<PAGE> 1
U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
AMENDMENT NO.1
TO
FORM 10-K
(MARK ONE)
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
--- SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 26, 1997
OR
--- TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
---------- -----------
COMMISSION FILE NUMBER: 0-21067
TRUSTED INFORMATION SYSTEMS, INC.
(Exact Name of Registrant as specified in its charter)
DELAWARE 52-1281786
(State or other jurisdiction of (IRS employer
incorporation or organization) identification No.)
3060 WASHINGTON ROAD 21738
GLENWOOD, MARYLAND (Zip Code)
(Address of principal executive office)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (301) 854-6889
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
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Name of Each Exchange
Title of Each Class: on which Registered:
------------------- -------------------
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COMMON STOCK, PAR VALUE NASDAQ NATIONAL MARKET
$0.01 PER SHARE
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SECURITIES REGISTERED PURSUANT TO SECTION 12 (g) OF THE ACT:
NONE
Indicate by check mark whether the Registrant (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
<PAGE> 2
Documents incorporated by reference: Specified portions of the
Definitive Proxy Statement to be filed with the Commission pursuant to
Regulation 14A in connection with the 1998 Annual Meeting are incorporated
herein by reference into Part III of this Report. Such proxy statement will be
filed with the Securities and Exchange Commission not later than 120 days after
the Registrant's fiscal year ended December 26, 1997.
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K [X].
The aggregate market value of the voting stock held by non-affiliates
of the Registrant as of March 12, 1998 was approximately $208,942,206.
The number of shares outstanding of the Registrant's Common Stock, as
of March 12, 1998 was 13,882,789 shares of Common Stock.
<PAGE> 3
TRUSTED INFORMATION SYSTEMS, INC.
FORM 10-K
TABLE OF CONTENTS
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PART I
Item 1. Business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1
Overview
Industry Background
TIS Strategy
TIS Solution
Advanced Research and Engineering
Sales and Marketing
Customer Service and Support
Research and Development
Competition
Proprietary Information and Intellectual Property
Employees
Regulatory Matters
Item 2. Properties . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15
Item 3. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16
Item 4. Submission of Matters to a Vote of Security Holders . . . . . . . . . . . . . . . . . . . . . . . . 16
PART II
Item 5. Market for the Company's Common Equity and Related Stockholder Matters . . . . . . . . . . . . . . . 17
Item 6. Selected Consolidated Financial Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
Item 7A. Quantitative and Qualitative Disclosure About Market Risks . . . . . . . . . . . . . . . . . . . . . 28
Item 8. Financial Statements and Supplementary Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29
PART III
Item 10. Directors and Executive Officers of the Registrant . . . . . . . . . . . . . . . . . . . . . . . . . 30
Item 11. Executive Compensation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
Item 12. Security Ownership of Certain Beneficial Owners and Management . . . . . . . . . . . . . . . . . . . 30
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Item 13. Certain Relationships and Related Transactions . . . . . . . . . . . . . . . . . . . . . . . . . . . 30
PART IV
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K . . . . . . . . . . . . . . . . . . 31
Exhibit Index . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31
Signatures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54
</TABLE>
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FORWARD-LOOKING STATEMENTS
IN ADDITION TO HISTORICAL INFORMATION, THIS ANNUAL REPORT ON FORM 10-K
CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES THAT
COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY. FACTORS THAT MIGHT CAUSE OR
CONTRIBUTE TO SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED
IN THE SECTION ENTITLED "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS--FACTORS THAT MAY AFFECT FUTURE RESULTS OF
OPERATIONS." READERS SHOULD CAREFULLY REVIEW THE RISKS DESCRIBED IN OTHER
DOCUMENTS THE COMPANY FILES FROM TIME TO TIME WITH THE SECURITIES AND EXCHANGE
COMMISSION, INCLUDING THE QUARTERLY REPORTS ON FORM 10-Q FILED BY THE COMPANY
IN 1997. READERS ARE CAUTIONED NOT TO PLACE UNDUE RELIANCE ON THE
FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS OF THE DATE OF THIS ANNUAL
REPORT ON FORM 10-K. THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY RELEASE
ANY REVISIONS TO THE FORWARD-LOOKING STATEMENTS OR REFLECT EVENTS OR
CIRCUMSTANCES AFTER THE DATE OF THIS DOCUMENT.
PART I
ITEM 1. BUSINESS.
OVERVIEW
Trusted Information Systems, Inc. ("TIS", or the "Company") provides
comprehensive security solutions for protection of computer networks, including
global Internet-based systems, internal networks and individual workstations
and laptops and is a leading provider of firewall and intrusion detection
products. TIS, which was founded in 1983 to engage in computer security
consulting, draws upon the expertise of a senior management team with an
average of more than 20 years of experience in computer security and networking
issues in industry and government. The Company emphasizes the robustness of
its security solutions, its long experience with computer security and
cryptography issues and its ability to provide comprehensive solutions to
customers. The Company also emphasizes its strong reputation with corporate
and government computer security professionals in the United States and abroad
as a pioneer in the field of computer network security. The Company's
customers include the following or subsidiaries thereof: Chrysler Corporation,
E.I. duPont de Nemours and Company (DuPont), Microsoft Corporation, NationsBank
Corporation, Royal Dutch Shell Company (Shell International B.V.), Sears
Corporation, and Swiss Bank Corporation.
The Company develops, markets, licenses and supports the Gauntlet(R)
family of firewall products. These products allow customers to create "trusted"
networks that are protected from access, theft and damage by unauthorized users
from "untrusted" networks such as the Internet and also enable the creation of
virtual private networks ("VPNs") through the encrypted transmission of
information across untrusted networks. The Company's Gauntlet Internet
Firewall, introduced in 1994, was derived from the TIS Internet Firewall
Toolkit which has been available on the Internet since 1993 and has been
downloaded more than 75,000 times to more than 50,000 users worldwide. In
January 1996, the Company initiated a telemarketing program to upgrade TIS
Internet Firewall Toolkit users to the Gauntlet family of firewall products.
Through December 1997, more than 7,500 Gauntlet Internet Firewalls have been
licensed to customers. To build, maintain and enhance customer relationships,
TIS also offers a full range of consulting in information security policies and
planning to its customers. The Company further provides research and
development and consulting to government agencies, including the National
Security Agency ("NSA") and Defense Advanced Research Projects Agency
("DARPA"), in areas such as next generation firewalls, distributed trusted
operating systems, Internet domain name services, international cryptography
and advanced cryptographic key handling and recovery techniques.
In October 1997, TIS acquired Haystack Laboratories, Inc.
("Haystack"). Haystack, maker of Stalker(R) intrusion detection products, was
complementary to TIS because the multi-dimensional network and server security
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market is an emerging market in which the Stalker family of products provide
high end intrusion detection products that are complimentary to TIS products,
and because Haystack has a similar focus on industry leaders as customers and
partners. In addition, the Stalker based technology provides a solid base for
future products which can be easily integrated with TIS' Gauntlet firewall
family.
Prior to founding TIS in 1983, Stephen T. Walker, Chairman and Chief
Executive Officer, spent over 20 years working on computer security issues for
the U.S. government at the NSA and the Advanced Research Projects Agency
("ARPA"), the predecessor agency of DARPA.
Recent Development- Proposed Merger
In February 1998, Network Associates, Inc. (Nasdaq:NETA) and TIS
announced a definitive agreement under which Network Associates will acquire
the Company in a stock-for-stock pooling of interest merger. With this
transaction, Network Associates will become one of the largest security
software companies in the industry, delivering a comprehensive suite of
security products encompassing enterprise encryption, authentication, intrusion
detection, anti-virus, and firewall protection.
INDUSTRY BACKGROUND
The Internet
The Internet, derived from ARPA research in the 1970s, is a global web
of inter-connected computer networks which enables commercial organizations,
educational institutions, government agencies and individuals to freely
communicate, access and share information and conduct business remotely. The
networks that constitute the Internet are connected in a variety of ways,
including by the public switched telephone network and by high speed, dedicated
leased lines.
While there has been significant media interest in the consumer
potential of the Internet, business and professional organizations also account
for a significant percentage of Internet usage. The recent growth in the
Internet has been driven primarily by the increasing popularity of two
applications: the World Wide Web and e-mail. The emergence of the World Wide
Web allows commercial organizations a new medium in which to publish
multi-media documents and other information for public access and to advertise
or provide products and services to users. Many such commercial enterprises
have established a "home page" to enhance these new market opportunities.
Customer service, electronic commerce, advertising and market data generation
are all being conducted across the World Wide Web. The growth of e-mail usage
on the Internet is being driven by ease-of-use and standardization. Today,
there are a number of commercially available e-mail programs that an
organization or individual may use to facilitate Internet communications.
The Company believes that full commercial utilization of the Internet
has been hampered by a lack of security and the vulnerability of the Internet
and private networks directly connected to the Internet. The very openness of
the Internet means that transmitted information and data stored in connected
hosts are exposed to other users who are able, in the absence of effective
security measures, to gain access to, manipulate and divert the data. This
fundamental weakness mandates that organizations and individuals weigh security
concerns against the perceived commercial opportunities presented by millions
of Internet users.
Private Networks and Intranets
As network technology has advanced, enterprise computing has evolved
from mainframe computers supporting a number of terminals toward networks of
inter-connected personal computers. Organizations have developed local area
networks ("LANs") to share data and applications within work groups.
Increasingly, businesses are using the Internet's non-proprietary TCP/IP
protocol for internal network communications which facilitates corporate
communications using Internet tools and applications. Internal networks that
employ TCP/IP as a network protocol are known as "Intranets."
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Organizations are increasingly dependent on electronic communications
among geographically dispersed internal operations, customers, suppliers and
other partners. Many organizations have connected together LANS, including
geographically dispersed networks, into wide-area networks ("WANs"), and
further connect multiple LANs and WANs, including remote networks and mobile
PCs, over dedicated leased lines or other costly telecommunication links.
Private networks can support remote access from other private networks to
provide customer support bulletin board services, electronic data interchange
("EDI") and database sharing. Organizations can use the Internet as a
low-cost, if less secure, communications "backbone" for a WAN, thereby
extending internal information systems and enterprise applications to
geographically dispersed facilities, remote offices and mobile employees.
The increasing number of authorized users having direct access to
expanding networks and the data contained on such networks have increased the
need to provide protection for sensitive data on such networks from
unauthorized users with general access to a system. Network administrators
face the challenge of creating accessible, shared LANs and Intranets while
protecting the integrity and confidentiality of the information being shared.
Network Security
As a result of the increased use of the Internet and Intranets,
unauthorized access to organization networks and corporate data is an
increasingly costly business problem. Sensitive data that require protection
from unauthorized use include financial results, medical records, personnel
files, research and development projects, marketing plans and other business
information. Unauthorized access to this information may go undetected by the
computer user customer lists or network administrator, especially if the
information is read but not altered by the unauthorized party. Organizations
are vulnerable not only to unauthorized access to information resources by
outsiders, but also to abuse by employees within their own organizations,
requiring information security measures which prevent, detect, and monitor
harmful information security anomalies.
TIS believes the requirements for information security in these
complex communications systems can be described in terms of three major
requirements:
Confidentiality: controlling who gets to read information
Integrity: assuring that information is changed only in a
specified and authorized manner, and
Availability: assuring that authorized users have continued
access to information and resources.
The relative importance of these requirements differs depending upon
the application. For example, funds transfer systems require strong integrity
controls, while product design or mineral exploration systems may focus chiefly
on confidentiality.
These information security requirements typically are stated in a
security policy--a concise statement of information sensitivities, protection
responsibilities and organizational commitment. The Company believes that a
strong security policy must state specific security needs in terms which
balance the system's risk and vulnerabilities with the need to operate. An
organization must consider following in establishing a system security policy:
the value of the asset being protected;
the vulnerabilities of the system--what damage can insiders/outsiders
do to the system;
the threats to the system--can adversaries exploit these
vulnerabilities; and
the risks to the system--what are the costs of recovery if an
adversary exploits a system's vulnerability.
These policies then need to be implemented by the organization at a number of
levels, for example, (a) between sections or particular groups within a site,
(b) for each site, (c) throughout the organization with its many sites and
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(d) between the organization, its customers and suppliers. Each level of
communications requires the implementation of information security technology
to carry out these security policies.
Firewalls
Without any firewall protection, a computer on an untrusted network
can easily exploit any weaknesses in the software on a computer on a trusted
network. Firewalls have developed as key elements in implementing different
security policies at the different levels within networks. The growth in
Internet users and Intranets, as well as the growing concerns about network
security, are fueling increasing demand for firewalls. A report released in
June 1997 by International Data Corporation projects that firewall product
licenses will grow from 36,610 units in 1996 to 1,121,900 units in 2001.
Firewalls prevent harmful information security anomalies by providing
strong points of defense and controlled, audited access to services at all
levels of communications -- both from within and without an organization's
private network. A firewall is a computer or software system that is
interposed between two networks, generally an organization's internal or
private computer network and a more public or untrusted network. The private,
or trusted, network can be as large as the internal network of a Fortune 500
company, or as small as a network serving a single department at a single site.
The public or untrusted network can be as specific as the enterprise's network
or as general and open as the Internet. One "firewalled" private network can
exist inside another. A firewall can restrict the access to a trusted network
by user, by application and by location. A firewall can also require users to
provide authentication based on cryptography that is much less vulnerable than
the simple passwords which have been historically used in computer systems.
Thus, any organization linking a trusted network to an untrusted network,
either internal or external, will generally and increasingly require a firewall
to enforce network security and protect the trusted network.
The two major types of firewalls are filtering gateways and
application gateways. Both gateway types work to enforce a network security
policy without adversely limiting flexibility or affecting performance.
However, each design strikes a different balance between these three goals:
filtering gateways sacrifice aspects of security in order to be more flexible
and generally provide for performance, and application gateways provide higher
security at the expense of some flexibility and performance.
Filtering Gateway Firewalls. Filtering gateway firewalls are either
"static" or "dynamic" packet filters. Dynamic filtering is sometimes referred
to as "Stateful Multi-Layer Inspection." All filtering gateways make routing
decisions based on information contained in each network "packet." If a
packet's content meets the security policy criteria, it is forwarded to the
destination. Otherwise, it is blocked at the gateways. Static filters, which
are typically implemented in routers, examine each packet as it arrives at the
gateway and make a routing decision based on the packet's header (information
such as source and destination address, protocols, and port numbers) and
sometimes on portions of the packet's contents. Dynamic filters can make
forwarding decisions based on the application protocols contained within the
packets, by maintaining the state of the application program. All filtering
gateways are limited in the amount of content filtering that may be done for a
given session.
Since filtering gateways operate by routing traffic, they provide
direct connectivity between untrusted and trusted networks. This direct
connection places a large burden for the network's security policy on internal
systems because they are directly exposed for all services the firewall lets
through. A typical example is electronic mail: if the filtering gateway is
configured to permit inbound e-mail, the security of the e-mail server becomes
critical--if it is running an insecure mail service such as the UNIX "sendmail"
program, history has shown that the system will be vulnerable to penetration,
and could then be used as a starting place to attack the rest of the computers
on the network intended to be protected by the firewall.
Application Gateway Firewalls. Application gateways, also known as
proxy gateways, control network connections rather than individual packets. At
the point where a connection is requested, the proxy for the given protocol
will check the firewall's security policy and decide whether the connection is
permitted. If it is, the proxy will then mediate all future traffic for that
connection and verify that it conforms to the given protocol and security
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policy. Application gateways permit or deny connections which mediate traffic
based on security policy considerations such as user name, addresses,
protocols, and protocol-specific functions (e.g., download data but not upload,
e-mail scanning, Java filtering).
Virtual Private Networks (VPNs). Once firewalls are in place at
multiple sites on a WAN, the ability to establish encrypted communications
links over WANs becomes practical. These VPNs provide the most complete
protection among networks, whether among a corporation's internal information
systems at different locations or among those locations and widely dispersed
customers and suppliers. VPNs permit the safe commercial use of the Internet,
thereby providing significant cost savings by reducing reliance on more costly
dedicated telecommunications alternatives. A report prepared by an industry
consultant indicates that for the set of applications covered, such cost
savings could provide a full payback of the VPN investment within the first
year of it operation.
Export controls imposed by most governments are a significant
impediment to the establishment of Global VPNs ("GVPNs"). Recent initiatives
and interim regulations by the U.S. and other governments to allow export of
cryptography when combined with some form of key recovery system offer an
excellent opportunity to realize the full potential of GVPNs on an
international basis. The Company believes that as appropriate government
policies are put in place, the combination of application gateway firewalls and
key recovery enabled encryption (such as the Company's RecoverKey(TM)/Key
Recovery Technology(TM) [KRT]) will serve to radically alter the landscape of
today's private networks, providing reliable, protected communications through
public networks such as the Internet. See "-- Commercial Products and Services
- -- Cryptographic Products/RecoverKey/Key Recovery Technology System."
Intrusion detection
Intrusion detection network security products complement the
firewall's preventative features by providing strong measures of detection and
monitoring inside a firewall's protected environment. Traditional access
control tools protect networks and network hosts by allowing access to the
network through only one point of entry, such as a firewall. However, since
the majority of security breaches occur within an enterprise's firewall
protected environment, and because firewalls don't monitor information within
their protected network, discovering when and how breaches occur is virtually
impossible.
Identification and authorization tools such as password checkers and
Kerberos and token-based authentication systems prevent unauthorized internal
access by making the login process more user-specific. Encryption technology
using public and private keys presumes initial connection capabilities, and is
impractical for most open system applications. These tools require extensive
system planning and administration, and each must be set up individually to
determine authorized access levels for individual users and devices. All of
the tools place added time and memory burdens on both users and systems.
Finally, these devices are insufficient for investigating and intercepting
system misuse.
Detection is the "smart part" of active security tools. Intrusion
detection products use an ongoing stream of data about computer and network
activities to identify computer misuse and report users' activities in
real-time. These detection tools look for and identify patterns of events that
are known to reflect misuse of the system, establishing 100% user
accountability. Active detection also monitors all processes on the system, and
can detect whether server processes such as the Web server, are still
operating. Automatic, real-time response to external and internal intrusions
truly distinguishes active security from more passive security strategies.
Active security tools allow the operator to specify a customized security
policy through an HTML interviewer, establishing who can access the network,
how they can access the system and when they can access it. In addition,
active responses ranging from notification of misuse (via pager, email or
SNMP), to forced logoff, to termination of offenders' processes may be
selected. Only active response coupled with real-time detection can provide
ongoing and complete protection required for today's open systems and active
security tools provide increased network integrity and availability as networks
scale up in size.
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TIS INFORMATION SECURITY SOLUTIONS
TIS offers a comprehensive set of products and services for the
protection of computer networks, including global Internet-based systems,
internal networks and individual workstations and laptops. As part of this
complete solution, TIS provides consulting services to evaluate and design
information security policies and firewall and other network security products
that address the major requirements of confidentiality, integrity and
availability.
The TIS Trusted System Design Principles, derived from decades of
computer security experience, include:
- Simplicity in mechanisms and services provided.
- Simplicity in software design, development and implementation.
- A "Crystal Box" approach, in which source code is made
available to allow for assurance reviews by the Company's
customers, resellers and other experts.
- Logging every event that can be logged; the customer can then
customize a complete and appropriate security audit trail.
- Supporting all forms of user authentication methods and
mechanisms.
- Enforcing an organization's security policy, instead of
imposing one of its own.
Management believes that the integrity of the Company's security
solutions, the simplicity and brevity of its Gauntlet code, the transparency of
its "Crystal Box" approach and the experience and expertise of its management
team and consultants attract customers to purchase the Company's products and
services. In addition, the Company believes that the encryption technology of
its firewall products, which allows organizations to establish secure
communication between geographically dispersed sites through VPNs and GVPNs,
further attracts customers due to the potential cost savings which may be
achieved by communicating over the Internet rather than over more expensive,
private lines.
COMMERCIAL PRODUCTS AND SERVICES
Gauntlet Firewall Products
The following table sets forth certain information regarding certain of the
current TIS product offerings.
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ENVIRONMENT PRODUCT NAME DESCRIPTION DATE OF
INTRODUCTION
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Internet Internet Firewall A research-based collection of modules, Q4 1993
Toolkit available free on the Internet for use but not
for resale, from which one can build a firewall
and which has served as the foundation for the
initial version of the Company's Gauntlet
family of firewall products.
Intranets Stalker Intrusion and misuse detection for the network Q4 1993
behind the firewall
Internet WebStalker(TM) Intrusion and real time monitoring for the web Q4 1993
server
Internet Gauntlet Internet Application gateway firewall that protects Q2 1994
Firewall internal networks from external intrusion.
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Intranets Gauntlet Intranet Distributed firewall technology that protects Q2 1996
Firewall departmental Intranets from unauthorized access
by internal users.
Remote Sites Gauntlet Net Distributed firewall technology that provides Q2 1996
Extender secure communications over the Internet and
WANs to and from remote networks through the
use of encryption.
Mobile PC Users Gauntlet PC Provides secure communications over the Q2 1996
Extender Internet and other public networks to and from
mobile PC users.
Internet Gauntlet Internet Application gateway firewall that protects Q4 1996
Firewall for internal networks which run on Sun Microsystems
Solaris Solaris from external intrusion.
Internet Gauntlet Internet Application gateway firewall that protects Q4 1996
Firewall for internal NT networks from external intrusion.
Windows NT
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Internet Firewall Toolkit. The Company introduced its Internet
Firewall Toolkit on the Internet in 1993, free for use but not for resale. The
TIS Internet Firewall Toolkit, which has been downloaded more than 75,000 times
to more than 50,000 discrete locations worldwide, is a collection of computer
programs from which a skilled programmer can build an application gateway
firewall to secure communications over public networks such as the Internet.
To build a firewall from the TIS Internet Firewall Toolkit, the toolkit
programs must be compiled on the programmer's hardware and operating systems
and the user must configure the operating system on which the firewall is
housed to be a suitably secure base for the firewall software. A firewall
compiled from the TIS Internet Firewall Toolkit provides basic protection for
common Internet applications including e-mail and the World Wide Web browsers
and supports user authentication. Compared to the Gauntlet family of firewall
products, such a firewall will provide limited management features and lacks
firewall-to-firewall encryption that allows the construction of a VPN.
Additionally, a firewall built from the TIS Internet Firewall Toolkit generally
must be maintained and enhanced by the programmer who constructed it. The
Company has initiated a program to upgrade TIS Internet Firewall Toolkit users
to the Gauntlet family of firewall products.
Gauntlet Internet Firewall. The Gauntlet Internet Firewall is an
application gateway firewall which is the corner-stone of the Company's
comprehensive security solution. The Gauntlet Internet Firewall functions as a
barrier between the user's trusted network and untrusted networks such as the
Internet and was initially based on the TIS Internet Firewall Toolkit. The
Gauntlet Internet Firewall enables secure communications over public networks
such as the Internet, including firewall-to-firewall encryption that allows a
firewall owner to construct a VPN. In addition to standard encryption and VPN
capabilities, authentication and proxy services, the Gauntlet Internet Firewall
includes a secure GUI for management and includes audit and alert capabilities
and tools. The Company introduced the GUI for the Gauntlet Internet Firewall
in January 1996 and continues to develop additional enhancements for ease of
use and administration. The Gauntlet Internet Firewall software operates on a
number of popular versions of the UNIX operating system. The Company has
developed and packages as part of the Gauntlet Internet Firewall selective
modifications to the operating systems to increase the Gauntlet Internet
Firewall's usability and to harden the operating systems to make them more
resistant to attack. Because of these modifications, the Gauntlet Internet
Firewall is "transparent" and supports network services without requiring
action by individual end users or modifications to their client software. Also
because of these modifications, the Gauntlet Internet Firewall prevents
"spoofing" attacks in which a computer on the untrusted network pretends to be
on the trusted network. and it detects attempts from either network to probe
for unprotected services or points of access. To date, more than 7,500
Gauntlet Internet Firewall products have been installed.
Gauntlet Intranet Firewall. The Gauntlet Intranet Firewall was
designed for improving the internal security of a LAN or Intranet. The
Gauntlet Intranet Firewall provides protection against unauthorized access to
network
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resources by internal users, and protects communications among individual PCs
within and across workgroups. The Gauntlet Intranet Firewall also currently
supports Sun, Hewlett-Packard and BSDI operating systems. The Company
introduced its Gauntlet Intranet Firewall product supporting Sun Microsystems'
Solaris in the fourth quarter of 1996 and has released updates throughout 1997.
Gauntlet Net Extender. Extending the capabilities of the Gauntlet
firewall, the Gauntlet Net Extender is a remote Gauntlet Internet Firewall that
network administrators can manage from another Gauntlet Internet Firewall. The
Gauntlet Net Extender is marketed to customers which are enterprises with
multiple divisions and remote locations. Using encryption, the Gauntlet Net
Extender works in conjunction with a Gauntlet Internet Firewall to provide
remote site network security and remote management and control from a
centralized location. The Gauntlet Net Extender also currently supports Sun,
Hewlett-Packard and BSDI operating systems. The Company's Gauntlet Net
Extender product supporting Sun Microsystem Solaris was made available in the
fourth quarter of 1996, and has released updates throughout 1997.
Gauntlet PC Extender. The Gauntlet PC Extender provides multiple
levels of security for remote users utilizing a PC running on Microsoft Windows
3.1 or Microsoft Windows for Workgroups 3.11 to connect to an internal network
or communicate within an Intranet. The encryption provided by the Gauntlet PC
Extender protects passwords, provides user authentication to prevent
unauthorized access to internal network resources and provides data encryption
to protect the confidentiality and integrity of information transmitted over
the Internet or other public or privacy networks. Gauntlet PC Extender product
for PCs supporting Microsoft Windows 95 was made available in the first quarter
of 1997, and has released updates throughout 1997.
Gauntlet Internet Firewall for Solaris. The Gauntlet Internet
Firewall for Sun's Solaris Operating System is a reimplementation of the
Gauntlet Internet Firewall for Solaris, including kernel level changes to
support the full range of Gauntlet Internet Firewall features and security.
The Company introduced its Gauntlet Internet Firewall for Solaris in the fourth
quarter of 1996, and has released updates throughout 1997.
Gauntlet Internet Firewall for Windows NT. The Gauntlet Internet
Firewall for Microsoft Windows NT is a complete reimplementation of a Gauntlet
Firewall whose internal structure and user interface are adapted to the unique
functional and performance attributes of the Windows NT operating system
environment. The Company introduced Gauntlet Internet Firewall for Windows NT
in the fourth quarter of 1996, and has released updates throughout 1997.
Stalker and Webstalker(TM): The Stalker and Webstalker intrusion
detection products were made available in the fourth quarter of 1997, after the
Haystack acquisition.
The specific uses and applications of the Company's network security
products vary significantly among market sectors and business organizations.
Examples of actual uses by customers of the Company's products include:
- A U.S. company that is a provider of software solutions for
electronic commerce has installed multiple Gauntlet Internet
Firewalls at the organization's sites in the United States and
abroad to create a GVPN utilizing encryption. This enables
personnel at the various domestic and overseas sites to share
proprietary software product development and business
information securely over the Internet.
- A multi-national banking institution has installed multiple
Gauntlet Internet Firewalls on corporate Intranets to enforce
the bank's security policies that require isolation of
different organizations within the bank located throughout the
world. Each Gauntlet Internet Firewall is configured to allow
only selected applications to pass financial and other
important information onto the appropriate internal system.
The Company's "Crystal Box" approach and the ability to log
all Internet Firewall activities are essential to enforcement
of bank security policy.
- A software industry leader uses a number of Gauntlet Internet
Firewalls in a parallel configuration which enables responsive
Internet access for internal and external users of its major
World Wide Web site. The Gauntlet Internet Firewalls enforce
the company's security policies and procedures and protect the
company's internal systems and networks, which process over
100,000 e-mail messages a day.
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The Gauntlet Internet Firewall is offered by the Company at a U.S.
list price of approximately $5,000, $11,500 and $17,500 depending on the number
of users. WebStalker is priced at $4,995. The Stalker manager is $9,995 and
the Stalker agents are $395-$795 each. Volume discounts are generally
available. The Company provides initial on-site installation, testing and
training and offers a variety of continuing maintenance and support options to
customers of the Gauntlet family of firewall products.
The Company plans to extend its firewall products to include new
proxies for new services and to defend against new threats. Customer input
will be an important part of the Company's continued development of
improvements in ease of use and management functions. In addition, the Company
is developing products which will be compatible with Microsoft's Internet
Security Framework. This framework provides an open, interoperable and
cross-platform set of technologies and enables the effective interface of
products developed and marketed by a variety of software companies which will
allow individuals to exchange information securely, control access to their
systems and conduct secure financial transactions across public networks.
Cryptographic Products/RecoverKey/Key Recovery Technology (KRT)
System. In 1997, several of the Company's cryptographic products were
introduced into the marketplace. Enhancements and new versions are currently
under development. The Company is continuing its efforts to license the
RecoverKey/KRT toolkit, Key Recovery Centers(TM) ("KRCs"), and CryptAll(TM).
The Company has signed licenses for its RecoverKey/KRT products and technology
with several companies, including IBM, Atalla, Sterling Commerce, and Silicon
Graphics, Inc.
RecoverKey/KRT Toolkit. The RecoverKey/KRT Toolkit consists of
software and a license to the Company's RecoverKey/KRT technology to enable
companies to incorporate key recovery technology into their products either to
enable their cryptographic functions to satisfy U.S. (and possibly other)
government requirements for general export to foreign markets
(RecoverKey-International(TM), formerly known as Commercial Key Escrow or CKE).
This also enables companies to provide emergency access to encrypted data in
case an encryption key is lost or unavailable for any reason (RecoverKey,
formerly known as Commercial Key Recovery or CKR). Using the RecoverKey/KRT
Toolkit, the vendor can enable its product to encrypt any user secret (e.g., a
key used to encrypt a file) using the public key of a KRC and storing it in a
Key Recovery Field ("KRF"). This KRF permits future access to that secret for
any reason through the designated KRC.
Key Recovery Centers. KRCs are an essential part of the Company's
RecoverKey/KRT. A KRC is a system (hardware and software) with a set of public
and private keys for the recovery of encrypted data. A KRC receives and
records user registrations which include the access information required for
future recovery requests. Upon registration, the user's RecoverKey/KRT-enabled
application can create a KRF which will be recognized by the KRC. If a user
needs to recover an encrypted file or message, the KRF is sent to the KRC, the
user's identity is authenticated and the KRC provides the user with a decrypted
version of the key located in the KRF to decrypt the file or message.
CryptAll. CryptAll is a client software product containing a Microsoft
Cryptographic Application Programming Interface (CAPI) compliant Cryptographic
Service Provider (CSP) combined with various messaging functionality to permit
secure communication with a KRC for registration and key recovery purposes. It
is available in both a domestic version, and an exportable version that has
been approved for export by the U.S. government. Both versions are based on
RSA's BSAFE version 3.0 toolkit technology. The exportable version uses the
Data Encryption Standard ("DES") algorithm (56 bit) without key recovery and
Triple-DES and 128 bit RC2/RC4 in conjunction with
RecoverKey-International(TM). The domestic version contains the same suite of
algorithms, using Triple-DES as its standard mode of operation, but can also
interoperate with the exportable version. Both versions use the Company's
RecoverKey/KRT technology and have optional, user selected, key recovery
features.
The Company has been a leader in developing a key recovery solution to
enable the interests of national security and law enforcement agencies to be
addressed while permitting the export of products with strong
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<PAGE> 14
cryptography. The U.S. government, both in the context of executive branch
regulations and decision-making, as well as pending legislation in the U.S.
Congress, is actively considering a variety of options regarding cryptography
export policy. The Clinton administration's current policy on exportable
strong cryptography links the relaxation of export controls to systems that
include the use of key recovery. However, certain parties, including companies
in the computer industry and members of the U.S. Congress, call for removing
export controls on products containing encryption technology. Those options
could have an adverse impact on the development of a market for current
RecoverKey-International products, and those the Company plans to introduce in
the future.
In January 1996, the U.S. government granted the Company an export
license for a particular transaction involving the Gauntlet Internet Firewall
using the DES algorithm. This was the first export license granted because the
encryption was combined with a key recovery system. In June 1996, the U.S.
government granted the Company several export licenses to sell the Gauntlet
Internet Firewall in order to provide GVPN services. In February 1997, the
U.S. government granted the Company an export license exception for the general
purpose export of the RecoverKey-International enabled Gauntlet Internet
Firewall and in July 1997, the Company received an export license exception for
a version of the CSP (included in the current version of CryptAll)
incorporating multiple modes of operation including Triple-DES and 128 bit
RC2/RC4. In September 1997, the Company received U.S. government approval to
export its RecoverKey Toolkit without an export license, and in January 1998
the Company received U.S. government approval to ship certain Key Recovery
Center products under a licensing arrangement that allows the Company to export
these products worldwide, without prior Commerce Department approval, to end
users in all free world nations.
On October 2, 1996, the Company, along with ten other companies
including IBM, announced the formation of an alliance to develop an exportable,
worldwide approach to strong encryption, using key recovery. This alliance now
includes approximately 70 corporations that meet periodically to help establish
worldwide standards for key recovery, which will promote worldwide
interoperability while enabling secure international electronic commerce.
On January 24, 1997, the Company and International Business Machines
Corporation ("IBM") entered into a patent and software license agreement.
Pursuant to the terms and conditions of the agreement, IBM has been granted the
right to use, sell, sublicense and distribute the Company's RecoverKey
technology and IBM is permitted to bundle the Company's technology in IBM
products for resale. IBM received a license to make, use, sublicense and sell
the Company's Toolkits. IBM also received a license to make and sell key
recovery centers that incorporate the Company's proprietary technologies and to
operate and sublicense the Company's Key Recovery Centers. Generally, the
licenses granted under the agreement terminate upon the expiration of the
underlying patents. Under the terms of the license agreement, the Company will
receive fees and royalty revenue from IBM based upon IBM's sale of products
that incorporate the Company's technology. At IBM's election, the Company will
perform certain ancillary services and provide maintenance and support, for
which the Company also receives revenue.
Commercial Consulting
TIS offers a full range of consulting in information security policies
and planning. TIS' Commercial Consulting Practice grew out of the Company's
original consulting practice founded by Stephen T. Walker. It is currently led
by members of senior management and carried out by TIS' staff of experts who
average more than 15 years of information security experience in both
commercial and government communities. TIS offers the following commercial
consulting services: technology research services; consultation on security
issues associated with products and services; corporate information security
policy development; architectural and diagnostic security analysis and firewall
configuration; and training for corporate network and security administration
personnel. TIS' consulting customer base includes a wide range of institutions
from financial, industrial, regulatory, entertainment, research, information
systems and telecommunications organizations.
Management believes that the Commercial Consulting Practice has and
will continue to play a key role in generating follow-on sales of the Company's
security products. Corporations with the most complete information security
needs, such as those in industries targeted by the Company, often look to
outside consultants to assist them in designing, maintaining and improving
network security systems and policies. The Company believes that its
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<PAGE> 15
reputation in the field of computer security along with its team of experienced
consultants attracts customers to engage TIS' services in solving their complex
security needs.
The Commercial Consulting Practice continuously evaluates emerging
network services and technologies, the security vulnerabilities inherent in new
offerings, and evolving methods employed by hackers and professional system
penetrators to exploit system vulnerabilities. The findings from this effort
not only enable more effective consultation and the development of automated
analysis tools, but also feed into the ongoing network security product
development and enhancement activities of TIS.
ADVANCED RESEARCH AND ENGINEERING
The Company engages in research and development of computer and
communications security technology under contracts with departments and
agencies of the U.S. government. The Company provides security technology
analysis and consulting under contracts both directly and indirectly with the
U.S. government and the governments of other countries. Prior to 1996, the
principal source of the Company's revenues was from government contracts. In
1995 approximately 68% of the Company's total revenues were derived directly or
indirectly from government contracts. In 1996 and 1997 the percentage of the
Company's total revenue derived from government contracts was 41% and 23%
respectively. These revenues, along with the Company's reputation as a pioneer
in the field of computer and network security, have permitted the Company to
assemble a group of renowned scientists and engineers.
The government research and development efforts include Trusted
Mach(R) technology, a high assurance operating system base that controls access
to all system resources and enforces security policies based upon labels
associated with the sensitivity of the resources and access privileges of the
users. High-Assurance Firewalls, World Wide Web servers and file servers built
on the Trusted Mach technology will provide strong protection for data that is
to be shared, either within an organization or externally, but which must also
be protected from unauthorized reading or writing. Another operating system
security technology derived from government-funded research enforces a broad
spectrum of security policies, including those tailored to the user's
individual role in an organization. This technology can greatly improve the
security of existing operating systems by partitioning their capabilities into
various domains. The Company has demonstrated significant improvements to UNIX
systems security using this technology.
Other government research and development efforts include the
development of prototype secure distributed systems, the incorporation of
cryptographic services into various applications and the enhancement and
broader application of access control techniques. Under government contracts,
the Company has incorporated cryptography into e-mail to provide the ability to
digitally sign e-mail in addition to protecting the contents from change or
perusal. The Company is developing techniques to improve the security of the
Internet infrastructure, such as Domain Name Service and routing, by digitally
signing communications between cooperating elements. Security services are
being incorporated into distributed systems using access control techniques
that work with Common Object Request Broker Architecture ( CORBA), an emerging
international standard.
Government-related consulting has focused primarily upon security
assessment and design assistance for security features and attributes of the
systems and applications of the U.S. Department of Defense. The Company's
consulting has helped to discover approaches that provide both the security and
functionality that is needed to support the defense mission. Many of the
security issues and architectures have commercial counterparts, and the Company
has generally reserved the rights to develop such related technologies for
commercial uses.
The Company's backlog for direct and indirect U.S. government
contracts as of December 26, 1997 was approximately $16.8 million. The
government-related backlog represents firm orders or contracts for research,
development and consulting analysis with performance and delivery schedules
that extend up to 30 months. Funded backlog represents the portion of the
backlog for which agencies, departments or companies have actually obligated
payment. As of December 26, 1997, approximately $5.3 million of the
government-related backlog is funded. The Company's U.S. government contracts
are subject to audit by the DCAA. The DCAA has audited the Company's
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<PAGE> 16
cost accounting system through 1995 without material cost disallowances and is
currently performing a similar audit of the Company's cost accounting system
for 1996.
Most of the Company's government-related contracts require the Company
to perform specified services for which the Company is paid its costs incurred
and a negotiated fee. Two contracts for the development of the Trusted Mach
technology accounted for approximately 33% of the Company's total revenues
during 1995. The smaller contract ended in December 1995. The larger
contract, with the NSA, accounted for approximately 25% of the Company's total
revenues during 1995 and was completed in early 1997. Security technology
research and development contracts with the Defense Advanced Research Projects
Agency ("DARPA"), formerly ARPA, accounted for approximately 17%, 15% and 8% of
the Company's 1995, 1996 and 1997 revenues, respectively. During 1995, 1996 and
1997, 8%, 1% and 8% of the Company's total revenues, respectively, came from
security technology research and development contracts with the Air Force Rome
Laboratories ("RL").
SALES AND MARKETING
The Company intends to pursue a focused marketing strategy to achieve
greater market penetration for TIS network security products and services by
utilizing complementary domestic and international distribution channels,
including direct sales, resellers and telesales. The Company believes these
channels will provide broad customer coverage while maintaining a highly
cost-effective effort. The Company has organized its direct sales, resellers
and telesales teams, currently consisting of over 40 employees, on a regional
basis in order to approach the market in a coordinated manner. The Company has
initiated a strategy of directly marketing to its current base of users who
have downloaded the TIS Internet Firewall Toolkit and seeks to convert them
into users of Gauntlet products. In addition, the Company's Fortune 500
marketing strategy with large organizations is to establish relationships
through consulting assistance in the architectural design, installation and
operational phases of their major security initiatives. The Company has
attended and plans to continue to attend popular Internet and network shows,
advertise in trade journals and submit articles that will deliver its message
to decision makers and to the people who make information security
recommendations.
Direct Sales. The Company's direct sales force markets its products
and services to large corporations and organizations with complex information
security needs, such as telecommunications companies, finance and banking
institutions, petrochemical companies and pharmaceutical companies. The
Company's direct sales staff solicits these customers and provides strategy and
solutions as well as insights into security architecture alternatives while
gathering insight into customers' future requirements.
Resellers. The Company currently maintains a worldwide network of
approximately 190 resellers which can be categorized into four areas based on
business segmentation and end user focus: Internet service providers, value
added resellers and hardware vendors, system integrators and security product
vendors. The Company views these reseller partners as an extension of its
direct sales force and supports these relationships with on-going training in
security planning, installation and maintenance as well as by providing such
resellers with updated information, software enhancements and advance notice of
announcements of future products through a TIS World Wide Web site designed
specifically for that purpose. The following are some of the Company's
resellers in each of the designated categories:
- Internet Service Providers: In the United States, these
include GTE Internetworking (formerly BBN Corporation),
Compuserve, PSINet, Inc. and UUNet Technologies, Inc. UUNet
Pipex is one of the Company's Internet service provider
resellers in Europe. Internet Initiative Japan is one of the
Company's Internet service provider resellers in the Pacific
Rim.
- Value Added Resellers and Hardware Vendors: In the United
States, these include Silicon Graphics, Inc. In Europe and
the Pacific Rim, these include Bull Enterprise Systems,
HITACHI Ltd. and Sumitomo Electric Systems Company, Ltd.
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<PAGE> 17
- System Integrators: These include Planning Research
Corporation and Media Communications STM AB.
- Security Product Vendors: These include Hanil Telecom Co.,
Ltd. in the Pacific Rim and V-One in the United States.
The Company's agreements with its resellers generally provide the
reseller with a limited license to market, distribute and install the Company's
Gauntlet family of firewall products in a particular territory and to make such
modifications to the Company's Gauntlet family of firewall products as may be
required to serve the customer's needs. The agreements obligate the Company to
provide its resellers with updates to the licensed Gauntlet family of firewall
products and with ongoing maintenance and support. The reseller is required to
provide the Company with periodic reports regarding its activities in
connection with such products and to pay related license fees to the Company.
The agreements also contain confidentiality, indemnification and warranty
disclaimer provisions.
Telesales. The TIS Telesales Team maintains frequent and open
communications with customers. The TIS Telesales Team is geographically
focused to develop, service and transact business. The 1993 decision to make
the Company's firewall technology available via the Company's World Wide Web
page proved very successful and of strategic importance. The Telesales Team
targets members of this user community as potential customers for the Gauntlet
family of firewall products. TIS also provides these prospects with
information through a Firewall Toolkit user group and Birds of a Feather
sessions at conferences. Other leads for the Telesales Team are generated
through trade shows, an 800 number, e-mail and direct mailings.
For information regarding the Company's revenues from outside North
America, see Note 1 of Notes to Consolidated Financial Statements.
CUSTOMER SERVICE AND SUPPORT
The Company offers extensive training to customers and resellers for
firewall installation and management. As part of the training program, the
Company provides onsite or offsite classroom instruction and related
instructional materials which enable customer and reseller personnel to deliver
the first level of support and to tailor a support scenario for a client's
unique requirements.
The Company offers support services by e-mail and telephone for its
Gauntlet family of firewall products. These services encompass diagnosing
problems in the network associated with the firewall and answering questions
about configuration and operation alternatives. Most customers purchase
support services in the form of a support contract covering a single firewall
or in the form of a corporate support agreement. The Company offers a variety
of support contracts, including one offering support seven days a week, 24
hours per day (7 x 24).
RESEARCH AND DEVELOPMENT
The Company's research and development efforts are focused on core
information security technologies, enhancements to existing technologies and
products, and development of new products. The Company's information security
products research and development program has focused primarily on feature and
performance enhancements, expansion of the family of scaleable firewall and
cryptographic security products, and development of applications of
cryptography, in particular those associated with cryptographic key recovery.
The Company's government research and development program focuses on extensions
and enhancements to current firewall technology, access control techniques for
operational systems and networks, the application of cryptography within
operating systems, network components and network infrastructure and security
for distributed systems. See " -- Advanced Research and Engineering." Through
a combination of independent and government-funded research and development
efforts, the Company is able to maintain a broad base of computer and network
security technology expertise and to remain a leader in information security
technology development.
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As of January, 1998, the Company's research and development staff
included more than 190 scientists and engineers. Of these, 13 have PhDs, 60
have master's degrees and 87 have bachelor's degrees. The Company believes
that its ability to attract and retain a highly qualified technical staff will
continue to be essential to the success of its research and development
programs. The market for such personnel is highly competitive and the
Company's research and development activities could be adversely affected if
the Company is unable to attract and retain skilled technical personnel.
COMPETITION
Competition in the information security market is intense and
constantly evolving, and the Company expects such competition to increase in
the future. In addition, the Company's industry is consolidating at a rapid
pace. The Company believes that significant competitive factors affecting this
market are depth of product functionality, product quality and performance,
product price, customer support, conformance to protocols and industry
standards and breadth of platform support. In addition, the Company believes
that the ability to rapidly develop and implement new products and features for
the market is critical. There can be no assurance that the Company can
maintain or enhance its competitive position against current and future
competitors. Significant factors such as the emergence of new products,
fundamental changes in computing technology and aggressive pricing and
marketing strategies may also affect the Company's competitive position. Many
of these factors are out of the Company's control.
The principal competitors for the Company's government-funded research
and development are GTE Internetworking (formerly BBN Corporation), The Open
Group (formerly known as "Open Software Foundation"), Secure Computing
Corporation and SRI International.
The Company's principal current competitors for its network security
products include America Online, Inc.'s Advanced Network and Services
subsidiary, Bay Networks Inc., Check Point Software Technologies Ltd., Cisco
Systems, Inc., Digital Equipment Corporation, Harris Computer Systems
Corporation, International Business Machines Corporation, Microsoft
Corporation, Milkyway Networks Corporation, Raptor Systems, Inc. (acquired by
Axent), Secure Computing Corporation, Sun Microsystems, Inc. and V-One. Due to
the rapid expansion of the network security market, the Company may face
competition from new entrants in the network security industry, possibly
including increased competitive pressures from the Company's resellers who may
elect to carry an increasing number of products.
The Company and other entities, including IBM, have received approval
from the U.S. Department of Commerce to export products using DES algorithm
without key recovery features under the government's current cryptography
export regulations. The Company is currently the only entity that has received
approval from the U.S. Department of Commerce to export products using
cryptography substantially stronger than the 56 bit DES algorithm (e.g.
TRIPLE-DES and 128 bit RC2/RC4) provided they incorporate RecoverKey
- -International features.
PROPRIETARY INFORMATION AND INTELLECTUAL PROPERTY
The Company's success is dependent in part on its proprietary
technology. TIS relies on a combination of patent, trade secret, copyright and
trademark laws, non-disclosure agreements and contractual provisions to
establish and protect its proprietary rights. The Company has received five
patents and has five pending domestic patent applications and two pending
international patent applications pursuant to the Patent Cooperation Treaty
(PCT) on its KRT and computer security technology. The Company has filed
foreign applications under the European Patent Convention for the countries of
Austria, Belgium, Denmark, France, Germany, Greece, Ireland, Italy,
Liechtenstein, Luxembourg, Monaco, Netherlands, Portugal, Spain, Sweden, and
United Kingdom. Foreign patent applications are also pending in Australia,
Brazil, Canada, China, Japan, S. Korea, Mexico, and the Russian Federation.
The Company uses a printed "shrink-wrap" license for users of its products in
order to protect certain of its copyrights and trade secrets. The Company
attempts to protect its trade secrets and other proprietary information through
agreements with suppliers and non-disclosure agreements with employees and
consultants and other security measures.
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<PAGE> 19
Despite the Company's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy aspects of the Company's products or
to obtain and use information that the Company regards as proprietary.
Policing unauthorized use of the Company's products is difficult, and, while
the Company is unable to determine the extent to which piracy of its software
products exists, such piracy can be expected to be a persistent problem,
particularly in international markets and as a result of the growing use of the
Internet. Some courts have held that shrink-wrap licenses, because the
licensee does not sign them, are not enforceable. The laws of Maryland, which
the shrink-wrap licenses purport to make the governing law, are unclear on this
subject. In addition, there can be no assurance that patent applications filed
by the Company will result in patents being issued or that its existing
patents, and any patents that may be issued to it in the future, will afford
protection against competitors with similar technology; nor can there be any
assurance that patents issued to the Company will not be infringed upon or
designed around by others or that others will not obtain patents that the
Company would need to license or design around.
The Company licenses encryption and other portions of the software
included in its products from third parties and its success will depend in part
on its continued ability to use technology that is important to the
functionality of its products licensed from these or other parties. If its
licenses were to be terminated and the Company were unable to obtain licenses
to similar software from others there could be a material adverse effect on its
financial condition or results of operations.
EMPLOYEES
As of January 1998, the Company employed 315 people on a full-time
basis and 25 people on a temporary or part-time basis. All employees are
required to sign agreements containing confidentiality and non-disclosure
provisions. Additionally, the Company hires independent contractors and
temporary employees on an as-needed basis to assist with specialized
assignments in certain areas, including commercial product development,
advanced research and engineering, customer support and installations.
None of the Company's employees is represented by a labor union or is
subject to a collective bargaining agreement. The Company considers its
relations with its employees to be good.
REGULATORY MATTERS
Certain of the Company's information security products are subject to
the export restrictions administered by the U.S. Department of State and the
U.S. Department of Commerce, which permit the export of encryption products
only with the required level of export license. In addition, these U.S. export
laws prohibit the export of encryption products to a number of hostile
countries. U.S. export regulations regarding the export of encryption
technology require either a transactional export license or the granting of
Department of Commerce classification determination. To date, the Company has
been able to secure all required U.S. export licenses, including the first two
export licenses for transactions involving a network security product using the
industry standard DES algorithm (56 bits), and the first classification
determination permitting the export of a general purpose cryptographic product
containing TRIPLE-DES, which were granted because they included a key recovery
system. Additionally, the Company has received several export licenses and
favorable classification determinations and has a number of export license and
classification determination applications pending before the U.S. government
with respect to the export of products utilizing RecoverKey/KRT. There can be
no assurance that the Company will continue to be able to secure such licenses
in a timely manner in the future, or at all. The Company does not expect that
such RecoverKey/KRT products will generate significant revenues prior to 1999.
See "-- Commercial Products and Services -- Cryptographic
Products/RecoverKey/Key Recovery Technology (KRT) System." In certain foreign
countries, the Company's distributors are required to secure licenses or formal
permission before encryption products can be imported.
ITEM 2. PROPERTIES.
The Company's principal administrative, research, sales, marketing and
consulting facility is located in 44,681 square feet of office space in
Glenwood, Maryland which is owned by the Company. The Company leases other
domestic research, sales, marketing and consulting offices, including
approximately 31,484 square feet in Rockville, Maryland. The Company has also
entered into a lease for 6,271 square feet in McLean, Virginia. Additional
domestic offices are located in Mountain View and Los Angeles, California where
the Company leases 4,472 and 14,189 square feet, respectively, and Austin,
Texas where the Company leases approximately 4,200 square feet. The Company
also maintains a sales, marketing and consulting office located in 2,675 square
feet of leased space in the United Kingdom and a similar facility of
approximately 1,000 square feet in Germany. The Company also owns a 1,700
square foot building adjacent to its main facility in Glenwood, Maryland which
is currently leased to a local small business. The Company believes that its
existing facilities are adequate for its needs and the alternative or
additional space will be available as needed.
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ITEM 3. LEGAL PROCEEDINGS.
The Company is not presently a party to any material pending or
threatened legal proceedings except as described below.
On February 13, 1998 Entrust Technologies Limited and Entrust
Technologies, Inc. filed a complaint in the United States District Court for
the District of Maryland against the Company for infringement of United States
Patent No. 5,481,613. As of the date of this report, the Company has not been
served with said complaint. The amount of liability, or the potential impact
on the Company's operations, if any, cannot be ascertained.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
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PART II
ITEM 5. MARKET FOR THE COMPANY'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.
The Common Stock of Trusted Information Systems, Inc. is traded on the
Nasdaq National Market under the symbol "TISX." Prior to October 10, 1996,
there was no established public trading market for any of the Company's
securities.
The following table sets forth, for the periods indicated, the range
of high and low closing sales price for the Common Stock as reported on the
Nasdaq National Market.
<TABLE>
<S> <C> <C>
Fiscal 1996 High Low
----- ---
Fourth Quarter (from October 10, 1996-
December 27, 1996) 17 3/4 10
Fiscal 1997 High Low
---- ---
First Quarter (ending March 28, 1997) 18 3/8 10
Second Quarter (ending June 27, 1997) 13 3/4 8 1/4
Third Quarter (ending September 26, 1997) 12 3/4 8 5/8
Fourth Quarter (ending December 26, 1997) 12 1/4 7 1/2
Fiscal 1998
First Quarter (through March 12, 1998) 22 7/8 7 5/8
</TABLE>
On March 12, 1998, the last reported sale price of the Common Stock
was $22 per share. As of March 12, 1998, the Company had approximately 253
shareholders of record.
The Company has never declared or paid any cash dividends on its
common stock. In addition, the agreements relating to certain of the Company's
borrowings from Mercantile-Safe Deposit & Trust Company ("Mercantile Bank")
restrict the Company's ability to pay cash dividends without Mercantile Bank's
consent. The Company intends to retain its earnings to fund development of its
business and does not anticipate paying cash dividends in the foreseeable
future.
PERFORMANCE GRAPH
The following graph shows a month by month comparison of cumulative
total shareholder return on the Company's Common Stock, based on the market
price of the Common Stock assuming reinvestment of dividends, with the
cumulative total return of companies in the Nasdaq National Market and the
Russell 2000 Index for the period beginning October 10, 1996, the day the
Company's Common Stock began trading, through February 27, 1998.
-17-
<PAGE> 22
COMPARISON OF CUMULATIVE TOTAL RETURNS*
[GRAPH]
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
10/10/96 10/31/96 11/29/96 12/31/96 1/31/97 2/28/97 3/31/97 4/30/97 5/30/97
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Trusted Information
Systems, Inc. $ 100 $ 91 $ 78 $ 78 $ 102 $ 99 $ 87 $ 60 $ 72
Russell 2000
Index $ 100 $ 99 $ 101 $ 104 $ 107 $ 104 $ 99 $ 99 $ 110
NASDAQ US
Company Index $ 100 $ 99 $ 103 $ 104 $ 111 $ 105 $ 96 $ 99 $ 110
- -------------------------------------------------------------------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
- -------------------------------------------------------------------------------------------------------------------------------
6/30/97 7/31/97 8/29/97 9/30/97 10/31/97 11/28/97 12/31/97 1/30/98 2/27/98
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Trusted Information
Systems, Inc. $ 79 $ 73 $ 61 $ 69 $ 63 $ 62 $ 67 $ 64 $ 139
Russell 2000 Index $ 115 $ 120 $ 123 $ 132 $ 126 $ 125 $ 128 $ 126 $ 135
NASDAQ US Company
Index $ 113 $ 125 $ 125 $ 133 $ 126 $ 126 $ 124 $ 128 $ 140
- -------------------------------------------------------------------------------------------------------------------------------
</TABLE>
* Assumes $100 invested on October 10, 1996, with dividends reinvested.
-18-
<PAGE> 23
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
The consolidated statement of operations data set forth below for the
fiscal years ended December 31, 1993, December 30, 1994, December 29, 1995,
December 27, 1996 and December 26, 1997 and the consolidated balance sheet data
at December 29, 1995, December 27, 1996 and December 26, 1997 are derived from,
and should be read in conjunction with, the audited consolidated financial
statements of the Company. The Company's fiscal 1996 and 1997 statements of
operations include the results of Haystack Laboratories, Inc., giving effect to
the merger with Haystack which occurred on October 16, 1997, and which was
accounted for under the pooling of interests method of accounting. Prior
period consolidated statements of operations and balance sheets do not give
effect to the merger with Haystack, as the effect of the business combination
was not material to the financial statements of the Company.
The consolidated statements of operations data for the fiscal years
ended December 31, 1993 and December 30, 1994, and the consolidated balance
sheet data at December 31, 1993, December 30, 1994 and December 29, 1995 are
derived from audited or unaudited consolidated financial statement of the
Company not included herein. The unaudited consolidated financial statements
include all adjustments (consisting only of normal recurring adjustments and
accruals) that in the opinion of management are necessary for a fair
presentation of the financial information set forth therein. The selected
financial data set forth below are qualified in their entirety by, and should
be read in conjunction with, the consolidated financial statements, the related
notes thereto and "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
-19-
<PAGE> 24
<TABLE>
<CAPTION>
Fiscal Year
--------------------------------------------------------
In thousands, except per share data 1993 1994 1995 1996 1997
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Statement of Operations Data:
Revenues:
Government contracts . . . . . . . . $8,343 $11,258 $12,327 $ 11,095 $ 9,606
Commercial products . . . . . . . . __ 1,003 4,271 14,603 28,782
Commercial consulting services . . . 448 856 1,492 1,677 3,834
------ ------- ------- --------- --------
8,791 13,117 18,090 27,375 42,223
Cost of revenues:
Government contracts . . . . . . . . 5,512 7,377 8,845 7,865 6,557
Commercial products . . . . . . . . __ 333 1,142 3,451 4,231
Commercial consulting services . . . 307 493 878 988 2,247
------ ------- ------- --------- --------
5,819 8,203 10,865 12,303 13,035
------ ------- ------- --------- --------
Gross profit . . . . . . . . . . . . . . 2,972 4,914 7,225 15,072 29,188
Operating expenses:
Selling, general and administrative 2,198 2,997 3,727 15,473 28,642
Research and development . . . . . . 582 646 1,145 4,310 8,533
Non-recurring transaction and other related costs -- -- -- -- 3,535
------ ------- ------- --------- --------
2,780 3,643 4,872 19,783 40,710
------ ------- ------- --------- --------
Income (loss) from operations . . . . . . 192 1,271 2,353 (4,711) (11,522)
Other income (expense):
Interest income . . . . . . . . . . 8 44 50 518 1,902
Interest expense . . . . . . . . . . (128) (134) (159) (415) (260)
Non-recurring gain on sale of marketable
securities -- -- -- -- 1,670
------ ------- ------- --------- --------
(120) (90) (109) 103 3,312
------ ------- ------- --------- --------
Income (loss) before income taxes . . . . 72 1,181 2,244 (4,608) (8,210)
Income tax provision (benefit) . . . . . 37 506 900 (1,397) 354
------ ------- ------- --------- --------
Net income (loss) . . . . . . . . . . . . $ 35 $ 675 $ 1,344 $ (3,211) $(8,564)
====== ======= ======= ========= ========
Net income (loss) per share . . . . . . . $ -- $ .09 $ .18 $ (0.32) $ (0.63)
====== ======= ======= ========= ========
Weighted average shares outstanding . . . 7,503 7,508 7,334 9,952 13,532
Net income (loss) per share, assuming dilution -- $ .09 $ .17 $ (0.32) $ (0.63)
====== ======= ======= ========= ========
Weighted average shares outstanding, assuming dilution 7,503 7,660 8,019 9,952 13,532
</TABLE>
<TABLE>
<CAPTION>
Fiscal year Ended
----------------------------------------------------------
1993 1994 1995 1996 1997
---- ---- ---- ---- ----
<S> <C> <C> <C> <C> <C>
Balance Sheet Data:
Cash, cash equivalents and marketable securities $ 37 $ 262 $ 54 $ 42,304 $ 28,450
Working capital . . . . . . . . . . . . . . (68) 400 210 44,364 34,259
Total assets . . . . . . . . . . . . . . . 4,412 5,229 10,222 59,955 53,768
Total debt . . . . . . . . . . . . . . . . 1,835 973 3,264 2,575 2,429
Shareholders' equity . . . . . . . . . . . 793 1,467 2,407 49,099 40,733
</TABLE>
-20-
<PAGE> 25
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
Management's Discussion and Analysis of Financial Condition and Results of
Operations and other parts of the Annual Report contain forward-looking
statements which involve risks and uncertainties. The Company's actual results
could differ materially from the results discussed in forward-looking
statements.
OVERVIEW
Trusted Information Systems, Inc. founded in 1983, provides comprehensive
security solutions for protection of computer networks, including global
Internet-based systems, internal networks and individual workstations and
laptops and is a leading provider of firewall products. The Company currently
has two operating divisions: the Commercial Division and the Advanced Research
and Engineering ("AR&E") Division.
The Commercial Division
The Commercial Division derives revenues from the Company's Gauntlet family of
firewall products, its commercial consulting services, its Stalker line of
intrusion detection products, and from its RecoverKey exportable cryptography
enabling products. The Commercial Division accounted for 31.9%, 59.5%, and
77.2% of the Company's total revenues in 1995, 1996 and 1997, respectively. The
Company expects that the Commercial Division will account for an increased
percentage of total revenues in future years.
Prior to 1996, the Company distributed its only revenue producing product, the
Gauntlet Internet Firewall which was introduced in 1994, exclusively through
resellers and a small sales administration staff. The Company presently has
more than 170 persons to develop, promote, sell and deliver its network
security products and services, including the Gauntlet family of firewall
products. Prior to 1996, the Company's Gauntlet Internet Firewall was licensed
as software or as software and hardware on one platform, frequently combined
(or "bundled") with installation for pricing purposes. Since April 15, 1996,
installation for the Gauntlet family of firewall products has been offered as a
separate (or "unbundled") optional service provided to customers.
During 1996 the Company began to incur substantial increases in its selling,
general and administrative expenses as it began to build its marketing and
sales efforts to support sales of the Gauntlet Internet Firewall product and of
its other products introduced in 1996: the Gauntlet Intranet Firewall, the
Gauntlet Net Extender, the Gauntlet PC Extender, the Gauntlet Internet
Firewall, Stalker, WebStalker and certain of its RecoverKey exportable
cryptography products. During 1997, the Company continued to expand its
selling and general and administrative expenses at a lesser rate.
The Company offers a full range of consulting in information security planning
and product support. The Company's commercial consulting practice offers expert
technology research services, consultation on security issues associated with
products and services, corporate information security policy development,
architectural and diagnostic security analysis services, firewall configuration
and maintenance support, and training for corporate network and security
administration personnel. These services are carried out by a staff of over 30
persons with substantial information security experience in both commercial and
government organizations.
The Advanced Research and Engineering Division
The Advanced Research and Engineering Division (the "AR&E Division") consists
primarily of research, development and consulting in computer and related
security systems, currently including major contracts with three agencies of
the U.S. government: the NSA, Air Force Rome Laboratories ("RL") and DARPA.
Revenues from the AR&E Division increased consistently through 1995, but
decreased in 1996 and 1997. The aggregate award value of the Company's current
active government contracts at December 26, 1997 was approximately $37.5
million. The Company's active contracts with DARPA, which range in value from
$0.5 million to $9.1 million have all
-21-
<PAGE> 26
commenced and will expire through 2001. While the Company expects to continue
to obtain government contracts for its AR&E Division, it does not anticipate
that revenues from such contracts will attain the levels realized in 1995.
Most of the Company's government contracts provide for compensation to the
Company in the form of reimbursement of costs plus a fee. Gross profit under
government contracts generally represents the fee plus recovered operating
expenses. Under these government contracts, the Company is entitled to recover
associated direct labor costs, overhead and selling, general and administrative
expenses, including allowable research and development expenses. Selling,
general and administrative expenses allowable under government contracts
include salaries and benefits, marketing, bid and proposal costs, management,
accounting, legal and contract administration and certain other administrative
expenses.
Under its government contracts, the Company bears the risk that recoverable
expenses billed by the Company are subject to review and audit by the Defense
Contract Audit Agency (the "DCAA"). The DCAA has performed audits of the
Company's cost accounting system through 1995. Pursuant to their terms, these
contracts are also subject to termination at the convenience of the applicable
government agency. If the contract is terminated, the Company would typically
be reimbursed for its costs to the date of termination plus the cost of any
orderly termination and would be paid a portion of the fee.
RESULTS OF OPERATIONS
The Company's fiscal 1996 and 1997 statements of operations include the results
of Haystack Laboratories, Inc., giving effect to the merger with Haystack which
occurred on October 16, 1997, and which was accounted for under the pooling of
interests method of accounting. Prior period consolidated statements of
operations and balance sheets do not give effect to the merger with Haystack,
as the effect of the business combination was not material to the financial
statements of the Company.
Fiscal 1997 Compared to Fiscal 1996
Revenues. The Company's total revenues increased 54.2% to $42,222,683 in 1997
from $27,375,268 in 1996. Commercial product revenues increased 97.1% to
$28,782,406 in 1997 from $14,602,736 in 1996, primarily because of increased
sales of licenses of Gauntlet Internet Firewalls and intrusion detection
products directly to customers and through the Company's resellers. Commercial
consulting services revenues increased 128.6% to $3,834,400 in 1997 from
$1,677,285 in 1996, primarily because of the Company's efforts to implement new
management over and competitively staff its commercial consulting practice and
its focus on high end corporate customer needs for information security
consulting contracts during the second half of 1997. Government contract
revenues decreased 13.4% to $9,605,877 in 1997 from $11,095,247 in 1996,
primarily because of an expected decrease in revenues, following the Company's
completion of a $16.1 million research contract which began in 1994 and was
completed in the first four months of 1997.
Gross Profit. Gross profit increased 93.7% to $29,187,815 in 1997 from
$15,071,958 in 1996 primarily due to the increase in the Company's commercial
revenues, particularly its higher margin software and license products. The
gross profit associated with commercial products increased 120.2% to
$24,551,355 in 1997 from $11,151,982 in 1996, primarily because of increased
shipments of Gauntlet firewall products and a continual revenue shift towards
software and license only products, away from lower margin hardware software
combined solutions as the security market becomes more familiar with firewall
technology. The gross profit on commercial consulting services increased
130.2% to $1,587,754 in 1997 from $689,591 in fiscal 1996, primarily because of
increased revenues. Gross profit from the Company's government contracts
decreased 5.6% to $3,048,706 in 1997 from $3,230,385 in 1996, primarily because
of lower related revenues.
As a percentage of related revenues, gross profit on commercial products
increased to 85% in 1997 from 76% in 1996, primarily due to increased margins
on sales through the Company's resellers and because of a higher level of
software and license only revenues than lower margin hardware software product
combinations . As a percentage of related revenues, gross profit on commercial
consulting and government contracts remained substantially unchanged at 41% and
30%, respectively, for fiscal years 1996 and 1995.
-22-
<PAGE> 27
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased 85.1% to $28,641,944 in 1997 from $15,472,859
in 1996, due primarily to the increase in personnel and related operating costs
associated with the increase in the Company's commercial products sales, as
well as the Company's efforts towards developing the infrastructure to support
the current and future commercial growth during the first half of fiscal 1997.
Non-recurring transaction and other related costs In connection with the
Company's acquisition of Haystack Laboratories, Inc., in the fourth quarter of
fiscal 1997 for approximately 2.1 million shares of TIS common stock, the
Company incurred non-recurring transaction and other related costs of
$3,534,957. These costs consisted primarily of fees paid to outside
consultants, legal fees, and accounting fees of approximately $2.8 million and
employee related costs of approximately $0.7 million.
Research and Development Expenses. Research and development expenses, which do
not include such expenses directly reimbursed under government contracts,
increased 98.0% to $8,532,987 in 1997 from $4,309,891 in 1996. This increase
primarily resulted from the Company's efforts in developing the new members of
the Gauntlet family of firewall products and the Stalker intrusion detection
product lines. These efforts included developing new members of the Gauntlet
family of firewall products, the Microsoft Windows NT and Sun Microsystems'
Solaris firewall product versions and, RecoverKey exportable cryptography
enabling products, as well as the reseller versions of the Company's Stalker
technology products.
Other income and expense . Interest income increased by 266.8% to $1,901,561
in 1997 from $518,404 in 1996, primarily due to interest earned for the entire
fiscal 1997 period on cash and marketable securities generated by the proceeds
from the Company's initial public offering, which occurred in October of 1996.
Interest expense decreased 37.4% to $259,750 in 1997 from $415,243 in 1996 due
principally to the fourth quarter fiscal 1996 payoff of all of the Company's
borrowings under debt other than its mortgage notes. The Company recorded
$1,670,377 in non operating gains and losses in connection with its sale during
the third quarter of fiscal 1997 of the 100,000 shares of Cybercash (NASDAQ:
CYCH) stock it had received as founders stock in 1994.
Fiscal 1996 Compared to Fiscal 1995
Revenues. The Company's total revenues increased 51.3% to $27,375,268 in 1996
from $18,090,087 in 1995. Commercial product revenues increased 241.9% to
$14,602,736 in 1996 from $4,270,294 in 1995, primarily because of increased
sales of licenses of Gauntlet Internet Firewalls and Stalker intrusion
detection products directly to customers and through the Company's resellers.
Commercial consulting services revenues increased 12.4% to $1,677,285 in 1996
from $1,491,661 in 1995, primarily because of the Company's completion of a
substantial number of commercial consulting contracts during the third and
fourth quarters of 1996. Government contract revenues decreased 10.0% to
$11,095,247 in 1996 from $12,327,502 in 1995, primarily because of the
Company's reallocation of personnel to its commercial activities.
Gross Profit. Gross profit increased 108.6% to $15,071,958 in 1996 from
$7,225,140 in 1995 primarily due to the increase in the Company's commercial
product sales. The gross profit associated with commercial products increased
256.4% to $11,151,982 in 1996 from $3,128,642 in 1995, primarily because of
increased shipments of Gauntlet firewall products. The gross profit on
commercial consulting services increased 12.4% to $689,591 in 1996 from
$613,715 in fiscal 1995, primarily because of increased revenues. Gross profit
from the Company's government contracts decreased 7.3% to $3,230,385 in 1996
from $3,482,783 in 1995, primarily because of lower related revenues.
As a percentage of related revenues, gross profit on commercial products
increased to 76% in 1996 from 73% in 1995, primarily due to increased margins
on sales through the Company's resellers. As a percentage of related revenues,
gross profit on commercial consulting and government contracts remained
virtually unchanged at 41% and 29%, respectively, for fiscal years 1996 and
1995.
Selling, General and Administrative Expenses. Selling, general and
administrative expenses increased 315.1% to $15,472,859 in 1996 from $3,727,701
in 1995, due primarily to the substantial increase in personnel and related
-23-
<PAGE> 28
operating costs associated with the increase in the Company's commercial
products sales, as well as the Company's efforts towards developing the
infrastructure to support the current and future commercial revenue growth.
Research and Development Expenses. Research and development expenses, which do
not include such expenses directly reimbursed under government contracts,
increased 276.5% to $4,309,891 in 1996 from $1,144,737 in 1995. This increase
primarily resulted from the Company's efforts in developing the new members of
the Gauntlet family of firewall products announced in April of 1996 and of its
intrusion detection products. These efforts included developing new members of
the Gauntlet family of firewall products, the Microsoft Windows NT and Sun
Microsystems' Solaris firewall product versions and its RecoverKey exportable
cryptography enabling products.
Interest and Other Expense. Interest expense increased 161.5% to $415,243 in
1996 from $158,778 in 1995 due to the Company's increased borrowings under its
short term lines of credit and its construction credit line. Interest income
increased by 931.1% to $518,404 in 1996 from $50,276 in 1995 due primarily to
interest earned on cash and marketable securities generated by the proceeds
from the Company's initial public offering, which occurred in October of 1996.
QUARTERLY RESULTS OF OPERATIONS
The following tables set forth certain unaudited consolidated statement of
operations data for each of the four quarters in 1996 and 1997, which has been
restated to give effect to the Company's merger with Haystack Laboratories,
Inc., as well as the percentage of the Company's revenues represented by each
item. The unaudited consolidated financial statements have been prepared on the
same basis as the audited consolidated financial statements contained herein
and include all adjustments (consisting only of normal recurring adjustments)
that the Company considers necessary for a fair presentation of such
information when read in conjunction with the Company's Consolidated Financial
Statements and accompanying notes. The Company believes that
quarter-to-quarter comparisons of its financial results are not necessarily
meaningful and should not be relied upon as an indication of future
performance.
-24-
<PAGE> 29
<TABLE>
<CAPTION>
Fiscal Quarter Ended
-----------------------------------------------------------------------------------
MARCH 29, JUNE 28, SEPTEMBER 27, DECEMBER 27, MARCH 28, JUNE 27,
1996 1996 1996 1996 1997 1997
<S> <C> <C> <C> <C> <C> <C>
Dollars in thousands
CONSOLIDATED STATEMENT
OF OPERATIONS DATA:
Revenues:
Government contracts $2,432 $2,920 $ 2,881 $ 2,862 $ 2,566 $ 2,200
Commercial products 1,619 2,536 4,066 6,380 5,573 6,532
Commercial consulting
services 247 287 505 640 797 915
------ ------ ------- ------- ------- -------
4,298 5,743 7,452 9,882 8,936 9,647
Cost of revenues:
Government contracts 1,774 2,090 1,979 2,021 1,818 1,461
Commercial products 479 745 967 1,259 1,136 803
Commercial consulting
services 166 164 267 392 395 552
------ ------ ------- ------- ------- -------
2,419 2,999 3,213 3,672 3,349 2,816
Gross profit:
Government contracts 658 830 902 841 748 739
Commercial products 1,140 1,791 3,099 5,121 4,437 5,729
Commercial consulting
services. 81 123 238 248 402 363
------ ------ ------- ------- ------- -------
1,879 2,744 4,239 6,210 5,587 6,831
Operating expenses:
Selling, general and
administrative 2,152 2,968 4,077 6,276 7,054 7,668
Research and development 427 702 1,295 1,885 2,088 2,145
Non-recurring transaction
and other related costs -- -- -- -- -- --
------ ------ ------- ------- ------- -------
2,579 3,671 5,372 8,161 9,142 9,813
------ ------ ------- ------- ------- -------
Income (loss) from
operations (700) (927) (1,133) (1,951) (3,555) (2,982)
Other income (expense):
Interest income 7 23 33 455 500 523
Interest expense (89) (74) (172) (80) (54) (59)
Non-recurring gain on sale
of marketable securities -- -- -- -- -- --
------ ------ ------- ------- ------- -------
(82) (51) (139) 375 446 464
------ ------ ------- ------- ------- -------
Income (loss) before income
taxes (782) (978) (1,272) (1,576) (3,109) (2,518)
Income tax provision
(benefit) (315) (372) (354) (356) (836) (643)
------ ------ ------- ------- ------- -------
Net loss $ (467) $ (606) $ (918) $(1,220) $(2,273) $(1,875)
====== ====== ======= ======= ======= =======
Net loss per share and net
loss per share, assuming
dilution $(0.05) $(0.07) $ (0.10) $ (0.10) $ (0.17) $ (0.14)
====== ====== ======= ======= ======= =======
Weighted average shares
outstanding, and weighted
average shares outstanding,
assuming dilution 8,359 9,082 9,280 12,663 13,247 13,312
</TABLE>
<TABLE>
<CAPTION>
Fiscal Quarter Ended
---------------------------------
SEPTEMBER 26, DECEMBER 26,
1997 1997
<S> <C> <C>
Dollars in thousands
CONSOLIDATED STATEMENT
OF OPERATIONS DATA:
Revenues:
Government contracts $ 2,402 $ 2,438
Commercial products 7,875 8,802
Commercial consulting
services 930 1,193
------- -------
11,207 12,433
Cost of revenues:
Government contracts 1,685 1,593
Commercial products 1,119 1,173
Commercial consulting
services 512 788
------- -------
3,316 3,554
Gross profit:
Government contracts 717 845
Commercial products 6,756 7,629
Commercial consulting
services. 418 405
------- -------
7,891 8,879
Operating expenses:
Selling, general and
administrative 7,262 6,658
Research and development 2,162 2,138
Non-recurring transaction
and other related costs -- 3,535
------- -------
9,424 12,331
------- -------
Income (loss) from
operations (1,533) (3,452)
Other income (expense):
Interest income 448 431
Interest expense (66) (81)
Non-recurring gain on sale
of marketable securities 1,670 --
------- -------
2,052 350
------- -------
Income (loss) before income
taxes 519 (3,102)
Income tax provision
(benefit) 657 1,176
------- -------
Net loss $ (138) $(4,278)
======= =======
Net loss per share and net
loss per share, assuming
dilution $ (0.01) $ (0.31)
======= =======
Weighted average shares
outstanding, and weighted
average shares outstanding,
assuming dilution 13,385 13,731
</TABLE>
-25-
<PAGE> 30
<TABLE>
<CAPTION>
Fiscal Quarter Ended
---------------------------------------------------------------------------------------------------
March 29, June 28, September 27, December 27, March 28, June 27, September 26, December 26,
1996 1996 1996 1996 1997 1997 1997 1997
CONSOLIDATED STATEMENT OF
OPERATIONS AS A
PERCENTAGE OF REVENUES:
Revenues:
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Government contracts 56.6% 50.8% 38.7% 29.0% 28.7 22.8 21.4 19.6
Commercial products 37.7 44.2 54.6 64.6 62.4 67.7 70.3 70.8
Commercial consulting
services 5.7 5.0 6.7 6.4 8.9 9.5 8.3 9.6
------ ------ ------ ------ ------ ------ ------ ------
100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Cost of revenues:
Government contracts 41.3 36.3 26.7 20.5 20.3 15.1 15.0 12.8
Commercial products 11.1 13.0 13.0 12.7 12.7 8.3 10.0 9.4
Commercial consulting
services 3.9 2.9 3.4 4.0 4.5 5.8 4.6 6.4
------ ------ ------ ------ ------ ------ ------ ------
56.3 52.2 43.1 37.2 37.5 29.2 29.6 28.6
------ ------ ------ ------ ------ ------ ------ ------
Gross profit 43.7 47.8 56.9 62.8 62.5 70.8 70.4 71.4
------ ------ ------ ------ ------ ------ ------ ------
Operating expenses:
Selling, general and
administrative 50.1 51.7 54.7 63.5 78.9 79.5 64.8 53.6
Research and development 9.9 12.2 17.4 19.0 23.4 22.2 19.3 17.2
Non-recurring
transition and
other related costs -- -- -- -- -- -- -- 28.4
------ ------ ------ ------ ------ ------ ------ ------
60.0 63.9 72.1 82.5 102.3 101.7 84.1 99.2
------ ------ ------ ------ ------ ------ ------ ------
Income (loss) from
operations (16.3) (16.1) (15.2) (19.7) (39.8) (30.9) (13.7) (27.8)
Other income (expense):
Interest income 0.2 0.1 0.1 4.6 5.6 5.4 4.0 3.5
Interest expense (2.1) (1.0) (2.0) (0.9) (0.6) (0.6) (0.6) (0.7)
Non-recurring gain on
sale of marketable
securities -- -- -- -- -- -- 14.9 --
------ ------ ------ ------ ------ ------ ------ ------
Income (loss) before
income taxes (18.2) (17.0) (17.1) (16.0) (34.8) (26.1) 4.6 (25.0)
Income tax provision
(benefit) (7.3) (6.5) (4.8) (3.6) (9.4) (6.7) 5.8 9.5
------ ------ ------ ------ ------ ------ ------ ------
Net income (loss) (10.9)% (10.5)% (12.3)% (12.4)% (25.4) (19.4) (1.2) (34.4)
------ ------ ------ ------ ------ ------ ------ ------
SELECTED INFORMATION AS A
PERCENTAGE OF RELATED
REVENUES:
Gross profit by product
line:
Government contracts 27.0 28.4 31.3 29.4 29.2 33.6 29.9 34.7
Commercial products 70.4 70.7 76.2 80.3 79.6 87.7 85.8 86.7
Commercial consulting
services 32.8 42.9 47.1 38.7 50.4 39.7 44.9 34.0
------ ------ ------ ------ ------ ------ ------ ------
43.7 47.8 56.9 62.8 62.5 70.8 70.4 71.4
------ ------ ------ ------ ------ ------ ------ ------
</TABLE>
-26-
<PAGE> 31
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its operations and the purchase
of property and equipment through the issuance of common stock, borrowings
under short-term lines of credit, secured notes payable and stockholder loans
and by the generation of cash from operations. Cash and cash equivalents were
$1,290,075 at December 26, 1997 and $3,237,147 at December 27, 1996, and
marketable securities were $27,160,179 at December 26, 1997, as compared to
$39,066,569 at December 27, 1996. The Company used cash in operations of
$12,055,815 and $4,268,107, respectively, for fiscal years 1997 and 1996, but
provided cash from operations of $1,237 for fiscal year 1995. Net cash provided
by or used in operations for the fiscal year 1995 consisted primarily of net
income, plus growth in the Company's accounts payable, accrued expenses and
deferred revenues, offset by growth in the Company's accounts receivable. For
the year ended December 27, 1996, the Company used cash to fund its net loss of
$3,211,121, which was the primary component of the net cash used in operating
activities for the period, and to fund the growth in its accounts receivable
and unbilled receivables of $2,187,758, offset by cash provided from increasing
various accrued expenses. For the year ended December 26, 1997, the Company
used cash to fund its net loss of $8,564,170 and to fund the growth in its
accounts receivable and unbilled receivables of $5,519,912, offset by cash
provided from increasing various accrued expenses. The decline in cash provided
by operations in fiscal years 1996 and 1997 as compared to previous years was
primarily the result of funds consumed as the Company began to expand its
commercial activities and introduce new products.
During fiscal years 1995, 1996 and 1997, the Company used cash in investing
activities of $2,095,829, $3,457,150, and $2,311,308, respectively, to purchase
property and equipment. Of these amounts, approximately $1,340,000 and
$1,520,000 in 1995 and 1996, respectively, were spent in connection with the
purchase or construction of the Company's Glenwood, MD facilities. The Company
also used cash of $36,628,126 in investing activities during fiscal 1996 to
purchase marketable securities, and provided cash of $9,468,390 in investing
activities during fiscal 1997 through the sale of marketable securities..
The Company provided cash in financing activities for fiscal year 1995 of
$1,885,931, primarily through net borrowings offset by cash used to repurchase
stock from a former officer. The Company generated cash from financing
activities for fiscal year 1996 of $47,312,707, primarily from net proceeds
from the issuance of 3,910,000 shares of common stock in October 1996 in an
initial public offering, and generated cash from financing activities for
fiscal year 1997 of $1,455,835 primarily from net proceeds from the issuance of
stock upon the exercise of stock options.
At December 29, 1995, the Company had various short-term line of credit
arrangements with Mercantile Bank aggregating $2 million. Also in 1995, the
Company negotiated a construction loan in the amount of $1.8 million to provide
for the expansion of its facilities at its Glenwood, Maryland location. During
1996, the Company arranged for additional credit agreements and modified
existing credit agreements with Mercantile Bank to provide for additional
borrowings to fund the Company prior to its initial public offering. Subsequent
to September 27, 1996, in conjunction with the Company's initial public
offering, the Company paid off and terminated these line of credit
arrangements, and converted its construction loan into mortgage notes payable
to Mercantile Bank with a fixed interest rate, secured by the underlying
properties.
As of December 26, 1997, the Company had no material commitments for capital
expenditures.
On February 22, 1998 the Company entered into an agreement to be merged with
Network Associates, Inc. While the Company continues from time to time to
evaluate potential acquisitions of businesses, products and technologies that
could complement or expand the Company's business the Company has no plans,
agreements or commitments for any such acquisitions and, except as may be
contemplated under its agreement with Network Associates, is not engaged in any
negotiations with respect thereto.
The Company has not engaged in any hedging activities to date. Exposure to
currency risk is not significant.
While the Company may require additional financing to fund development of new
products and expansion of its domestic and international operations, it
believes that the net proceeds from the 1996 Offering, together with existing
-27-
<PAGE> 32
cash and cash equivalents and cash generated from operations will be sufficient
to finance its product development and operating needs through December 1998.
YEAR 2000 COMPLIANCE MATTERS
Until recently computer programs were written to store only two digits of
date-related information in order to more efficiently handle and store data.
Thus the programs were unable to properly distinguish between the year 1900 and
2000. This is frequently referred to as the "Year 2000 Problem." During
fiscal 1997, the Company initiated programs to address this issue. Utilizing
both internal and external resources, the Company is in the process of
defining, assessing and converting, or replacing various programs, hardware and
instrumentation systems to make them Year 2000 compatible. The Company's Year
2000 project is comprised of two components- business applications and
equipment. The business applications component consists of the Company's
business computer systems, as well as the computer systems of third-party
suppliers or customers whose Year 2000 problems could potentially impact the
company.
The Company currently runs its internal business applications on two systems
and is considering the conversion of one of those systems (the one which the
Company believes is not year 2000 compliant), to the other, which it believes
to be year 2000 compliant. The Company is assessing the extent to which its
operations are vulnerable to this operation and has not yet determined the
extent of that vulnerability, but believes that its conversion will
substantially alleviate these concerns. In addition, as the Company has
entered into a definitive agreement to merge with Network Associates, it has
not yet determined what impact, if any, such plans for business combinations
including corrective measures, will eliminate or alleviate these concerns.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
Except for the historical information contained in this report, the
matters discussed and the statements made in this Annual Report concerning the
Company's future prospects are "forward-looking statements" under the Federal
securities laws that involve risks and uncertainties. There can be no
assurance that future results will be achieved, and actual results could differ
materially from forecasts and estimates. Important factors that could cause
actual results to differ materially include, but are not limited to, the
Company's transition to commercial product vendor, its ability to manage
growth, the potential significant fluctuations in quarterly operating results
and lengthy sales cycle, certain sales and distribution risks, risks associated
with information security market, new product introductions, changes in
technology, dependence on the Internet, risks of doing business with the U.S.
Government, risks of error or failures, risks associated with international
sales, the effect of government regulation on technology exports and dependence
on key personnel.
The Company is currently devoting significant resources toward the
development of versions of Gauntlet Internet Firewall products, Stalker
intrusion detection products, RecoverKey/KRT products, and enhancements to
these families of products. There can be no assurance that the Company will
successfully complete the development of these products in a timely fashion, or
that the Company's current or future products will achieve market acceptance.
Any inability of the Company to develop products on a timely basis that address
changing customer requirements may have an adverse effect on the Company's
results of operations. In addition, the Company anticipates significant
quarterly fluctuations in its operating results in the future. Any shortfall
in revenue or earnings from levels expected by securities analysts could have
an immediate and significant adverse effect on the trading price of the
Company's common stock in any given period. In addition to factors specific to
the Company, changes in analysts' earnings estimates for the Company or its
industry and factors affecting the securities market in general will often
result in significant volatility of the Company's common stock.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS.
Not applicable.
-28-
<PAGE> 33
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required by Item 8 of Part II is incorporated herein
by reference to the Consolidated Financial Statements filed with this report;
see Item 14 of Part IV.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL
DISCLOSURE.
None.
-29-
<PAGE> 34
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE COMPANY.
The information required by Item 10 is hereby incorporated by
reference from the Proxy Statement for the 1998 Special Meeting of Trusted
Information Systems, Inc.
ITEM 11. EXECUTIVE COMPENSATION.
The information required by Item 11 is hereby incorporated by
reference from the Proxy Statement for the 1998 Special Meeting of Trusted
Information Systems, Inc.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required by Item 12 is hereby incorporated by
reference from the Proxy Statement for the 1998 Special Meeting of Trusted
Information Systems, Inc
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
In June 1996, the Company purchased the real property and improvements
located adjacent to the Company's Glenwood, Maryland headquarters (the
"Adjacent Property") from Glenwood Associates Limited Partnership ("Glenwood
Associates") for a purchase price of $360,000 at the time of the purchase.
Stephen T. Walker was the general partner of Glenwood Associates and Dr. Martha
A. Branstad was a limited partner of Glenwood Associates. The purchase price
was determined based on a valuation of the property prepared by the Company
based primarily upon an independent appraisal. Prior to such transaction, the
Company leased the Adjacent Property from Glenwood Associates pursuant to an
oral lease agreement which provided for monthly rent of $3,929 plus payment of
operating expenses.
In August 1996, in connection with a $2.0 million credit facility (the
"Credit Facility") with Mercantile Bank, Mr. Walker entered into a personal
guaranty agreement with Mercantile Bank. Under the Credit Facility, Mr. Walker
unconditionally and irrevocably guaranteed the obligations of the Company under
the Credit Facility. This guarantee was released by Mercantile Bank in 1997.
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 unaffiliated third parties and will be approved by a majority of
the disinterested members of the Board of Directors.
-30-
<PAGE> 35
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
<TABLE>
<CAPTION>
PAGE NUMBER
-----------
(a) DOCUMENTS FILED AS PART OF THE REPORT:
<S> <C> <C>
(1) Report of Independent Auditors F-2
Consolidated Balance Sheets at December 27, 1996
and December 26, 1997 F-3
Consolidated Statements of Operations for the years ended
December 29, 1995, December 27, 1996,
and December 26, 1997 F-4
Consolidated Statements of Shareholders' Equity for the
years ended December 29, 1995, December 27, 1996,
and December 26, 1997 F-5
Consolidated Statements of Cash Flows for the years ended
December 29, 1995, December 27, 1996,
and December 26, 1997 F-6
Notes to Consolidated Financial Statements F-8
(2) Financial Statement Schedules
Schedule II Valuation and Qualifying Accounts 57
(3) Exhibits 58
</TABLE>
<TABLE>
<CAPTION>
Exhibit Number Description
-------------- -----------
<S> <C>
3.1* Certificate of Incorporation of the Company.
3.1.1* Certificate of Amendment to Certificate of
Incorporation, as filed with the Delaware Secretary
of State on October 2, 1996.
3.2* Amended and Restated Bylaws of the Company.
4.1* Specimen stock certificate for shares of Common Stock
of the Company.
4.2* Target Stockholders' Agreement and Affiliate's
Agreement dated as of October 15, 1997 by and among
the Company, Certain Stockholders and the Investors
named therein.
4.3* Agreement and Plan of Merger dates as of
October 3,1997 by and among the Company, Trusted
Acquisitions,
Inc. and Haystack Laboratories, Inc.
10.1* Amended and Restated Employee Stock Option Plan.
10.2* Amended and Restated 1996 Stock Option Plan.
10.2.1* Form of Incentive Stock Option Agreement pursuant to
1996 Stock Option Plan.
10.2.2* Form of Non-Qualified Stock Option Agreement pursuant
to 1996 Stock Option Plan.
10.3* Amended and Restated 1996 Directors' Stock Option
Plan.
10.4* Form of Employee Agreement Regarding Confidentiality
and Inventions.
10.5* Form of Software License and Reseller Agreement.
10.6* Form of Consulting Services Agreement.
10.7* Form of Indemnification Agreement by and between the
Company and its directors and officers.
10.8* Construction Loan Agreement dated July 26, 1995, by
and between the Company and Mercantile-Safe Deposit
and Trust Company.
10.9* Construction Loan Promissory Note dated July 26,
1995, by and between the Company and Mercantile-Safe
Deposit and Trust Company.
</TABLE>
-31-
<PAGE> 36
<TABLE>
<S> <C>
10.10* Deed of Trust and Security Agreement dated July 26,
1995, by and between the Company and Mercantile-Safe
Deposit and Trust Company.
10.11* Security Agreement, dated July 26, 1995, by and among
the Company, Mercantile-Safe Deposit and Trust
Company and Stephen T. Walker.
10.12* Personal Guaranty Agreement dated July 26, 1995, by
and between Stephen T. Walker and Mercantile-Safe
Deposit and Trust Company.
10.13* Revolving Note issued by the Company on April 4,
1996, to Mercantile-Safe Deposit and Trust Company.
10.14* Security Agreement dated April 4, 1996, by and
between the Company and Mercantile-Safe Deposit and
Trust Company.
10.15* Revolving Note issued by the Company on April 4,
1996, to Mercantile-Safe Deposit and Trust Company.
10.16.1* Security Agreement as of August 27, 1996, by and
between the Company and Mercantile-Safe Deposit and
Trust Company.
10.16.2* Revolving Note issued by the Company as of August 27,
1996, to Mercantile-Safe Deposit and Trust Company.
10.17* Office Building Lease dated February 1, 1990, by and
between the Company and Perini Investment Properties,
Inc.
10.18* Lease Amendment I dated May 26, 1994, by and between
the Company and Robert R. Walker, Jr., Receiver
(relating to exhibit 10.17).
10.19* Standard Lease dated April 12, 1989, by and between
the Company and R&B Property Holding Company.
10.20* Amendment to Lease effective November 1, 1992, by and
between the Company and R&B Property Holding Company
(relating to exhibit 10.19).
10.21* Lease Agreement dated as of October 3, 1995, by and
between Trusted Information Systems (UK) Limited and
Theale Estates Limited.
10.22* Deed dated July 17, 1996, by and between the Company
and Glenwood Associates Limited Partnership.
10.22.1* Promissory Note issued by the Company on July 17,
1996, to Glenwood Associates Limited Partnership.
10.22.2* Deed of Trust and Security Agreement dated December
1, 1993, by and between Glenwood Associates Limited
Partnership and Mercantile-Safe Deposit and Trust
Company.
10.22.3* Promissory Note issued by Glenwood Associates Limited
Partnership on December 1, 1993 to Mercantile-Safe
Deposit and Trust Company.
10.23* Deed and Confirmatory Deed dated July 26, 1995, by
and between the Company and Stephen T. Walker.
10.24* Agreement and Plan of Merger dated May 30, 1996.
10.25+ Patent and Software License Agreement dated January
24, 1997, by and between the Company and
International Business Machines Corporation.
21.1* Subsidiaries of the Registrant.
23.1** Consent of Ernst & Young LLP, Independent Auditors
24.1** Power of Attorney (included in signature pages).
27** Restated Financial Data Schedule.
27.1 Restated Financial Data Schedule.
-----------------------------------------------------------------------
</TABLE>
* Previously filed as an exhibit to the Company's Registration Statement
Number 333-5419 on Form S-1 and incorporated herein by reference.
** Filed herewith.
+ Portions of this Exhibit were omitted and have been filed separately
with the Secretary of the Commission pursuant to the Registrant's Application
Requesting Confidential Treatment under Rule 12b-24 of the Securities Exchange
Act of 1934, as amended, filed on March 27, 1997.
- ---------------------------
-32-
<PAGE> 37
(b) REPORTS ON FORM 8-K
On October 24, 1997, a Form 8-K, Item 2, was filed disclosing
the merger between Haystack Laboratories, Inc. and Trusted Acquisitions, Inc. a
Delaware corporation and a wholly-owned subsidiary of the Company.
On October 27, 1997, a Form 8-K, Item 2 was filed to include
as an exhibit the Merger Agreement by and between Haystack Laboratories, Inc.
and Trusted Acquisitions, Inc.
On December 24, 1997, an amendment to the Form 8-K was filed
to include financial statements of Haystack Laboratories, Inc.
On February 25, 1998, a Form 8-K, Items 5 and 7 was filed to
include as an exhibit the Agreement and Plan of Merger dated February 22, 1998
, by and among Network Associates, Inc., Thor Acquisition Corporation, and
Trusted Information Systems, Inc.
(c) EXHIBITS
The exhibits required by this Item are listed under Item
14(a)(3).
(d) FINANCIAL STATEMENT SCHEDULE
Schedule II- Valuation and Qualifying Accounts
-33-
<PAGE> 38
TRUSTED INFORMATION SYSTEMS, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Independent Auditors F-2
Consolidated Balance Sheets at December 27, 1996
and December 26, 1997 F-3
Consolidated Statements of Operations for the years ended
December 29, 1995, December 27, 1996
and December 26, 1997 F-4
Consolidated Statements of Shareholders' Equity for the
years ended December 29, 1995, December 27, 1996 and
December 26, 1997 F-5
Consolidated Statements of Cash Flows for the years ended
December 29, 1995, December 27, 1996
and December 26, 1997 F-6
Notes to Consolidated Financial Statements F-8
</TABLE>
F-1
<PAGE> 39
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Shareholders
Trusted Information Systems, Inc.
We have audited the accompanying consolidated balance sheets of Trusted
Information Systems, Inc. as of December 27, 1996 and December 26, 1997 and the
related consolidated statements of operations, shareholders' equity, and cash
flows for each of the three years in the period ended December 26, 1997. Our
audits also included the financial statement schedule listed in the Index at
Item 14(a). These financial statements and schedule are the responsibility of
the Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the 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 consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Trusted Information Systems, Inc. at December 27, 1996 and December 26, 1997,
and the consolidated results of its operations and its cash flows for each of
the three years in the period ended December 26, 1997, in conformity with
generally accepted accounting principles. Also, in our opinion, the related
financial statement schedule, when considered in relation to the basic
financial statements taken as a whole, presents fairly in all material respects
the information set forth therein.
/s/ Ernst & Young LLP
Vienna, Virginia
March 2, 1998
F-2
<PAGE> 40
Trusted Information Systems, Inc.
Consolidated Balance Sheets
<TABLE>
<CAPTION>
============= ============
DECEMBER 27, DECEMBER 26,
1996 1997
<S> <C> <C>
Assets
Current assets:
Cash and cash equivalents . . . . . . . $ 3,237,147 $ 1,290,075
Marketable securities . . . . . . . . . 39,066,569 27,160,179
Accounts receivable, net of allowance of
$174,592 and 700,389 for 1996 and 1997,
respectively 6,208,367 11,365,888
Unbilled receivables . . . . . . . . . 1,746,370 2,108,761
Prepaid expenses and other current assets 983,231 2,537,079
Refundable income taxes . . . . . . . . 1,507,121 480,000
----------- -----------
Total current assets . . . . . . . . . . 52,748,805 44,941,982
Property and equipment, net . . . . . . . 6,851,062 8,161,497
Other assets . . . . . . . . . . . . . . 355,593 664,962
----------- -----------
Total assets . . . . . . . . . . . . . . $59,955,460 $53,768,441
=========== ===========
Liabilities and shareholders' equity
Current liabilities:
Accounts payable . . . . . . . . . . . $ 1,044,914 $ 568,425
Accrued expenses . . . . . . . . . . . 4,505,385 6,515,196
Deferred income taxes . . . . . . . . . 403,324 --
Deferred revenue . . . . . . . . . . . 2,280,126 3,446,422
Notes payable, current portion . . . . 150,857 152,811
----------- -----------
Total current liabilities . . . . . . . . 8,384,606 10,682,854
Notes payable, net of current portion . . 2,424,355 2,276,345
Other non-current liabilities . . . . . . 47,365 76,607
----------- -----------
Total liabilities . . . . . . . . . . . . 10,856,326 13,035,806
Commitments
Shareholders' equity:
Preferred stock, $.01 par value; 5,000,000
shares authorized; no shares issued or -- --
outstanding . . . . . . . . . . . . . .
Common stock, $.01 par value; 40,000,000 shares
authorized; 13,235,890 and 13,792,762 shares
issued and outstanding at December 27, 1996
and December 26, 1997, respectively 132,359 137,928
Additional paid-in capital . . . . . . 49,702,117 51,152,383
Unrealized gains, net of income taxes of
$932,838. . . . . . . . . . . . . . . . 1,495,162 --
Foreign currency translation adjustment 12,663 (26,712)
Retained deficit . . . . . . . . . . . (1,298,884) (9,863,054)
Deferred stock compensation . . . . . . (944,283) (667,910)
----------- -----------
Total shareholders' equity . . . . . . . 49,099,134 40,732,635
----------- -----------
Total liabilities and shareholders' equity $59,955,460 $53,768,441
=========== ===========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-3
<PAGE> 41
<TABLE>
<CAPTION>
Trusted Information Systems, Inc.
Consolidated Statements of Operations
==========================================================
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 29, DECEMBER 27, DECEMBER 26,
1995 1996 1997
----------------- --------------- --------------
<S> <C> <C> <C>
Revenues:
Government contracts................ $ 12,327,502 $ 11,095,247 $ 9,605,877
Commercial products................. 4,270,924 14,602,736 28,782,406
Commercial consulting
services.......................... 1,491,661 1,677,285 3,834,400
----------------- --------------- -------------
18,090,087 27,375,268 42,222,683
Cost of revenues:
Government contracts................ 8,844,719 7,864,862 6,557,171
Commercial products................. 1,142,282 3,450,754 4,231,051
Commercial consulting
services.......................... 877,946 987,694 2,246,646
----------------- --------------- -------------
10,864,947 12,303,310 13,034,868
----------------- --------------- -------------
Gross profit.......................... 7,225,140 15,071,958 29,187,815
Operating expenses:
Selling, general and
administrative..................... 3,727,701 15,472,859 28,641,944
Research and development............ 1,144,737 4,309,891 8,532,987
Non-recurring transaction and
other related costs............... -- -- 3,534,957
----------------- --------------- -------------
4,872,438 19,782,750 40,709,888
----------------- --------------- -------------
Income (loss) from
operations........................... 2,352,702 (4,710,792) (11,522,073)
Other income (expense):
Interest income..................... 50,276 518,404 1,901,561
Interest expense.................... (158,778) (415,243) (259,750)
Non-recurring gain on sale of
marketable securities............. -- -- 1,670,377
----------------- --------------- -------------
(108,502) 103,161 3,312,188
----------------- --------------- -------------
Income (loss) before income
taxes............................... 2,244,200 (4,607,631) (8,209,885)
Income tax provision
(benefit)........................... 900,137 (1,396,510) 354,285
----------------- -------------- -------------
Net income (loss)..................... $ 1,344,063 $ (3,211,121) $ (8,564,170)
================= =============== =============
Earnings (loss) per share............. $ 0.18 $ (0.32) $ (0.63)
================= =============== =============
Earnings (loss) per share
assuming dilution................... $ 0.17 $ (0.32) $ (0.63)
================= =============== =============
Weighted average shares outstanding 7,333,676 9,952,120 13,531,876
================= =============== =============
Weighted average shares outstanding
assuming dilution................... 8,018,579 9,952,120 13,531,876
================= =============== =============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-4
<PAGE> 42
Trusted Information Systems, Inc.
Consolidated Statements of Shareholders' Equity
<TABLE>
<CAPTION>
======================================================================
Common Stock
-------------------------------
Additional
Number Paid-in Unrealized
of Shares Amount Capital Gains
--------- ------ ---------- ----------
<S> <C> <C> <C> <C>
BALANCE AT DECEMBER 30,
1994, AS PREVIOUSLY
REPORTED 7,516,079 $ 75,161 $ 359,200 $ 0
Adjustment for pooling
of interests 1,378,726 13,787 644,709
---------- -------- ----------- -----------
BALANCE AT DECEMBER 30,
1994, AS RESTATED 8,894,805 88,948 1,003,909 --
Net income for 1995
Exercise of stock options 6,453 64 3,169
Repurchase of common
Stock (588,921) (5,889) (362,369)
Translation adjustment
---------- -------- ----------- -----------
BALANCE AT DECEMBER 29,
1995 8,312,337 83,123 644,709 0
Net loss for 1996
Exercise of stock options 646,979 6,470 341,454
Issuance of common stock
net of costs 366,574 3,666 2,246,904
Sale of common stock, net of related costs
of $1,869,250 3,910,000 39,100 45,363,550
Unrealized gain on available-for-sale
securities, net of tax 1,495,162
Deferred stock
compensation 1,105,500
Amortization of deferred
stock compensation
Translation adjustment
---------- -------- ----------- -----------
BALANCE AT DECEMBER 27,
1996 13,235,890 132,359 49,702,117 1,495,162
Net loss for 1997
Exercise of stock options 556,872 5,569 760,698
Stock Issued Compensation Plan 689,568
Gain on sale of available for-sale
securities, net of tax (1,495,162)
Amortization of deferred
stock compensation
Translation adjustment
---------- -------- ----------- -----------
BALANCE AT DECEMBER 26,
1997 13,792,762 $137,928 $51,152,383 $ 0
========== ======== =========== ===========
</TABLE>
<TABLE>
<CAPTION>
======================================================================
Foreign
Currency Retained Deferred
Translation Earnings Stock
Adjustment (Deficit) Compensation Total
----------- --------- ------------ -----------
<S> <C> <C> <C> <C>
BALANCE AT DECEMBER 30,
1994, AS PREVIOUSLY
REPORTED $ (6,103) $ 1,038,263 $ 0 $ 1,466,521
Adjustment for pooling
of interests (430,827) 227,669
----------- ------------- ------------ ------------
Balance at December 30,
1994, as restated (6,103) 607,436 -- $ 1,694,190
Net income for 1995 1,344,063 1,344,063
Exercise of stock options 3,233
Repurchase of common
Stock (39,262) (407,520)
Translation adjustment 982 982
----------- ------------- ------------ ------------
BALANCE AT DECEMBER 29,
1995 (5,121) 1,912,237 0 2,634,948
Net loss for 1996 (3,211,121) (3,211,121)
Exercise of stock options 347,924
Issuance of common stock
net of costs 2,250,570
Sale of common stock, net of related costs
of $1,869,250 45,402,650
Unrealized gain on available-for-sale
securities, net of tax 1,495,162
Deferred stock
compensation (1,105,500) 0
Amortization of deferred
stock compensation 161,217 161,217
Translation adjustment 17,784 17,784
----------- ------------- ------------ ------------
BALANCE AT DECEMBER 27,
1996 12,663 (1,298,884) (944,283) 49,099,134
Net loss for 1997 (8,564,170) (8,564,170)
Exercise of stock options 766,267
Stock Issued Compensation Plan 689,568
Gain on sale of available for-sale
securities, net of tax (1,495,162)
Amortization of deferred
stock compensation 276,373 276,373
Translation adjustment (39,375) (39,375)
----------- ------------- ------------ ------------
BALANCE AT DECEMBER 26,
1997 (26,712) $ (9,863,054) $ (667,910) $ 40,732,635
=========== ============== ============ ============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-5
<PAGE> 43
TRUSTED INFORMATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
========================================================================
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 29, DECEMBER 27, DECEMBER 26,
1995 1996 1997
-------------- ----------------- ---------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income (loss).............................. $ 1,344,063 $ (3,211,121) $ (8,564,170)
Adjustments:
Depreciation................................ 261,020 347,929 1,000,873
Deferred income taxes....................... (136,386) (102,244) 528,634
Amortization of deferred stock
compensation.............................. -- 161,217 276,373
Gain on sale of marketable securities -- -- (1,670,377)
Changes in operating assets and
liabilities:
Accounts receivable and
unbilled receivables.................... (2,924,877) (2,187,758) (5,519,912)
Prepaid expenses and other
current assets.......................... (119,829) (724,793) (1,553,848)
Other assets.............................. 22,065 (292,146) (309,369)
Accounts payable.......................... 219,099 337,834 (476,489)
Accrued payroll and other accrued
expenses................................ 819,102 1,745,238 2,009,811
Other non-current liabilities............. -- 47,365 29,242
Income taxes
payable/refundable...................... (276,546) (1,629,295) 1,027,121
Deferred revenue.......................... 999,706 1,239,667 1,166,296
------------- --------------- --------------
Net cash provided by (used in)
operating activities........................ 207,417 (4,268,107) (12,055,815)
INVESTING ACTIVITIES
Purchases of property and
equipment.................................... (2,095,829) (3,457,150) (2,311,308)
Sale of marketable securities -- -- 1,681,258
(Purchase)/Redemption of marketable
securities.................................. -- (36,628,126) 9,468,390
------------- --------------- --------------
Net cash (used in) provided by investing
activities.................................. (2,095,829) (40,085,276) 8,838,340
FINANCING ACTIVITIES
Proceeds from issuance of common
stock, net of related costs................. -- 47,653,220 --
Proceeds from exercise of stock
options and stock issued compensation
plan........................................ 3,233 347,924 1,455,835
Repurchase of common stock.................... (407,520) -- --
Net borrowings (repayments) of
short-term borrowings....................... 1,523,000 (1,523,000) --
Proceeds from issuance of notes
payable..................................... 1,036,299 1,801,777 600,000
Repayments of notes payable................... (269,081) (967,214) (746,057)
------------- --------------- --------------
Net cash provided by
financing activities........................ 1,885,931 47,312,707 1,309,778
------------- --------------- --------------
</TABLE>
F-6
<PAGE> 44
<TABLE>
<S> <C> <C> <C>
Effect of exchange rate changes on
cash........................................ 982 17,784 (39,375)
------------- --------------- --------------
Net change in cash and cash
equivalents................................. (1,499) 2,977,108 (1,947,072)
Cash and cash equivalents at beginning
of period............................... 261,538 260,039 3,237,147
------------- --------------- --------------
Cash and cash equivalents at end
of period.................................. $ 260,039 $ 3,237,147 $ 1,290,075
============= =============== ==============
SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION
Interest paid during the period................ $ 162,724 $ 499,474 $ 263,723
============= =============== ==============
Income taxes paid during the
period......................................... $ 1,176,683 $ 325,537 $ 0
============= =============== ==============
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
F-7
<PAGE> 45
TRUSTED INFORMATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION AS OF DECEMBER 26, 1997 AND FOR THE YEARS ENDED
DECEMBER 29, 1995, DECEMBER 27, 1996 AND DECEMBER 26, 1997)
1. BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION OF FINANCIAL STATEMENTS
Description of Business
Trusted Information Systems, Inc. (the "Company" or "TIS") provides
comprehensive security solutions for the protection of computer networks,
including global Internet-based systems, internal networks and individual
workstations and laptops. The Company develops, markets, licenses, and supports
the Gauntlet family of firewall products, the Stalker line of intrusion
detection products and other network security products as well as TIS' patented
RecoverKey(TM) technology. In addition to providing leading edge information
security products, TIS performs an array of services in the areas of
cryptography, security consulting, training, and advanced research and
engineering for commercial and government customers on a worldwide basis.
Fiscal Periods
The Company's fiscal year is based on a 52-53 week year ending on the last
Friday in December. The years ended December 29, 1995, December 27, 1996 and
December 26, 1997 were 52-week years. Each of the Company's fiscal quarters
consists of a 13-week period.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries, Trusted Information Systems U.K.
Limited ("TIS UK"), Trusted Information Systems GmbH ("TIS GmbH"), and Haystack
Laboratories ("Haystack"). The TIS UK subsidiary was established in 1992 to
conduct the Company's activities in the United Kingdom and the TIS GmbH
subsidiary was established in 1996 to conduct the Company's activities in
Germany. All material intercompany accounts and transactions have been
eliminated upon consolidation. Prior period consolidated financial statements
and corresponding notes to financial statements have been restated to give
effect to the merger unless the effect of the business combination was not
material to the financial statements of the Company (1995 was not restated due
to immateriality).
Revenues from the Company's European subsidiaries amounted to 3.1%, 3.8% and
6.7% of total revenues for the years ended December 29, 1995, December 27,
1996, and December 26, 1997, respectively. Translation adjustments from
foreign operations are not significant in the current year nor is the risk
associated with foreign operations considered to be significant.
F-8
<PAGE> 46
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 amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates.
Initial Public Offering and Related Matters
Effective May 31, 1996, the Company consummated a tax-free reorganization for
the purposes of becoming a Delaware corporation by issuing 40 shares of a new
class of $.01 par value common stock in exchange for each share of the then
outstanding no par value Class A (voting) and Class B (non-voting) common
stock. The effect of this reorganization is reflected as if it had occurred at
the beginning of the earliest period presented.
On August 30, 1996, the Board of Directors approved a 1-for-1.6301 reverse
stock split of the Company's common stock, which with stockholder approval
became effective on September 28, 1996. All references in the accompanying
financial statements to the number of shares of common stock and per share
amounts have been restated to reflect the reverse stock split.
In June 1996, the Company filed a registration statement with the SEC
permitting the Company to sell 3,910,000 shares of its common stock to the
public, including up to 510,000 shares to cover over-allotments. Pursuant to
the registration statement, the Company completed its initial public offering
(IPO) on October 10, 1996. The initial public offering resulted in proceeds to
the Company of approximately $45.4 million, net of approximately $1.9 million
in underwriting fees and offering expenses. The Company repaid approximately
$4.9 million of its short-term borrowings and notes payable out of the
proceeds.
Other Information Regarding Basis of Presentation
Amounts receivable, directly and indirectly, from government agencies
approximated 15.9% and 16.8% of total accounts receivable at December 27, 1996
and December 26, 1997, respectively. Sales to these agencies accounted for
approximately 68%, 41% and 23% of total revenues for the years ended December
29, 1995, December 27, 1996 and December 26, 1997, respectively.
Export sales, primarily to Europe, were 4.8%, 7.6%, and 12.7% of total revenues
for the years ended December 29, 1995, December 27, 1996, and December 26,
1997, respectively.
SIGNIFICANT ACCOUNTING POLICIES
Marketable Securities
Marketable securities are classified as available-for-sale and are carried at
fair market value with unrealized gains and losses, net of taxes reported in a
separate component of shareholders' equity. At December 27, 1996, marketable
securities consisted of an investment in 100,000 shares of Cybercash, Inc. and
approximately $36.7 million in U.S. Government and U.S. Government-sponsored
securities, all with maturities of less than three months. At December 26,
1997, marketable securities consisted of approximately $27.2 million in
government-sponsored securities with maturities of less than 9 months, carried
at cost, which approximates their fair value.
Realized gains in value judged to be other-than-temporary are included in
investment income. Interest and dividends are included in investment income.
At December 27, 1996, the common stock of Cybercash, Inc., which the Company
purchased in connection with the formation of the company, had a cost basis of
approximately $10,000 and an unrealized gain and estimated fair value of
approximately $1.5 million (net of taxes of $932,838). The Company sold the
Cybercash stock in the third quarter of 1997. Proceeds from this transaction
were $1,681,258 and a gross gain of $1,670,377 was realized on the sale.
F-9
<PAGE> 47
Fair Value of Financial Instruments
The Company considers the recorded costs of its financial assets and
liabilities, which consist primarily of cash and cash equivalents, accounts
receivable, marketable securities, accounts payable and long-term debt to
approximate the fair value of the respective assets and liabilities at December
27, 1996 and December 26, 1997. The Company performs periodic credit
evaluations of the financial condition of its customers and typically does not
require collateral from its customers.
Property and Equipment
Property and equipment is stated at cost. Additions prior to fiscal year 1996
are depreciated on an accelerated basis using estimated useful lives of 20-40
years for buildings and improvements and 5-10 years for furniture and
equipment. Additions for fiscal years 1996 and 1997 are depreciated on a
straight line basis over similar lives.
Stock Options Granted to Employees
The Company records compensation expense for all stock-based compensation plans
using the intrinsic value method prescribed by APB Opinion No. 25, Accounting
for Stock Issued to Employees. In October 1995, the Financial Accounting
Standards Board issued Statement No. 123, Accounting for Stock-Based
Compensation, which encourages companies to recognize expense for stock-based
awards based on their estimated fair value on the date of grant. Statement No.
123, effective for 1996, does not require companies to change their existing
accounting for stock-based awards, but if the new fair value method is not
adopted, pro forma income and earnings per share data should be provided in the
footnotes to the financial statements. The Company's financial statements
supplementally disclose the required pro forma information as if the fair value
method had been adopted for 1996 and 1997. (See footnote 6.)
Revenue Recognition
Commercial Products and Services -- Revenues from the sale of goods, including
software products, are recognized upon shipment, when collection of the
receivable is probable and the Company has no significant remaining
obligations. In instances where the Company directly installs its products,
related installation revenues are recognized upon completion of installation.
Commercial consulting services are provided primarily on a time and materials
basis. The Company accounts for obligations under customer service, support and
maintenance agreements by deferring a pro rata portion of revenue and
recognizing it either ratably as the obligations are fulfilled or upon
completion of performance.
Government Contracts -- The Company enters into research and development
contracts with government agencies under various pricing arrangements. Revenue
from "cost-plus-fixed-fee" contracts is recognized on the basis of reimbursable
contract costs incurred during the period, plus a percentage of the fixed fee.
Revenue from "time and material" contracts is recognized on the basis of hours
utilized, plus other reimbursable contract costs incurred during the period.
Revenue from "firm-fixed-price" contracts is recognized on the percentage of
completion method. Under this method, individual contract revenues are recorded
based on the percentage relationship that contract costs incurred bear to
management's estimate of total contract costs. Losses, if any, are accrued when
their occurrence becomes known and the amount of the loss is reasonably
determined.
Under its government contracts, the Company is subject to audit by the Defense
Contract Audit Agency (DCAA) which could result in the renegotiation of amounts
previously billed. The DCAA has performed audits of the Company's costs through
1995. Management believes that the results of such audits will not have a
material adverse effect on the Company's financial position or results of
operations.
F-10
<PAGE> 48
Revenues recognized in excess of amounts billed to government agencies and
retainage related to long-term contracts have been recorded as unbilled
receivables in the accompanying balance sheets.
Research and Development
Research and development expenditures are charged to operations as incurred.
Statement of Financial Accounting Standard No. 86, Accounting for the Costs of
Computer Software to be Sold, Leased or Otherwise Marketed, requires
capitalization of certain software development costs subsequent to the
establishment of technological feasibility. Based on the Company's product
development process, technological feasibility is established upon completion
of a working model. Costs incurred by the Company between completion of the
working model and the point at which the product is ready for general release
have been insignificant. The distribution of products incorporating encryption
technology may be subject to U.S. government export restrictions.
Advertising Costs
All advertising costs are expensed when incurred. Costs which are included in
expense for the years ended December 29, 1995, December 27, 1996, and December
26, 1997 were approximately $28,700, $340,453 and $854,715, respectively.
Earnings (Loss) Per Share
In February 1997, the Financial Accounting Standards Board issued Statement No.
128, Earnings per Share. Statement 128 replaced the calculation of primary and
fully diluted earnings per share with basic and diluted earnings per share.
Unlike primary earnings per share, basic earnings per share exclude any
dilutive effects of options, warrants and convertible securities. Diluted
earnings per share is very similar to the previously reported fully dilutive
earnings per share. All earnings per share amounts for all periods have been
presented, and where appropriate, restated to conform to the Statement 128
requirements.
Recently Issued Accounting Standards
In June 1997, FASB issued Statement No. 130, "Reporting Comprehensive Income"
which is effective for fiscal years beginning after December 15, 1997. The
Statement establishes standards for reporting and display of comprehensive
income and its components in financial statements. The Company will adopt
Statement No. 130 in the first quarter of 1998 and will provide the financial
statement disclosures as required by the Statement. The application of the new
rules will not have an impact on the Company's financial position or results
from operations.
In June 1997, FASB issued Statement No. 131, "Disclosures about Segments of an
Enterprise and Related Information" which is effective for fiscal years
beginning after December 15, 1997. The Statement changes the way public
companies report segment information in annual financial statements and also
requires those companies to report selected segment information in interim
financial statements to shareholders. The Statement also establishes standards
for related disclosures about products and services, geographic areas, and
major customers. The Company will adopt Statement No. 131 in 1998 resulting in
additional segment disclosures as required by the Statement. The application
of the new rules will not have an impact on the Company's financial position or
results from operations.
In October 1997, the AICPA issued SOP 97-2, "Software Revenue Recognition,"
which changes the requirements for revenue recognition of software licenses and
sales for transactions that the Company will enter into beginning January 1,
1998. The Company has not yet assessed what the impact of the SOP will be on
the 1998 financial statements.
2. SUBSEQUENT EVENTS
Networks Associates, Inc. ("Network Associates") a Delaware corporation, and
Trusted Information Systems, Inc., a
F-11
<PAGE> 49
Delaware corporation ("TIS"), have entered into an Agreement and Plan of
Reorganization, dated as of February 22, 1998, (the "Reorganization
Agreement"), among Network Associates, Thor Acquisition Corp., a wholly-owned
subsidiary of Network Associates ("Merger Sub"), and TIS. Pursuant to the
Reorganization Agreement, Merger Sub will merge with and into TIS, TIS will
continue as the surviving corporation and will become a wholly-owned subsidiary
of Network Associates, and each outstanding share of common stock of TIS, $0.01
par value ("TIS Common Stock"), will be converted into the right to receive
0.323 of a share (the "Exchange Ratio") of the common stock of Network
Associates.
The Company has separation agreements with Gina Dubbe, Martha Branstad, Harvey
Weiss, Homayoon Tajalli, and Ronald Kaiser which may compensate them and
provide for certain benefits for up to one year after their services are
separated in the event of certain circumstances.
F-12
<PAGE> 50
3. MERGERS AND ACQUISITIONS
On October 16, 1997, the Company acquired 100% of the outstanding stock of
Haystack Laboratories, Inc. ("Haystack"), an intrusion detection organization
based in Austin, Texas, for 2,098,935 shares of the Company's Common Stock.
The Company recognized approximately $3.5 million in non-recurring transaction
and other related costs in connection with the merger. The business
combination was accounted for by the pooling of interests method of accounting.
As such, the assets, liabilities and shareholders' equity of Haystack were
combined with the Company's respective accounts at recorded values. Prior
period consolidated financial statements and corresponding notes to financial
statements have been restated to give effect to the merger unless the effect of
the business combination was not material to the financial statements of the
Company (1995 was not restated due to immateriality).
Included in the consolidated statements of operations for the year ended
December 26, 1997 are the following results of the previously separate
companies:
<TABLE>
<CAPTION>
Period from December 28, 1996 to September 26, 1997 (approximating the
combination date)
- -------------------------------------------------------------------------
(in thousands) TIS Haystack Consolidated
- -------------------------------------------------------------------------
<S> <C> <C> <C>
Revenues $ 28,481 $ 1,309 $ 29,270
Net loss (2,069) $ (2,215) $ (4,264)
</TABLE>
The following is a reconciliation of revenues and net loss previously reported
by the Company for the year ended December 27, 1996, with the combined amounts
currently presented in the financial statements for that year:
<TABLE>
<CAPTION>
Year Ended December 27, 1996
- -------------------------------------------------------------------------
(in thousands) TIS Haystack Consolidated
- -------------------------------------------------------------------------
<S> <C> <C> <C>
Revenues $ 26,370 $ 1,005 $ 27,375
Net loss $ (2,164) $ (1,047) $ (3,211)
</TABLE>
In connection with the acquisition of Haystack, an escrow was established of
approximately 10% of the Company's shares issued to Haystack shareholders. In
March, 1998, a contingent claim, the amount of which was indeterminate at
December 26, 1997 and will be determined in accordance with the related escrow,
was filed by the Company against a portion of those shares.
4. PROPERTY AND EQUIPMENT
Property and equipment consists of::
<TABLE>
<CAPTION>
December 27, December 26,
1996 1997
------------- -------------
<S> <C> <C>
Land $ 322,926 $ 322,926
Buildings and building improvements 4,657,585 4,783,818
Furniture and equipment 3,214,021 5,091,510
Software 254,659 515,765
Vehicles -- 22,134
Leasehold improvements 116,123 140,469
------------- -------------
8,565,314 10,876,622
Less: accumulated depreciation and
amortization (1,714,252) (2,715,125)
------------- -------------
$ 6,851,062 $ 8,161,497
============= =============
</TABLE>
F-13
<PAGE> 51
5. NOTES PAYABLE
Notes payable to banks and others consists of the following:
<TABLE>
<CAPTION>
December 27, December 26,
1996 1997
----------- -----------
<S> <C> <C>
Small Business Administration mortgage note due in
monthly principal and interest (10.1% per annum)
installments of approximately $5,000 through 2009
Notes payable to a bank: $ 405,052 $ 387,453
Mortgage note; principal due in monthly installments of
$10,000 and interest payable monthly at a three year
fixed rate of 8.46%, balance due December, 2011 1,750,000 1,640,000
Mortgage note; due in monthly principal and interest
(8.46% per annum) installments of $4,128; balance due
December 2011 420,160 401,703
----------- -----------
2,575,212 2,429,156
Less: current portion 150,857 152,811
----------- -----------
$ 2,424,355 $ 2,276,345
=========== ===========
</TABLE>
In 1996, the Company modified its existing credit agreements and arranged for
additional credit agreements to fund the Company's growth prior to its initial
public offering. These short-term credit facilities were paid off in
conjunction with the Company's initial public offering.
The Company completed its expansion of its facilities at its Glenwood, Maryland
location in 1996, and substantially paid down the balance on its construction
loan of $1.8 million. This loan was then converted in December 1996 into a
mortgage note which is collateralized by the underlying properties.
Aggregate maturities of all notes payable at December 26, 1997 are as follows:
<TABLE>
<S> <C>
1998 $ 152,811
1999 158,746
2000 162,547
2001 166,723
2002 171,312
Thereafter 1,617,017
-----------
Total $ 2,429,156
===========
</TABLE>
6. STOCK OPTIONS
The Company has adopted the Amended and Restated Employee Stock Option Plan
("Employee Option Plan") and the 1996 Stock Option Plan ("1996 Option Plan")
which provide for the grant of incentive stock options and non-statutory stock
options to executives, employees and consultants. The Employee Option Plan
authorizes the issuance of options to acquire 6,134,593 shares of common stock
and at December 27, 1996, options to acquire 111,391 shares of common stock
under this plan were outstanding. No further options were granted under this
plan and no options related to this plan were outstanding at December 26, 1997.
The 1996 Option Plan authorizes the issuance of options to acquire 1,625,667
shares of common stock, and, at December 27, 1996 and December 26, 1997,
options to acquire 1,352,793 and 1,276,507 shares of common stock,
respectively, were outstanding under this plan.
The vesting period, contractual life, and the exercise price of each option
shall be determined by the respective plan administration committee. However,
for incentive stock options, the exercise price shall not be less than the fair
market value of the common stock on the date of the grant.
F-14
<PAGE> 52
The Company has also adopted the 1996 Directors' Stock Option Plan ("Director
Plan") which provides for the grant of non-statutory stock options to
non-employee directors of the Company. The Director Plan authorizes the
issuance of options to acquire 200,000 shares of common stock. On August 15,
1996 each of the Company's two existing outside directors were granted options
to purchase 9,202 shares of common stock at an exercise price of $7.04 per
share, and options to purchase 6,000 shares of common stock will be granted to
each future director upon initial election to the board of directors. The
options vest ratably over three years. Additionally, commencing in 1997, each
director is entitled to annual grants of options to purchase 1,250 shares of
common stock. Such annual options 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 equal the closing price per share of the common stock on the
date of grant. As of December 27, 1996 and December 26, 1997, 18,404 and 20,904
options were outstanding under the Director Plan at weighted per share prices
of $7.04 and $7.47, respectively.
Upon a change in control of the Company, as defined by the plans, 50% of any
outstanding unvested options under the 1996 Option Plan or the Director Plan
prior to the date of such change in control shall vest and be immediately
exercisable.
In connection with the initial public offering, the Company recorded deferred
compensation of $1,105,500 as a separate component of shareholders' equity
related to the issuance in June 1996 of options for 92,018 shares of the
Company's common stock. This deferred compensation is being amortized evenly
over the four-year vesting period of the options. At December 27, 1996 and
December 26, 1997, of the options for 92,018 shares, no options and options for
36,432 shares were exercisable, respectively.
Option activity under the Employee Option Plan and the 1996 Option Plan is as
follows:
<TABLE>
<CAPTION>
WEIGHTED
OPTIONS OUTSTANDING PRICE AVERAGE
UNDER THE STOCK PER PRICE PER
PLANS SHARE SHARE
------------------- ---------- ---------
<S> <C> <C> <C>
Balance at December 30, 1994 1,205,188 $ 50-.69 $ .60
Options granted . . . . . . . . -- -- --
Options exercised . . . . . . . (6,453) .50 .50
Options canceled . . . . . . . (122,693) .50-.69 .54
--------- ---------- --------
Balance at December 29, 1995 1,076,042 .50-.69 .69
Options granted . . . . . . . . 1,304,712 2.66-7.04 2.98
Options exercised . . . . . . . (646,979) .50-7.04 .54
Options canceled . . . . . . . (269,591) .50-7.04 .73
--------- ---------- --------
Balance at December 27, 1996 1,464,184 .69-7.04 2.73
Options granted . . . . . . . . 583,749 .85-13.88 8.39
Options exercised . . . . . . . (556,872) .69-7.04 1.53
Options canceled . . . . . . . (214,554) .85-13.88 4.80
--------- ---------- --------
Balance at December 26, 1997 1,276,507 $.69-13.88 $ 5.64
========= ========== ========
</TABLE>
Options exercisable at December 26, 1997 totaled 439,522 at a weighted average
per share price of $ 3.62.
The Company adopted Financial Accounting Standard No. 123 entitled "Accounting
for Stock-Based Compensation" ("FAS 123") as of December 27, 1996. The
provisions of FAS 123 allow companies to either expense the estimated fair
value of stock options or to continue their current practice but disclose the
pro forma effects on net income and earnings per share had the fair value of
the options been expensed. TIS has elected to continue its practice of
recognizing compensation expense for its stock option incentive plans using the
intrinsic value based method of accounting (see Note 1) and to provide the
required pro forma information for stock options granted after December 29,
1995. Accordingly, TIS recognizes compensation expense for its stock option
incentive plans using the intrinsic value method of accounting. Under the
terms of the intrinsic value method, compensation
F-15
<PAGE> 53
cost is the excess, if any, of the quoted market price of the stock at the
grant date, or other measurement date, over the amount an employee must pay to
acquire the stock.
Pro Forma Disclosure
Had compensation expense for TIS' stock option incentive plans for options
granted after December 29, 1995 been determined based on the estimated fair
value at the grant dates for awards under those plans, TIS' pro forma net loss
and loss per share for 1996 would have been $3,652,402 and ($.37),
respectively, and TIS pro forma net loss and loss per share for 1997 would have
been $9,738,786 and ($0.72), respectively. Since no options were granted by
the Company, there is no pro forma effect for the year ended December 29, 1995.
The effects on 1996 and 1997 pro forma net income and earnings per share of
expensing the estimated fair value of stock options are not necessarily
representative of the effects on reported net income for future years due to
such things as the vesting period of the stock options and the potential for
issuance of additional stock options in future years.
The fair value of options granted after December 29, 1995, used as a basis for
the above pro forma disclosures, was estimated as of the date of grant using a
Black-Scholes option pricing model. The option pricing assumptions for 1996
include a dividend yield of 0%; an expected volatility of 1.414; a risk-free
interest rate of 6.13%; and an expected life of 4 years. The option pricing
assumptions for 1997 include a dividend yield of 0%, an expected volatility of
0.974, a risk-free interest rate of 5.74%, and an expected life of 4 years.
Weighted-average fair value and exercise price per option granted during 1996
were $2.87 and $2.86, respectively for options whose exercise price was equal
to the fair value of the options on the date of the grant. For options whose
exercise price was less than the fair value on the date of the grant, the
weighted average fair value and exercise price per option granted during 1996
were $13.92 and $2.66, respectively. Weighted-average fair value and exercise
per option granted during 1997 were $7.98 and $11.31, respectively, for options
where exercise price was equal to the fair value of the options on the date of
the grant and no options were granted at less than the fair value on the date
of the grant. The weighted average contractual life for all options
outstanding at December 26, 1997 was 3.67 years.
The following table summarizes information regarding stock options outstanding
at December 26, 1997:
<TABLE>
<CAPTION>
Exercise Prices Number Of Options Weighted Average
Outstanding Contractual Life
<S> <C> <C>
$ 2.66 790,213 3.33
$ 7.04 103,177 3.64
$13.875 23,000 4.22
$11.125 353,867 4.40
$12.625 6,250 4.49
--------- ----
Total 1,276,507 3.67
</TABLE>
F-16
<PAGE> 54
7. INCOME TAXES
Significant components of the Company's deferred tax assets and liabilities are
as follows:
<TABLE>
<CAPTION>
DECEMBER 27, DECEMBER 26,
1996 1997
------------- ------------
<S> <C> <C>
Deferred tax assets:
Allowance for doubtful accounts $ 70,718 $ 208,272
Other accrued expenses 69,668 72,885
Accrued vacation 208,454 230,082
Deferred revenues 342,266 41,945
Deferred compensation 65,212 168,997
Accrual to cash adjustment 37,000 40,358
Tax credit carryforwards - 253,083
Net operating loss carryforwards 329,000 1,664,893
------------- ------------
1,122,318 2,680,515
Deferred tax liabilities:
Property and equipment 144,240 299,768
Unbilled receivables 49,154 68,754
Unrealized gain on marketable securities 936,728 -
Other 29,520 -
------------- ------------
1,159,642 368,522
Net deferred tax asset (liability) (37,324) 2,311,993
Less: valuation allowance 366,000 2,311,993
------------- ------------
Net deferred tax asset (liability) $ (403,324) $ -
============= ============
</TABLE>
SFAS 109 requires a valuation allowance to reduce the deferred tax assets
reported if, based on the weight of evidence, it is more likely than not that
some portion or all of the deferred tax assets will not be realized. At
December 27, 1996 and December 26, 1997, management established a valuation
allowance of $366,000 and $2,311,993, respectively, to reduce the deferred tax
assets to the amount that will more likely than not be realized. The change in
the valuation allowance for the current year is an increase of $1,945,993.
At December 26, 1997, the Company had net operating loss carryforwards
approximating $3,463,000, which will expire in the year 2012. Approximately
$400,000 of the net operating loss carryforwards relates to deductions
associated with disqualifying dispositions of incentive stock options. The tax
benefit of these deductions, when realized through a valuation allowance
reduction, will be credited to additional paid in capital and will not reduce
future period income tax expense.
F-17
<PAGE> 55
The provision (benefit) for income taxes consists of the following:
<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 29, DECEMBER 27, DECEMBER 26,
1995 1996 1997
----------- ------------- -------------
<S> <C> <C> <C>
Current:
Federal $ 855,775 $(1,169,020) $ (231,409)
State 180,748 (246,909) (31,443)
Foreign - - 83,722
----------- ------------- -------------
1,036,523 (1,415,929) (179,130)
Deferred:
Federal (125,518) 18,118 505,024
State (10,868) 1,301 28,391
----------- ------------- -------------
(136,386) 19,419 533,415
----------- ------------- -------------
Total income tax provision (benefit) $ 900,137 $(1,396,510) $ 354,285
=========== ============= =============
</TABLE>
The Company's provision for income taxes resulted in effective tax rates that
varied from the statutory federal income tax rate as follows:
<TABLE>
<CAPTION>
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 29, DECEMBER 27, DECEMBER 26,
1995 1996 1997
<S> <C> <C> <C>
Expected federal income tax
provision at 34% $ 763,028 $ (1,567,642) $ (2,791,361)
Expenses not deductible for tax
purposes 13,336 26,111 1,328,338
State income taxes, net of
federal benefit 112,121 (199,101) (198,799)
Change in tax status - 92,000 (253,083)
S Corp income not taxed at the
corporation level - (66,000) -
Adjustment of prior year tax expense - - 248,565
Other 11,652 (47,878) (9,090)
Foreign - - 83,722
Change in valuation allowance - 366,000 1,945,993
----------- ---------------- ---------------
$ 900,137 $ (1,396,510) $ 354,285
=========== ================ ===============
</TABLE>
8. PROFIT SHARING AND STOCK PURCHASE PLAN
The Company has a 401(k) profit sharing plan covering all permanent U.S.
employees who work at least 20 hours per week and similar pension plans for
non-U.S. employees. Participants may make voluntary contributions to the plans
and the Company matches these contributions, up to 5% of the employee's salary.
In addition, the Company may make discretionary contributions to the plans.
Participant contributions vest immediately and Company contributions vest over
a six-year period. For the plan years ended December 29, 1995 and December 27,
1996, the Company paid the expenses of operating the plan which were
approximately $4,500 and $4,800, respectively. For the plan year ended
December 26, 1997, forfeitures of $69,042 from terminated employees were used
to pay $6,861 in operating expenses of the plan and to reduce the Company's
contributions. Contributions to the plan charged to operations for the years
ended December 29, 1995, December 27, 1996 and December 26, 1997 totaled
$532,170, $880,478, and $815,350 respectively.
In May 1997, the Company introduced an Employee Stock Purchase Plan to
encourage and facilitate the purchase of Common Stock by employees of the
Company. Under the plan, employees of the Company who elect to participate
F-18
<PAGE> 56
may purchase Common Stock at 85% of the fair market value of the Common Stock
at the lesser of the stock closing price on the commencement date or the ending
date of each offering period. The plan permits an enrolled employee to make
contributions through the use of payroll deductions. The aggregate amount of
stock which may be purchased under this plan is 400,000 shares. For fiscal
1997, 30,727 shares at a purchase price of $8.50 were paid for and issued on
December 31, 1997.
9. COMMITMENTS
The Company leases certain office space in California, Maryland, and Virginia,
and sales satellite offices, under non-cancelable operating lease agreements.
Certain leases contain escalation clauses and require the Company to pay its
share of any increases in operating expenses and real estate taxes. Rent
expense was $281,381, $591,440 and $1,289,552 for the years ended December 29,
1995, December 27, 1996 and December 26, 1997, respectively. Future minimum
lease payments under all non-cancelable operating lease arrangements are
approximately as follows:
<TABLE>
<S> <C>
1998 $ 1,632,685
1999 1,567,183
2000 1,394,304
2001 862,939
2002 271,298
Thereafter _
-----------
Total $ 5,728,409
</TABLE>
The Company maintains self-insurance programs for health care and short-term
disability costs with stop-loss insurance. Expense incurred for group medical
claims, program premiums and stop-loss limit charged to operations for the
years ended December 29, 1995, December 27, 1996 and December 26, 1997 totaled
$621,378, $780,888, and $1,186,147 respectively.
10. RELATED PARTY TRANSACTIONS
The Company purchased property adjacent to its Glenwood, Maryland headquarters
from a related party on June 28, 1996 for $360,000 by assuming a mortgage note
payable (see Note 5) and the elimination of a receivable. Such property had
previously been rented by the Company from the related party. Rent expense
under the lease agreement for the years ended December 29, 1995 and December
27, 1996 totaled approximately $47,000 and $24,000, respectively.
In August 1995, the Company issued a promissory note for the benefit of a
shareholder and former officer in the principal amount of $307,520 representing
the balance of monies due to him in connection with the repurchase by the
Company of 588,921 shares of common stock. This promissory note was paid in
full in September 1995.
F-19
<PAGE> 57
11. COMPUTATION OF EARNINGS (LOSS) PER SHARE.
The following schedule sets forth the computation of basic and diluted earnings
(loss) per share:
<TABLE>
<CAPTION>
For fiscal years ending
December 29, 1995 December 27, 1996 December 26, 1997
-------------------------------------------------------------
<S> <C> <C> <C>
Numerator for basic and diluted earnings
per share:
Net income (loss) $1,344,063 $(3,211,121) $(8,564,170)
Denominator:
Denominator for basic earnings per
share - weighted average shares 7,333,676 9,952,120 13,531,876
Effect of dilutive securities:
Stock options 684,903 -- --
-------------------------------------------------------------
Dilutive potential common shares 684,903 -- --
Denominator for diluted earnings per
share - adjusted weighted average
shares and assumed conversions 8,018,579 9,952,120 13,531,876
========= ========= ==========
Basic earnings (loss) per share $0.18 $(0.32) $(0.63)
===== ======= =======
Diluted earnings (loss) per share $0.17 $(0.32) $(0.63)
===== ======= =======
</TABLE>
Options to purchase 1,464,184 shares of common stock at a weighted average per
share price of $2.73 and 1,276,507 shares of common stock at a weighted average
per share price of $5.64 were outstanding during 1996 and 1997, respectively,
but were not included in the computation of diluted earnings per share as the
effect would be antidilutive.
F-20
<PAGE> 58
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, as amended, the Company has duly caused this Report to be
signed on its behalf by the undersigned, thereunto duly authorized, in
Glenwood, Maryland, on the 25th of March, 1998.
TRUSTED INFORMATION SYSTEMS, INC.
By: /s/ Stephen T. Walker
-----------------------------------
Stephen T. Walker
President, Chief Executive Officer,
Chairman of the Board and Director
Pursuant to the requirements of the Securities Exchange Act of 1934,
as amended, this Report has been signed below by the following persons on
behalf of the Company in the capacities and on the date indicated.
Each person whose signature appears below in so signing also makes,
constitutes and appoints Stephen T. Walker and Edwin M. Martin, Jr., and each
of them acting alone, his true and lawful attorney-in-fact, with full power of
substitution, for him in any and all capacities, to execute and cause to be
filed with the Securities and Exchange Commission any and all amendments and
post-effective amendments to this Report, with exhibits thereto and other
documents in connection therewith, and hereby ratifies and confirms all that
said attorney-in-fact or his substitute or substitutes may do or cause to be
done by virtue hereof.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ Stephen T. Walker President, Chief Executive March 25, 1998
- ----------------------------------------------- Officer, Chairman of the
Stephen T. Walker Board and Director
/s/ Martha A. Branstad Executive Vice President and March 25, 1998
- ----------------------------------------------- Chief Operating Officer
Martha A. Branstad President of Advanced Research
and Engineering Division and Director
/s/ Harvey L. Weiss Executive Vice President, President March 25, 1998
- ----------------------------------------------- of the Commercial Division, Secretary
Harvey L. Weiss and Director
/s/ Ronald W. Kaiser Executive Vice President and Chief March 25, 1998
- ----------------------------------------------- Financial Officer
Ronald W. Kaiser
/s/ Gerald J. Popek Director March 25, 1998
- -----------------------------------------------
Gerald J. Popek
/s/ Charles W. Stein Director March 25, 1998
- -----------------------------------------------
Charles W. Stein
</TABLE>
-54-
<PAGE> 59
TRUSTED INFORMATION SYSTEMS, INC.
FORM 10-K
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT DESCRIPTION SEQUENTIAL PAGE NO.
- ------- ----------- -------------------
<S> <C>
3.1* Certificate of Incorporation of the Company.
3.1.1* Certificate of Amendment to Certificate of Incorporation, as
filed with the Delaware Secretary of State on October 2, 1996.
3.2* Amended and Restated Bylaws of the Company.
4.1* Specimen stock certificate for shares of Common Stock of the
Company.
4.2* Target Stockholders' Agreement and Affiliate's Agreement dated
as of October 15, 1997 by and among the Company, Certain
Stockholders and the Investors named therein.
4.3* Agreement and Plan of Merger dates as of October 3,1997 by and
among the Company, Trusted Acquisitions, Inc. and Haystack
Laboratories, Inc
10.1* Amended and Restated Employee Stock Option Plan.
10.2* Amended and Restated 1996 Stock Option Plan.
10.2.1* Form of Incentive Stock Option Agreement pursuant to 1996
Stock Option Plan.
10.2.2* Form of Non-Qualified Stock Option Agreement pursuant to 1996
Stock Option Plan.
10.3* Amended and Restated 1996 Directors' Stock Option Plan.
10.4* Form of Employee Agreement Regarding Confidentiality and
Inventions.
10.5* Form of Software License and Reseller Agreement.
10.6* Form of Consulting Services Agreement.
10.7* Form of Indemnification Agreement by and between the Company
and its directors and officers.
10.8* Construction Loan Agreement dated July 26, 1995, by and
between the Company and Mercantile-Safe Deposit and Trust
Company.
10.9* Construction Loan Promissory Note dated July 26, 1995, by and
between the Company and Mercantile-Safe Deposit and Trust
Company.
10.10* Deed of Trust and Security Agreement dated July 26, 1995, by
and between the Company and Mercantile-Safe Deposit and Trust
Company.
10.11* Security Agreement, dated July 26, 1995, by and among the
Company,Mercantile-Safe Deposit and Trust Company and Stephen
T. Walker.
10.12* Personal Guaranty Agreement dated July 26, 1995, by and
between Stephen T. Walker and Mercantile-Safe Deposit and
Trust Company.
10.13* Revolving Note issued by the Company on April 4, 1996, to
Mercantile-Safe Deposit and Trust Company.
10.14* Security Agreement dated April 4, 1996, by and between the
Company and Mercantile-Safe Deposit and Trust Company.
10.15* Revolving Note issued by the Company on April 4, 1996, to
Mercantile-Safe Deposit and Trust Company.
10.16.1* Security Agreement as of August 27, 1996, by and between the
Company and Mercantile-Safe Deposit and Trust Company.
10.16.2* Revolving Note issued by the Company as of August 27, 1996, to
Mercantile-Safe Deposit and Trust Company.
10.17* Office Building Lease dated February 1, 1990, by and between
the Company and Perini Investment Properties, Inc.
10.18* Lease Amendment I dated May 26, 1994, by and between the
Company and
</TABLE>
55
<PAGE> 60
<TABLE>
<S> <C>
Robert R. Walker, Jr., Receiver (relating to exhibit 10.17).
10.19* Standard Lease dated April 12, 1989, by and between the
Company and R&B Property Holding Company.
10.20* Amendment to Lease effective November 1, 1992, by and between
the Company and R&B Property Holding Company (relating to
exhibit 10.19).
10.21* Lease Agreement dated as of October 3, 1995, by and between
Trusted Information Systems (UK) Limited and Theale Estates
Limited.
10.22* Deed dated July 17, 1996, by and between the Company and
Glenwood Associates Limited Partnership.
10.22.1* Promissory Note issued by the Company on July 17, 1996, to
Glenwood Associates Limited Partnership.
10.22.2* Deed of Trust and Security Agreement dated December 1, 1993,
by and between Glenwood Associates Limited Partnership and
Mercantile-Safe Deposit and Trust Company.
10.22.3* Promissory Note issued by Glenwood Associates Limited
Partnership on December 1, 1993 to Mercantile-Safe Deposit and
Trust Company.
10.23* Deed and Confirmatory Deed dated July 26, 1995, by and between
the Company and Stephen T. Walker.
10.24* Agreement and Plan of Merger dated May 30, 1996.
10.25+ Patent and Software License Agreement dated January 24, 1997,
by and between the Company and International Business Machines
Corporation.
21.1* Subsidiaries of the Registrant.
23.1** Consent of Ernst & Young LLP, Independent Auditors
24.1** Power of Attorney (included in signature pages).
27** Restated Financial Data Schedule.
27.1 Restated Financial Data Schedule.
</TABLE>
- ------------
* Previously filed as an exhibit to the Company's Registration Statement
Number 333-5419 on Form S-1 and incorporated herein by reference.
** Filed herewith.
+ Portions of this Exhibit were omitted and have been filed separately
with the Secretary of the Commission pursuant to the Registrant's Application
Requesting Confidential Treatment under Rule 12b-24 of the Securities Exchange
Act of 1934, as amended, filed on March 27, 1997.
56
<PAGE> 61
Schedule II - Valuation and Qualifying Accounts
Trusted Information Systems, Inc. and Subsidiaries
<TABLE>
<CAPTION>
COL A COL B COL C COL D COL E
Description. Balance at Additions Additions Deductions - Balance at End
Beginning of Charged to Charged to Describe of Period
Period Costs and Other Accounts
Expenses - Describe
<S> <C> <C> <C> <C> <C>
Reserves and allowances deducted
from asset accounts:
YEAR ENDED DECEMBER 29, 1995:
Allowance for uncollectible accounts $24,000 $20,000 $ - $ - $44,000
YEAR ENDED DECEMBER 27, 1996:
Allowance for uncollectible accounts $44,000 $130,592 $ - $ - $174,592
YEAR ENDED DECEMBER 26, 1997:
Allowance for uncollectible accounts $174,592 $736,997 $ - $ 211,200(1) $700,389
</TABLE>
(1) Uncollectible accounts written off, net of receivables.
57
<PAGE> 1
EXHIBIT 23.1
Consent of Independent Auditors
We consent to the incorporation by reference in the Registration Statements
(Form S-8) listed below of Trusted Information Systems, Inc. of our report dated
March 2, 1998, with respect to the consolidated financial statements and
schedule of Trusted Information Systems, Inc. included in this Annual Report on
Form 10-K, as amended on Form 10-K/A for the year ended December 26, 1997.
1) No. 333-20311 1994 Stock Option Plan
2) No. 333-20313 Amended and Restated 1996 Stock Option Plan
3) No. 333-24849 Amended and Restated 1996 Directors' Stock Option Plan
4) No. 333-30971 1997 Employee Stock Purchase Plan
/s/Ernst & Young LLP
Vienna, Virginia
March 24, 1998
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Company's consolidated financial statements, as restated, as of December 29,
1995, December 27, 1996 and December 26, 1997 and for the years ended December
29, 1995, December 27, 1996 and December 26, 1997 and is referenced to such
financial statements.
</LEGEND>
<S> <C> <C> <C>
<PERIOD-TYPE> 12-MOS 12-MOS 12-MOS
<FISCAL-YEAR-END> DEC-29-1995 DEC-27-1996 DEC-26-1997
<PERIOD-START> DEC-30-1994 DEC-30-1995 DEC-28-1996
<PERIOD-END> DEC-29-1995 DEC-27-1996 DEC-26-1997
<CASH> 260,039 3,237,147 1,290,075
<SECURITIES> 0 39,066,569 27,160,179
<RECEIVABLES> 4,412,881 6,382,959 12,066,277
<ALLOWANCES> 44,000 174,592 700,389
<INVENTORY> 0 0 0
<CURRENT-ASSETS> 6,723,179 52,748,805 44,941,982
<PP&E> 5,108,164 8,565,314 10,876,622
<DEPRECIATION> 1,366,326 1,714,252 2,715,125
<TOTAL-ASSETS> 10,528,457 59,955,460 53,768,441
<CURRENT-LIABILITIES> 6,313,509 8,384,606 10,682,854
<BONDS> 1,580,000 2,424,355 2,276,345
0 0 0
0 0 0
<COMMON> 83,123 132,359 137,928
<OTHER-SE> 2,551,825 48,966,775 40,594,707
<TOTAL-LIABILITY-AND-EQUITY> 2,634,948 59,955,460 53,768,441
<SALES> 18,090,087 27,375,268 42,222,683
<TOTAL-REVENUES> 18,090,087 27,375,268 42,222,683
<CGS> 10,864,947 12,303,310 13,034,868
<TOTAL-COSTS> 10,864,947 12,303,310 13,034,868
<OTHER-EXPENSES> 4,872,438 19,782,750 40,709,888
<LOSS-PROVISION> 0 0 0
<INTEREST-EXPENSE> 108,502 (103,161) (1,641,811)
<INCOME-PRETAX> 2,244,200 (4,607,631) (8,209,885)
<INCOME-TAX> 900,137 (1,396,510) 354,285
<INCOME-CONTINUING> 1,344,063 (3,211,121) (8,564,170)
<DISCONTINUED> 0 0 0
<EXTRAORDINARY> 0 0 0
<CHANGES> 0 0 0
<NET-INCOME> 1,344,063 (3,211,121) (8,564,170)
<EPS-PRIMARY> 0.18 (0.32) (0.63)
<EPS-DILUTED> 0.17 (0.32) (0.63)
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
Company's unaudited consolidated financial statements, as restated, as of and
for the nine months ending September 27, 1996, the three months ended March 28,
1997, the six months ended June 27, 1997 and the nine months ended September 26,
1997 and is qualified in its entirety by reference to such consolidated
financial statements of the Company.
</LEGEND>
<S> <C> <C> <C> <C>
<PERIOD-TYPE> 9-MOS 3-MOS 6-MOS 9-MOS
<FISCAL-YEAR-END> DEC-27-1996 DEC-26-1997 DEC-26-1997 DEC-26-1997
<PERIOD-START> DEC-30-1995 DEC-28-1996 DEC-28-1996 DEC-28-1996
<PERIOD-END> SEP-27-1996 MAR-28-1997 JUN-27-1997 SEP-26-1997
<CASH> 479,794 1,337,620 2,736,466 1,106,040
<SECURITIES> 3,000,000 37,754,778 32,757,990 31,897,426
<RECEIVABLES> 4,545,521 5,737,735 8,504,235 10,283,941
<ALLOWANCES> 144,000 276,349 416,589 512,140
<INVENTORY> 0 0 0 0
<CURRENT-ASSETS> 12,691,664 51,012,208 49,434,604 49,257,866
<PP&E> 8,439,733 9,029,996 9,778,971 10,684,451
<DEPRECIATION> 1,789,699 1,949,747 2,470,019 2,761,119
<TOTAL-ASSETS> 19,443,486 58,445,314 57,129,896 57,677,943
<CURRENT-LIABILITIES> 12,284,496 9,362,582 10,192,994 11,611,690
<BONDS> 3,562,399 2,493,680 2,499,945 2,316,602
0 0 0 0
0 0 0 0
<COMMON> 82,933 122,609 123,488 137,587
<OTHER-SE> 3,513,658 46,419,414 44,266,776 43,568,170
<TOTAL-LIABILITY-AND-EQUITY> 19,443,486 58,445,314 57,129,896 57,677,943
<SALES> 17,493,863 8,936,444 18,583,324 29,790,301
<TOTAL-REVENUES> 17,493,863 8,936,444 18,583,324 29,790,301
<CGS> 8,631,257 3,349,232 6,164,940 9,480,998
<TOTAL-COSTS> 8,631,257 3,349,232 6,164,940 9,480,998
<OTHER-EXPENSES> 11,622,651 9,141,334 18,954,930 28,378,691
<LOSS-PROVISION> 0 0 0 0
<INTEREST-EXPENSE> 270,964 (445,955) (910,520) (2,963,318)
<INCOME-PRETAX> (3,031,009) (3,108,167) (5,626,026) (5,106,070)
<INCOME-TAX> (1,041,077) (836,491) (1,479,724) (822,243)
<INCOME-CONTINUING> (1,989,932) (2,271,676) (4,146,302) (4,283,827)
<DISCONTINUED> 0 0 0 0
<EXTRAORDINARY> 0 0 0 0
<CHANGES> 0 0 0 0
<NET-INCOME> (1,989,932) (2,271,676) (4,146,302) (4,283,827)
<EPS-PRIMARY> (0.22) (0.17) (0.31) (0.32)
<EPS-DILUTED> (0.22) (0.17) (0.31) (0.32)
</TABLE>
