime, many problems that would otherwise last for days and require
on-site visits of highly skilled personnel can be diagnosed remotely
within minutes. Because Visual UpTime is architected to allow both the
provider and the subscriber to access
27
<PAGE> 29
the same reports and analyses simultaneously, more problem conditions can
be resolved collaboratively.
- MORE ACCURATE NETWORK ENGINEERING AND PLANNING. Visual UpTime
continuously provides an accurate and detailed view of historical WAN
service usage patterns along with automated guidance regarding the need
to change circuit capacities. This allows subscribers and providers to
implement a network design optimized for cost and performance.
VISUAL NETWORKS' STRATEGY
The Company's strategy is to maintain and build upon its market leadership
in the deployment of WAN service level management systems for statistically
multiplexed WAN services. Key elements of the Company's strategy include:
EMBED SERVICE LEVEL MANAGEMENT FUNCTIONALITY INTO NETWORK
INFRASTRUCTURE. Visual UpTime provides an innovative integration of service
level management functionality with WAN access equipment. The Company believes
that this integration substantially enhances the cost effectiveness of deploying
Visual UpTime.
DEPLOY VISUAL UPTIME AS PART OF PROVIDER NETWORKS. The Company believes
providers will become the predominant vehicle for the deployment of service
level management systems such as Visual UpTime. Although these systems can be
deployed by either providers or subscribers, the Company believes the maximum
benefit is achieved when the systems are deployed by the providers and access to
performance data is provided by the providers to their subscribers. In this
deployment model, providers can employ collaborative fault and performance
management techniques that lead to greater network quality. More importantly,
the Company believes the benefits of lower provisioning and maintenance costs
may be most effectively captured if the system is deployed by the provider.
EXTEND TECHNOLOGY LEADERSHIP. The Company believes a combination of
technological competencies have been crucial to its success. These competencies
include network analysis technology and its application to the effective
operation of WANs, the integration of network analysis with WAN access
technology, and collaborative subscriber/provider system architectures. Since
introducing Visual UpTime in mid-1995, the Company has continued to invest in
its core competencies by focusing on feature development, architectural
enhancements and cost reductions. The Company intends to continue to invest in
the development of Visual UpTime, with particular emphasis on features and
architectural improvements designed to accommodate large scale deployment by
providers. This includes leveraging its current Frame Relay and IP/Internet
technologies to address emerging opportunities such as ATM and virtual private
networks ("VPN") over the Internet.
ACHIEVE COST LEADERSHIP. The Company believes its sales levels represent a
volume advantage over any other systems being used to manage statistically
multiplexed WAN services. The Company intends to leverage this volume advantage
with investments in cost reduction to continue to provide the lowest cost WAN
service level management system.
EXPAND SALES AND SUPPORT FUNCTIONS GLOBALLY. Although over 70% of the
worldwide circuits for Frame Relay and ATM are deployed in the U.S., many of the
Company's largest provider and subscriber customers are multinational
corporations. The Company intends to develop a presence outside of the U.S. with
particular focus on the providers which have the largest share of the worldwide
markets for Frame Relay, ATM and IP/Internet services.
LEVERAGE OUTSOURCED MANUFACTURING MODEL. The Company believes scaleable
and flexible manufacturing will be critical to its growth. The Company believes
it can best meet these requirements by outsourcing the majority of its
manufacturing, allowing the Company to focus on its core competencies in product
development and sales and marketing.
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<PAGE> 30
VISUAL UPTIME SYSTEM
Visual UpTime is a service level management system consisting of analysis
service elements ("ASEs"), performance archive managers ("PAMs") and platform
applicable clients ("PACs") that perform data collection, data interpretation
and presentation, respectively. By intelligently monitoring network-wide
performance, Visual UpTime enables users to track and solve service level
problems either on the subscriber or provider side of the demarc.
THE VISUAL UPTIME SYSTEM
[THE VISUAL UPTIME SYSTEM CHART GRAPHIC]
COMPONENTS
ASE. The ASE is a combination of embedded proprietary software and
hardware that performs detailed analysis of network performance at the demarc.
Most versions of the ASE provide the functionality of WAN access equipment, such
as a DSU/CSU. Visual UpTime ASEs use sophisticated proprietary software in
conjunction with networking-specific microprocessors and integrated circuits to
perform detailed analysis of every bit, frame and packet traversing the demarc.
The ASEs generally store the analysis results locally in memory and wait for the
PAM to request the results. When the ASE detects an anomalous condition, it
sends an unsolicited alert to the PAM so that network operators can take prompt
action. The analysis results are organized in accordance with the structure of
standard management information bases ("MIBs") as defined by the Internet
Engineering Task Force ("IETF"). These MIBs are compatible with simple network
management protocol ("SNMP") and include relevant parts of industry standard
MIBs such as MIB I, MIB II and the remote monitoring ("RMON") MIB. Additionally,
the ASEs include proprietary MIB extensions that provide added value for WAN
service level management. Depending on customer requirements, the Company's core
ASE technology can be deployed in a number of configurations based on physical
circuit speed, number of virtual circuits supported, type of access
functionality and subscriber local area network environment.
PAM. The PAM is the system database and request broker between the PACs
and either the database or ASEs. The PAM runs the Company's proprietary software
on Microsoft's WindowsNT Server and SQL Server database. The PAM communicates
with the PACs using a proprietary application programming interface ("API"). The
PAM communicates with the ASEs using either SNMP or trivial file transfer
protocol ("TFTP"). Unlike traditional SNMP management architectures which depend
on continuous polling between the manager (PAM) and agents (ASEs), a bandwidth
consuming process, Visual UpTime distributes most of the processing burden to
the ASE, allowing
29
<PAGE> 31
the PAM-ASE data sharing to take place less frequently, typically once a day.
This feature is critical in WAN environments where costly bandwidth makes
continuous management polling impractical.
PAC. The PAC is Visual UpTime's client software for packaging and
presenting information stored in the PAM and ASE. Multiple PACs may access a
single PAM or ASE. Current versions of the PAC run on Windows95, WindowsNT and
major versions of UNIX.
The PAC includes three integrated toolsets:
PERFORMANCE MONITORING. This toolset is an early warning system,
alerting operators to impending service degradation, that allows corrective
action to be taken before the subscriber's application performance
degrades. This toolset displays network performance related events and
alarms. The performance monitoring toolset is tightly linked to the
troubleshooting toolset, allowing an operator to evaluate quickly and
precisely the conditions which caused the event or alarm.
TROUBLESHOOTING. This toolset enables an operator to rapidly perform
detailed diagnostics to identify the cause of service level problems. This
toolset displays real-time and historical network performance statistics.
The troubleshooting toolset includes a protocol capture and analysis
capability used by network operators to isolate problems arising from the
interplay between a subscriber's CPE or applications and the WAN service.
PLANNING AND REPORTING. This toolset is a report generation tool that
creates a wide variety of reports from the network performance data stored
in the PAM. This toolset is used primarily for capacity planning and
network engineering, management of service level agreements between
provider and subscriber and executive reporting from the network operations
staff to senior management personnel. The planning and reporting toolset is
accessible through a PAC or a Web-browser.
The Visual UpTime components are sold as a complete system which requires
at least one PAC/PAM per deployment along with one ASE deployed at the demarc of
each circuit on which service level management is required. The system
architecture currently scales to support up to approximately 3,000 managed
circuits per PAM. The Company believes the system is currently deployed in
configurations managing as few as 3 circuits and as many as 1,000 circuits.
System pricing varies by size of deployment and relative mix between circuit
speeds. For the year ended December 31, 1997, the Company's average selling
price per system approximated $1,500 for each circuit on which the system was
deployed. The Company expects its average selling price to decrease
significantly as its sales to providers increase.
VISUAL'S SELLING STRATEGY AND VISUAL UPTIME SYSTEM DEPLOYMENT MODELS
The Company has deployed a long-term, multi-stage selling strategy.
Initially, the Company sold Visual UpTime to subscribers, with the objective of
creating demand among subscribers for higher service levels for statistically
multiplexed WAN services and stimulating demand among providers for the
infrastructure necessary to provide and maintain such service levels. In 1995
and 1996, the majority of the Company's sales were made to subscribers directly
or through value-added resellers. At the same time, the Company commenced
marketing Visual UpTime to providers for resale or lease as value-added CPE in
conjunction with their service offerings. In furtherance of this stage of the
Company's selling strategy, the Company has executed reseller agreements with
Sprint and MCI. The portion of the Company's revenue derived from these and
other provider relationships has grown from approximately 30% for the three
months ended March 31, 1997, to approximately 52% for the three months ended
December 31, 1997.
Substantially all Visual UpTime systems sold to date have been deployed by
subscribers and are configured so that only the subscriber has access to the WAN
service performance data collected and presented by the system ("subscriber
deployment model"). The Company recently has focused on demonstrating to
providers the incremental value of provisioning and operating cost
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<PAGE> 32
savings arising from wide scale deployment by the provider. The Company's
selling strategy contemplates an evolution of the deployment model so that sales
of Visual UpTime systems will be made directly to providers and the providers
will deploy the systems as a part of their network infrastructure ("provider
deployment model").
SUBSCRIBER DEPLOYMENT MODEL
In the subscriber deployment model, a subscriber deploys an ASE instead of
conventional WAN access equipment on each circuit to be managed, thus providing
instrumentation on every circuit. The PAM is deployed at the subscriber's
network operations center. PACs are deployed wherever there are subscriber
network operators who need to access the system.
SUBSCRIBER DEPLOYMENT MODEL
[GRAPHIC: SUBSCRIBER DEPLOYMENT MODEL]
PROVIDER DEPLOYMENT MODEL
In the provider deployment model, the WAN access equipment is similarly
replaced by an ASE. The ASE is then owned by the provider and represents a
critical element of the provider's network infrastructure, thereby extending the
WAN service demarc to include the functionality of the WAN access equipment. By
extending WAN service level management capabilities to the subscriber's site,
the providers will be in a position to offer a new class of "intelligent"
service levels, which can effectively increase revenue, increase quality of
service levels and decrease cost at the same time. The provider can scale the
service by adding additional ASEs. In the provider deployment model, the PAM is
deployed within the provider's network operations center and one PAM typically
supports multiple subscribers, yielding significant economies of scale for the
provider. PACs are deployed at
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<PAGE> 33
the provider network operations center and at the subscriber network operations
centers, enabling simultaneous access for providers and subscribers to the
information generated by Visual UpTime.
PROVIDER DEPLOYMENT MODEL
[GRAPHIC: PROVIDER DEPLOYMENT MODEL]
CUSTOMERS
Visual UpTime has been shipped to more than 300 subscribers. Subscriber
deployments represent the majority of deployments to date. The following
subscribers each have generated, either directly or through resellers,
cumulative revenue of more than $250,000:
<TABLE>
<S> <C>
ABN-AMRO Bank Federal Express Corporation
Cargill, Inc. Household International,
Columbia Gas System Inc. Inc.
Delta Air Lines, Inc. Marriott International, Inc.
EDS Electronic Commerce Division Waste Management, Inc.
</TABLE>
The Company is dependent on a small number of customers for a substantial
portion of its revenue. For the year ended December 31, 1996, sales of products
or services to HP and Sprint accounted for 13% and 10%, respectively, of the
Company's revenue. For the year ended December 31, 1997, sales of products or
services to Sprint, FedEx and AT&T accounted for 31%, 11% and 7%, respectively,
of the Company's revenue, substantially all of which was attributable to sales
to subscribers. See "Risk Factors -- Dependence on Major Customers".
During the second half of 1996 and during 1997, the Company developed
business relationships with a number of providers, including AT&T, MCI, Sprint,
BellAtlantic and Ameritech. These providers supply approximately 50% of
worldwide Frame Relay and ATM services. While these relationships are at
different levels of business maturity, the portion of the Company's revenue
derived from these relationships has grown from approximately 30% in the three
months ended March 31, 1997, to approximately 52% in the three months ended
December 31, 1997. The Company expects to expend substantial additional effort
to evolve these business partners to the provider
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<PAGE> 34
deployment model. See "Risk Factors -- Implementation of Provider Deployment
Model; Lengthy Sales Cycle".
AT&T RELATIONSHIP
In December 1997, the Company entered into a non-exclusive procurement
agreement with AT&T. The agreement is for an initial term of three years and
automatically renews until terminated by either party upon 30 days' notice.
Prices and discounts for all equipment purchased by AT&T are fixed for the term,
except in certain limited circumstances. The equipment carries a five-year
warranty. If the Company offers more favorable prices and terms to any other
customer during the term of the agreement, the Company will amend the agreement
to provide AT&T with the same or comparable overall terms. The agreement does
not obligate AT&T to make any minimum purchases from the Company. The Company
also provides certain support services to AT&T.
MCI RELATIONSHIP
In August 1997, the Company entered into a non-exclusive three-year
reseller agreement with MCI, which automatically renews for successive one-year
terms unless terminated by either party at least 60 days prior to expiration.
Prices and discounts for all equipment purchased by MCI are fixed for the term.
The equipment carries a five year warranty. If the Company offers more favorable
prices to any other customer for the same quantity of products purchased over a
similar period of time, the prices charged to MCI will be adjusted to the more
favorable price. The reseller agreement does not obligate MCI to make any
minimum purchases from the Company. The Company also provides certain support
services to MCI.
SPRINT RELATIONSHIP
In August 1996, the Company entered into a non-exclusive three-year
reseller agreement with Sprint. Prices for all equipment purchased by Sprint are
fixed for the term, unless Sprint does not purchase a certain minimum amount of
equipment and services, in which event prices for equipment and services are
subject to increase. The equipment carries a five year warranty. If the Company
offers more favorable prices and terms to any other customer during the term of
the agreement, such terms and prices will be applicable to Sprint's orders. The
reseller agreement does not obligate Sprint to make any minimum purchases from
the Company. The Company also provides certain escrow rights and support
services to Sprint.
SALES, MARKETING AND SUPPORT
The Company's sales, marketing and support operations vary according to the
type of deployment model being targeted:
SUBSCRIBER DEPLOYMENT
The Company has targeted subscriber deployment opportunities through a
combination of direct sales, sales through value-added resellers and integrators
and sales through providers acting in the capacity of resellers. The Company
provides pre-sale technical support to each of its channels. The development of
relationships with the various channels varies from 2 to 12 months for value
added resellers and integrators and from 12 to 24 months in the case of
providers. The sales cycle for subscriber deployment when handled directly or
through resellers is typically 4 to 6 months, and, for this reason,
significantly all sales to date have been subscriber deployments.
PROVIDER DEPLOYMENT
The Company targets provider deployment opportunities on an account by
account basis in descending order of their Frame Relay and ATM market shares.
According to Vertical Systems, AT&T, Sprint and MCI together control more than
55% of the U.S. market and 40% of the worldwide
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<PAGE> 35
market for Frame Relay and ATM services. Because of current levels of
competition for WAN services, the Company believes its most significant
opportunities for Visual UpTime are with U.S.-based long distance providers. The
Company believes its relationships with AT&T, Sprint and MCI will influence
other providers to adopt Visual UpTime .
The provider deployment model involves a complex sale with very large
companies. The sales cycle begins with the presentation of Visual UpTime's value
proposition to multiple departments within a provider organization followed by a
lengthy evaluation process. The Company then works with the provider to develop
a service definition and business plan for the integration of Visual UpTime into
the provider's existing services.
The Company has sales and technical support teams assigned to each account.
In addition, the Company's senior management team devotes significant time
furthering the business relationships with these providers and the Company
invests significant marketing resources to stimulate sales to these providers.
The Company expects to increase its sales, marketing and support efforts
addressed to these providers and extend those efforts to international and
IP/Internet providers.
As of December 31, 1997, the Company employed 46 persons in sales,
marketing and technical support. The Company's expenditures on sales, marketing
and support were approximately $0.7 million, $6.4 million and $9.7 million for
the years ended December 31, 1995, 1996 and 1997, respectively.
RESEARCH AND DEVELOPMENT
The Company has developed core competencies in network analysis technology
and its application to the effective operation of WANs, the integration of
network analysis with WAN access technology and collaborative
subscriber/provider system architectures.
The Company has made significant investments in Visual UpTime architecture
and feature development. The Company's success will depend to a substantial
degree on its ability to bring to market in a timely fashion new products and
enhancements to Visual UpTime that meet changing market requirements. The
Company expects to employ a combined strategy of developing products internally
and acquiring products and technology to meet evolving market requirements. The
Company is focused on the further enhancement and refinement of Visual UpTime,
including the development of the architectural scaleability that will be
required for wide scale implementation through the provider deployment model.
The Company has begun to extend Visual UpTime from Frame Relay networks and IP
over Frame Relay networks to ATM networks and VPNs over the Internet.
Additionally, the Company expects to invest in system refinements which increase
the economic benefit of deployments outside North America.
As of December 31, 1997, there were 43 persons working in the Company's
research and development area, 7 of whom focus on ATM. The Company's research
and development expenditures were approximately $1.0 million, $3.0 million and
$4.3 million for the years ended December 31, 1995, 1996 and 1997, respectively.
COMPETITION
The markets for telecommunications equipment and software are intensely
competitive. Visual UpTime integrates key functionality traditionally found in
three distinct market segments: the WAN access equipment market; the network
test and analysis market; and the market for telecommunications operational
support systems ("OSS"). The Company believes that Visual UpTime is the only
system which integrates functional attributes from these three market segments
to cost-effectively provide WAN service level management. Because of the size
and growth opportunity associated with the WAN service level management market,
the Company expects to encounter increased competition from current and
potential participants in each of these segments. See "Risk Factors -- Intense
and Evolving Competition".
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<PAGE> 36
WAN ACCESS EQUIPMENT
The WAN access equipment market is highly fragmented. This market includes
DSU/CSUs, low to mid-range time division multiplexers, Frame Relay access
devices and ATM access products. Leading vendors in this segment include ADC,
Paradyne, Adtran, Sync and Digital Link. The Company expects that, in some
cases, these companies may partner with companies offering network test and
analysis products in order to compete in the WAN service level management
market. The Company is aware of such an arrangement between Digital Link and
NetScout. Furthermore, internetworking providers, such as Cisco Systems, Inc.,
may integrate WAN access functionality with routers, which may adversely affect
Visual UpTime's cost justification.
NETWORK TEST AND ANALYSIS
An essential element of a WAN service level management system is technology
and expertise associated with network test and analysis. Products in this market
include portable and distributed protocol analyzers and transmission test
instruments. The major vendors in this market segment are Network Associates,
HP, Telecommunications Techniques Corp. and NetScout.
TELECOMMUNICATIONS OPERATIONAL SUPPORT SYSTEMS ("OSS")
OSSs encompass all of the systems related to service deployment including
provisioning systems, billing systems, trouble-ticketing systems, and fault and
performance management systems. Historically, OSS's have been developed by the
in-house staffs of the providers and have sometimes been a source of competitive
advantage to providers. Visual UpTime provides a significant portion of the
functionality that might otherwise be found in a fault and performance
management system for statistically multiplexed WAN services. Therefore, in some
cases, a provider may consider in-house development as an alternative to
deployment of Visual UpTime.
The Company intends to compete by offering superior features, performance,
reliability and flexibility at competitive prices. The Company also intends to
compete on the strength of its relationships with providers. As competition in
the WAN service level management market increases, the Company believes that the
industry may be characterized by intense price competition similar to that
present in the broader networking market. In response to competitive trends, the
Company expects that it will continue to reduce the cost of its systems to seek
ways to improve upon Visual UpTime's price-to-performance ratio. Increased
competition may result in price reductions, reduced profitability and loss of
market share, any of which would have a material adverse effect on the Company's
business, financial condition and results of operations.
MANUFACTURING
The Company currently uses a combination of subcontracting and internal
manufacturing, but anticipates moving to a predominately outsourced
manufacturing model in order to achieve significant scaleability. In connection
with its outsourcing strategy and increased volumes, the Company is seeking to
secure additional sources of supply, including additional contract
manufacturers. The Company has not experienced any significant delays or
material unanticipated costs resulting from the use of subcontractors; however,
such a strategy involves certain risks, including the potential absence of
adequate capacity and reduced control over delivery schedules, manufacturing
yields, quality and costs. Although the Company attempts to maintain appropriate
back-up suppliers, in the event that any significant subcontractor were to
become unable or unwilling to continue to manufacture and/or test the Company's
products in required volumes, the Company would have to identify and qualify
acceptable replacements. This qualification process could be lengthy and no
assurance could be given that any additional sources would become available to
the Company on a timely basis. A delay or reduction in component shipments, or a
delay or increase in costs in the assembly and testing of products by third
party subcontractors, could materially and adversely affect the Company's
business, financial condition and results of operations.
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<PAGE> 37
Although the Company generally uses standard parts and components for its
products, several key components are currently purchased only from sole, single
or limited sources. Any interruption in the supply of these components, or the
inability of the Company or its subcontractors to procure these components from
alternate sources at acceptable prices and within a reasonable time, could have
a material adverse effect upon the Company's business, financial condition and
results of operations. See "Risk Factors -- Dependence on Sole and Limited
Source Suppliers and Fluctuations in Component Pricing".
The Company is currently seeking to obtain ISO 9001 certification, which it
believes will be a further competitive strength. The Company anticipates
receiving this certification during 1998. To the extent that the Company does
not achieve ISO 9001 certification and its potential competitors do, the
Company's competitive position may be materially and adversely affected.
PATENTS AND OTHER INTELLECTUAL PROPERTY RIGHTS
The Company presently has one issued patent on the "Measurement of Round
Trip Delay", which expires in April 2015. It also has one patent pending and one
provisional patent application. No assurance can be given that competitors will
not successfully challenge the validity or scope of the Company's patents or
that such patents will provide a competitive advantage to the Company. As part
of its confidentiality procedures, the Company generally enters into
non-disclosure agreements with its employees and business partners and license
agreements with respect to its software, documentation and other proprietary
information. Despite these precautions, it may be possible for a third party to
copy or otherwise obtain and use the Company's products or technology without
authorization, or to develop similar technology independently. Policing
unauthorized use of the Company's products is difficult. Effective protection of
intellectual property rights is unavailable or limited in certain foreign
countries. There can be no assurance that the Company's protection of its
proprietary rights will be adequate or that the Company's competitors will not
independently develop similar technology, duplicate the Company's products or
design around any patents issued to the Company or other intellectual rights of
the Company.
The Company expects that software and communications product developers
will increasingly be subject to claims of infringement of patents as the number
of products and competitors in the Company's industry segment grows and the
functionality of products in the industry segment overlaps. The Company is not
aware that any of its products infringe the property rights of third parties.
There can be no assurance, however, that third parties will not claim such
infringement by the Company with respect to current or future products. Any such
claims, with or without merit, could result in costly litigation that could
absorb significant management time, which could have a material adverse effect
on the Company's business, financial condition and results of operations. Such
claims might require the Company to enter into license or royalty agreements.
Such license or royalty agreements, if required, may not be available on terms
acceptable to the Company or at all, which could have a material adverse effect
on the Company's business, financial condition and results of operations. See
"Risk Factors -- Intellectual Property and Proprietary Rights".
LITIGATION
The Company is involved in legal proceedings from time to time in the
ordinary course of its business. Management believes that none of these legal
proceedings will have a materially adverse effect on the Company's business,
financial condition or results of operations.
FACILITIES
The Company's principal administrative, sales and marketing, research and
development and customer support facility is located in approximately 23,000
square feet of office space in Rockville, Maryland which the Company has leased
through November 2000. The Company is obligated to lease an additional 13,000
square feet at this location at the earlier of November 1999 or the
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<PAGE> 38
departure of the current tenant. While the Company believes that its facilities
are adequate for its immediate needs, it may need additional space in late 1998.
EMPLOYEES
As of December 31, 1997, the Company had 120 full-time employees, including
43 in product development, 35 in sales, 7 in marketing, 10 in manufacturing, 4
in customer service and 21 in finance, centralized services and administration.
The Company's future success will depend in significant part on the
continued service of its key technical, sales and senior management personnel.
Competition for such personnel is intense and there can be no assurance that the
Company can retain its key managerial, sales and technical employees, or that it
can attract, assimilate or retain other highly qualified technical, sales and
managerial personnel in the future. None of the Company's employees is
represented by a labor union. The Company has not experienced any work stoppages
and considers its relations with its employees to be good.
37
<PAGE> 39
MANAGEMENT
EXECUTIVE OFFICERS AND DIRECTORS
The table below sets forth certain information concerning each of the
directors and executive officers of the Company:
<TABLE>
<CAPTION>
NAME AGE POSITION
- ------------------------------------- --- --------------------------------------------------
<S> <C> <C>
Scott E. Stouffer.................... 37 Chairman of the Board of Directors, President and
Chief Executive Officer
Peter J. Minihane.................... 49 Executive Vice President, Chief Financial Officer
and Treasurer
Henry A. Cheli....................... 47 Senior Vice President, Market Operations
Gregory J. Langford.................. 47 Senior Vice President, Product Operations
Robert C. Troutman................... 41 Senior Vice President, Advance Planning
Patricia L. Cotter................... 39 Vice President, Manufacturing Operations
Grant G. Behrman..................... 44 Director
Marc F. Benson(1).................... 48 Director
Theodore R. Joseph(1)(2)............. 58 Director
Ted H. McCourtney(2)................. 59 Director
Thomas A. Smith(1)(2)................ 35 Director
William J. Smith..................... 62 Director
</TABLE>
- ---------------
(1) Member of the Compensation Committee.
(2) Member of the Audit Committee.
SCOTT E. STOUFFER has been Chairman of the Board of Directors, President
and Chief Executive Officer of the Company since its inception in 1993. From
August 1990 to May 1993, Mr. Stouffer was Director of Marketing of
Telecommunications Techniques Corporation, a wholly-owned subsidiary of Dynatech
Corporation, a global communications equipment and network technology company.
PETER J. MINIHANE has been Executive Vice President, Chief Financial
Officer and Treasurer of the Company since October 1997. From June 1997 to
October 1997, Mr. Minihane was Senior Vice President, Chief Financial Officer
and Treasurer of the Company. From August 1985 to May 1997, Mr. Minihane was
Executive Vice President, Chief Financial Officer and Treasurer of Microcom,
Inc., a remote access technology company.
HENRY A. CHELI has been Senior Vice President, Market Operations of the
Company since March 1997. From June 1994 to March 1996, Mr. Cheli was Senior
Vice President America's Product Business of Racal Datacom Inc., USA, a
telecommunications, electronics and technology company. From December 1993 to
June 1994, Mr. Cheli was General Manager and Corporate Vice President Network
Products Division of Andrew Corporation, Inc., a communications hardware
company. From July 1993 to December 1993, Mr. Cheli was Senior Vice President
and General Manager of America's Managed Network Services Division of Racal
Managed Service LTD, UK. From April 1992 to July 1993, Mr. Cheli was Director,
Racal Data Group Sales and Special Products of Racal Data Group LTD, UK.
GREGORY J. LANGFORD has been Senior Vice President, Product Operations of
the Company since October 1997. From November 1996 to October 1997, he was Vice
President, Product Management and Planning of the Company. From February 1995 to
August 1996, Mr. Langford was Vice President, Marketing of IPC Information
Systems, Inc, a provider of telecommunications products and services to the
financial services industry. From January 1991 to January 1995, Mr. Langford
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<PAGE> 40
was Vice President, Marketing, of Integrated Network Corporation, a broadband
networking company.
ROBERT C. TROUTMAN has been Senior Vice President, Advance Planning of the
Company since October 1997. From the Company's inception in 1993 to October
1997, he was Vice President, Engineering and Manufacturing of the Company. From
March 1992 to March 1994, Mr. Troutman was a Vice President of Cardzilla, Inc.,
a retail company. From August 1981 until August 1992, Mr. Troutman was employed
by Telecommunications Techniques Corporation, in various capacities, including
as Director of Engineering.
PATRICIA L. COTTER has been Vice President of Manufacturing Operations of
the Company since September 1996. From October 1993 to September 1996, she was
Director of Corporate Programs at Stratus Computer, Inc., a provider of fault
tolerant computers. From 1987 to September 1993, Ms. Cotter was Manufacturing
Engineering Manager at Sun Microsystems, Inc., a provider of UNIX computing
platforms.
GRANT G. BEHRMAN has been a director of the Company since September 1996.
Mr. Behrman has been a Managing Partner of Behrman Capital, a venture capital
fund, since February 1991. Mr. Behrman is also a director of Nimbus CD
International, Inc., a compact disc manufacturing company.
MARC F. BENSON has been a director of the Company since December 1994.
Since July 1992, Mr. Benson has been a principal and partner of Mid-Atlantic
Venture Funds, formerly NEPA Venture Funds, a venture capital fund.
THEODORE R. JOSEPH has been a director of the Company since December 1995.
Mr. Joseph has been the President, Chief Executive Officer and a director of
Relay Technologies, Inc., a provider of mobile and connectivity software, since
December 1994. From March 1993 until August 1994, Mr. Joseph was the Chairman of
the Board, President and Chief Executive Officer of Bridge Builder Technologies,
Inc., a graphical user interface application development company.
TED H. MCCOURTNEY has been a director of the Company since January 1996.
Mr. McCourtney has been a general partner of Venrock Associates, a venture
capital fund, since 1970. Mr. McCourtney is also a director of MedPartners,
Inc., a physician practice management company and NTL, Inc., a
telecommunications company.
THOMAS A. SMITH has been a director of the Company since September 1995.
Mr. Smith has been a general partner of Edison Venture Fund, a venture capital
fund, since June 1993. From October 1990 until May 1993, Mr. Smith was an
employee of Edison Venture Fund. Mr. Smith is a director of Versatility, Inc., a
software company.
WILLIAM J. SMITH has been a director of the Company since March 1997. Since
November 1997, Mr. Smith has been Vice President, Sales of FlowWise Networks,
Inc., an IP switching technology company. From August 1992 to October 1997, Mr.
Smith was Senior Vice President, Sales and Marketing of Premisys Communications,
Inc., an integrated digital access company.
ELECTION OF DIRECTORS
Officers of the Company are elected by the Board of Directors on an annual
basis and serve until their successors have been duly elected and qualified. The
Company's Certificate of Incorporation provides for a classified Board of
Directors consisting of three classes of directors with each class required to
be as nearly equal in number as possible. The number of directors is determined
from time to time by the Board of Directors and is currently fixed at seven
members. A single class of directors is elected each year at the Company's
annual meeting of stockholders. Directors elected at each such meeting will
serve for a term ending on the date of the third annual meeting of stockholders
after election and the election and qualification of their respective
successors. Messrs. Behrman and Thomas Smith are serving for terms expiring on
the date of the Company's
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<PAGE> 41
1998 Annual Meeting of Stockholders, Messrs. Joseph and Benson are serving for
terms expiring on the date of the Company's 1999 Annual Meeting of Stockholders
and Messrs. Stouffer, McCourtney and William Smith are serving for terms
expiring on the date of the Company's 2000 Annual Meeting of Stockholders.
There are no family relationships among any of the Company's directors or
executive officers.
BOARD COMMITTEES
The Company's Board of Directors currently has two committees, the Audit
Committee and the Compensation Committee. The Audit Committee, among other
things, recommends the firm to be appointed as independent accountants to audit
the Company's financial statements, discusses the scope and results of the audit
with the independent accountants, reviews with management and the independent
accountants the Company's interim and year-end operating results, considers the
adequacy of the internal accounting controls and audit procedures of the Company
and reviews the non-audit services to be performed by the independent
accountants. The current members of the Audit Committee are Messrs. Joseph,
McCourtney and Thomas Smith. The Compensation Committee reviews and recommends
the compensation arrangements for management of the Company and administers the
Company's stock option plans. The members of the Compensation Committee are
Messrs. Benson, Joseph and Thomas Smith.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Compensation Committee of the Company's Board of Directors was formed
in December 1994, and the current members of the Compensation Committee are
Messrs. Benson, Joseph and Thomas Smith. None of the members was, during 1997,
an officer or employee of the Company at any time.
DIRECTORS' COMPENSATION
Messrs. Joseph and William Smith have been granted options to purchase the
Company's Common Stock as compensation for their services as Board members. Mr.
Joseph was granted options to purchase 29,400 shares of Common Stock in December
1995, at an exercise price of $.19 per share, of which options to purchase 9,800
shares vested immediately and options to purchase 9,800 shares vested on the
first and second anniversary of the grant date. Mr. William Smith was granted
options to purchase 27,000 shares of Common Stock in March 1997, at an exercise
price of $1.43 per share, of which options to purchase 9,000 shares will vest on
each of the first, second and third anniversaries of the grant date.
Following the completion of this offering, each Eligible Director will
receive options under the Company's 1997 Directors' Stock Option Plan. See
"Directors' Stock Option Plan".
EXECUTIVE COMPENSATION
The following summary compensation table sets forth the compensation paid
by the Company during the fiscal year ended December 31, 1997 to the Company's
chief executive officer and the other most highly compensated executive officers
whose total compensation for services in all capacities exceeded $100,000 during
such year (the "Named Executive Officers").
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SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
------------
ANNUAL COMPENSATION SECURITIES
--------------------------------- UNDERLYING
SALARY BONUS(1) OTHER OPTIONS
-------- -------- -------- ------------
<S> <C> <C> <C> <C>
Scott E. Stouffer
Chairman of the Board, President and
Chief Executive Officer............... $165,000 $71,880 $ -- --
Peter J. Minihane
Executive Vice President, Chief Financial
Officer and Treasurer................. 100,550(2) 45,939 92,951(3) 175,000
Henry A. Cheli
Senior Vice President, Market
Operations............................ 119,048(2) 82,618 96,697(4) 135,000
Gregory J. Langford
Senior Vice President, Product
Operations............................ 125,000 50,940 61,662(3) 35,000
Robert C. Troutman
Senior Vice President, Advance
Planning.............................. 140,000 61,366 -- --
</TABLE>
- ---------------
(1) These bonuses are payable in 1998.
(2) The salaries paid Messrs. Minihane and Cheli are for the periods from their
respective dates of employment, June 15, 1997 and March 20, 1997.
(3) Consists of relocation payments.
(4) Consists of commissions of $40,000 and relocation payments of $56,697.
OPTION GRANTS
The following table provides information concerning grants of options to
purchase the Company's Common Stock made during the fiscal year ended December
31, 1997 to each of the Named Executive Officers.
<TABLE>
<CAPTION>
OPTION GRANTS IN LAST FISCAL YEAR
-------------------------------------------------------------------------------------
POTENTIAL REALIZABLE
VALUE AT ASSUMED
ANNUAL RATES OF
NUMBER OF PERCENTAGE OF STOCK PRICE
SECURITIES TOTAL OPTIONS APPRECIATION FOR
UNDERLYING GRANTED TO EXERCISE OPTION TERM(4)
OPTIONS EMPLOYEES IN PRICE EXPIRATION --------------------
GRANTED(1) FISCAL 1997(2) PER SHARE(3) DATE 5% 10%
---------- -------------- ------------ ---------- -------- --------
<S> <C> <C> <C> <C> <C> <C>
Scott E.
Stouffer......... -- --% $ -- -- $ -- $ --
Peter J.
Minihane......... 175,000 18.8 1.75(3) 6/18/07 192,599 488,084
Henry A. Cheli..... 135,000 14.5 1.43(3) 3/17/07 121,408 307,672
Gregory J.
Langford......... 35,000 3.8 3.00(3) 8/20/07 66,034 167,343
Robert C.
Troutman......... -- -- -- -- -- --
</TABLE>
- ---------------
(1) All options were granted under the Company's 1994 Stock Option Plan (the
"1994 Plan"), and become exercisable at a rate of 1.67% monthly over the
five-year period following the date of grant provided that such officer
remains continuously employed by the Company.
(2) Based on options to purchase 928,955 shares of Common Stock granted in 1997.
(3) All options were granted at exercise prices equal to the fair market value
of the Common Stock, as determined by the Board of Directors, on the grant
date, based upon the price at which the Company's Preferred Stock had been
issued, an independent valuation of the Company's
41
<PAGE> 43
Common Stock in November 1996, arms-length transactions in the Company's
Preferred Stock, valuations of comparable companies and the financial
condition and results of operations of the Company at each of the dates of
grant. The Company's Common Stock was not traded publicly at the time the
options were granted to the Named Executive Officers.
(4) Potential realizable values are net of exercise price, but before taxes
associated with exercise. Amounts represent hypothetical gains that could be
achieved for the respective options if exercised at the end of the option
term. The assumed 5% and 10% rates of stock price appreciation are provided
in accordance with rules of the United States Securities and Exchange
Commission and do not represent the Company's estimate or projection of the
future Common Stock price. Actual gains, if any, on stock option exercises
are dependent on the future performance of the Common Stock, overall market
conditions and the option holders' continued employment through the vesting
period. This table does not take into account any appreciation in the price
of the Common Stock from the date of grant to date. Assuming the fair market
value of the Common Stock at the date of grant was the initial public
offering price of $12.50, the potential realizable value of these options
(a) at a 5% assumed annual rate of stock price appreciation would be
$3,256,960 for Mr. Minihane, $2,555,712 for Mr. Cheli and $607,642 for Mr.
Langford.
None of the Named Executive Officers exercised any stock options during
1997.
YEAR-END OPTION VALUES
The following table provides the specified information concerning
unexercised options held as of December 31, 1997 by the Named Executive
Officers.
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING IN-THE-MONEY
UNEXERCISED OPTIONS AT OPTIONS AT
DECEMBER 31, 1997 DECEMBER 31, 1997(1)
---------------------------- ----------------------------
EXERCISABLE UNEXERCISABLE EXERCISABLE UNEXERCISABLE
----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Scott E. Stouffer.......................... 38,237 25,012 $ 377,119 $ 244,892
Peter J. Minihane.......................... -- 175,000 -- 1,443,750
Henry A. Cheli............................. -- 135,000 -- 1,156,950
Gregory J. Langford........................ 5,584 94,416 44,162 757,888
Robert C. Troutman......................... 13,799 21,201 135,368 207,982
</TABLE>
- ---------------
(1) Calculated on the basis of $10.00 per share, the fair market value of the
Common Stock at December 31, 1997, as determined by the Company's Board of
Directors, less the exercise price payable for such shares, multiplied by
the number of shares underlying the option.
No compensation intended to serve as incentive for performance to occur
over a period longer than one year was paid pursuant to a long-term incentive
plan during the last year to any of the Named Executive Officers.
EMPLOYMENT ARRANGEMENTS
The Company has entered into employment agreements with Scott E. Stouffer
and Robert C. Troutman (the "Employees"), dated December 15, 1994 (the
"Employment Agreements"). The Employment Agreements provide that Mr. Stouffer
and Mr. Troutman currently receive annual salaries of $165,000 and $140,000,
respectively (to be reviewed annually), an annual bonus and reimbursement of
certain expenses. The Employees are also entitled to participate in any heath,
life or accident insurance plans or programs made available to other similarly
situated employees. The Employees are also entitled to 20 business days
sabbatical following completion of every four years of employment.
42
<PAGE> 44
The Employment Agreements continue on a year-to-year basis, renewing each
December 15 unless terminated (1) upon 90 days notice from either the applicable
Employee or the Company prior to the end of the then-current term; (2) by death;
(3) due to disability; (4) by the Company without cause upon 45 days' prior
written notice to the Employee; or (5) by the Company for cause upon 30 days'
prior written notice, or in the case of embezzlement or theft, immediately
without notice. Upon termination without cause by the Company, the Company will
pay the Employee severance equal to six months base salary.
The Employment Agreements contain a covenant not to compete which provides
that for a period of 24 months (decreasing to 12 months after the Employee has
been an employee for four years) after the Employee's termination for any
reason, the Employee is subject to a non-solicitation restriction and will not
compete with the Company or accept employment with a competitor of the Company.
The Employment Agreements also contain confidentiality and assignment of
inventions provisions.
In March 1997, Mr. Cheli entered into an employment arrangement with the
Company, pursuant to which Mr. Cheli serves as Senior Vice President, Market
Operations. The arrangement provides for an initial annual base salary of
$150,000, in addition to certain other benefits. Mr. Cheli's compensation can
increase based on the Company's 1997 financial performance. Upon termination of
employment by the Company without cause, Mr. Cheli is entitled to receive the
compensation and benefits which would otherwise be payable to him for a maximum
of six months following such termination. The Company granted Mr. Cheli an
option to purchase 135,000 shares of Common Stock at an exercise price of $1.43
per share, vesting 20% at the end of the first year after grant and in equal
monthly increments over the next four years. Upon a change of control of the
Company, Mr. Cheli's options will automatically vest, depending on the time of
the change of control, as follows: (i) 40% if the change of control occurs on or
before the first anniversary of Mr. Cheli's option grant; (ii) 80% if the change
of control occurs after the first anniversary, but prior to the second
anniversary of the option grant; and (iii) 100% after the second anniversary of
the option grant.
In November 1996, Mr. Langford entered into an employment arrangement with
the Company, pursuant to which Mr. Langford serves as Vice President, Product
Management and Planning. He subsequently has been promoted to Senior Vice
President, Product Operations. The arrangement provides for an initial annual
base salary of $125,000, in addition to certain other benefits. Mr. Langford's
compensation can increase based on the Company's 1997 financial performance.
Upon termination of employment by the Company without cause, Mr. Langford is
entitled to receive the compensation and benefits which would otherwise be
payable to him for a maximum of six months following such termination. Mr.
Langford was granted options to purchase 49,000 shares of Common Stock in
November 1996 at an exercise price of $1.43 per share, vesting 20% at the end of
the first year after grant and in equal monthly increments over the next four
years, options to purchase 16,000 shares of Common Stock in December 1996 at an
exercise price of $1.43 per share, vesting in equal monthly increments over five
years, and options to purchase 35,000 shares of Common Stock in August 1997 at
an exercise price of $3.00 per share, vesting 20% at the end of two years after
grant and in equal monthly increments over the next three years. Fifty percent
of Mr. Langford's unvested options vest upon a change of control of the Company.
In June 1997, Mr. Minihane entered into an employment arrangement with the
Company, pursuant to which Mr. Minihane serves as Executive Vice President,
Chief Financial Officer and Treasurer of the Company. The arrangement provides
for an initial annual base salary of $120,000, increasing to $160,000 in June
1998, in addition to certain other benefits. Mr. Minihane's compensation can
increase based on the Company's 1997 financial performance. Upon termination of
employment by the Company without cause, Mr. Minihane is entitled to receive the
compensation and benefits which would otherwise be payable to him for a maximum
of six months following such termination. Mr. Minihane was granted options to
purchase 175,000 shares of Common Stock in June 1997 at an exercise price of
$1.75 per share, vesting 20% at the end of the first year after grant
43
<PAGE> 45
and in equal monthly increments over the next four years. All of Mr. Minihane's
unvested options vest upon a change of control of the Company. Upon commencement
of his employment with the Company, Mr. Minihane purchased 25,000 shares of the
Company's Common Stock at $1.75 per share.
The Company's employment agreement with each of Messrs. Cheli, Langford and
Minihane contains general non-solicitation and non-competition provisions
applicable during the period of such employee's employment with the Company and
for two years thereafter (or one year if his employment terminates after January
1, 1999).
All other employees of the Company are required to sign agreements which
prohibit the employee from directly or indirectly competing with the Company
while employed by the Company and generally for a period of two years thereafter
(or one year if their employment terminates after January 1, 1999). All
employees have executed agreements which prohibit the disclosure of the
Company's confidential or proprietary information.
STOCK PLANS
1994 STOCK OPTION PLAN
The Company's 1994 Plan authorizes the issuance of an aggregate of
1,975,000 shares of Common Stock pursuant to the exercise of stock options. As
of December 31, 1997, 120,200 shares had been issued under the 1994 Plan,
options to purchase 1,840,501 shares were outstanding and 14,299 shares remained
available for future grant under the 1994 Plan.
The 1994 Plan provides for grants of options to employees, consultants and
directors of the Company. Each stock option granted under the 1994 Plan is
evidenced by a written stock option agreement between the Company and the
optionee. The 1994 Plan provides for the granting of both "incentive stock
options" within the meaning of Section 422 of the Internal Revenue Code of 1986,
as amended, and non-statutory options. The 1994 Plan is administered by the
Compensation Committee, which has sole discretion and authority, consistent with
the provisions of the 1994 Plan, to determine which eligible participants will
receive options, the time when options will be granted, the terms of options
granted and the number of shares that will be subject to options granted under
the 1994 Plan.
For any option intended to qualify as an incentive stock option, the
exercise price must not be less than 100% of the fair market value of the Common
Stock on the date the option is granted (110% of the fair market value of such
Common Stock with respect to any optionee who immediately before any option is
granted, directly or indirectly, possesses more than 10% of the total combined
voting power of all classes of stock of the Company ("10% Owners")). The
Compensation Committee has the authority to determine the time or times at which
options granted under the 1994 Plan become exercisable; provided that, for any
option intended to qualify as an incentive stock option, such option must expire
no later than ten years from the date of grant (five years with respect to 10%
Owners). Options are non-assignable and non-transferable, unless a stock option
agreement provides that such option may be transferred by the optionee upon
death, by will or the laws of descent and distribution. Options generally may be
exercised only while the optionee is either employed by, or rendering services
to, the Company or within a specified period of time thereafter. The
Compensation Committee may accelerate the date of exercise of any option or
waive any condition or restriction pertaining to such option at any time. Unless
terminated sooner by the Board, the 1994 Plan will terminate in December 2004 or
the date on which all shares available for issuance shall have been issued
pursuant to the exercise or cancellation of options granted under the 1994 Plan.
44
<PAGE> 46
1997 OMNIBUS STOCK PLAN
The Company's 1997 Omnibus Stock Plan (the "Omnibus Plan") authorizes the
issuance of an aggregate of up to 1,000,000 shares of Common Stock with respect
to certain "Awards" made under the Omnibus Plan. As of December 31, 1997, all
such shares remained available for future grant under the Omnibus Plan.
The Omnibus Plan provides for grants of options to employees, officers,
directors and consultants of the Company or any affiliate of the Company;
provided, however, that no individual may receive an award of more than 250,000
shares in any one fiscal year. "Awards" under the Omnibus Plan may take the form
of grants of stock options, stock appreciation rights, restricted or
unrestricted stock, phantom stock, performance awards or any combination
thereof. The Omnibus Plan is administered by the Board of Directors, or by such
committee or committees as may be appointed by the Board of Directors from time
to time (the "Administrator"). The Administrator has sole power and authority,
consistent with the provisions of the Omnibus Plan, to determine which eligible
participants will receive Awards, the form of the Awards and the number of
shares of Common Stock covered by each Award, to impose terms, limits,
restrictions and conditions upon Awards, to modify, amend, extend or renew
Awards (with the consent of the awardee), to accelerate or change the exercise
timing of Awards or to waive any restrictions or conditions to an Award and to
establish objective and conditions for earning Awards.
Unless otherwise determined by the Administrator, and in any event in the
case of an incentive stock option or a stock appreciation right granted with
respect to an incentive stock option, Awards are not transferable other than by
will or the laws of descent and distribution. Unless otherwise determined by the
Administrator in accord with the provisions of the immediately preceding
sentence, an Award may be exercised during the lifetime of the grantee, only by
the grantee or, during the period the grantee is under a legal disability, by
the grantee's guardian or legal representative. Unless terminated sooner by the
Board, the Omnibus Plan terminates in October 2007 or the date on which all
shares available for issuance shall have been issued pursuant to the exercise or
cancellation of Awards under the Omnibus Plan.
1997 DIRECTORS' STOCK OPTION PLAN
The 1997 Directors' Stock Option Plan (the "Director Plan") was adopted in
October 1997. Under the terms of the Director Plan, directors of the Company who
are not employees of the Company (the "Eligible Directors") are eligible to
receive non-statutory options to purchase shares of Common Stock. A total of
300,000 shares of Common Stock may be issued upon exercise of options granted
under the Director Plan. Unless terminated sooner by the Board of Directors, the
Director Plan will terminate in October 2007, or the date on which all shares
available for issuance under the Director Plan shall have been issued pursuant
to the exercise of options granted under the Director Plan.
Upon a member's initial election or appointment to the Board of Directors
after the date of this Prospectus, or for current Eligible Directors at the date
of the closing of this offering, such member will be granted options to purchase
up to 24,000 shares of Common Stock, vesting over four years, with options to
purchase 6,000 shares vesting at the first anniversary of the grant and options
to purchase the remaining 18,000 shares vesting in 36 equal monthly
installments. Annual options to purchase 6,000 shares of Common Stock (the
"Annual Options") will be granted to each Eligible Director on the date of each
annual meeting of stockholders after the closing of the offering. Annual Options
will vest at the rate of one-twelfth of the total grant per month, and will vest
in full at the earlier of (i) the first anniversary of the date of the grant or
(ii) the date of the next annual meeting of stockholders. The exercise price of
options granted under the Director Plan will be calculated as follows: (x) for
options issued at the closing of this offering, the exercise price will equal
the initial public offering price; and (y) for all other grants, the exercise
price will equal the fair market value per share of the Common Stock on the date
of grant.
45
<PAGE> 47
Options granted under the Director Plan are not transferable by the
optionee except by will or by the laws of descent and distribution or pursuant
to a qualified domestic relations order. In the event an optionee ceases to
serve as a director, each option may be exercised by the optionee for the
portion then exercisable at any time within 60 days after the optionee ceases to
serve as a director; provided, however, that in the event that the optionee
ceases to serve as a director due to his death or disability, then the optionee,
or his or her administrator, executor or heirs, may exercise the exercisable
portion of the option for up to 180 days following the date the optionee ceases
to serve as a director. No option is exercisable after the expiration of five
years from the date of grant.
INDEMNIFICATION OF DIRECTORS AND EXECUTIVE OFFICERS AND LIMITATION OF LIABILITY
The Company's Certificate of Incorporation provides that to the fullest
extent permitted by Delaware law a director of the Company shall not be liable
to the Company or its stockholders for monetary damages for breach of fiduciary
duty as a director. Under current Delaware law, liability of a director may not
be limited (i) for any breach of the director's duty of loyalty to the Company
or its stockholders, (ii) for acts or omissions not in good faith or which
involve intentional misconduct or a knowing violation of law, (iii) in respect
of certain unlawful dividend payments or stock redemptions or repurchases and
(iv) for any transaction from which the director derives an improper personal
benefit. The effect of this provision of the Company's Certificate of
Incorporation is to limit or eliminate the rights of the Company and its
stockholders (through stockholders' derivative suits on behalf of the Company)
to recover monetary damages against a director for breach of the fiduciary duty
of care as a director (including breaches resulting from negligent or grossly
negligent behavior) except in those circumstances described in clauses (i)
through (iv) above. This provision does not limit or eliminate the rights of the
Company or any stockholder to seek nonmonetary relief such as an injunction or
rescission in the event of a breach of a director's duty of care. In addition,
the Company's Certificate of Incorporation and Bylaws provide that the Company
shall indemnify its directors, officers, employees and agents to the fullest
extent permitted by Delaware law.
The Company's Bylaws provide that the Company shall indemnify its officers
and directors to the fullest extent permitted by Delaware law, including in
circumstances in which indemnification is otherwise discretionary under Delaware
law. The Company intends to obtain officer and director liability insurance with
respect to liabilities arising out of certain matters, including matters arising
under the Securities Act.
At present, there is no pending litigation or proceeding involving any
officer or director, employee or agent of the Company where indemnification will
be required or permitted. The Company is not aware of any threatened litigation
or proceeding which may result in a claim for such indemnification.
CERTAIN TRANSACTIONS
In December 1994, the Company issued 347,070 shares of its Series A
Convertible Preferred Stock at a price of $0.3477 per share, including 29,069
shares to affiliates of Mr. Stouffer.
In December 1994, the Company issued 2,588,438 shares of its Series B
Convertible Preferred Stock at a price of $0.4636 per share, including 939,207
shares to NEPA Venture Fund II, L.P. ("NEPA"), 256,148 shares to Tritech
Partners, L.P. ("Tritech"), 426,913 shares to William Oakes ("Oakes") and
539,257 shares to the Maryland Department of Business and Economic Development
("DBED"). DBED has the right to require the Company to repurchase all of its
shares at the greater of cost or fair market value if the Company relocates its
principal place of business outside of the State of Maryland prior to December
15, 1999.
46
<PAGE> 48
In August 1995, the Company issued 1,600,000 shares of its Series C
Convertible Preferred Stock at a price of $1.25 per share, including 800,000
shares to Edison Venture Fund III, L.P. ("Edison"), 366,666 shares to NEPA,
120,501 shares to Tritech and 125,666 shares to Oakes.
In January 1996, the Company issued 2,285,714 shares of its Series D
Convertible Preferred Stock at a price of $1.75 per share, including an
aggregate of 1,428,571 shares to Venrock Associates and Venrock Associates II,
L.P. (collectively, "Venrock"), 261,258 shares to Edison, 225,917 shares to
NEPA, 105,350 shares to Tritech, 25,000 shares to Oakes and 42,857 shares to Mr.
Joseph.
In September 1996, the Company issued 754,321 shares of its Series E
Convertible Preferred Stock at a price of $6.66 per share, including 120,120
shares to Venrock, 120,120 shares to Edison, 18,769 shares to NEPA, 7,508 shares
to Tritech, 12,012 shares to Mr. Joseph and affiliates and an aggregate of
454,021 shares to Behrman Capital L.P., Behrman Capital B L.P. and Strategic
Entrepreneur Fund L.P.
On June 15, 1997, the Company issued 25,000 shares of its Common Stock at a
price of $1.75 per share to Mr. Minihane. See "Management -- Employment
Arrangements".
On September 13, 1997, the Company issued 10,504 shares of its Common Stock
at a price of $4.76 per share to Mr. William Smith. The Company's Board of
Directors, excluding Mr. Smith, determined the sale price based on a recently
completed arms-length sale of securities by William R.T. and Carol B. Oakes to
the Individual Retirement Account of Theodore R. Joseph, a director of the
Company.
The Company believes that all transactions set forth above were made on
terms no less favorable to the Company than would have been obtained from
unaffiliated third parties. The Company has adopted a policy whereby all future
transactions between the Company and its officers, directors and affiliates will
be on terms no less favorable to the Company than could be obtained from
unrelated third parties and will be approved by a majority of the disinterested
members of the Board of Directors.
47
<PAGE> 49
PRINCIPAL STOCKHOLDERS
The following table sets forth certain information regarding the beneficial
ownership of the Company's Common Stock as of December 31, 1997, and as adjusted
to reflect the sale of the shares of Common Stock offered hereby: (i) by each
person who is known by the Company to own beneficially more than five percent of
the Company's Common Stock, (ii) by each director and Named Executive Officer,
and (iii) by all executive officers and directors as a group.
<TABLE>
<CAPTION>
PERCENT OF OWNERSHIP
NUMBER OF SHARES -----------------------
BENEFICIALLY BEFORE THE AFTER THE
NAME OF BENEFICIAL OWNER OWNED(1) OFFERING OFFERING
- -------------------------------------------------------- ---------------- ---------- ---------
<S> <C> <C> <C>
NEPA Venture Fund II, L.P.(2)........................... 2,170,780 16.0% 12.7%
c/o Mid-Atlantic Venture Funds
1801 Reston Parkway -- Suite 203
Reston, VA 20190
Venrock Entities(3)..................................... 2,160,680 15.9 12.7
30 Rockefeller Plaza
New York, NY 10112
Edison Venture Fund III, L.P.(4)........................ 1,653,929 12.2 9.7
997 Lenox Drive, Building No. 3
Lawrenceville, NJ 08648
William R.T. and Carol B. Oakes(5)...................... 780,610 5.8 4.6
Maryland Department of Business
and Economic Development(6)........................... 754,959 5.6 4.4
217 E. Redwood Street
Baltimore, MD 21202
Tritech Partners, L.P.(7)............................... 685,309 5.1 4.0
300 East Joppa Road, Suite 1111
Baltimore, MD 21286
Marc F. Benson(8)....................................... 2,170,780 16.0 12.7
Grant G. Behrman(9)..................................... 635,628 4.7 3.7
Henry A. Cheli(16)...................................... 0 0 0
Theodore R. Joseph(10).................................. 120,204 * *
Gregory J. Langford(11)(16)............................. 7,282 * *
Ted H. McCourtney(12)................................... 2,160,680 15.9 12.7
Peter J. Minihane(16)................................... 25,000 * *
Thomas A. Smith(13)..................................... 1,653,929 12.2 9.7
William J. Smith........................................ 10,504 * *
Scott E. Stouffer (14) (16)............................. 1,494,285 11.0 8.7
Robert C. Troutman(15) (16)............................. 468,545 3.5 2.7
All executive officers and directors as a group (12
persons)(17).......................................... 8,753,136 64.1 51.0
</TABLE>
- ---------------
* Less than 1%.
(1) The persons named in this table have sole voting power with respect to all
shares of Common Stock shown as beneficially owned by them, subject to
community property laws where applicable and except as indicated in the
other footnotes to this table. Beneficial ownership is determined in
accordance with the rules of the SEC. In computing the number of shares
beneficially owned by a person and the percentage ownership of that person,
shares of Common Stock subject to options held by that person that are
currently exercisable or exercisable within 60 days after December 31,
1997, are deemed outstanding. Such shares, however, are not deemed
outstanding for the purpose of computing the percentage ownership of any
other person.
(2) Marc F. Benson, a director of the Company, is a principal and partner of
Mid-Atlantic Venture Funds, formerly NEPA Venture Funds ("NEPA"). Mr.
Benson has shared voting and investment power over the shares held by NEPA
but disclaims beneficial ownership thereof except to the extent of his
proportionate partnership interest therein.
(3) Represents 1,338,475 shares of Common Stock beneficially owned by Venrock
Associates and 822,205 shares of Common Stock beneficially owned by Venrock
Associates II, L.P.
48
<PAGE> 50
(Venrock Associates and Venrock Associates II, L.P., collectively
"Venrock"). Ted H. McCourtney, a director of the Company, is a general
partner of both Venrock Associates and Venrock Associates II, L.P. Mr.
McCourtney has shared voting and investment power over the shares held by
Venrock but disclaims beneficial ownership thereof except to the extent of
his proportionate partnership interest therein.
(4) Thomas A. Smith, a director of the Company, is a general partner of Edison
Venture Fund III, L.P. ("Edison"). Mr. Smith has shared voting and
investment power over shares held by Edison but disclaims beneficial
ownership thereof except to the extent of his proportionate partnership
interest therein.
(5) The address of Mr. and Mrs. Oakes is c/o the Company, 2092 Gaither Road,
Rockville, Maryland 20850.
(6) The Maryland Department of Business and Economic Development ("DBED")
provides administrative services for the Maryland Venture Capital Trust
(the "Trust"). The Trust is a body politic and corporate and is constituted
as a public instrumentality of the State of Maryland. The Trust is a
limited partner in both Edison and Tritech Partners, L.P. ("Tritech"), and
as such may be deemed to beneficially own its proportionate partnership
share of the securities owned by Edison and Tritech. Neither DBED nor the
Trust exercises any voting power or investment power over the securities
owned by Edison or Tritech and therefore each disclaims beneficial
ownership of such securities.
(7) Jeffrey A. Davison and Barbara A. Melera, officers of First Technology,
Inc., the general partner of the general partner of Tritech Partners, L.P.,
have shared voting and investment power with respect to the shares held by
Tritech Partners, L.P., but disclaim beneficial ownership thereof except to
the extent of their proportionate partnership interest therein.
(8) Represents 2,170,780 shares of Common Stock beneficially owned by NEPA
which Mr. Benson may be deemed to beneficially own by virtue of his status
as a principal and general partner of NEPA. Mr. Benson has shared voting
and investment power over shares held by NEPA but disclaims beneficial
ownership thereof except to the extent of his proportionate partnership
interest therein.
(9) Represents 251,441 shares of Common Stock held by Behrman Capital L.P.,
379,188 shares held by Behrman Capital B L.P., and 4,999 shares held by
Strategic Entrepreneur Fund, L.P., which Mr. Behrman may be deemed to
beneficially own by virtue of his status as a General Partner of Behrman
Brothers L.P., the general partner of such entities. Mr. Behrman has shared
voting and investment power over shares held by these entities but
disclaims beneficial ownership thereof except to the extent of his
proportionate partnership interest therein.
(10) Represents 68,404 shares of Common Stock held by Mr. Joseph, 22,400 shares
held by Mr. Joseph's IRA and 29,400 shares of Common Stock issuable upon
exercise of stock options.
(11) Represents 7,282 shares of Common Stock issuable upon exercise of options.
(12) Represents shares of Common Stock beneficially owned by Venrock which Mr.
McCourtney may be deemed to beneficially own by virtue of his status as a
general partner of Venrock. Mr. McCourtney has shared voting and investment
power over the shares held by Venrock but disclaims beneficial ownership
thereof except to the extent of his proportionate partnership interest
therein.
(13) Represents shares of Common Stock beneficially owned by Edison which Mr.
Smith may be deemed to beneficially own by virtue of his status as a
general partner of Edison. Mr. Smith has shared voting and investment power
over shares held by Edison but disclaims beneficial ownership thereof
except to the extent of his proportionate partnership interest therein.
(14) Includes 854,000 shares of Common Stock held by Mr. Stouffer, 280,000
shares of Common Stock held by the Scott E. Stouffer GRAT, 320,696 shares
of Common Stock held by Mr. Stouffer's wife and 39,589 shares of Common
Stock issuable upon exercise of options.
(15) Includes 397,600 shares of Common Stock held by Mr. Troutman, 49,000 shares
held by the Robert C. Troutman Grantor Retained Annuity Trust ("GRAT"),
3,500 shares held by Mr. Troutman as custodian for each of two children and
14,945 shares of Common Stock issuable upon exercise of stock options.
(16) The address of Messrs. Cheli, Langford, Minihane, Stouffer and Troutman is
c/o the Company, 2092 Gaither Road, Rockville, Maryland 20850.
(17) Includes an aggregate of 95,417 shares of Common Stock issuable upon
exercise of options. See notes 10, 11, 14 and 15 above.
49
<PAGE> 51
DESCRIPTION OF CAPITAL STOCK
Upon the closing of the offering, the Company's authorized capital stock
will consist of 50,000,000 shares of Common Stock, $.01 par value per share, and
5,000,000 shares of Preferred Stock, $.01 par value per share.
COMMON STOCK
At December 31, 1997, the Company had outstanding 2,955,704 shares of
Common Stock held of record by approximately 37 stockholders. Each holder of
Common Stock is entitled to one vote for each share held. Following the
conversion of the Convertible Preferred Stock to Common Stock, the holders of
Common Stock, voting as a single class, will be entitled to elect all of the
directors of the Company.
Holders of Common Stock are entitled to receive ratably such dividends as
may be declared by the Board of Directors out of funds legally available
therefor. See "Dividend Policy." In the event of a liquidation, dissolution or
winding up of the Company, holders of Common Stock would be entitled to share in
the Company's assets remaining after the payment of liabilities and the
satisfaction of any liquidation preference granted the holders of any
outstanding shares of Preferred Stock. Holders of Common Stock have no
preemptive or other subscription rights. The shares of Common Stock are not
convertible into any other security. The outstanding shares of Common Stock are,
and the shares being offered hereby will be, upon issuance and sale, fully paid
and nonassessable.
PREFERRED STOCK
At December 31, 1997, the Company had outstanding an aggregate of 7,575,543
shares of Convertible Preferred Stock, consisting of 347,070 shares of Series A
Convertible Preferred Stock, 2,588,438 shares of Series B Convertible Preferred
Stock, 1,600,000 shares of Series C Convertible Preferred Stock, 2,285,714
shares of Series D Convertible Preferred Stock and 754,321 shares of Series E
Convertible Preferred Stock. The Series A, B, C, D and E Preferred Stock are
held of record by 16, 5, 7, 12 and 16 stockholders, respectively. Pursuant to
the terms of the Convertible Preferred Stock, upon the closing of the offering,
all the outstanding Convertible Preferred Stock will be converted into
10,605,735 shares of Common Stock. All shares of the currently outstanding
Convertible Preferred Stock will be canceled upon conversion.
Upon the closing of the offering, the Company will have the authority to
issue up to 5,000,000 shares of Preferred Stock. The Board of Directors has the
authority to issue, without any further action by the stockholders, the
Preferred Stock in one or more series, to establish from time to time the number
of shares to be included in each series, and to fix the designations, powers,
preferences and rights of the shares of each series and the qualifications,
limitations or restrictions thereof. Although the ability of the Board of
Directors to designate and issue Preferred Stock could provide flexibility in
possible acquisitions or other corporate purposes, issuance of Preferred Stock
may have adverse effects on the holders of Common Stock, including restrictions
on dividends on the Common Stock if dividends on the Preferred Stock have not
been paid; dilution of voting power of the Common Stock to the extent the
Preferred Stock has voting rights; or deferral of participation in the Company's
assets upon liquidation until satisfaction of any liquidation preference granted
to holders of the Preferred Stock. In addition, issuance of Preferred Stock
could make it more difficult for a third party to acquire a majority of the
outstanding voting stock and accordingly may be used as an "anti-takeover"
device. The Board of Directors, however, currently does not contemplate the
issuance of any Preferred Stock and is not aware of any pending transactions
that would be affected by such issuance.
REGISTRATION RIGHTS OF CERTAIN HOLDERS
Holders of an aggregate of 10,119,845 shares of Common Stock issuable upon
the conversion of the Convertible Preferred Stock (the "Registrable Shares") are
entitled to certain demand rights
50
<PAGE> 52
with respect to the registration of such shares under the Securities Act.
Subject to certain limitations, the Company is required, upon request of the
holders of at least two-thirds of the Registrable Shares outstanding, to file a
registration statement under the Securities Act covering such Registrable Shares
(a "Demand Registration"). The Company is not required to effect more than two
Demand Registrations. In addition to the Demand Registration rights described
above, and subject to certain conditions and limitations, such holders may
require the Company to file an unlimited number of registration statements on
Form S-2 or Form S-3 under the Securities Act, when such form is available for
use by the Company, provided that no more than two such requests may be made per
year.
Holders of an aggregate of 10,605,735 shares of Common Stock also are
entitled to include their shares of Common Stock in a registered offering of
securities by the Company (a "Piggyback Registration") for its own account,
subject to certain conditions and restrictions.
All expenses incurred in connection with Demand or Piggyback Registrations
(excluding underwriters' discounts and commissions but including the reasonable
fees and disbursements of one counsel chosen by the holders requesting a Demand
Registration or a registration on Form S-2 or S-3) shall be borne by the
Company; except, that if a Demand Registration is begun and subsequently
withdrawn by the requesting holders, the requesting holders may elect to either
treat such withdrawn registration as one of their two Demand Registrations or
pay all expenses with respect to the registration.
DELAWARE LAW AND CERTAIN CHARTER PROVISIONS
The Company's Certificate of Incorporation or Bylaws, as applicable, among
other things, (i) provide that the number of directors shall be determined from
time to time by resolution adopted by a majority of the Board of Directors; and
(ii) provide for a classified Board of Directors consisting of three classes of
directors having staggered terms of three years each, with each of the classes
being as nearly equal in number as possible. The Company's Certificate of
Incorporation provides that, upon the closing of the offering, any action
required or permitted to be taken by the stockholders of the Company may be
taken only at a duly called annual or special meeting of the stockholders, and
may not be effected by any consent in writing of such stockholders. These and
other provisions could have the effect of making it more difficult for a third
party to effect, or of discouraging a third party from trying to effect, a
change in the control of the Board of Directors. Such provisions may also
discourage another person from making a tender offer for the Company's Common
Stock, including offers at a premium over the market price of the Common Stock,
and might result in a delay in changes in control of management.
Section 203 of the Delaware General Corporation Law, as amended ("Section
203"), provides that, subject to certain exceptions specified therein, an
"interested stockholder" of a Delaware corporation shall not engage in any
business combination, including mergers or consolidations or acquisitions of
additional shares of the corporation, with the corporation for a three-year
period following the date at which the stockholder becomes an "interested
stockholder" unless (i) prior to such date, the board of directors of the
corporation approved either the business combination or the transaction which
resulted in the stockholder becoming an "interested stockholder," (ii) upon
consummation of the transaction which resulted in the stockholder becoming an
"interested stockholder," the interested stockholder owned at least 85% of the
voting stock of the corporation outstanding at the time that the transaction
commenced (excluding certain shares), or (iii) on or subsequent to such date,
the business combination is approved by the board of directors of the
corporation and authorized at an annual or special meeting of stockholders by
the affirmative vote of at least 66 2/3% of the outstanding voting stock which
is not owned by the "interested stockholder." Except as otherwise specified in
Section 203, an "interested stockholder" is defined to include (x) any person
which is the owner of 15% or more of the outstanding voting stock of the
corporation, or is an affiliate or associate of the corporation and was the
owner of 15% or more of the outstanding voting stock of the corporation at any
time within three years immediately prior to
51
<PAGE> 53
the relevant date and (y) the affiliates and associates of any such person. The
Company's stockholders, by adopting an amendment to its Certificate of
Incorporation or Bylaws, may elect not to be governed by Section 203, effective
twelve months after adoption. Neither the Certificate of Incorporation nor the
Bylaws presently exclude the Company from the restrictions imposed by Section
203.
TRANSFER AGENT AND REGISTRAR
The Transfer Agent and Registrar for the Common Stock is Boston EquiServe.
SHARES ELIGIBLE FOR FUTURE SALE
Upon completion of the offering, the Company will have 17,061,439 shares of
Common Stock outstanding, assuming no exercise of options to purchase Common
Stock after December 31, 1997. Of this amount, 3,500,000 shares offered hereby
will be available for immediate sale in the public market as of the date of this
Prospectus. Of the remaining 13,561,439 shares, approximately 3,437,864
additional shares will be eligible for immediate sale in the public market
pursuant to Rule 144(k) under the Securities Act, all of which are subject to
lock-up agreements. Within 90 days after the date of this Prospectus
approximately 10,095,575 shares will become eligible for sale in the public
market, of which 10,065,950 are subject to lockup agreements. Approximately
14,073,454 shares, which includes options exercisable for approximately 541,640
shares, become eligible for sale in the public market following the expiration
of 180-day lockup agreements with the Representatives of the Underwriters,
subject in some cases to compliance with the volume and other limitations of
Rule 144.
In general, under Rule 144 as currently in effect, a person (or persons
whose shares are aggregated) who has beneficially owned shares for at least one
year is entitled to sell within any three-month period commencing 90 days after
the date of this Prospectus a number of shares that does not exceed the greater
of (i) 1% of the then outstanding shares of the Common Stock (approximately
170,601 shares immediately after the offering) or (ii) the average weekly
trading volume during the four calendar weeks preceding such sale, subject to
the filing of Form 144 with respect to such sale. A person (or persons whose
shares are aggregated) who is not deemed to have been an affiliate of the
Company at any time during the 90 days immediately preceding the sale who has
beneficially owned his or her shares for at least two years is entitled to sell
such shares pursuant to Rule 144(k) without regard to the limitations described
above. Persons deemed to be affiliates must always sell pursuant to Rule 144,
even after the applicable holding periods have been satisfied.
The Company is unable to estimate the number of shares that will be sold
under Rule 144, since this will depend on the market price for the Common Stock
of the Company, the personal circumstances of the sellers and other factors.
Prior to the offering, there has been no public market for the Common Stock, and
there can be no assurance that a significant public market for the Common Stock
will develop or be sustained after the offering. Any future sale or anticipated
future sale of substantial amounts of Common Stock in the open market may
adversely affect the market price of the Common Stock offered hereby.
The Company, its directors, executive officers, stockholders with
registration rights and certain other stockholders have agreed pursuant to the
Underwriting Agreement and other agreements that they will not sell any Common
Stock without the prior consent of the Representatives of the Underwriters for a
period of 180 days from the date of this Prospectus (the "180-day Lockup
Period"), except that the Company may, without such consent, grant certain
options to purchase stock pursuant to the Option Plan, Director Plan and Omnibus
Plan. The Representatives of the Underwriters may, at their sole discretion and
at any time without notice, release all or any portion of the securities subject
to the lockup arrangements.
52
<PAGE> 54
Any employee or consultant to the Company who purchased his or her shares
pursuant to a written compensatory plan or contract is entitled to rely on the
resale provisions of Rule 701, which permits nonaffiliates to sell their Rule
701 shares without having to comply with the public information, holding period,
volume limitation or notice provisions of Rule 144 and permits affiliates to
sell their Rule 701 shares without having to comply with the Rule 144 holding
period restrictions, in each case commencing 90 days after the date of this
Prospectus.
The Company intends to file a registration statement on Form S-8 under the
Securities Act to register shares of Common Stock issued or reserved for
issuance under the Option Plans, thus permitting the resale of such shares by
nonaffiliates in the public market without restriction under the Securities Act.
Such registration statement will not be effective prior to the date 90 days
after the date of this Prospectus.
In addition, after the offering, the holders of 10,605,735 shares
(including options exercisable into shares) of Common Stock will be entitled to
certain rights with respect to registration of such shares under the Securities
Act. Registration of such shares under the Securities Act would result in such
shares becoming freely tradable without restriction under the Securities Act
(except for shares purchased by affiliates of the Company) immediately upon the
effectiveness of such registration. See "Description of Capital
Stock -- Registration Rights".
LEGAL MATTERS
The validity of the shares of Common Stock being offered hereby and certain
other legal matters regarding the shares of Common Stock will be passed upon for
the Company by Piper & Marbury L.L.P., Washington, D.C., counsel to the Company.
Certain legal matters in connection with the offering will be passed upon for
the Underwriters by Hale and Dorr LLP, Washington, D.C.
EXPERTS
The financial statements and schedules of the Company as of December 31,
1996 and 1997, and for each of the three years in the period ended December 31,
1997, included in this Prospectus and elsewhere in the Registration Statement
have been audited by Arthur Andersen LLP, independent public accountants, as
indicated in their reports with respect thereto, and are included herein in
reliance upon the authority of said firm as experts in giving said reports.
OTHER MATTERS
In August 1997, the Company's Board of Directors retained Arthur Andersen
LLP as its independent public accountants and dismissed the Company's former
auditors. From the Company's inception and throughout the time they were
retained by the Company, the former auditors did not disagree with the Company
on any matter of accounting principles or practices, financial statement
disclosure or auditing scope or procedure or any reportable events. The former
auditors' reports on the Company's financial statements, contained no adverse
opinion or disclaimer of opinion and were not qualified or modified as to
uncertainty, audit scope or accounting principles. Prior to retaining Arthur
Andersen LLP, the Company had not consulted with Arthur Andersen LLP on any
accounting, auditing or reporting matter.
ADDITIONAL INFORMATION
The Company has filed with the Securities and Exchange Commission (the
"Commission"), Washington, D.C. 20549, a Registration Statement on Form S-1
(including all amendments thereto, the "Registration Statement") under the
Securities Act of 1933, with respect to the Common Stock offered hereby. As
permitted by the rules and regulations of the Commission, this prospectus omits
certain information contained in the Registration Statement. For further
information with respect to
53
<PAGE> 55
the Company and the Common Stock offered hereby, reference is made to the
Registration Statement and the exhibits and schedules filed therewith.
Statements contained in this Prospectus concerning the contents of any contract
or any other document referred to are not necessarily complete; reference is
made in each instance to the copy of such contract or document filed as an
exhibit to the Registration Statement. Each such statement is qualified in all
respects by such reference to such exhibits. The Registration Statement,
including exhibits and schedules thereto, may be inspected without charge at the
Securities and Exchange Commission's principal office in Washington, D.C., and
copies of all or any part thereof may be obtained from such office after payment
of fees prescribed by the Securities and Exchange Commission. The Commission
also maintains a Web site that contains reports, proxy statements and other
information regarding registrants, including the Company, that file such
information electronically with the Commission. The address of the Commission's
Web site is http://www.sec.gov.
54
<PAGE> 56
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Independent Public Accountants............................................ F-2
Balance Sheets as of December 31, 1996 and 1997 and Pro Forma Balance Sheet as of
December 31, 1997................................................................. F-3
Statements of Operations for the years ended December 31, 1995, 1996 and 1997....... F-4
Statements of Changes in Stockholders' Equity (Deficit) for the years ended December
31, 1995, 1996 and 1997........................................................... F-5
Statements of Cash Flows for the years ended December 31, 1995, 1996 and 1997....... F-6
Notes to Financial Statements....................................................... F-7
</TABLE>
F-1
<PAGE> 57
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Board of Directors and Stockholders of
Visual Networks, Inc.:
We have audited the accompanying balance sheets of Visual Networks, Inc., a
Delaware corporation, as of December 31, 1996 and 1997, and the related
statements of operations, changes in stockholders' equity (deficit) and cash
flows for each of the three years in the period ended December 31, 1997. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform an audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of Visual Networks, Inc., as of
December 31, 1996 and 1997, and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1997, in conformity
with generally accepted accounting principles.
ARTHUR ANDERSEN LLP
Washington, D.C.
January 9, 1998
F-2
<PAGE> 58
VISUAL NETWORKS, INC.
BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
<TABLE>
<CAPTION>
DECEMBER 31, PRO FORMA
-------------------- DECEMBER 31,
1996 1997 1997
-------- -------- ------------
(UNAUDITED)
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents............................................. $ 3,404 $ 8,693
Accounts receivable, net of allowance of $250 and $392,
respectively........................................................ 1,888 2,918
Inventory............................................................. 933 2,681
Other current assets.................................................. 211 567
-------- --------
Total current assets................................................ 6,436 14,859
Property and equipment, net............................................. 813 1,507
-------- --------
Total assets........................................................ $ 7,249 $ 16,366
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable and accrued expenses................................. $ 1,059 $ 3,171
Customer deposits..................................................... -- 3,068
Accrued compensation.................................................. 862 1,448
Deferred revenue...................................................... 1,124 4,913
Bank line of credit................................................... 848 --
Current portion of capital lease obligation........................... 49 222
-------- --------
Total current liabilities........................................... 3,942 12,822
Capital lease obligation, net of current portion........................ 28 256
-------- --------
Total liabilities................................................... 3,970 13,078
-------- --------
Commitments and contingencies (Note 8)
Redeemable convertible preferred stock (Note 3):
Series B, Series C, Series D and Series E redeemable convertible
cumulative preferred stock, $.01 par value, 7,229,438 shares
authorized in aggregate, 7,228,473 shares issued and outstanding in
aggregate as of December 31, 1996 and 1997, respectively, and no
shares outstanding on a pro forma basis (aggregate liquidation
preference of $13,262 and $14,484 as of December 31, 1996 and 1997,
respectively)....................................................... $ 13,398 $ 14,855 $ --
-------- -------- ----------
Stockholders' equity (deficit) (Note 4):
Preferred stock, $.01 par value, 5,000,000 shares authorized, no
shares issued and outstanding....................................... -- -- --
Series A convertible cumulative preferred stock, $.01 par value,
347,070 shares authorized, 347,070 shares issued and outstanding as
of December 31, 1996 and 1997 and no shares outstanding on a pro
forma basis (liquidation preference of $130 and $149 as of December
31, 1996 and 1997, respectively).................................... 3 3 --
Common stock, $.01 par value, 50,000,000 shares authorized, 2,800,000
and 2,955,704 shares outstanding as of December 31, 1996 and 1997,
respectively, and 13,561,439 on a pro forma basis................... 28 29 135
Deferred compensation................................................. -- (247) (247)
Additional paid-in capital............................................ 121 528 15,280
Accumulated deficit................................................... (10,271) (11,880) (11,880)
-------- -------- ----------
Total stockholders' equity (deficit)................................ (10,119) (11,567) 3,288
-------- -------- ----------
Total liabilities and stockholders' equity (deficit)................ $ 7,249 $ 16,366 $ 16,366
======== ======== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-3
<PAGE> 59
VISUAL NETWORKS, INC.
STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED
DECEMBER 31,
--------------------------------
1995 1996 1997
------- ------- ----------
<S> <C> <C> <C>
Revenue..................................................... $ 250 $6,335 $23,651
Cost of goods sold.......................................... 44 2,550 7,616
------- ------- ----------
Gross profit.............................................. 206 3,785 16,035
------- ------- ----------
Operating expenses:
Research and development.................................. 994 2,988 4,253
Sales and marketing....................................... 700 6,386 9,696
General and administrative................................ 343 1,469 2,286
------- ------- ----------
Total operating expenses............................... 2,037 10,843 16,235
------- ------- ----------
Loss from operations........................................ (1,831) (7,058) (200)
Interest income, net........................................ 40 75 48
------- ------- ----------
Net loss.................................................... $(1,791) $(6,983) $(152)
======= ======= ==========
Pro forma basic and diluted net loss per common share....... $(0.01)
==========
Pro forma weighted average common shares outstanding........ 14,222,785
==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-4
<PAGE> 60
VISUAL NETWORKS, INC.
STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
STOCKHOLDERS' EQUITY (DEFICIT)
------------------------------------------------------------
REDEEMABLE
CONVERTIBLE SERIES A CONVERTIBLE
PREFERRED STOCK PREFERRED STOCK COMMON STOCK
--------------------- ----------------------- ------------------- DEFERRED
SHARES AMOUNT SHARES AMOUNT SHARES AMOUNT COMPENSATION
---------- -------- ---------- ---------- ---------- ------ ------------
<S> <C> <C> <C> <C> <C> <C> <C>
BALANCE, DECEMBER 31, 1994................. 2,588,438 $ 1,170 347,070 $ 3 2,800,000 $ 28 $ --
Issuance of Series C preferred stock... 1,600,000 1,965 -- -- -- -- --
Accretion of Series B and Series C
preferred stock...................... -- 47 -- -- -- -- --
Accrued dividends on Series B and
Series C preferred stock............. -- 203 -- -- -- -- --
Net loss............................... -- -- -- -- -- -- --
---------- -------- -------- --- ---------- ---- ----
BALANCE, DECEMBER 31, 1995................. 4,188,438 3,385 347,070 3 2,800,000 28 --
Issuance of Series D preferred stock... 2,285,714 3,983 -- -- -- -- --
Issuance of Series E preferred stock... 754,321 5,018 -- -- -- -- --
Accretion of Series B, Series C,
Series D and Series E preferred
stock................................ -- 177 -- -- -- -- --
Accrued dividends on Series B, Series
C, Series D and Series E preferred
stock................................ -- 835 -- -- -- -- --
Net loss............................... -- -- -- -- -- -- --
---------- -------- -------- --- ---------- ---- ----
BALANCE, DECEMBER 31, 1996................. 7,228,473 13,398 347,070 3 2,800,000 28 --
Issuance of common stock............... -- -- -- -- 35,504 -- --
Exercise of stock options.............. -- -- -- -- 120,200 1 --
Deferred compensation.................. -- -- -- -- -- -- (292)
Amortization of deferred
compensation......................... -- -- -- -- -- -- 45
Accretion of Series B, Series C, Series
D and Series E preferred stock....... -- 235 -- -- -- -- --
Accrued dividends on Series B, Series
C, Series D and Series E preferred
stock................................ -- 1,222 -- -- -- -- --
Net loss............................... -- -- -- -- -- -- --
---------- -------- -------- --- ---------- ---- ----
BALANCE, DECEMBER 31, 1997................. 7,228,473 14,855 347,070 3 2,955,704 29 (247)
Pro forma adjustments.................. (7,228,473) (14,855) (347,070) (3) 10,605,735 106 --
---------- -------- -------- --- ---------- ---- ----
PRO FORMA BALANCE, DECEMBER 31, 1997....... -- $ -- -- $ -- 13,561,439 $135 $ (247)
========== ======== ======== === ========== ==== ====
<CAPTION>
ADDITIONAL
PAID-IN- ACCUMULATED
CAPITAL DEFICIT TOTAL
---------- ----------- --------
<S> <C> <C> <C>
BALANCE, DECEMBER 31, 1994................. $ 121 $ (235) $ (83)
Issuance of Series C preferred stock... -- -- --
Accretion of Series B and Series C
preferred stock...................... -- (47) (47)
Accrued dividends on Series B and
Series C preferred stock............. -- (203) (203)
Net loss............................... -- (1,791) (1,791)
------- ------- --------
BALANCE, DECEMBER 31, 1995................. 121 (2,276) (2,124)
Issuance of Series D preferred stock... -- -- --
Issuance of Series E preferred stock... -- -- --
Accretion of Series B, Series C,
Series D and Series E preferred
stock................................ -- (177) (177)
Accrued dividends on Series B, Series
C, Series D and Series E preferred
stock................................ -- (835) (835)
Net loss............................... -- (6,983) (6,983)
------- ------- --------
BALANCE, DECEMBER 31, 1996................. 121 (10,271) (10,119)
Issuance of common stock............... 94 -- 94
Exercise of stock options.............. 21 -- 22
Deferred compensation.................. 292 -- --
Amortization of deferred
compensation......................... -- -- 45
Accretion of Series B, Series C, Series
D and Series E preferred stock....... -- (235) (235)
Accrued dividends on Series B, Series
C, Series D and Series E preferred
stock................................ -- (1,222) (1,222)
Net loss............................... -- (152) (152)
------- ------- --------
BALANCE, DECEMBER 31, 1997................. 528 (11,880) (11,567)
Pro forma adjustments.................. 14,752 -- 14,855
------- ------- --------
PRO FORMA BALANCE, DECEMBER 31, 1997....... $ 15,280 $ (11,880) $ 3,288
======= ======= ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-5
<PAGE> 61
VISUAL NETWORKS, INC.
STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED
DECEMBER 31,
-----------------------------
1995 1996 1997
------- ------- -------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss....................................................... $(1,791) $(6,983) $ (152)
Adjustments to reconcile net loss to net cash (used in)
provided by operating activities --
Depreciation and amortization............................. 59 204 574
Changes in assets and liabilities --
Accounts receivable....................................... (166) (1,722) (1,030)
Inventory................................................. (362) (571) (1,748)
Other current assets...................................... (9) (195) (356)
Accounts payable and accrued expenses..................... 105 873 2,112
Customer deposits......................................... -- -- 3,068
Accrued compensation...................................... 160 702 586
Deferred revenue.......................................... -- 1,124 3,789
------- ------- -------
Net cash (used in) provided by operating
activities......................................... (2,004) (6,568) 6,843
------- ------- -------
Cash flows from investing activities:
Proceeds from sale leaseback transactions................. 138 -- 544
Expenditures for property and equipment................... (227) (826) (1,223)
------- ------- -------
Net cash used in investing activities................ (89) (826) (679)
------- ------- -------
Cash flows from financing activities:
Proceeds from issuance of preferred stock, net of issuance
costs................................................... 1,965 9,001 --
Borrowings (repayments) under credit agreements........... -- 848 (848)
Proceeds from issuance of common stock.................... -- -- 116
Principal payments on capital lease obligations........... (16) (44) (143)
------- ------- -------
Net cash provided by (used in) financing
activities......................................... 1,949 9,805 (875)
------- ------- -------
Net (decrease) increase in cash and cash equivalents........... (144) 2,411 5,289
Cash and cash equivalents, beginning of period................. 1,137 993 3,404
------- ------- -------
Cash and cash equivalents, end of period....................... $ 993 $ 3,404 $ 8,693
======= ======= =======
Supplemental cash flow information:
Cash paid for interest......................................... $ 13 $ 46 $ 104
======= ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-6
<PAGE> 62
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS
AS OF DECEMBER 31, 1995, 1996 AND 1997
1. NATURE OF OPERATIONS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Visual Networks, Inc. (the "Company") is engaged in developing,
manufacturing and marketing wide-area-network service level management systems.
The Company's operations are subject to certain risks and uncertainties,
including among others, successful implementation of the Company's sales and
distribution model, dependence on significant customers, rapidly changing
technology, current and potential competitors with greater financial,
technological, production, and marketing resources, dependence on sole and
limited source suppliers, dependence on key management personnel, limited
protection of intellectual property and proprietary rights, uncertainty of
future profitability and possible fluctuations in financial results.
UNAUDITED PRO FORMA INFORMATION
The unaudited pro forma information is being presented to show the
mandatory conversion of the Series B, Series C, Series D and Series E redeemable
convertible preferred stock and Series A convertible preferred stock into common
stock upon a qualified initial public offering. If the initial public offering
is consummated under terms presently anticipated, all of the Company's preferred
stock will automatically convert into shares of common stock at the rate of 1.4
shares of common stock for each share of preferred stock outstanding.
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 the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid instruments with an original
maturity of three months or less at the time of purchase to be cash equivalents.
FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying values of current assets and current liabilities approximate
fair value because of the relatively short maturities of these instruments.
REVENUE RECOGNITION
The Company generally recognizes revenue from sales of its products upon
delivery and passage of title to the customer. Revenue is recognized provided
that no significant obligations remain and that collection of the resulting
receivable is probable. Where agreements provide for evaluation or customer
acceptance, the Company recognizes revenue upon the completion of the evaluation
process and acceptance of the product by the customer. Maintenance contracts
call for the Company to provide technical support and software updates to
customers. The Company recognizes product support and maintenance revenue,
including maintenance revenue that is bundled with product sales, ratably over
the term of the contract period, which ranges from one to three years.
F-7
<PAGE> 63
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
The Company has an agreement with one reseller that provides price
protection for units that remain in that reseller's inventory. Reserves for
estimated inventory credits are established by the Company concurrently with the
recognition of revenue. The Company monitors the factors that influence the
pricing of its products and reseller inventory levels and makes adjustments to
these reserves when management believes that actual inventory credits may differ
from established estimates.
CREDIT RISK
Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash and cash equivalents
and accounts receivable. The Company maintains its cash and cash equivalents
with high credit quality financial institutions. The Company's cash equivalents
consist primarily of investments in a money market fund that invests in U.S.
Treasury obligations and may also invest in repurchase agreements collateralized
by U.S. Treasury securities. As of December 31, 1996 and 1997, the Company had
approximately $2,637,000 and $8,650,000, respectively, invested in this money
market fund.
The Company sells its hardware and software products to large
telecommunications providers and subscribers primarily in the United States. The
Company grants uncollateralized credit terms to its customers and has not
experienced any significant credit related losses. Accounts receivable include
allowances to record receivables at their estimated net realizable value. During
1996, two customers individually represented 13% and 10% of revenue,
respectively. During 1997, two customers individually represented 31% and 11% of
revenue, respectively.
WARRANTY
The Company warrants its hardware products for a period of five years.
Estimated warranty costs are charged to cost of goods sold in the period in
which revenue from the related product sale is recognized.
INVENTORY
Inventory is stated at the lower of average cost or market. Inventory
consists of the following (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1996 1997
---- ------
<S> <C> <C>
Raw materials..................................................... $158 $ 221
Work-in-progress.................................................. 304 471
Finished goods.................................................... 471 1,989
---- ------
$933 $2,681
==== ======
</TABLE>
PROPERTY AND EQUIPMENT
Property and equipment is carried at cost and depreciated over its
estimated useful life, ranging from three to four years, using the straight-line
method. Equipment held under capital leases is recorded at the present value of
the future minimum lease payments and is amortized on a straight-line basis over
the shorter of the assets' useful lives or the relevant lease term, ranging from
three to four years.
F-8
<PAGE> 64
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
Property and equipment consists of the following (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
----------------
1996 1997
------ ------
<S> <C> <C>
Equipment.......................................................... $1,060 $2,090
Furniture and fixtures............................................. 2 50
------ ------
1,062 2,140
Less-Accumulated depreciation...................................... (249) (633)
------ ------
$ 813 $1,507
====== ======
</TABLE>
RESEARCH AND DEVELOPMENT
Research and development costs are expensed as incurred.
The Company accounts for software development costs in accordance with
Statement of Financial Accounting Standards ("SFAS") No. 86, "Accounting for the
Costs of Computer Software to be Sold, Leased, or Otherwise Marketed". Costs
incurred prior to establishment of technological feasibility are expensed as
incurred and reflected as research and development costs in the accompanying
statements of operations.
For the years ended December 31, 1995, 1996 and 1997, the Company did not
capitalize any costs related to software development. During these periods, the
time between the establishment of technological feasibility and general release
of products was very short. Consequently, costs otherwise capitalizable after
technological feasibility were expensed as they were immaterial.
INCOME TAXES
The Company accounts for income taxes in accordance with SFAS No. 109
"Accounting for Income Taxes". Under SFAS No. 109, deferred tax assets and
liabilities are computed based on the difference between the financial statement
and income tax bases of assets and liabilities using the enacted marginal tax
rate. SFAS No. 109 requires that the net deferred tax asset be reduced by a
valuation allowance if, based on the weight of available evidence, it is more
likely than not that some portion or all of the net deferred tax asset will not
be realized.
PRO FORMA BASIC AND DILUTED NET LOSS PER COMMON SHARE
Pro forma net loss per common share is computed using the pro forma
weighted average number of common shares outstanding during each period. Pro
forma weighted average common shares includes the assumed conversion of all
outstanding convertible preferred stock into common stock. Since the conversion
of the preferred stock has a significant effect on the loss per share
calculation, the historical loss per share has not been presented.
Pursuant to the requirements of the Securities and Exchange Commission,
common stock, stock options and convertible preferred stock issued by the
Company during the twelve months immediately preceding the filing of the initial
registration statement have been included in the calculation of the pro forma
weighted average common shares outstanding using the treasury stock method based
upon an initial public offering price of $12.50 per share.
In March 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 128, "Earnings Per Share". SFAS No. 128 is effective for financial
statements issued for periods ending
F-9
<PAGE> 65
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
after December 15, 1997. The Company has implemented SFAS No. 128 for 1997. SFAS
No. 128 requires dual presentation of basic and diluted earnings per share.
Basic loss per share includes no dilution and is computed by dividing net loss
available to common stockholders by the weighted average number of common shares
outstanding for the period. Diluted loss per share includes the potential
dilution that could occur if securities or other contracts to issue common stock
were exercised or converted into common stock. Options to purchase 1,016,254
shares of common stock with exercise prices ranging from $1.43 to $10.00 that
were granted or issued during the twelve months preceding the filing of the
initial registration statement and 35,504 shares of common stock issued during
1997 have been included in the calculation of both basic and diluted loss per
share pursuant to the requirements of the Securities and Exchange Commission
using the treasury stock method. Options to purchase 825,833 shares of common
stock with exercise prices ranging from $0.07 to $1.43 per share that were
outstanding at December 31, 1997 were not included in the computation of diluted
loss per share as their effect would be anti-dilutive. As a result the basic and
diluted loss per share amounts are identical.
2. CREDIT AGREEMENT:
As of January 8, 1998, the Company entered into a new credit agreement with
its bank replacing the existing credit agreement. This revolving line of credit
(the "Revolving Line") provides for borrowings up to the lesser of $7,000,000 or
75% of eligible accounts receivable. The Revolving Line matures on January 5,
1999 and borrowings under the Revolving Line bear interest at the prime rate +
0.5%. Borrowings are collateralized by the assets of the Company. The loan and
security agreement also contains restrictive covenants, including, but not
limited to, restrictions related to liquidity, profitability, net worth, and
indebtedness, as well as restrictions related to acquisitions, dispositions of
assets, distributions and investments. As of December 31, 1997, the Company had
no borrowings against the Revolving Line. In addition, as of December 31, 1997,
$190,000 had been committed against the Revolving Line through the issuance of a
letter of credit (Note 8).
3. PREFERRED STOCK:
The Company has a total of 12,576,508 shares of authorized preferred stock
of which 7,576,508 have been designated as Series A, B, C, D and E convertible
preferred stock and 5,000,000 of which has not been designated. The following
details the number of shares issued and the liquidation preference (in
thousands) for each series of the convertible preferred stock.
<TABLE>
<CAPTION>
AMOUNT LIQUIDATION PREFERENCE
SHARES OUTSTANDING ---------------------------- ----------------------------
AS OF DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
1996 AND 1997 1996 1997 1996 1997
------------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C>
Series A.............. 347,070 $ 3 $ 3 $ 130 $ 149
Series B.............. 2,588,438 1,464 1,611 1,440 1,560
Series C.............. 1,600,000 2,316 2,551 2,283 2,483
Series D.............. 2,285,714 4,433 4,904 4,373 4,773
Series E.............. 754,321 5,185 5,789 5,166 5,668
--------- ------- ------- ------- -------
7,575,543 $ 13,401 $ 14,858 $ 13,392 $ 14,633
========= ======= ======= ======= =======
</TABLE>
F-10
<PAGE> 66
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
SERIES A PREFERRED STOCK
In connection with the Series B Preferred Stock ("Series B") offering,
notes payable of $119,500 together with accrued interest of $1,176 were
converted into shares of Series A Preferred Stock ("Series A"). The Series A has
liquidation preferences over the common stock. The Series A has cumulative
dividends equal to 8% per annum. Dividends are not payable for a period of
twenty-four months from the date of issuance (December 1994). The Company has
not declared dividends through December 1997 on Series A shares based on legal
limitations on the declarations of dividends. In the event that by the end of
calendar years 1998 and 1999, the Company's net revenues are greater than
$39,000,000 and net income (after taxes, but excluding extraordinary items) is
greater than $6,000,000, the holders of Series A shall no longer be entitled to
receive those dividends. At December 31, 1996 and 1997, dividends in arrears on
Series A were approximately $19,270 and $28,850, respectively.
The Series A shares have voting rights entitling Series A holders to the
number of votes per share equal to the number of shares of common stock into
which each share of Series A is then convertible. The Series A shares are
convertible at any time at the option of the holder, or automatically upon the
consummation of an underwritten public offering at a selling price per share of
common stock equal to or exceeding $3.57 per share and where aggregate proceeds
are not less than $10,000,000, into an aggregate of 485,890 shares of common
stock. The conversion price is subject to adjustment for certain dilutive
events.
Upon conversion, all accrued and unpaid dividends may also be converted
into common stock at the then current market price of the common stock (as
defined). The Company may, however, elect to pay any accrued but unpaid
dividends in cash in lieu of converting such dividends into shares of common
stock.
SERIES B PREFERRED STOCK
In December 1994, the Company issued 2,588,438 shares of Series B and
received approximately $1,170,000 in proceeds, net of issuance costs of
approximately $30,000. The Series B has liquidation preferences over the Series
A and the common stock. The holders of Series B are entitled to receive
dividends payable equal to 10% of the Series B stated value annually. Such
dividends are cumulative from the date of issuance. Upon the conversion of
Series B shares into shares of common stock, any accrued but unpaid or
undeclared dividends on Series B shall be waived.
At any time after five years following the Series E Preferred Stock
("Series E") issuance, the Company is required to redeem at the option of the
holder, the outstanding Series B shares at a redemption price equal to 110% of
the Series B stated value plus all accrued and unpaid dividends. The Company
records periodic accretion under the interest method for the excess of the
redemption value over the stated value.
The Series B shares have voting rights entitling Series B holders to the
number of votes per share equal to the number of shares of common stock into
which each share of Series B is then convertible and to vote as a single class.
The Series B is convertible at any time at the option of the holder, or
automatically upon the consummation of an underwritten public offering at a
selling price per share of common stock equal to or exceeding $3.57 per share,
and where aggregate proceeds are not less than $10,000,000, into an aggregate of
3,623,811 shares of common stock. The conversion price is subject to adjustment
for certain dilutive events.
F-11
<PAGE> 67
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
SERIES C PREFERRED STOCK
In August 1995, the Company issued 1,600,000 shares of Series C Preferred
Stock ("Series C") and received approximately $1,965,000 in proceeds, net of
issuance costs of approximately $35,000. The Series C has liquidation
preferences over the Series B and Series A and the common stock and has parity
with the Series D Preferred Stock ("Series D") with respect to liquidation. The
holders of Series C are entitled to receive dividends payable equal to 10% of
the Series C stated value annually. Such dividends are cumulative from the date
of issuance. Upon the conversion of Series C shares into shares of common stock,
any accrued but unpaid or undeclared dividends on Series C shall be waived.
At any time after five years following the issuance of the Series E, the
holders of at least 66 2/3% of the shares of Series C, Series D and Series E,
together as one class, may request that the Company redeem all or a part of the
outstanding Series C, Series D, and Series E. Any redemption is to be made pro
rata among all of the holders of the Series C, Series D, and Series E, in
proportion to their respective stated values. The redemption price for each
series of preferred stock is equal to 110% of the stated value for such series
of preferred stock plus all accrued and unpaid dividends. The Company records
periodic accretion under the interest method of the excess of the redemption
values of each series over the stated value.
The Series C shares have voting rights entitling Series C holders to the
number of votes per share equal to the number of shares of common stock into
which each share of Series C is then convertible and to vote as a single class.
The Series C is convertible at any time at the option of the holder, or
automatically upon the consummation of an underwritten public offering at a
selling price per share of common stock equal to or exceeding $3.57 per share,
and where aggregate proceeds are not less than $10,000,000, into an aggregate of
2,239,998 shares of common stock. The conversion price is subject to adjustment
for certain dilutive events.
SERIES D PREFERRED STOCK
In January 1996, the Company issued 2,285,714 shares of Series D and
received approximately $3,983,000 in proceeds, net of issuance costs of
approximately $17,000. The Series D has liquidation preferences over the Series
B and Series A preferred stock and the common stock and has parity with the
Series C with respect to liquidation. The holders of Series D are entitled to
receive dividends payable equal to 10% of the Series D stated value annually.
Such dividends are cumulative from the date of issuance. Upon the conversion of
Series D shares into shares of common stock, any accrued but unpaid or
undeclared dividends on Series D shall be waived.
At any time after five years following the issuance of the Series E, the
holders of at least 66 2/3% of the shares of Series C, Series D and Series E,
together as one class, may request that the Company redeem all or a part of the
outstanding Series C, Series D and Series E. Any redemption is to be made pro
rata among all of the holders of the Series C, Series D and Series E, in
proportion to their respective stated values. The redemption price for each
series of preferred stock is equal to 110% of the stated value for such series
of preferred stock plus all accrued and unpaid dividends. The Company records
periodic accretion under the interest method of the excess of the redemption
values of each series over the stated value.
The Series D shares have voting rights entitling Series D holders to the
number of votes per share as equal to the number of shares of common stock into
which each share of Series D is then convertible and to vote as a single class.
The Series D is convertible at any time at the option of the
F-12
<PAGE> 68
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
holder, or automatically upon the consummation of an underwritten public
offering at a selling price per share of common stock equal to or exceeding
$3.57 per share, and where aggregate proceeds are not less than $10,000,000,
into an aggregate of 3,199,996 shares of common stock. The conversion price is
subject to adjustment for certain dilutive events.
SERIES E PREFERRED STOCK
In September 1996, the Company issued 754,321 shares of Series E and
received approximately $5,018,000 in proceeds, net of issuance costs of
approximately $6,000. The Series E has liquidation preferences over the Series
D, Series C, Series B and Series A preferred stock and the common stock. The
holders of Series E are entitled to receive dividends payable equal to 10% of
the Series E stated value annually. Such dividends are cumulative from the date
of issuance. Upon the conversion of Series E shares into shares of common stock,
any accrued but unpaid or undeclared dividends on Series E shall be waived.
At any time after five years following the issuance of the Series E, the
holders of at least 66 2/3% of the shares of Series C, Series D and Series E,
together as one class, may request that the Company redeem all or a part of the
outstanding Series C, Series D, and Series E. Any redemption is to be made pro
rata among all of the holders of the Series C, Series D and Series E, in
proportion to their respective stated values. The redemption price for each
series of preferred stock is equal to 110% of the stated value for such series
of preferred stock plus all accrued and unpaid dividends. The Company records
periodic accretion under the interest method of the excess of the redemption
values of each series over the stated value.
The Series E shares have voting rights entitling Series E holders to the
number of votes per share as equal to the number of shares of common stock into
which each share of Series E is then convertible and to vote as a single class.
The Series E is convertible at any time at the option of the holder, or
automatically upon the consummation of an underwritten public offering at a
selling price per share of common stock equal to or exceeding $7.86 per share,
and where aggregate proceeds are not less than $10,000,000, into an aggregate of
1,056,040 shares of common stock. The conversion price is subject to adjustment
for certain dilutive events.
4. STOCKHOLDERS' EQUITY (DEFICIT):
COMMON STOCK SPLIT
In December 1996, the Board of Directors declared a 1.4 for one stock split
of the common stock of the Company effected in the form of a stock dividend. All
share and per-share amounts, including stock option information, have been
restated in these notes and the accompanying financial statements to reflect
this stock split.
COMMON STOCK
The Company initially authorized the issuance of 5,000 shares of common
stock at a par value of $1.00. The Company was initially capitalized in 1993 for
$1,000 through the issuance of common stock subscriptions to the founders for
1,000 shares of common stock. During 1994, in connection with a
recapitalization, the Company authorized the issuance of up to 7,000,000 shares
of common stock with a $.01 par value and issued 2,000,000 shares to existing
stockholders in exchange for shares previously held. Each stockholder received
their pro rata share of new shares for old shares tendered. Simultaneously,
notes payable to the shareholders totaling $24,000 were converted to
F-13
<PAGE> 69
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
common stock. As a result of this transaction the Company recorded additional
paid-in capital of $4,000 for the year ended December 31, 1994. The number of
shares of common stock authorized for issuance was increased to 10,000,000
shares upon the issuance of the Series D in January 1996 and to 20,000,000 in
September 1996 upon the issuance of the Series E. At December 31, 1997, the
Company has reserved 10,684,259 shares of common stock for the conversion of the
Series A, Series B, Series C, Series D and Series E. An additional 800,000
shares of common stock were issued to existing stockholders on December 21, 1996
resulting from the 1.4 to one stock split effected in the form of a stock
dividend. A total of 1,975,000 shares of common stock have been reserved for
issuance under the 1994 stock option plan.
In June 1997, the Company sold 25,000 shares of common stock to an officer
of the Company for $1.75 per share. In September 1997, the Company sold 10,504
shares of common stock to a director of the Company for $4.76 per share.
5. STOCK OPTIONS:
1994 STOCK OPTION PLAN
The Company's 1994 stock option plan (the "Option Plan") authorizes the
issuance of an aggregate of 1,975,000 shares of Common Stock pursuant to the
exercise of stock options. The Option Plan provides for grants of options to
employees, consultants, and directors of the Company. The Option Plan provides
for the granting of both incentive stock options and non-statutory option. The
Option Plan is administered by the Compensation Committee of the Board of
Directors, which has sole discretion and authority, consistent with the
provisions of the Option Plan, to determine which eligible participants will
receive options, the time when options will be granted, the terms of options
granted, and the number of shares that will be subject to options granted under
the Option Plan.
For any option intended to qualify as an incentive stock option, the
exercise price must not be less than 100% of the fair market value of the common
stock on the date the option is granted (110% of the fair market value of such
common stock with respect to any optionee who immediately before any option is
granted, directly or indirectly, possesses more than 10% of the total combined
voting power of all classes of stock of the Company ("10% Owners")). In the case
of non-statutory options, the exercise price shall not be less than 20% of the
fair value of the common stock at the time of the grant. The Compensation
Committee has the authority to determine the time or times at which options
granted under the Option Plan become exercisable (typically up to five years);
provided that, for any option intended to qualify as an incentive stock option,
such option must expire no later than ten years from the date of grant (five
years with respect to 10% Owners). Unless terminated sooner by the Board, the
Option Plan terminates in December 2004 or the date on which all shares
available for issuance shall have been issued pursuant to the exercise or
cancellation of options granted under the Option Plan.
1997 OMNIBUS STOCK PLAN
The Company's 1997 Omnibus Stock Plan (the "Omnibus Plan") authorizes the
issuance of an aggregate of up to 1,000,000 shares of common stock with respect
to certain "Awards" made under the Omnibus Plan. The Omnibus Plan provides for
grants of options to employees, officers, directors, and consultants of the
Company or any affiliate of the Company; provided, however, that no individual
may receive an award of more than 250,000 shares in any one fiscal year.
"Awards" under the Omnibus Plan may take the form of grants of stock options,
stock appreciation rights,
F-14
<PAGE> 70
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
restricted or unrestricted stock, phantom stock, performance awards, or any
combination thereof. The Omnibus Plan is administered by the Board of Directors,
or by such committee or committees as may be appointed by the Board of Directors
from time to time (the "Administrator"). The Administrator has sole power and
authority, consistent with the provisions of the Omnibus Plan, to determine
which eligible participants will receive Awards, the form of the Awards and the
number of shares of Common Stock covered by each Award, to impose terms, limits,
restrictions, and conditions upon Awards, to modify, amend, extend, or renew
Awards (with the consent of the awardee), to accelerate or change the exercise
timing of Awards or to waive any restrictions or conditions to an Award and to
establish objectives and conditions for earning Awards. Unless terminated sooner
by the Board, the Omnibus Plan will terminate in October 2007 or the date on
which all shares available for issuance shall have been issued pursuant to the
exercise or cancellation of Awards under the Omnibus Plan.
DIRECTORS' STOCK OPTION PLAN
The 1997 Directors' Stock Option Plan (the "Director Plan") was adopted in
October 1997. Under the terms of the Director Plan, directors of the Company who
are not employees of the Company (the "Eligible Directors") are eligible to
receive non-statutory options to purchase shares of common stock. A total of
300,000 share of common stock may be issued upon exercise of options granted
under the Director Plan. Unless terminated sooner by the Board of Directors, the
Director Plan will terminate in October 2007, or the date on which all shares
available for issuance under the Director Plan shall have been issued pursuant
to the exercise of options granted under the Director Plan.
Upon a member's initial election or appointment to the Board of Directors
after the date of this Prospectus, or for current Eligible Directors at the date
of the closing of this offering, such member will be granted options to purchase
24,000 shares of common stock, vesting over four years, with options to purchase
6,000 shares vesting at the first anniversary of the grant and options to
purchase the remaining 18,000 shares vesting in 36 equal monthly installments.
Annual options to purchase 6,000 shares of common stock (the "Annual Options")
will be granted to each Eligible Director on the date of each annual meeting of
stockholders after the closing of the initial public offering. Annual Options
will vest at the rate of one-twelfth of the total grant per month, and will vest
in full at the earlier of (i) the first anniversary of the date of the grant or
(ii) the date of the next annual meeting of stockholders. The exercise price of
options granted under the Director Plan will be calculated as follows: (x) for
options issued at the time of this offering, the exercise price will equal the
initial public offering price; and (y) for all other grants, the exercise price
will equal the fair market value per share of the common stock on the date of
grant.
F-15
<PAGE> 71
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
A summary of the Company's stock option activity is presented below:
<TABLE>
<CAPTION>
WEIGHTED
OPTION AVERAGE
PRICE PER EXERCISE
OPTIONS SHARE PRICE
--------- ----------- --------
<S> <C> <C> <C>
Options outstanding at December 31, 1993......... -- -- --
Granted.......................................... 155,605 $0.07- 0.08 $ 0.07
--------- ----------- -------
Options outstanding at December 31, 1994......... 155,605 0.07- 0.08 0.07
Granted.......................................... 380,660 0.07- 0.19 0.13
Canceled......................................... (56,000) 0.07 0.07
--------- ----------- -------
Options outstanding at December 31, 1995......... 480,265 0.07- 0.19 0.12
Granted.......................................... 742,400 0.19- 1.43 0.76
Canceled......................................... (89,951) 0.19- 1.07 0.24
--------- ----------- -------
Options outstanding at December 31, 1996......... 1,132,714 0.07- 1.43 0.54
Granted.......................................... 928,955 1.43-10.00 3.88
Canceled......................................... (100,968) 0.07- 7.00 1.63
Exercised........................................ (120,200) 0.07- 7.00 0.18
--------- ----------- -------
Options outstanding at December 31, 1997......... 1,840,501 $0.07-10.00 $ 2.18
========= =========== =======
</TABLE>
As of December 31, 1996 and 1997, options to purchase 193,906 and 334,814
shares of common stock were exercisable with a weighted average exercise price
of $0.14 and $0.70, respectively. The weighted average remaining contractual
life of options outstanding at December 31, 1996 and 1997 was 8.87 and 8.70
years, respectively.
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation". SFAS No. 123 is effective for awards granted in 1995 and 1996.
SFAS No. 123 defines a "fair value based method" of accounting for stock-based
compensation. Under the fair value based method, compensation cost is measured
at the grant date based on the fair value of the award and is recognized over
the service period. Prior to the issuance of SFAS No. 123, stock-based
compensation was accounted for under the "intrinsic value method" as defined by
Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued
to Employees". Under the intrinsic value method, compensation is the excess, if
any, of the market price of the stock at grant date or other measurement date
over the amount an employee must pay to acquire the stock.
SFAS No. 123 allows an entity to continue to use the intrinsic value
method. However, entities electing the accounting in APB Opinion No. 25 must
make pro forma disclosures as if the fair value based method of accounting had
been applied. The Company applies APB Opinion No. 25 and the related
interpretations in accounting for its stock-based compensation. Under APB
Opinion No. 25, no compensation expense has been recognized in the accompanying
financial statements related to stock option grants in 1995 and 1996. The
Company has recorded deferred compensation of approximately $292,000 related to
stock option grants in 1997, of which approximately $45,000 has been amortized
in the year ended December 31, 1997.
Had compensation expense been determined based on the fair value of the
options at the grant dates consistent with the method of accounting under SFAS
No. 123, the Company's net loss and
F-16
<PAGE> 72
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
net loss per share would have been increased to the pro forma amounts indicated
below (in thousands, except per share amounts):
<TABLE>
<CAPTION>
1995 1996 1997
------- ------- ------
<S> <C> <C> <C>
NET LOSS:
As reported........................................... $(1,791) $(6,983) $ (152)
Pro forma............................................. (1,792) (7,006) (270)
PRO FORMA NET LOSS PER COMMON AND COMMON EQUIVALENT
SHARE:
As reported........................................... $(0.01)
Pro forma............................................. (0.02)
</TABLE>
The fair value of each option is estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions used for
grants during the years ended December 31, 1995, 1996 and 1997: no dividend
yield, expected volatility of zero, risk-free interest rates from 5.2% to 7.6%
and an expected term of 5 years.
6. EMPLOYEE 401(K) SAVINGS PLAN:
Effective January 1, 1996, the Company adopted a defined contribution plan
(the "Savings Plan"), available to all full-time employees upon employment. The
Savings Plan qualifies for preferential tax treatment under Section 401(a) of
Internal Revenue Code. Employee contributions are voluntary and are determined
on an individual basis with a maximum annual amount for 1995, 1996 and 1997
equal to 15% of compensation paid during the plan year, not to exceed the annual
Internal Revenue Service contribution limitations. All participants are fully
vested in their contributions. There were no employer contributions under the
Savings Plan.
7. INCOME TAXES:
For the years ended December 31, 1995, 1996 and 1997, the tax provision was
comprised primarily of a deferred tax benefit which was offset by a valuation
allowance of the same amount. The tax provision differed from the expected tax
benefit, computed by applying the U.S. Federal statutory rate of 35% to the loss
before income taxes, principally due to the effect of increases in the valuation
allowance.
F-17
<PAGE> 73
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
The components of the Company's net deferred tax asset (liability) are as
follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
------------------
1996 1997
------- -------
<S> <C> <C>
Deferred tax asset:
Net operating loss carryforwards................................ $ 2,250 $ 831
Depreciation.................................................... 15 31
Allowance for doubtful accounts................................. 55 144
Inventory valuation............................................. 253 412
Warranty reserve................................................ 23 106
Accrued liabilities............................................. 196 221
Deferred revenue................................................ 435 1,547
Valuation allowance............................................. (3,227) (3,292)
----- ------
Total net deferred tax asset.......................... $ -- $ --
===== ======
</TABLE>
The Company had net operating loss carryforwards to offset future taxable
income of approximately $2,260,000 as of December 31, 1997. These net operating
loss carryforwards expire through 2011. Under the provisions of the Tax Reform
Act of 1986, when there has been a change in an entity's ownership, utilization
of net operating loss carryforwards may be limited. The Company's ability to use
its net operating losses in future periods may be limited in the event of
significant ownership changes. The Company does not believe that the anticipated
initial public offering will result in such a limitation. In addition, the
Company has research and development tax credit carryforwards of approximately
$270,000 to offset future taxable income subject to certain limitations.
8. COMMITMENTS AND CONTINGENCIES:
LEASES
The Company leases office space and office equipment under noncancelable
operating leases expiring through October 2001. The Company recorded rent
expense of approximately $38,000, $146,000 and $557,000 during 1995, 1996 and
1997, respectively.
F-18
<PAGE> 74
VISUAL NETWORKS, INC.
NOTES TO FINANCIAL STATEMENTS -- (CONTINUED)
AS OF DECEMBER 31, 1995, 1996 AND 1997
The Company also leases certain equipment under noncancelable capital lease
agreements which expire through April 2000. Future minimum lease payments under
noncancelable operating and capital leases are as follows (in thousands):
<TABLE>
<CAPTION>
CAPITAL OPERATING
LEASES LEASES
------- ---------
<S> <C> <C>
1998.............................................................. $ 286 $ 406
1999.............................................................. 233 425
2000.............................................................. 49 639
2001.............................................................. -- 637
---- ------
Total minimum lease payments............................ 568 $ 2,107
======
Interest element of lease payment................................. (90)
----
Present value of future minimum lease payments.................... 478
Current portion................................................... (222)
----
Long-term portion................................................. $ 256
====
</TABLE>
The Company's office lease required a $230,000 letter of credit through
either the 5-year lease term plus two months or ninety days after the
registration of the Company's stock on a nationally recognized stock exchange.
Effective November 25, 1997, the required letter of credit was reduced to
$190,000.
The required letter of credit decreases on a straight-line basis over the
period of the lease to a minimum of $50,000. The Company's letter of credit is
collateralized by the line of credit which expires in January 1999 (Note 2). If
the line of credit is not extended beyond its current maturity date, the letter
of credit will become collateralized by a pledged treasury investment or pledged
certificate of deposit for the remaining period in which a letter of credit is
required pursuant to the lease agreement.
During 1995, the Company entered into two sale-leaseback transactions under
which equipment with a net book value of approximately $122,000 was sold and
leased back under noncancelable capital leases. Proceeds generated from the
sale-leaseback transactions totaled approximately $138,000. The gain of $16,000
resulting from the sale has been deferred and is being amortized on a basis
consistent with the amortization of the asset.
During 1997, the Company entered into additional sale-leaseback
transactions in which equipment with a net book value of approximately $544,000
was sold and leased back under noncancelable capital leases. Proceeds from the
transactions totaled approximately $544,000, resulting in no gain or loss on the
transactions.
LITIGATION
The Company is periodically a party to disputes arising from normal
business activities. In the opinion of management, resolution of these matters
will not have a material adverse effect upon the financial position or future
operating results of the Company, and adequate provision for any potential
losses has been made in the accompanying financial statements.
F-19
<PAGE> 75
UNDERWRITING
Subject to the terms and conditions of the Underwriting Agreement, the
Company has agreed to sell to each of the Underwriters named below, and each of
such Underwriters, for whom Goldman, Sachs & Co., Deutsche Morgan Grenfell Inc.
and Wessels, Arnold & Henderson, L.L.C. are acting as representatives
(collectively, the "Representatives"), has severally agreed to purchase from the
Company, the respective number of shares of Common Stock set forth opposite its
name below:
<TABLE>
<CAPTION>
NUMBER OF
SHARES OF
UNDERWRITER COMMON STOCK
-------------------------------------------------------------------------- ------------
<S> <C>
Goldman, Sachs & Co. ..................................................... 876,000
Deutsche Morgan Grenfell Inc. ............................................ 876,000
Wessels, Arnold & Henderson, L.L.C. ...................................... 876,000
Adams, Harkness & Hill, Inc. ............................................. 109,000
J.C. Bradford & Co. ...................................................... 109,000
Dain Rauscher Incorporated ............................................... 109,000
Gerard Klauer Mattison & Co., Inc. ....................................... 109,000
Legg Mason Wood Walker Incorporated ...................................... 109,000
Needham & Company, Inc. .................................................. 109,000
SoundView Financial Group, Inc. .......................................... 109,000
Wheat First Butcher Singer ............................................... 109,000
-----------
Total................................................................ 3,500,000
===========
</TABLE>
Under the terms and conditions of the Underwriting Agreement, the
Underwriters are committed to take and pay for all of the shares offered hereby,
if any are taken.
The Underwriters propose to offer the shares of Common Stock in part
directly to the public at the initial public offering price set forth on the
cover page of this Prospectus and in part to certain securities dealers at such
price less a concession of $0.50 per share. The Underwriters may allow, and such
dealers may reallow, a concession not in excess of $0.10 per share to certain
brokers and dealers. After the shares of Common Stock are released for sale to
the public, the offering price and other selling terms may from time to time be
varied by the representatives.
The Company has granted the Underwriters an option exercisable for 30 days
after the date of this Prospectus to purchase up to an aggregate of 525,000
additional shares of Common Stock solely to cover over-allotments, if any. If
the Underwriters exercise their over-allotment option, the Underwriters have
severally agreed, subject to certain conditions, to purchase approximately the
same percentage thereof that the number of shares to be purchased by each of
them, as shown in the foregoing table, bears to the 3,500,000 shares of Common
Stock offered.
The Company, its directors and officers and certain of its stockholders and
optionholders have agreed that, during the period beginning from the date of
this Prospectus and continuing to and including the date 180 days after the date
of the Prospectus, they will not offer, sell, contract to sell or otherwise
dispose of any shares of Common Stock or any other securities of the Company
(other than, in the case of the Company, pursuant to employee stock option plans
existing, or on the conversion or exchange of convertible or exchangeable
securities outstanding, on the date of this Prospectus) which are substantially
similar to the shares of the Common Stock or which are convertible into or
exchangeable for securities which are substantially similar to the shares of
Common Stock without the prior written consent of the Representatives.
The Representatives have informed the Company that they do not expect sales
to accounts over which the Underwriters exercise discretionary authority to
exceed 5% of the total number of shares of Common Stock offered by them.
U-1
<PAGE> 76
Prior to the offering, there has been no public market for the shares. The
initial public offering price was negotiated between the Company and the
Representatives. Among the factors considered in determining the initial public
offering price of the Common Stock, in addition to prevailing market conditions,
were the Company's historical performance, estimates of the business potential
and earnings prospects of the Company, an assessment of the Company's management
and the consideration of the above factors in relation to market valuation of
companies in related businesses.
In connection with the offering, the Underwriters may purchase and sell the
Common Stock in the open market. These transactions may include over-allotment
and stabilizing transactions and purchases to cover syndicate short positions
created by the Underwriters in connection with the offering. Stabilizing
transactions consist of certain bids or purchases for the purpose of preventing
or retarding a decline in the market price of the Common Stock; and syndicate
short positions created by the Underwriters involve the sale by the Underwriters
of a greater number of shares of Common Stock than they are required to purchase
from the Company in the offering. The Underwriters also may impose a penalty
bid, whereby selling concessions allowed to syndicate members or other
broker-dealers in respect of the securities sold in the offering for their
account may be reclaimed by the syndicate if such shares of Common Stock are
repurchased by the syndicate in stabilizing or covering transactions. These
activities may stabilize, maintain or otherwise affect the market price of the
Common Stock, which may be higher than the price that might otherwise prevail in
the open market; and these activities, if commenced, may be discontinued at any
time. These transactions may be effected on the Nasdaq National Market, in the
over-the-counter market or otherwise.
The Common Stock has been approved for quotation on the Nasdaq National
Market under the symbol "VNWK".
The Company has agreed to indemnify the several Underwriters against
certain liabilities, including liabilities under the Securities Act of 1933.
U-2
<PAGE> 77
GLOSSARY
ASYNCHRONOUS TRANSFER MODE
("ATM") A communications protocol and switching
technology using fixed-length packets of data
to transport voice, data, and video traffic
across WANs or LANs.
BANDWIDTH The information carrying capacity of a
transmission line, typically measured in bits
per second.
CUSTOMER PREMISES EQUIPMENT
("CPE") Communications and network equipment physically
located on a subscriber's property (e.g.
router, DSU/CSU).
DATA SERVICE UNIT/CHANNEL
SERVICE
UNIT ("DSU/CSU") A type of CPE that adapts the physical
interface of data terminal equipment (such as a
router) to the physical interface requirement
of a digital WAN service.
DEMARC see Service Demarcation.
FRAME RELAY A communications protocol using variable-length
packets of data to transport data from a
subscriber location to the provider network.
FRAME RELAY ACCESS DEVICE
("FRAD") A type of CPE that is predominantly used to
connect mainframe, host-centric computing
environments over a Frame Relay WAN.
INTERNET Originally, a government-funded initiative to
interconnect networks from a variety of
scientific and educational institutions. More
recently, a publicly available network
interconnecting scientific, educational,
government, and commercial institutions as well
as individuals.
INTERNET PROTOCOL ("IP") A communications protocol widely used to enable
computer-to-computer communication for
distributed computing applications.
INTEGRATED SERVICES DIGITAL
NETWORK ("ISDN") A time division multiplexed WAN service that
allows for circuits to be established or broken
down on demand.
LOCAL AREA NETWORK ("LAN") A data communications network that connects a
variety of data devices in the same location to
enable the exchange and sharing of files,
applications, and other services.
LEASED LINE A time division multiplexed WAN service that
dedicates fixed bandwidth between two
subscriber locations.
MULTIPLEXER A type of network equipment that aggregates
multiple low-speed inputs onto a high speed
output.
MANAGEMENT INFORMATION BASE
("MIB") A structured approach to storing network
management information within network
equipment.
NETWORK OPERATIONS CENTER
("NOC") A control center from which network operators
run a network, typically engaging in
performance monitoring and troubleshooting.
PROTOCOL ANALYZER A diagnostic instrument that evaluates network
traffic by monitoring and analyzing the
conditions of the underlying communications
protocols.
G-1
<PAGE> 78
OPERATIONAL SUPPORT SYSTEM
("OSS") The software systems used by providers to
provision, maintain and administer their WAN
services.
ROUTER The prevalent type of CPE used to interconnect
LANs.
SERVICE DEMARCATION ("DEMARC") The point at which a subscriber's CPE connects
to a provider's WAN service.
STATISTICAL MULTIPLEXING A technique for combining multiple traffic
streams dynamically based on the activity of
each traffic stream.
SIMPLE NETWORK MANAGEMENT
PROTOCOL ("SNMP") A communications protocol used to transfer
network management information.
SWITCHED MULTIMEGABIT DATA
SERVICE ("SMDS") A communications protocol using fixed-length
packets of data to transport voice, data, and
video traffic across WANs.
TIME DIVISION MULTIPLEXING
("TDM") A technique for combining multiple traffic
streams by allocating a fixed amount of
bandwidth for each traffic stream.
VIRTUAL PRIVATE NETWORK
("VPN") A network used for intra-enterprise
communications over the Internet but
characterized by robust security.
WIDE AREA NETWORK ("WAN") A network used to connect geographically
dispersed computing locations.
X.25 A communications protocol using variable-length
packets of data to transport data from a
subscriber location to the provider network.
G-2
<PAGE> 79
================================================================================
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS OTHER THAN THOSE CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR
MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN
AUTHORIZED. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR THE
SOLICITATION OF AN OFFER TO BUY ANY SECURITIES OTHER THAN THE SECURITIES TO
WHICH IT RELATES OR AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY SUCH
SECURITIES IN ANY CIRCUMSTANCES IN WHICH SUCH OFFER OR SOLICITATION IS UNLAWFUL.
NEITHER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER
ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE
AFFAIRS OF THE COMPANY SINCE THE DATE HEREOF OR THAT THE INFORMATION CONTAINED
HEREIN IS CORRECT AS OF ANY TIME SUBSEQUENT TO ITS DATE.
------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary.................... 3
Risk Factors.......................... 5
Use of Proceeds....................... 13
Dividend Policy....................... 13
Capitalization........................ 14
Dilution.............................. 15
Selected Financial Data............... 16
Management's Discussion and Analysis
of Financial Condition and Results
of Operations....................... 17
Business.............................. 23
Management............................ 38
Certain Transactions.................. 46
Principal Stockholders................ 48
Description of Capital Stock.......... 50
Shares Eligible for Future Sale....... 52
Legal Matters......................... 53
Experts............................... 53
Other Matters......................... 53
Additional Information................ 53
Index to Financial Statements......... F-1
Underwriting.......................... U-1
Glossary.............................. G-1
</TABLE>
------------------
THROUGH AND INCLUDING MARCH 2, 1998 (THE 25TH DAY AFTER THE DATE OF THIS
PROSPECTUS), ALL DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK, WHETHER OR
NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS.
THIS IS IN ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS WHEN
ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR
SUBSCRIPTIONS.
================================================================================
================================================================================
3,500,000 SHARES
VISUAL NETWORKS, INC.
COMMON STOCK
(PAR VALUE $.01 PER SHARE)
------------------------
[VISUAL NETWORKS LOGO]
------------------------
GOLDMAN, SACHS & CO.
DEUTSCHE MORGAN GRENFELL
WESSELS, ARNOLD & HENDERSON
REPRESENTATIVES OF THE UNDERWRITERS
================================================================================
