<PAGE>
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2000
COMMISSION FILE NUMBER: 000-26223
------------------------
TUMBLEWEED COMMUNICATIONS CORP.
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
DELAWARE 94-3336053
(State of other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
</TABLE>
700 SAGINAW DRIVE
REDWOOD CITY, CA 94063
(Address of principal executive offices, including zip code)
(650) 216-2000
(Registrant's telephone number, including area code)
------------------------
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS
REQUIRED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS. YES /X/ NO / /
THE NUMBER OF SHARES OF COMMON STOCK OUTSTANDING AS OF JULY 31, 2000 WAS
26,398,936.
--------------------------------------------------------------------------------
--------------------------------------------------------------------------------
<PAGE>
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This Quarterly Report on Form 10-Q contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934, which are subject to the "safe harbor"
created by those sections. The forward-looking statements are based on
Tumbleweed Communications Corp.'s current expectations and projections about
future events, including, but not limited to, implementing its business
strategy; attracting and retaining customers; obtaining and expanding market
acceptance of the products and services it offers; forecasts of Internet usage
and the size and growth of relevant markets; rapid technological changes in its
industry and relevant markets; competition in its market; and its ability to
complete the proposed acquisition of Interface Systems, Inc. Discussions
containing such forward-looking statements may be found in "Management's
Discussion and Analysis of Financial Condition and Results of Operations." In
some cases, forward-looking statements can be identified by terminology such as
"may," "will," "should," "could," "predicts," "potential," "continue,"
"expects," "anticipates," "future," "intends," "plans," "believes," "estimates,"
and similar expressions. These forward-looking statements are based on current
beliefs, expectations and assumptions and involve certain risks and
uncertainties that could cause actual results, levels of activity, performance,
achievements and events to differ materially from those implied by such
forward-looking statements. These forward-looking statements are made as of the
date of this Quarterly Report on Form 10-Q. Tumbleweed disclaims any obligation
to update these statements or to explain the reasons why actual results may
differ. The risks and uncertainties under the caption "Management's Discussion
and Analysis of Financial Condition and Results of Operations--Risks and
Uncertainties That You Should Consider Before Investing in Tumbleweed" contained
herein, among other things, should be considered in evaluating Tumbleweed's
prospects and future financial performance.
2
<PAGE>
TUMBLEWEED COMMUNICATIONS CORP.
INDEX
<TABLE>
<CAPTION>
PAGE NO.
---------
<S> <C> <C>
PART I FINANCIAL INFORMATION
Item 1: FINANCIAL STATEMENTS
Condensed Consolidated Balance Sheets as of June 30, 2000
(unaudited) and December 31, 1999......................... 4
Condensed Consolidated Statements of Operations for the
three and six months ended June 30, 2000 and 1999
(unaudited)............................................... 5
Condensed Consolidated Statements of Cash Flows for the six
months ended June 30, 2000 and 1999 (unaudited)........... 6
Notes to Condensed Consolidated Financial Statements
(unaudited)............................................... 7
Item 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS................................. 12
Item 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK...................................................... 30
PART II OTHER INFORMATION
Item 1: Legal Proceedings........................................... 31
Item 2: Changes in Securities and Use of Proceeds................... 31
Item 4: Submission of Matters to a Vote of Security Holders......... 31
Item 6: Exhibits.................................................... 32
Signatures............................................................ 33
</TABLE>
TRADEMARKS
Tumbleweed-Registered Trademark-, WorldSecure-Registered Trademark- and
Worldtalk-Registered Trademark- are registered trademarks and Integrated
Messaging Exchange-TM-, IME-TM-, Messaging Management System (MMS)-TM-,
WorldSecure/Mail-TM-, Secure Inbox-TM-, Secure Envelope-TM-, Tumbleweed IME
Platform-TM-, Tumbleweed IME Applications-TM-, IME Statements-TM-, IME
Developer-TM-, IME Messenger-TM-, IME Personalize-TM-, and IME Alert-TM- are
trademarks of Tumbleweed Communications Corp.
3
<PAGE>
PART I--FINANCIAL INFORMATION
ITEM 1--FINANCIAL STATEMENTS
TUMBLEWEED COMMUNICATONS CORP.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
----------- -------------
(UNAUDITED)
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents................................. $ 32,711 $ 60,544
Accounts receivable....................................... 11,962 5,182
Prepaid expenses and other current assets................. 2,028 3,574
-------- --------
Total current assets.................................... 46,701 69,300
Property and equipment, net................................. 6,536 3,485
Other assets................................................ 3,031 2,898
-------- --------
Total assets............................................ $ 56,268 $ 75,683
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.......................................... $ 2,774 $ 2,878
Current installments of long-term debt.................... 533 840
Accrued liabilities....................................... 8,341 6,398
Deferred revenue.......................................... 2,702 2,579
-------- --------
Total current liabilities............................... 14,350 12,695
Long-term debt, excluding current installments.............. 660 1,017
Other long-term liabilities................................. 483 258
-------- --------
Total liabilities....................................... 15,493 13,970
Commitments and contingencies
Minority interest........................................... 1,396 --
Stockholders' equity:
Common stock.............................................. 26 26
Additional paid-in capital................................ 137,591 132,167
Deferred compensation expense............................. (4,608) (5,283)
Accumulated other comprehensive income (loss)............. (231) 53
Accumulated deficit....................................... (93,399) (65,250)
-------- --------
Total stockholders' equity.............................. 39,379 61,713
-------- --------
Total liabilities and stockholders' equity.............. $ 56,268 $ 75,683
======== ========
</TABLE>
4
<PAGE>
TUMBLEWEED COMMUNICATIONS CORP.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS ENDED
ENDED JUNE 30, JUNE 30,
------------------- -------------------
2000 1999 2000 1999
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenue:
License................................................... $ 6,824 $ 2,382 $ 11,180 $ 5,084
Services.................................................. 1,748 491 3,272 1,055
Transaction fees.......................................... 1,518 203 2,248 206
------- ------- -------- -------
Revenue from continuing product lines................... 10,090 3,076 16,700 6,345
Discontinued product line................................. -- 561 -- 1,199
------- ------- -------- -------
Total revenue......................................... 10,090 3,637 16,700 7,544
Cost of revenue:
License................................................... 290 125 557 242
Services.................................................. 2,882 983 4,823 1,765
Transaction fees.......................................... 20 15 60 20
------- ------- -------- -------
Total cost of revenue................................. 3,192 1,123 5,440 2,027
------- ------- -------- -------
Gross profit................................................ 6,898 2,514 11,260 5,517
------- ------- -------- -------
Operating expenses:
Research and development (1)................................ 3,171 2,077 6,014 3,871
Sales and marketing (2)..................................... 9,742 4,177 16,934 7,321
General and administrative (3).............................. 2,312 1,036 3,921 1,821
Stock compensation.......................................... 1,451 969 2,525 1,305
Amortization of goodwill.................................... 59 31 90 62
Merger related and restructuring expenses................... -- -- 10,803 --
------- ------- -------- -------
Total operating expenses.............................. 16,735 8,290 40,287 14,380
------- ------- -------- -------
Operating loss........................................ (9,837) (5,776) (29,027) (8,863)
Other income, net........................................... 365 157 1,021 295
------- ------- -------- -------
Net loss before provision for taxes................... (9,472) (5,619) (28,006) (8,568)
Provision for taxes................................... 150 93 238 75
Minority interest..................................... (94) -- (94) --
------- ------- -------- -------
Net loss.............................................. $(9,528) $(5,712) $(28,150) $(8,643)
======= ======= ======== =======
Other comprehensive income (loss)--translation adjustment... (301) 2 (284) 6
------- ------- -------- -------
Comprehensive loss........................................ $(9,829) $(5,710) $(28,434) $(8,637)
======= ======= ======== =======
Net loss per share--basic and diluted....................... $ (0.37) $ (0.79) $ (1.09) $ (1.22)
======= ======= ======== =======
Weighted average shares--basic and diluted.................. 26,068 7,267 25,828 7,059
======= ======= ======== =======
</TABLE>
--------------------------
(1) Exclusive of non-cash compensation expense of $188 and $294 for the three
months ended June 30, 2000 and 1999, respectively, and $462 and $434 for the
six months ended June 30, 2000 and 1999, respectively.
(2) Exclusive of non-cash compensation expense of $1,146 and $544 for the three
months ended June 30, 2000 and 1999, respectively, and $1,782 and $691 for
the six months ended June 30, 2000 and 1999, respectively.
(3) Exclusive of non-cash compensation expense of $117 and $131 for the three
months ended June 30, 2000 and 1999, respectively, and $281 and $180 for the
six months ended June 30, 2000 and 1999, respectively.
5
<PAGE>
TUMBLEWEED COMMUNICATIONS CORP.
AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
JUNE 30,
-------------------
2000 1999
-------- --------
<S> <C> <C>
Cash flow from operating activities:
Net loss.................................................... $(28,150) $(8,643)
Adjustments to reconcile net loss to net cash used in
operating activities:
Compensation expense for grant of non-employee stock options
and warrant issuances..................................... 411 77
Amortization of deferred stock compensation expense......... 2,525 1,305
Depreciation and amortization............................... 1,076 529
Amortization of debt discount............................... -- 43
Minority interest........................................... (94) --
Changes in operating assets and liabilities:
Accounts receivable....................................... (5,986) (1,343)
Prepaid expenses and other current assets................. 1,767 (540)
Accounts payable and liabilities.......................... 1,169 1,477
Deferred revenue.......................................... (169) (292)
-------- -------
Net cash used in operating activities................... (27,451) (7,387)
-------- -------
Cash flows from investing activities:
Purchase of property and equipment........................ (4,824) (1,374)
Proceeds from the sale of short-term investments.......... -- 2,166
Cash acquired from TKK repurchase, net of cash payment.... 2,516 --
Other assets.............................................. (289) (961)
-------- -------
Net cash used in investing activities................... (2,597) (169)
-------- -------
Cash flows from financing activities:
Increase in borrowings.................................... -- 1,988
Repayments of borrowings.................................. (664) (1,215)
Proceeds from issuance of preferred stock and warrants,
net..................................................... -- 18,756
Issuance of common stock upon exercise of stock options... 3,163 757
-------- -------
Net cash provided by financing activities............... 2,499 20,286
Effect of exchange rate fluctuations........................ (284) 6
-------- -------
Net (decrease) increase in cash and cash equivalents........ (27,833) 12,736
Cash and cash equivalents, beginning of period.............. 60,544 4,556
-------- -------
Cash and cash equivalents, end of period.................... $ 32,711 $17,292
======== =======
Supplemental disclosures of cash flow information:
Cash paid during the period for interest.................. $ 33 $ 97
======== =======
Noncash investing and financing activities--
Deferred compensation expense associated with stock
option activity....................................... $ 2,261 $ 6,864
======== =======
</TABLE>
6
<PAGE>
TUMBLEWEED COMMUNICATIONS CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) BASIS OF PRESENTATION
The condensed consolidated financial statements as of June 30, 2000 and for
the three and six months ended June 30, 2000 and 1999 are unaudited and reflect
all adjustments (consisting of normal recurring accruals) which are, in the
opinion of management, necessary for fair presentation of Tumbleweed's financial
position and operating results for the interim periods presented.
The accompanying condensed consolidated financial statements include the
accounts of Tumbleweed Communications Corp. ("Tumbleweed"), Tumbleweed's wholly
owned subsidiary Worldtalk Communications Corp. ("Worldtalk"), and Tumbleweed's
wholly owned subsidiary in the United Kingdom, in addition to the United
Kingdom's wholly owned subsidiaries in France, Germany, Australia, the
Netherlands and Sweden.
In addition, Tumbleweed's consolidated financial statements also include the
results of Tumbleweed Communications K.K. ("TKK"), as of June 30, 2000 and for
the three months ended June 30, 2000. TKK was a wholly owned subsidiary in Japan
until August 31, 1999 when TKK sold 200 shares of its common stock representing
a 50% ownership interest in TKK. As such, the results of TKK for the period from
September 1, 1999 through March 31, 2000 were accounted for on the equity method
of accounting rather than the consolidation method. On May 15, 2000, Tumbleweed
repurchased 5% of the outstanding shares of the jointly owned Japanese
subsidiary, increasing Tumbleweed's ownership position to 55%. As a result,
Tumbleweed owns a controlling interest of the Japanese subsidiary and began
accounting for the Japanese subsidiary under the consolidation method effective
April 1, 2000. No pro forma financial information has been presented due to the
insignificance of the TKK stock repurchase. All significant intercompany
accounts and transactions have been eliminated in consolidation.
(2) BUSINESS COMBINATIONS
On January 31, 2000, Tumbleweed completed its acquisition of Worldtalk.
Under the terms of the merger agreement, each Worldtalk share of common stock
converted into 0.26 shares of Tumbleweed's common stock. A total of 3,798,398
shares of Tumbleweed's common stock were exchanged for 14,609,374 shares of
Worldtalk common stock. The business combination has been accounted for as a
pooling of interests and, accordingly, Tumbleweed's historical financial
statements have been restated to include the accounts and results of operations
of Worldtalk.
7
<PAGE>
TUMBLEWEED COMMUNICATIONS CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) BUSINESS COMBINATIONS (CONTINUED)
The results of operations previously reported by the separate enterprises
and the combined amounts presented in the accompanying consolidated financial
statements are summarized below (in thousands).
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, 1999 JUNE 30, 1999
------------------ ----------------
(UNAUDITED) (UNAUDITED)
<S> <C> <C>
Revenue:
Tumbleweed............................... $ 1,008 $ 1,701
Worldtalk................................ 2,629 5,843
------- -------
Combined................................... $ 3,637 $ 7,544
======= =======
Net loss:
Tumbleweed............................... $(3,997) $(6,053)
Worldtalk................................ (1,715) (2,590)
------- -------
Combined................................. $(5,712) $(8,643)
======= =======
</TABLE>
As a result of the acquisition of Worldtalk, Tumbleweed recorded a pre-tax
charge of $10.8 million for restructuring and merger related expenses during the
three months ended March 31, 2000. The $10.8 million restructuring and merger
related expenses consisted of the following (in thousands):
<TABLE>
<S> <C>
Investment banker's fees.................................... $ 7,525
Legal fees.................................................. 1,347
Severances.................................................. 1,146
Accounting and printer fees................................. 485
Other....................................................... 300
-------
$10,803
=======
</TABLE>
As of June 30, 2000, Tumbleweed had approximately $237,000 of accrued merger
related and restructuring expenses.
On June 28, 2000, Tumbleweed entered into a merger agreement providing for
the acquisition of Interface Systems, Inc. ("Interface"). Pursuant to the merger
agreement, each outstanding share of Interface common stock will be converted
into the right to receive 0.264 shares of Tumbleweed's common stock upon the
closing of the merger, and Tumbleweed will assume all outstanding options and
warrants of Interface. As of June 28, 2000, there were 4,719,675 outstanding
shares of Interface common stock as well as options and warrants to purchase an
additional 886,018 shares of Interface common stock. The transaction, if
completed, will be treated as a purchase for accounting purposes. Accordingly,
Tumbleweed expects to expense up to $2.0 million of acquired in-process research
and development, and to record unearned compensation and goodwill and other
intangibles of approximately $66.1 million to be amortized over periods ranging
from one to three years. Our expectation with respect to these amounts and
periods are preliminary and therefore subject to substantial adjustments. We
also agreed to loan Interface $3.0 million in connection with this transaction.
The acquisition is subject to customary closing conditions, including approval
by the shareholders of Interface. We have announced our intention to divest the
Interface businesses other
8
<PAGE>
TUMBLEWEED COMMUNICATIONS CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(2) BUSINESS COMBINATIONS (CONTINUED)
than L2i. These businesses comprised a substantial majority of the historical
operating results of Interface.
(3) NET LOSS PER SHARE
Net loss per share is calculated in accordance with Statement of Financial
Accounting Standards (SFAS) No. 128, EARNINGS PER SHARE. Under the provisions of
SFAS No. 128, basic net loss per share is computed by dividing the net loss
available to common stockholders for the period by the weighted average number
of common shares outstanding during the period. Diluted net loss per share is
computed by dividing the net loss for the period by the weighted average number
of common and potential common shares outstanding during the period if their
effect is dilutive. Potential common shares comprise outstanding shares of
common stock issued to certain officers but subject to ratable repurchase by
Tumbleweed if such officers do not remain employees through August 1999, and
incremental common and preferred shares issuable upon the exercise of stock
options and warrants and upon the conversion of Series A, Series B, and
Series C preferred stock. The following potential common shares have been
excluded from the determination of diluted net loss per share for all periods
because the effect of such shares would have been anti-dilutive (in thousands):
<TABLE>
<CAPTION>
SIX MONTHS
ENDED JUNE 30,
-------------------
2000 1999
-------- --------
<S> <C> <C>
Shares issuable under stock options......................... 6,569 3,705
Shares of restricted stock subject to repurchase............ -- 30
Shares issuable pursuant to warrants or rights to purchase
common stock.............................................. 540 --
Shares issuable pursuant to warrants or rights to purchase
preferred stock........................................... -- 136
Shares of convertible preferred stock on an "as-if
converted" basis.......................................... -- 12,331
----- ------
7,109 16,202
===== ======
</TABLE>
(4) SEGMENT INFORMATION
Tumbleweed has adopted the provisions of SFAS No. 131, DISCLOSURE ABOUT
SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. SFAS No. 131 establishes
standards for the reporting by public business enterprises of information about
operating segments, products and services, geographic areas, and major
customers. The method for determining what information to report is based on the
way that management organizes the operating segments within Tumbleweed for
making operating decisions and assessing financial performance.
Tumbleweed's chief operating decision-maker is considered to be the Chief
Executive Officer. The CEO reviews financial information presented on a
consolidated basis accompanied by disaggregated information about revenue by
geographic region for purposes of making operating decisions and assessing
financial performance. The consolidated financial information reviewed by the
CEO is identical to the information presented in the accompanying consolidated
statement of operations. Therefore, Tumbleweed operates in a single operating
segment.
9
<PAGE>
TUMBLEWEED COMMUNICATIONS CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(4) SEGMENT INFORMATION (CONTINUED)
Revenue aggregating 3%, 7%, 2% and 9% of total revenue for the three months
ended June 30, 2000 and 1999 and for the six months ended June 30, 2000 and
1999, respectively, was generated from two customers who are also stockholders
of Tumbleweed, and whose ownership percentages as of June 30, 2000 were 6% and
4%, respectively.
Revenue information regarding operations in the different geographic regions
is as follows (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS SIX MONTHS ENDED
ENDED JUNE 30, JUNE 30,
------------------- -------------------
2000 1999 2000 1999
-------- -------- -------- --------
<S> <C> <C> <C> <C>
North America:
United States........................... $ 6,071 $2,648 $10,419 $5,265
Other................................... 79 -- 79 --
Europe:
United Kingdom.......................... 568 132 1,244 840
Norway.................................. 350 -- 350 --
Sweden.................................. 528 -- 568 1
Switzerland............................. 441 178 1,125 178
Belgium................................. 410 430 477 538
Other................................... 317 -- 325 8
Asia:
Japan................................... 1,182 225 1,566 664
Taiwan.................................. -- 24 -- 50
Other................................... 144 -- 547 --
------- ------ ------- ------
Total................................. $10,090 $3,637 $16,700 $7,544
======= ====== ======= ======
</TABLE>
(5) RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. SFAS
No. 133 establishes methods of accounting for derivative financial instruments
and hedging activities related to those instruments as well as other hedging
activities. SFAS No.133, as amended by SFAS No. 137, is effective for all fiscal
quarters of fiscal years beginning after June 15, 2000. To date, Tumbleweed has
not entered into any derivative financial instruments or hedging activities.
In December 1999, the SEC issued Staff Accounting Bulletin ("SAB") No. 101.
The SAB summarized certain of the SEC Staff's views in applying generally
accepted accounting principles to revenue recognition in financial statements.
SAB No. 101, as amended by SAB No. 101B, and any resulting change in accounting
principle that a registrant would have to report, is effective no later than
Tumbleweed's fiscal quarter ending December 31, 2000. Tumbleweed does not expect
the application of SAB No. 101 to have a material effect on its financial
position or results of operations, nor do we expect to report a change in
accounting principle resulting from its application.
In March 2000, FASB issued Financial Interpretation No. 44 ("FIN 44"). FIN
44 clarifies (a) the definition of EMPLOYEE for purposes of applying Accounting
Principles Board ("APB") Opinion 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES,
(b) the criteria for determining whether a plan qualifies as a
10
<PAGE>
TUMBLEWEED COMMUNICATIONS CORP.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
(5) RECENT ACCOUNTING PRONOUNCEMENTS (CONTINUED)
noncompensatory plan, (c) the accounting consequence of various modifications to
the terms of a previously fixed stock option or award, and (d) the accounting
for an exchange of stock compensation awards in a business combination. FIN 44
is effective July 1, 2000, but certain conclusions in this Interpretation cover
specific events that occur after either December 15, 1998, or January 12, 2000.
To the extent that this Interpretation covers events occurring during the period
after December 15, 1998, or January 12, 2000, but before the effective date of
July 1, 2000, the effects of applying this Interpretation are recognized on a
prospective basis from July 1, 2000. Tumbleweed does not expect the application
of FIN 44 to have a material effect on its financial position or results of
operations.
(6) RELATED PARTY TRANSACTIONS
On May 15, 2000, Tumbleweed repurchased from Hikari Tsushin ("Hikari") 5% of
the outstanding stock of Tumbleweed KK (TKK), for a price of Y70,000,000 (which
approximated $700,000 as of May 15, 2000). As a result of the equity
transaction, Tumbleweed owns 55% of the outstanding shares of common stock of
TKK, which represents a controlling interest. Tumbleweed began to account for
its investment in TKK under the consolidation method effective April 1, 2000.
(7) SUBSEQUENT EVENT--OFFERING OF COMMON STOCK
On August 1, 2000, Tumbleweed completed a primary and secondary public
offering of 3,000,000 shares of its common stock at a price of $56.00 per share.
Of the 3,000,000 shares of common stock, 1,500,000 primary shares were sold by
Tumbleweed and 1,500,000 secondary shares were sold by stockholders of
Tumbleweed. Tumbleweed will not receive any of the proceeds from shares sold by
its stockholders. Net proceeds to Tumbleweed from the offering of primary shares
are estimated to be approximately $77.8 million.
11
<PAGE>
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Tumbleweed is a leading provider of advanced messaging solutions for
business communications. Tumbleweed's products and services enable businesses to
extend existing networks and applications, creating secure online channels for
interactive, business-critical communication. Tumbleweed Integrated Messaging
Exchange, or Tumbleweed IME, is a platform and set of applications for creating
secure communications channels between a business and its customers, partners
and suppliers. Tumbleweed Messaging Management System, or Tumbleweed MMS, is a
comprehensive solution that extends internal e-mail systems to the Internet
through centralized management, policy enforcement, filtering and archiving.
Used together, Tumbleweed IME and Tumbleweed MMS automatically apply security
policies and redirect sensitive e-mail for secure, trackable delivery.
On January 31, 2000, we completed the acquisition of Worldtalk
Communications Corporation ("Worldtalk"), a leading provider of Internet
security and policy management solutions that enable organizations to define and
manage electronic mail and web security usage policies to manage the risks and
liabilities associated with Internet communications. The business combination
has been accounted for as a pooling of interests and, accordingly, Tumbleweed's
historical financial statements have been restated to include the accounts and
results of operations of Worldtalk. Except as otherwise indicated, the terms
"Tumbleweed," "we" and "our" refer to Tumbleweed and its subsidiaries, including
Worldtalk, in this discussion.
Tumbleweed's revenue consists of (i) license revenue, (ii) services revenue
and (iii) transaction revenue. License revenue consists of initial license fees
and the sale of distribution rights. License revenue typically is recognized
upon the later of customer acceptance or software shipment. Revenue from the
sale of distribution rights is recognized upon the execution of a distribution
agreement. Services revenue consists of consulting fees and support and
maintenance fees. Consulting fees related to installation are recognized upon
acceptance of the installation while all other consulting fees are recognized
based on percentage of completion. Support and maintenance fees are paid for
ongoing customer support as well as for the right to receive future upgrades of
our products during the term of the maintenance agreement. Revenue from support
and maintenance is recognized ratably over the period the support is provided.
Transaction revenue is based on the volume of transactions by our customers, and
the related revenue is recognized based on payment schedules and transaction
reports from our customers. A number of our contracts include minimum
transaction volume requirements. In these cases, the minimum guaranteed revenue
is recognized when fees are due and payable during those months where
transaction volume does not exceed the designated minimums.
In July 1999, Worldtalk completed the sale of its NetJunction e-mail
connectivity and directory integration product line to Wingra Technologies, LLC.
Under the terms of the agreement, Wingra acquired the assets related to the
NetJunction product line and assumed support and development responsibilities
for NetJunction customers and resellers with current agreements. As a result of
the sale of the NetJunction product line, revenue related to the NetJunction
product line is reported as discontinued product line in our consolidated
statement of operations.
Historically, Tumbleweed's revenue has been concentrated among a few
customers, but the customer base contributing to revenue has been diversifying.
For the six months ended June 30, 2000 and 1999, our top five customers
contributed 19% and 43% of total revenue, respectively. In addition, the
composition of the top 5 customers changes from quarter to quarter.
A substantial portion of Tumbleweed's revenue relates to international
customers or operations. Most of Tumbleweed's contracts are denominated in U.S.
dollars. However, in the future, an increasing number of contracts may be
denominated in foreign currencies. Tumbleweed currently does not have
12
<PAGE>
hedging or similar arrangements to protect us against foreign currency
fluctuations. Therefore, we increasingly may be subject to currency
fluctuations, which could harm our operating results in future periods. On
May 15, 2000, we repurchased from Hikari 5% of the outstanding stock of
Tumbleweed KK ("TKK"), for a price of approximately $700,000. As a result of the
equity transaction, Tumbleweed owns 55% of the outstanding shares of common
stock of TKK, which represents a controlling interest. Tumbleweed began to
account for its investment in TKK under the consolidation method effective
April 1, 2000.
Tumbleweed's future net income and cash flow may be adversely affected by
limitations on its ability to apply net operating losses for federal income tax
reporting purposes against taxable income in future periods, including
limitations due to ownership changes, as defined in Section 382 of the Internal
Revenue Code, arising from issuances of its stock.
On June 28, 2000, Tumbleweed entered into a merger agreement providing for
the acquisition of Interface Systems, Inc. Pursuant to the merger agreement,
each outstanding share of Interface common stock will be converted into the
right to receive 0.264 shares of Tumbleweed's common stock upon the closing of
the merger, and Tumbleweed will assume all outstanding options and warrants of
Interface. As of June 28, 2000, there were 4,719,675 outstanding shares of
Interface common stock as well as options and warrants to purchase an additional
886,018 shares of Interface common stock. The transaction, if completed, will be
treated as a purchase for accounting purposes. Accordingly, Tumbleweed expects
to expense up to $2.0 million of acquired in-process research and development,
and to record unearned compensation and goodwill and other intangibles of
approximately $66.1 million to be amortized over periods ranging from one to
three years. Our expectation with respect to these amounts and periods are
preliminary and therefore subject to substantial adjustments. We also agreed to
loan Interface $3.0 million in connection with this transaction. The acquisition
is subject to customary closing conditions, including approval by the
shareholders of Interface. The transaction will result in significant one-time
charges, whether completed or not, and, if completed, will substantially
increase our operating expenses in future periods. We have announced our
intention to divest the Interface businesses other than L2i. These businesses
comprised a substantial majority of the historical operating results of
Interface.
On August 1, 2000, Tumbleweed completed a primary and secondary public
offering of 3,000,000 shares of its common stock at a price of $56.00 per share.
Of the 3,000,000 shares of common stock, 1,500,000 primary shares were sold by
Tumbleweed and 1,500,000 secondary shares were sold by stockholders of
Tumbleweed. Tumbleweed will not receive any of the proceeds from shares sold by
its stockholders. Net proceeds to Tumbleweed from the offering of primary
shares, estimated by Tumbleweed to be approximately $77.8 million, will be used
for working capital and other general corporate purposes. In addition,
Tumbleweed may use a portion of the net proceeds to acquire complementary
products, technologies or businesses.
RESULTS OF OPERATIONS
THREE AND SIX MONTH PERIODS ENDED JUNE 30, 2000 AND 1999
REVENUE. Revenue is comprised of license revenue, services revenue and
transaction fees revenue. Total revenue from continuing product lines for the
three months ended June 30, 2000 increased 228% to $10.1 million from
$3.1 million (excluding revenue of $561,000 from discontinued product lines) for
the same three months in 1999. Total revenue from continuing product lines for
the six months ended June 30, 2000 increased 163% to $16.7 million from
$6.3 million (excluding $1.2 million from discontinued product lines) for the
same six months in 1999. Total revenue from continuing product lines increased
in both periods due to increases in license revenue and services revenue and
transaction fees revenue.
13
<PAGE>
License revenue for the three months ended June 30, 2000 increased 186% to
$6.8 million from $2.4 million for the same three months in 1999. License
revenue for the six months ended June 30, 2000 increased 120% to $11.2 million
from $5.1 million for the same six months in 1999. License revenue increased due
to bringing new customers into production and to additional license fees paid by
existing customers. The number of customers contributing to license revenue grew
from 196 as of June 30, 1999 to 273 as of June 30, 2000.
Services revenue for the three months ended June 30, 2000 increased 256% to
$1.7 million from $491,000 for the same three months in 1999. Services revenue
for the six months ended June 30, 2000 increased 210% to $3.3 million from
$1.1 million for the same six months in 1999. The increase in services revenue
was due to an increase in contract development work by our professional services
organization, and, to a lesser extent, increases in maintenance fees.
Transaction fees revenue for the three months ended June 30, 2000 increased
648% to $1.5 million from $203,000 for the same three months in 1999.
Transaction fees revenue for the six months ended June 30, 2000 increased 991%
to $2.2 million from $206,000 for the same six months in 1999. The increase in
transaction fees revenue resulted from minimum transaction fee payments made by
new customers who launched IME-based services and, to a lesser extent,
transaction fee payments from existing customers.
Total revenue from the Tumbleweed IME product line for the three months
ended June 30, 2000 increased 503% to $6.1 million from $1.0 million for the
same three months in 1999. Total revenue from the Tumbleweed IME product line
for the six months ended June 30, 2000 increased 492% to $10.1 million from $1.7
million for the same six months in 1999. These increases were due to increases
in license, services and transaction fees revenue. License revenue from the IME
product line for the three months ended June 30, 2000 increased 504% to $3.4
million from $570,000 for the same three months in 1999. License revenue from
the IME product line for the six months ended June 30, 2000 increased 430% to
$5.8 million from $1.1 million for the same six months in 1999. The increases in
license revenue were due to bringing new customers into production and to
additional license fees paid by existing customers. Services revenue from the
IME product line for the three months ended June 30, 2000 increased 408% to $1.2
million from $236,000 for the same three months in 1999. Services revenue from
the IME product line for the six months ended June 30, 2000 increased 419% to
$2.1 million from $409,000 for the same six months in 1999. The increases in
services revenue were due to an increase in contract development work by our
professional services organization, and, to a lesser extent, increases in
maintenance fees. Transaction fees revenue from the IME product line for the
three months ended June 30, 2000 increased 613% to $1.4 million from $203,000
for the same three months in 1999. Transaction fees revenue from the IME product
line for the six months ended June 30, 2000 increased 963% to $2.2 million from
$205,000 for the same six months in 1999. The increases in transaction fees
revenue resulted from minimum transaction fee payments made by new customers who
launched IME based services.
Total revenue from the Tumbleweed MMS product line for the three months
ended June 30, 2000 increased 93% to $4.0 million from $2.1 million for the same
three months in 1999 (excluding revenue of $561,000 from discontinued products).
Total revenue from the Tumbleweed MMS product line for the six months ended
June 30, 2000 increased 43% to $6.6 million from $4.6 million for the same six
months in 1999 (excluding revenue of $1.2 million from discontinued products).
These increases were due to increases in license, services and transaction fees
revenue. License revenue from the MMS product line for the three months ended
June 30, 2000 increased 75% to $3.2 million from $1.8 million for the same three
months in 1999. License revenue from the MMS product line for the six months
ended June 30, 2000 increased 31% to $5.2 million from $4.0 million for the same
six months in 1999. The increases in license revenue were due to bringing new
customers into production. Services revenue from the MMS product line for the
three months ended June 30, 2000 increased 196% to $740,000 from $250,000 for
the same three months in 1999. Services revenue from the MMS product line for
the
14
<PAGE>
six months ended June 30, 2000 increased 109% to $1.3 million from $642,000 for
the same six months in 1999. The increases in services revenue were due to an
increase in contract development work by our professional services organization,
and to a lesser extent, increases in maintenance fees and training. Transaction
fees for the three and six months ended June 30, 2000 were $70,000 compared to
$0 in the three and six months ended June 30, 1999.
COST OF REVENUE. Cost of revenue is comprised of license cost, services
cost and transaction fees cost. License cost is primarily comprised of royalties
paid to third parties for software licensed by Tumbleweed for inclusion in our
products. Services cost is comprised primarily of personnel and overhead costs
related to customer support and contract development projects. Transaction fees
cost is primarily comprised of royalties paid to third parties for software
licensed by us for inclusion in our products and hardware and band-width costs
associated with hosting IME servers for some customers. Total cost of revenue
for the three months ended June 30, 2000 increased 184% to $3.2 million from
$1.1 million for the same three months in 1999. Total cost of revenue for the
six months ended June 30, 2000 increased 168% to $5.4 million from $2.0 million
for the same six months in 1999. The increase in total cost of revenue
corresponds to increased revenues.
License cost for the three months ended June 30, 2000 increased 132% to
$290,000 from $125,000 for the same three months in 1999. License cost for the
six months ended June 30, 2000 increased 130% to $557,000 from $242,000 for the
same six months in 1999. License costs increased due to increased sales of
products containing software licensed from third parties.
Services cost for the three months ended June 30, 2000 increased 193% to
$2.9 million from $1.0 million for the same three months in 1999. Services cost
for the six months ended June 30, 2000 increased 173% to $4.8 million from
$1.8 million for the same six months in 1999. The increase was primarily due to
increased personnel costs supporting an increase in new contract development
projects and increases in facilities-related expenses.
Transaction fees cost for the three months ended June 30, 2000 increased 33%
to $20,000 from $15,000 for the same three months in 1999. Transaction fees cost
for the six months ended June 30, 2000 increased 200% to $60,000 from $20,000
for the same six months in 1999. The increases in transaction fees cost resulted
from royalties due on transaction fees revenue and, to a lesser extent,
depreciation expense and connectivity costs incurred in generating transaction
revenue.
RESEARCH AND DEVELOPMENT EXPENSES. Research and development expenses are
comprised of engineering and related costs associated with the development of
Tumbleweed IME applications, quality assurance and testing. Research and
development expenses for the three months ended June 30, 2000 increased 53% to
$3.2 million from $2.1 million for the same three months in 1999. Research and
development expenses for the six months ended June 30, 2000 increased 55% to
$6.0 million from $3.9 million for the same six months in 1999. The increases
were primarily due to an increase in personnel needed to support ongoing
development of Tumbleweed's products and new applications for our target
markets, increases in average salaries for development personnel in order to
provide a competitive salary in today's marketplace and increased facilities
related expenses. We expect that research and development expenses will increase
in absolute dollars in future periods due to increased personnel required to
support new projects that will allow us to expand the functionality of the core
IME and MMS platforms, increase the number of vertical applications built for
the our target markets and integrate with a wider array of third party software
packages.
SALES AND MARKETING EXPENSES. Sales and marketing expenses are comprised of
salaries, commissions, travel expenses and costs associated with trade shows,
advertising and other marketing efforts. Sales and marketing expenses for the
three months ended June 30, 2000 increased 133% to $9.7 million from
$4.2 million for the same three months in 1999. Sales and marketing expenses for
the six months ended June 30, 2000 increased 131% to $16.9 million from
$7.3 million for the same six
15
<PAGE>
months in 1999. The increase in sales and marketing expenses was primarily due
to increased sales staffing, increased offices in Europe and incentive
compensation costs. We expect that sales and marketing expenses will increase in
absolute dollars in future periods as we expand into new target markets and
geographic areas. We plan to significantly increase the number of our sales and
marketing personnel worldwide throughout 2000.
During the three month period ended June 30, 2000, Tumbleweed granted
fully-vested stock options in lieu of cash payments to certain sales personnel
for sales commissions earned during the period. Options were granted at an
exercise price which was less than the fair market value of Tumbleweed's stock
on the date of grant. Accordingly, Tumbleweed recorded expense of approximately
$560,000 for the three months ended June 30, 2000 in connection with these
grants, which is included in stock compensation expense.
GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
consist primarily of personnel and support costs for our finance, legal and
human resources departments as well as professional fees. General and
administrative expenses for the three months ended June 30, 2000 increased 120%
to $2.3 million from $1.1 million for the same three months in 1999. General and
administrative expenses for the six months ended June 30, 2000 increased 112% to
$4.0 million from $1.9 million for the same six months in 1999. The increase in
general and administrative expenses was due to an increase in legal fees
corresponding to the patent infringement lawsuit we brought against The docSpace
Company, Inc., which is still pending, as well as increased staffing expenses
and professional fees. We expect that general and administrative expenses will
increase in absolute dollars in future periods as we continue to grow our
infrastructure.
DEFERRED COMPENSATION EXPENSE. Deferred compensation expense is recorded in
connection with the grant of certain stock options to non-employees and
employees at exercise prices less than the deemed fair value on the grant date.
During the three months ended June 30, 2000, we recorded aggregate deferred
stock compensation expense of $954,000 compared to $4.5 million for the same
three months in 1999. During the six months ended June 30, 2000, we recorded
aggregate deferred stock compensation expense of $2.3 million compared to
$6.9 million for the same six months in 1999. The deferred stock compensation
expense is being amortized on an accelerated basis over the vesting period of
the options, which is generally four years. Of the total deferred stock
compensation expense, $892,000 and $969,000 was amortized in the three months
ended June 30, 2000 and 1999, respectively. Of the total deferred stock
compensation expense, $2.0 million and $1.3 million was amortized in the six
months ended June 30, 2000 and 1999, respectively.
MERGER RELATED AND RESTRUCTURING EXPENSES. Merger related and restructuring
expenses, which were recorded in connection with the acquisition of Worldtalk,
are primarily comprised of investment banker's fees, legal fees, severance
payments and accounting and printer fees. Merger related and restructuring
expenses for the six months ended June 30, 2000 were $10.8 million.
OTHER INCOME, NET. Other income, net, is primarily comprised of interest
income earned on investment securities. Other income, net, for the three months
ended June 30, 2000 increased 132% to $365,000 from $157,000 for the same three
months in 1999. Other income, net, for the six months ended June 30, 2000
increased 246% to $1.0 million from $295,000 for the same six months in 1999.
The increases in other income, net, are due to increased cash balances invested
in money market accounts and commercial paper. The increase in cash balances
available for investment resulted from proceeds from the issuance of equity
securities, including common stock issued in our initial public offering
completed in August 1999.
16
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have financed our operations primarily through the
issuance of equity securities. On June 30, 2000, we had $32.7 million in cash
and cash equivalents. This amount excludes the approximately $77.8 million in
net proceeds from our public offering completed on August 1, 2000.
Net cash used in operating activities for the six months ended June 30, 2000
was $27.4 million. Cash used in operating activities was primarily the result of
net operating losses, offset by certain non-cash charges and increases in
accounts payable and other liabilities, and an increase in accounts receivable.
Net cash used in investing activities for the six months ended June 30, 2000
was $2.6 million. Net cash used in investing activities was primarily the result
of capital expenditures related to increased facilities expansion, partially
offset by the net cash acquired from the TKK stock repurchase.
Net cash provided by financing activities for the six months ended June 30,
2000 was $2.5 million. Cash provided by financing activities was primarily
attributable to net proceeds from the issuance of common stock upon exercise of
stock options, partially offset by the repayments of credit facilities and
capital lease obligations.
As of June 30, 2000, our principal commitments consisted of obligations
outstanding under equipment and operating leases. Our equipment leases require
payment of rental fees to third party leasing providers at interest rates of
approximately 8.45%. In most cases, we have no obligations to purchase the
equipment at the end of the lease term. We anticipate a substantial increase in
capital expenditures consistent with potential growth in operations,
infrastructure and personnel.
In July 1998, we entered into an agreement with a bank, which included a
$1.5 million revolving credit facility, with availability based on outstanding
accounts receivable, and a $1.75 million equipment loan facility. Borrowings
under the credit facility and equipment facility carry interest at the prime
rate plus 0.5% and 0.75%, respectively, with interest payable monthly.
Borrowings under the equipment facility are due in 36 equal monthly installments
and are secured by certain assets of Tumbleweed. As of June 30, 2000, total
borrowings under the equipment loan facility were $1.2 million in the aggregate
and $300,000 remained available under the facility. There were no borrowings
under the credit facility as of June 30, 2000.
On December 30, 1998, Tumbleweed entered into a loan and security agreement
comprised of a $1.5 million line of credit, which expired on December 29, 1999
and a $250,000 term facility, which expires on December 29, 2000, bearing
interest at the prime rate (9.5% and 7.75% as of December 1999 and 1998) plus
0.25% and prime rate plus 0.50%, respectively. The agreement is collateralized
by the assets of Tumbleweed, contains certain financial covenants and restricts
Tumbleweed's ability to incur other indebtedness and pay dividends. As of
June 30, 2000, borrowings under the term facility were $73,000.
In September 1999, we entered into a $525,000 financing arrangement with
another company to finance our directors' and officers' liability insurance
premium. Borrowings under the loan agreement are payable in nine equal monthly
installments of $60,000. As of June 30, 2000, there were no borrowings
outstanding under this financing arrangement.
In connection with the proposed Interface transaction, we agreed to purchase
an aggregate of $3.0 million of convertible subordinated promissory notes of
Interface, pursuant to a convertible subordinated note purchase agreement dated
June 28, 2000. At our option, or upon the occurrence of certain other events,
the notes are convertible into Interface common stock at an initial conversion
price of $9.50 per share, subject to adjustment.
Our capital requirements depend on numerous factors, including revenue
generated from operations and market acceptance of our products and services,
the resources devoted to the
17
<PAGE>
development of our products and services and the resources devoted to sales and
marketing. We have experienced a substantial increase in capital expenditures
and operating expenses since inception consistent with relocation and the growth
in operations and staffing. We anticipate that these increases will continue for
the foreseeable future. Additionally, we expect to make additional investments
in technologies, and plan to expand our sales and marketing programs. We believe
that our existing capital resources, including the proceeds from our recent
secondary public offering, will enable us to maintain our current and planned
operations for at least the next 12 months. However, we may need to raise funds
prior to that time.
We intend to continue to consider future financing alternatives, which may
include the incurrence of indebtedness, additional public or private equity
offerings or an equity investment by a strategic partner. However, other than
the revolving credit and equipment loan facilities and the insurance premium
financing arrangement, we have no present commitments or arrangements assuring
us of any future equity or debt financing, and additional equity or debt
financing may not be available to us on favorable terms, if at all. We are not
aware of seasonal aspects of our business that will affect our business on a
short or long-term basis.
YEAR 2000 COMPLIANCE
We are currently not aware of any Year 2000 problems in any of our critical
systems and products. However, the success to date of our Year 2000 efforts
cannot guarantee that a Year 2000 problem affecting third parties upon which we
rely will not become apparent in the future that could harm our business.
RISKS AND UNCERTAINTIES THAT YOU SHOULD CONSIDER BEFORE INVESTING IN TUMBLEWEED.
BECAUSE TUMBLEWEED IS IN AN EARLY STAGE OF DEVELOPMENT AND TUMBLEWEED HAS A
HISTORY OF LOSSES, IT IS DIFFICULT TO EVALUATE TUMBLEWEED'S BUSINESS AND
TUMBLEWEED MAY FACE EXPENSES, DELAYS AND DIFFICULTIES.
Tumbleweed has only a limited operating history upon which an evaluation can
be based. Accordingly, Tumbleweed's prospects must be considered in light of the
risks, expenses, delays and difficulties frequently encountered by companies in
a similarly early stage of development, particularly companies engaged in new
and rapidly evolving markets like secure online communication services.
Tumbleweed incurred net losses of $28.2 million in the six months ended
June 30, 2000 and $24.2 million in the year ended December 31, 1999. As of
June 30, 2000, Tumbleweed had incurred cumulative net losses of $93.4 million.
TUMBLEWEED ANTICIPATES CONTINUED LOSSES.
Tumbleweed's success will depend in large part upon its ability to generate
sufficient revenue to achieve profitability and to effectively maintain existing
relationships and develop new relationships with customers and strategic
partners. If Tumbleweed does not succeed, its revenue may not increase, and it
may not achieve or maintain profitability on a timely basis or at all. In
particular, Tumbleweed intends to expend significant financial and management
resources on product development, sales and marketing, strategic relationships,
technology and operating infrastructure. As a result, Tumbleweed expects to
incur additional losses and continued negative cash flow from operations for the
foreseeable future.
18
<PAGE>
TUMBLEWEED'S QUARTERLY FINANCIAL RESULTS ARE SUBJECT TO SIGNIFICANT
FLUCTUATIONS.
As a result of Tumbleweed's limited operating history and the emerging
nature of the markets in which it competes, Tumbleweed is unable to accurately
forecast its revenue or expenses. Tumbleweed's success is dependent upon its
ability to enter into and maintain strategic relationships with customers and to
develop and maintain volume usage of its products by its customers and their
end-users. Tumbleweed's revenue has fluctuated and its quarterly operating
results will continue to fluctuate based on the timing of the execution of new
customer licenses in a given quarter. Tumbleweed's license revenue is comprised
entirely of initial license and distribution fees. As a result, Tumbleweed will
be required to regularly and increasingly sign additional customers with
substantial initial license fees on a timely basis to realize comparable or
increased license revenue.
Tumbleweed's services revenue historically has been comprised almost
entirely of implementation, customization and consulting fees and support and
maintenance fees, as actual transaction-based revenue to date has been minimal.
As a result, Tumbleweed will be required to increase its services revenue in the
short term through custom development work and contractual transaction minimums
and in the longer term through the increased transaction volume with the use of
its services. Unless and until Tumbleweed has developed a significant and
recurring transaction-based revenue stream from communications that are sent
with its services, its revenue will continue to fluctuate significantly.
Accordingly, Tumbleweed may be unable to achieve and recognize quarterly or
annual revenue consistent with its historical operating results or expectations.
In addition, Tumbleweed has experienced, and expects to continue to
experience, fluctuations in revenue and operating results from quarter to
quarter for other reasons, including, but not limited to:
- the amount and timing of operating costs and capital expenditures relating
to its business, operations and infrastructure, including its
international operations;
- its ability to accurately estimate and control costs;
- the announcement or introduction of new or enhanced products and services
in the secure online communications or document delivery markets; and
- acquisitions that it completes or proposes, including Worldtalk and
Interface Systems, Inc. ("Interface")
As a result of these factors, Tumbleweed believes that quarter-to-quarter
comparisons of its revenue and operating results are not necessarily meaningful,
and that these comparisons may not be accurate indicators of future performance.
Because Tumbleweed's staffing and operating expenses are based on anticipated
revenue levels, and because a high percentage of its costs are fixed, small
variations in the timing of the recognition of specific revenue could cause
significant variations in operating results from quarter to quarter. If
Tumbleweed is unable to adjust spending in a timely manner to compensate for any
unexpected revenue shortfall, any significant revenue shortfall would likely
have an immediate negative effect on its operating results. Moreover,
Tumbleweed's operating results in one or more future quarters may fail to meet
the expectations of securities analysts or investors. If this occurs, Tumbleweed
would expect to experience an immediate and significant decline in the trading
price of its stock.
A LIMITED NUMBER OF CUSTOMERS ACCOUNT FOR A HIGH PERCENTAGE OF TUMBLEWEED'S
REVENUE AND THE FAILURE TO MAINTAIN OR EXPAND THESE RELATIONSHIPS COULD
HARM ITS BUSINESS.
The loss of one or more of Tumbleweed's major customers, the failure to
attract new customers on a timely basis, or a reduction in usage and revenue
associated with the existing or proposed customers would harm its business and
prospects. Five customers comprised approximately 19% of Tumbleweed's revenue in
the first six months of fiscal 2000, and 24% of its revenue in fiscal 1999.
Tumbleweed
19
<PAGE>
expects that a small number of customers will continue to account for a
substantial portion of its revenue for the foreseeable future.
TUMBLEWEED'S SERVICE PROVIDER CUSTOMERS MAY COMPETE WITH IT OR FAIL TO
PROMOTE ITS PRODUCT.
To date, Tumbleweed has generated a significant amount of Tumbleweed IME
revenue from contracts with a limited number of service provider customers,
which use or intend to use its products for the communication of third-party
documents and data. If these customers do not effectively promote the use of
Tumbleweed IME to their end-users, the adoption of Tumbleweed's services and the
recognition of associated revenue could be limited. Because Tumbleweed's
contracts with its service provider customers are non-exclusive, these customers
could elect to offer competing secure online communication services to their
customers through its existing or future competitors. The service provider
customers also may compete with Tumbleweed's secure online communication
services through their traditional physical delivery channels.
IF TUMBLEWEED DOES NOT SECURE KEY RELATIONSHIPS WITH ENTERPRISE CUSTOMERS,
ITS ACCESS TO BROADER MARKETS WILL BE LIMITED.
Tumbleweed's enterprise customers, which use or intend to use its products
to intelligently manage the incoming and outgoing online communications of their
enterprises, are a significant source of its revenue. A key aspect of
Tumbleweed's strategy is to access target markets prior to adoption of
alternative online distribution solutions by the larger participants in these
markets. The failure to secure key relationships with new enterprise customers
in targeted markets could limit or effectively preclude Tumbleweed's entry into
these target markets, which would harm its business and prospects.
CUSTOMERS IN A PRELIMINARY PHASE OF IMPLEMENTING TUMBLEWEED'S PRODUCTS MAY
NOT PROCEED ON A TIMELY BASIS OR AT ALL.
Some of Tumbleweed's customers are currently in a pre-production or
pre-launch stage of implementing its products and may encounter delays or other
problems in introducing them. A customer's decision not to do so or a delay in
implementation could result in a delay or loss in related revenue or otherwise
harm Tumbleweed's businesses and prospects. Tumbleweed cannot predict when any
customer that is currently in a pilot or preliminary phase will implement
broader use of its services.
THE MARKETS FOR ENHANCED ONLINE COMMUNICATION SERVICES GENERALLY, AND FOR
TUMBLEWEED'S PRODUCTS SPECIFICALLY, ARE NEW AND MAY NOT DEVELOP.
The market for Tumbleweed's products and services is new and evolving
rapidly. If the market for Tumbleweed's products and services fails to develop
and grow, or if its products and services do not gain broad market acceptance,
its business and prospects will be harmed. In particular, Tumbleweed's success
will depend upon the adoption and use by current and potential customers and
their end-users of secure online communication services. Tumbleweed's success
will also depend upon acceptance of its technology as the standard for providing
these services. The adoption and use of Tumbleweed's products and services will
involve changes in the manner in which businesses have traditionally exchanged
information. In addition, sales and marketing of Tumbleweed's products and
services is to a large extent under the control of its customers. In some cases,
Tumbleweed's customers have little experience with products, services and
technology like those offered by us. Tumbleweed's ability to influence usage of
its products and services by customers and end-users is limited. For example,
the usage of Tumbleweed IME by the end-users of Tumbleweed's service provider
customers has been limited to date. Tumbleweed has spent, and intends to
continue to spend, considerable resources educating potential customers and
their end-users about the value of its products and services. It is difficult to
assess, or to predict with any assurance, the present and future size of the
potential market for Tumbleweed's products and services, or its growth rate, if
any. Moreover, Tumbleweed cannot
20
<PAGE>
predict whether its products and services will achieve any market acceptance.
Tumbleweed's ability to achieve its goals also depends upon rapid market
acceptance of future enhancements of its products. Any enhancement that is not
favorably received by customers and end-users may not be profitable and,
furthermore, could damage Tumbleweed's reputation or brand name.
THE MARKETS TUMBLEWEED ADDRESSES ARE HIGHLY COMPETITIVE AND RAPIDLY
CHANGING, AND IT MAY NOT BE ABLE TO COMPETE SUCCESSFULLY.
Tumbleweed may not be able to compete successfully against current and
future competitors, and the competitive pressures it faces could harm its
business and prospects. Tumbleweed IME is an alternative to traditional mail and
courier delivery services, such as those offered by Federal Express Corporation,
UPS or the U.S. Postal Service, and to general purpose e-mail applications and
services. As such, Tumbleweed competes with these options. Tumbleweed's direct
competition comes from other secure online communication service providers of
various sizes, some of which have products that are intended to compete directly
with our products. Examples of secure online communication service providers
include Automatic Data Processing, Inc., Critical Path, Inc., VeriCert.com,
e-Parcel, LLC, PostX Corporation and ZixIt Corporation. In addition, companies
with which Tumbleweed does not presently directly compete may become competitors
in the future, either through the expansion of their products and services or
through their product development in the area of secure online communication
services. These companies could include America Online, Inc./Netscape
Communications Corporation, International Business Machines Corporation/Lotus
Development Corporation, Microsoft Corporation and VeriSign, Inc.
TUMBLEWEED FACES TECHNICAL, OPERATIONAL AND STRATEGIC CHALLENGES THAT MAY
PREVENT IT FROM SUCCESSFULLY INTEGRATING WORLDTALK, OR ANY OTHER COMPANY IT
MAY ACQUIRE.
The integration of the Worldtalk Communications Corporation business,
including its technology, operations and personnel, has been and will be a
complex, time consuming and expensive process that may disrupt Tumbleweed's
business if not completed in a timely and efficient manner. Additionally, the
integration of any other company or business Tumbleweed may acquire in the
future, including Interface, will be a complex, time consuming and expensive
process that may disrupt its business if not completed in a timely and efficient
manner. Whenever an acquisition is completed, Tumbleweed must operate as a
combined organization utilizing common information and communication systems,
operating procedures, financial controls and human resources practices. In
particular, Tumbleweed is currently evaluating and upgrading its management
information systems and establishing uniformity among its systems and those
formerly operated by Worldtalk. Tumbleweed will be required to do the same for
any subsequently acquired company, including Interface. Tumbleweed may encounter
substantial difficulties, costs and delays involved in integrating the
operations of the Worldtalk, Interface, or any other company, including:
- potential incompatibility of business cultures;
- perceived adverse changes in business focus;
- potential conflicts in customer, advertising or strategic relationships;
- potential failure to complete anticipated sales; and
- the loss of key employees and diversion of the attention of management
from other ongoing business concerns.
As a result, Tumbleweed may not be successful in integrating Worldtalk,
Interface or any other business or technologies it acquires and may not achieve
anticipated revenue and cost benefits. Tumbleweed also cannot guarantee that
these acquisitions will result in sufficient revenues or earnings to justify its
investment in, or expenses related to, this acquisition. Nor can Tumbleweed
guarantee that
21
<PAGE>
any anticipated synergies will develop. If Tumbleweed fails to execute its
acquisition strategy successfully for any reason, its business will suffer
significantly.
TUMBLEWEED'S PRODUCT INTEGRATION EFFORTS MAY BE HINDERED BY A VARIETY OF
TECHNICAL FACTORS.
Tumbleweed faces certain risks associated with the ongoing integration of
the Worldtalk technology and proposed integration of Interface technology. For
example, because Worldtalk has historically based its products on an NT platform
and Tumbleweed has created a platform-independent architecture for the
Tumbleweed IME products, the integration of products from Worldtalk may result
in unanticipated architectural incompatibilities that would require additional
time and engineering resources to resolve. The loss of key engineering personnel
from Worldtalk, Interface or any other entities Tumbleweed may acquire may
increase the time and resources needed to resolve these and other technical
integration issues. Tumbleweed's offices and Interface's offices are in
different locations, which may create coordination issues and could increase
employee turnover. In addition, the installation of integrated or complementary
software products at customer sites may result in difficulties associated with
customer-specific installation processes.
TUMBLEWEED HAS EXPERIENCED RAPID GROWTH WHICH HAS PLACED A STRAIN ON ITS
RESOURCES AND TUMBLEWEED'S FAILURE TO MANAGE GROWTH COULD CAUSE ITS
BUSINESS TO SUFFER.
Tumbleweed has expanded its operations rapidly and intends to continue this
expansion. The number of Tumbleweed's employees increased from 75 as of
June 30, 1999 to 288 as of June 30, 2000. This expansion has placed, and is
expected to continue to place, a significant strain on managerial and
operational resources. To manage any further growth, Tumbleweed will need to
improve or replace its existing operational, customer service and financial
systems, procedures and controls. Any failure to properly manage these systems
and procedural transitions could impair Tumbleweed's ability to attract and
service customers, and could cause Tumbleweed to incur higher operating costs
and delays in the execution of Tumbleweed's business plan. Tumbleweed will also
need to continue the expansion of Tumbleweed's operations and employee base.
Tumbleweed's management may not be able to hire, train, retain, motivate and
manage required personnel. In addition, Tumbleweed's management may not be able
to successfully identify, manage and exploit existing and potential market
opportunities. If Tumbleweed cannot manage growth effectively, Tumbleweed's
business and operating results could suffer.
TUMBLEWEED HAS A LENGTHY SALES AND IMPLEMENTATION CYCLE WHICH COULD HARM
TUMBLEWEED'S BUSINESS.
If Tumbleweed is unable to license its services to new customers on a timely
basis or if its existing and proposed customers and their end-users suffer
delays in the implementation and adoption of Tumbleweed's services, Tumbleweed's
revenue may be limited and business and prospects may be harmed. Tumbleweed's
customers must evaluate its technology and integrate its products and services
into the products and services they provide. In addition, Tumbleweed's customers
may need to adopt a comprehensive sales, marketing and training program in order
to effectively implement Tumbleweed IME. Finally, Tumbleweed must coordinate
with its customers using its product for third-party communications in order to
assist end-users in the adoption of its products in order to generate usage
fees. For these and other reasons, the cycle associated with establishing
licenses in order to generate initial license fees and implementation of
Tumbleweed products in order to generate material transaction-based services
revenue can be lengthy. This cycle is also subject to a number of significant
delays over which Tumbleweed has little or no control.
22
<PAGE>
A FAILURE TO PROTECT TUMBLEWEED'S INTELLECTUAL PROPERTY MAY SIGNIFICANTLY
HARM ITS BUSINESS.
Tumbleweed currently relies on a combination of patents, trade secrets,
copyrights, trademarks and licenses, together with non-disclosure and
confidentiality agreements to establish and protect its proprietary rights in
its products. Tumbleweed holds certain patent rights with respect to some of its
products and currently has a lawsuit pending against The docSpace Company, Inc.
alleging infringement of one of its patents by docSpace. Tumbleweed has filed,
and expects in the future to file, additional patent applications. Tumbleweed's
existing patents or trademarks, as well as any future patents or trademarks
obtained by it, may be challenged, invalidated or circumvented, or its
competitors may independently develop or patent technologies that are
substantially equivalent or superior to its technology. Further patent or
trademark protection may not be obtained, in the United States or elsewhere, for
Tumbleweed's existing or new products, applications or services. In addition,
further protection, if obtained, may not be effective. In some countries,
meaningful patent or trademark protection is not available.
To date, Tumbleweed has not received any claims of infringement upon the
proprietary rights of third parties. However, third parties could assert
infringement claims against it in the future, and the cost of responding to such
assertions, regardless of their validity, could be significant. In addition,
such claims may be found to be valid and could result in awards against
Tumbleweed, which could harm its business.
Tumbleweed also relies, to some extent, on unpatented trade secrets and
other unpatented proprietary information. Tumbleweed's policy is to have
employees sign confidentiality agreements, to have selected parties sign
non-competition agreements and to have third parties sign non-disclosure
agreements. Although Tumbleweed takes precautionary measures to maintain its
unpatented proprietary information, others may acquire equivalent information or
otherwise gain access to or disclose its proprietary information and it may be
unable to meaningfully protect its rights to its proprietary information.
TUMBLEWEED'S EXPANSION INTO INTERNATIONAL MARKETS MAY BE DIFFICULT OR
UNPROFITABLE.
Tumbleweed has recently begun to invest significant financial and managerial
resources to expand its sales and marketing operations in international markets
and has opened sales offices in Germany, the United Kingdom, Japan, France,
Australia, The Netherlands and Sweden. In the first six months of fiscal 2000
and in fiscal 1999, Tumbleweed derived 37% and 41%, respectively, of its revenue
from international operations. However, to date, it has limited experience in
international operations and may not be able to compete effectively in
international markets. A key component of its long-term strategy is to further
expand into international markets, and Tumbleweed must continue to devote
substantial resources to its international operations in order to succeed in
these markets. In this regard, Tumbleweed may encounter difficulties such as:
- unexpected changes in regulatory requirements and trade barriers
applicable to the Internet or its business;
- challenges in staffing and managing foreign operations, including
employment laws and practices as it expands into continental Europe;
- seasonal reductions in business activity and economic downturns, in
particular, in Europe and Asia;
- longer payment cycles and problems in collecting accounts receivable;
- problems associated with the conversion of various European currencies
into a single currency, the Euro;
- legal challenges or regulatory requirements related to the export or
import of encryption technologies;
23
<PAGE>
- differing technology standards; and
- reduced protection for intellectual property rights in certain countries
in which it operates or plans to operate.
In addition, Tumbleweed's expansion into international markets will
increasingly subject it to fluctuations in currency exchange rates. In the
future, an increasing number of our contracts may be denominated in currencies
other than U.S. dollars. Tumbleweed does not presently engage in hedging or
similar transactions to protect it from currency fluctuations. Any of the
foregoing difficulties of conducting business internationally could harm
Tumbleweed's international operations and, consequently, its business and
prospects.
IF TUMBLEWEED DOES NOT PROVIDE ADEQUATE SUPPORT SERVICES TO ITS CUSTOMERS TO
IMPLEMENT ITS PRODUCTS, IT MAY LOSE CUSTOMERS OR REALIZE LOWER TRANSACTION
VOLUME.
Tumbleweed's professional services organization assists its customers in
implementing its products through software installation, integration with
existing customer systems, contract engineering, consulting and training. If the
professional services organization does not adequately assess customer
requirements or address technical problems, customers may seek to discontinue
their relationships with Tumbleweed due to dissatisfaction with the product or
its customer support. Furthermore, these customers may realize lower transaction
volume than they could have otherwise achieved because they did not fully
capitalize on the product in ways that could have been addressed by Tumbleweed's
professional services organization. Tumbleweed's products must be integrated
with existing hardware and complex software products of its customers or other
third parties, and its customers may not have significant experience with the
implementation of products similar to its own. In addition, the provision of
contract engineering and integration services is an increasingly important
aspect of Tumbleweed's strategy to strengthen customer loyalty to its product
and company. Therefore, Tumbleweed's business and future prospects significantly
depend on the strength of its professional services organization.
PRODUCT PERFORMANCE PROBLEMS, SYSTEM FAILURES AND INTERNET PROBLEMS COULD
SEVERELY DAMAGE TUMBLEWEED'S BUSINESS.
The ability of Tumbleweed's customers to use Tumbleweed-based services
depends on stable product performance, and the efficient and uninterrupted
operation of the computer and communications hardware as well as the software
and Internet network systems that they maintain. Although Tumbleweed's ability
to manage the effects of system failures which occur in computer hardware,
software and network systems is limited, the occurrences of these failures could
harm its reputation, business and prospects. The Internet has experienced a
variety of outages and other delays as a result of damage to portions of its
infrastructure, and the Internet could face similar outages and delays in the
future. In addition, an increasing number of its customers require Tumbleweed to
provide computer and communications hardware, software and Internet networking
systems to them as an outsourced data center service. All data centers, whether
hosted by Tumbleweed, its customers or by an independent third party to which it
outsources this function, are vulnerable to damage or interruption from fire,
flood, earthquake, power loss, telecommunications failure or other similar
events.
IF TUMBLEWEED'S SOFTWARE CONTAINS ERRORS, IT MAY LOSE CUSTOMERS OR
EXPERIENCE REDUCED MARKET ACCEPTANCE OF ITS PRODUCTS.
Tumbleweed's software products are inherently complex and may contain
defects and errors that are detected only when the products are in use. In
addition, some of Tumbleweed's customers require or may require enhanced
customization of our software for their specific needs, and these modifications
may increase the likelihood of undetected defects or errors. Further, Tumbleweed
often renders implementation, consulting and other technical services, the
performance of which typically involves
24
<PAGE>
working with sophisticated software, computing and networking systems, and it
could fail to meet customer expectations as a result of any defects or errors.
As a result, we may lose customers, customers may fail to implement our products
more broadly within their organization and it may experience reduced market
acceptance of its products. Tumbleweed's products are designed to facilitate the
secure transmission of sensitive business information to specified parties
outside the business over the internet. As a result, the reputation of its
software products for providing good security is vital to their acceptance by
customers. Tumbleweed's products may be vulnerable to break-ins, theft or other
improper activity that could jeopardize the security of information for which it
is responsible. Problems caused by product defects, failure to meet project
milestones for services or security breaches could result in loss of or delay in
revenue, loss of market share, failure to achieve market acceptance, diversion
of research and development resources, harm to Tumbleweed's reputation, or
increased insurance, service and warranty costs. To address these problems,
Tumbleweed may need to expend significant capital resources that may not have
been budgeted.
IF TUMBLEWEED LOSES THE SERVICES OF KEY MANAGEMENT PERSONNEL, INCLUDING
CO-FOUNDERS OR KEY SALES EXECUTIVES, ITS ABILITY TO DEVELOP OUR BUSINESS
AND SECURE CUSTOMER RELATIONSHIPS WILL SUFFER.
Tumbleweed is substantially dependent on the continued services and
performance of its senior management and other key personnel. The loss of the
services of any of its executive officers or other key employees, particularly
our co-founders, Jeffrey C. Smith and Jean-Christophe D. Bandini, could
significantly delay or prevent the achievement of Tumbleweed's development and
strategic objectives. In addition, the loss of key members of Tumbleweed's
senior management, including Kerry S. Champion and Shomit A. Ghose, could harm
its ability to develop its business. Moreover, the loss of key members of its
sales organization, including Donald R. Gammon and Donald N. Taylor, could harm
Tumbleweed's ability to secure key relationships contemplated by its business
plan. Tumbleweed does not have long-term employment agreements with any of its
key personnel. The loss of services of any of our senior management or other key
personnel could significantly harm Tumbleweed's business and prospects.
TUMBLEWEED'S EFFORTS TO ESTABLISH, MAINTAIN AND STRENGTHEN ITS BRANDS WILL
REQUIRE SIGNIFICANT EXPENDITURES AND MAY NOT BE SUCCESSFUL.
If the marketplace does not associate Tumbleweed's brands with high quality
Internet communication services, it may be more difficult for it to attract new
customers or introduce future products and services. The market for Tumbleweed's
services is new. Therefore, Tumbleweed's failure to establish brand recognition
at this stage could harm its ability to compete in the future with other
companies that successfully establish a brand name for their services.
Tumbleweed must succeed in its marketing efforts, provide high quality services
and increase its user base in order to build its brand awareness and
differentiate its products from those of Tumbleweed's competitors. These efforts
have required significant expenditures to date. Moreover, Tumbleweed believes
that these efforts will require substantial commitments of resources in the
future as its brands become increasingly important to its overall strategy and
as the market for its services grows.
BECAUSE TUMBLEWEED PRODUCTS UTILIZE THE INTERNET, IF USE OF THE INTERNET
DOES NOT INCREASE, THE LEVEL OF USE OF ITS PRODUCTS WILL SUFFER.
If the Internet and other products and services necessary for the
utilization of Tumbleweed's products are not sufficiently developed, fewer
customers and end-users will use its products and its business will be harmed.
In particular, the success of Tumbleweed's products and services will depend on
the development and maintenance of adequate Internet infrastructure, such as a
reliable network backbone with the necessary speed, data capacity and other
features demanded by users. Moreover, Tumbleweed's success will also depend on
the timely development of complementary products or
25
<PAGE>
services such as high speed modems for providing reliable Internet access and
services and this may not occur. Because the online exchange of information is
new and evolving, the Internet may not prove to be a viable platform for secure
online communication services in the long term. The Internet has experienced,
and is expected to continue to experience, significant growth in the numbers of
users and amount of traffic. As the Internet continues to experience increased
numbers of users and frequency of use, or if its users require increasingly more
resources, the Internet infrastructure may not be able to support the demands
placed on it. As a result, the performance or reliability of the Internet may be
harmed. This in turn could decrease the level of Internet usage and also the
level of utilization of Tumbleweed products and services.
ADDITIONAL GOVERNMENT REGULATION RELATING TO THE INTERNET MAY INCREASE COSTS
OF DOING BUSINESS OR REQUIRE CHANGES IN TUMBLEWEED'S BUSINESS MODEL.
Tumbleweed is subject to regulations applicable to businesses generally and
laws or regulations directly applicable to companies utilizing the Internet.
Although there are currently few laws and regulations directly applicable to the
Internet, it is possible that a number of laws and regulations may be adopted
with respect to the Internet. These laws could cover issues like user privacy,
pricing, content, intellectual property, distribution, taxation, antitrust,
legal liability and characteristics and quality of products and services. The
adoption of any additional laws or regulations could decrease the demand for
Tumbleweed products and services and increase its cost of doing business or
otherwise harm its business or prospects.
Moreover, the applicability to the Internet of existing laws in various
jurisdictions governing issues like property ownership, sales and other taxes,
libel and personal privacy is uncertain and may take years to resolve. For
example, tax authorities in a number of states are currently reviewing the
appropriate tax treatment of companies engaged in online commerce. New state tax
regulations may subject Tumbleweed to additional state sales and income taxes.
Any new legislation or regulation, the application of laws and regulations from
jurisdictions whose laws do not currently apply to Tumbleweed's business, or the
application of existing laws and regulations to the Internet and commercial
online services could harm its ability to conduct business and harm operating
results.
TUMBLEWEED'S PRODUCTS ARE SUBJECT TO IMPORT AND EXPORT CONTROLS, AND IT MAY
BE UNABLE TO OBTAIN NECESSARY APPROVALS.
Exports of software products utilizing encryption technology are generally
restricted by the U.S. and various foreign governments. All cryptographic
products require export licenses from certain U.S. government agencies.
Tumbleweed has obtained approval to export products using up to 128-bit
symmetric encryption and 1024-bit public key encryption, including IME Server,
IME Desktop, IME Receive Applet, IME Remote API using OmniORB with SSL, MMS
WorldWide/56 and MMS Strong WorldWide/128. Tumbleweed is not exporting other
products and services that are subject to export control under U.S. law.
However, the list of products and countries for which export approval is
required, and the related regulatory policies, could be revised, and Tumbleweed
may not be able to obtain necessary approval for the export of future products.
The inability to obtain required approvals under these regulations could limit
Tumbleweed's ability to make international sales. Furthermore, competitors may
also seek to obtain approvals to export products that could increase the amount
of competition Tumbleweed faces. Additionally, countries outside of the U.S.
could impose regulatory restrictions impairing Tumbleweed's ability to import
its products into those countries.
COSTS OF COMMUNICATING VIA THE INTERNET COULD INCREASE IF ACCESS FEES ARE
IMPOSED.
Certain local telephone carriers have asserted that the increasing
popularity and use of the Internet has burdened the existing telecommunications
infrastructure, and that many areas with high Internet use have begun to
experience interruptions in telephone service. These carriers have petitioned
26
<PAGE>
the Federal Communications Commission to impose access fees on Internet service
providers and online service providers. If these access fees are imposed, the
costs of communicating on the Internet could increase substantially, potentially
slowing the increasing use of the Internet. This could in turn decrease demand
for Tumbleweed's services or increase the costs of doing business.
TUMBLEWEED MAY HAVE LIABILITY FOR INTERNET CONTENT.
As a provider of Internet communication products and services, Tumbleweed
faces potential liability for defamation, negligence, copyright, patent or
trademark infringement and other claims based on the nature and content of the
materials transmitted online. Any imposition of liability, particularly
liability that is not covered by insurance or is in excess of insurance
coverage, could be costly and could require Tumbleweed to implement measures to
reduce exposure to this liability. This may require Tumbleweed to expend
substantial resources or to discontinue selected service or product offerings.
Tumbleweed does not and cannot screen all of the content generated by users
of its product but may be exposed to liability with respect to this content.
Furthermore, certain foreign governments, such as Germany, have enforced laws
and regulations related to content distributed over the Internet that are more
strict than those currently in place in the U.S. Other countries, such as China,
regulate or prohibit the transport of telephonic data in their territories.
Failure to comply with regulations in a particular jurisdiction could result in
fines or criminal penalties or the termination of service in one or more
jurisdictions. Moreover, the increased attention focused on liability issues as
a result of lawsuits and legislative proposals could impact the growth of
Internet use. Liability insurance may not cover claims of these types, or may
not be adequate to indemnify against all liability that may be imposed.
INTERNET RELATED STOCK PRICES ARE ESPECIALLY VOLATILE AND THIS VOLATILITY
MAY DEPRESS TUMBLEWEED'S STOCK PRICE.
The stock market has experienced significant price and volume fluctuations
and the market prices of securities of technology companies, particularly
Internet-related companies, have been highly volatile. In the past, following
periods of volatility in the market price of a company's securities, securities
class action litigation has often been instituted against companies. The
institution of this type of litigation against Tumbleweed could result in
substantial costs and a diversion of Tumbleweed management's attention and
resources, which could harm its business and prospects.
TUMBLEWEED'S MANAGEMENT WILL BE ABLE TO SUBSTANTIALLY INFLUENCE CORPORATE
EVENTS BECAUSE THEY OWN A SIGNIFICANT PERCENTAGE OF ITS STOCK.
Tumbleweed's present directors, executive officers and principal
stockholders as a group beneficially own approximately 31.6% of the outstanding
common stock. Accordingly, if all or particular stockholders were to act
together, they would be able to exercise significant influence over or control
the election of Tumbleweed's board of directors, its management and policies and
the outcome of particular corporate transactions or other matters submitted to
its stockholders for approval, including mergers, consolidations and the sale of
all or substantially all of its assets.
TUMBLEWEED'S CERTIFICATE OF INCORPORATION AND BYLAWS CONTAIN PROVISIONS THAT
COULD DISCOURAGE OR PREVENT AN ACQUISITION OF TUMBLEWEED, WHICH COULD
DEPRESS ITS STOCK PRICE.
Tumbleweed's certificate of incorporation and bylaws may inhibit changes of
control that are not approved by its board of directors. These provisions could
limit the price that investors might be willing to pay in the future for shares
of our common stock. In particular, Tumbleweed's certificate of incorporation
provides for a classified board of directors and prohibits stockholder action by
written consent. These provisions require advance notice for nomination of
directors and stockholders' proposals. In addition, as a Delaware corporation,
Tumbleweed is subject to Section 203 of the
27
<PAGE>
Delaware General Corporation Law. In general, this law prevents a person who
becomes the owner of 15% or more of the corporation's outstanding voting stock
from engaging in specified business combinations for three years unless
specified conditions are satisfied. In addition, Tumbleweed's certificate of
incorporation allows its board of directors to issue preferred stock without
further stockholder approval. This could have the effect of delaying, deferring
or preventing a change in control. The issuance of preferred stock also could
effectively limit the voting power of the holders of Tumbleweed common stock.
The provisions of Tumbleweed's certificate of incorporation and bylaws, as well
as provisions of Delaware law, may discourage or prevent an acquisition or
disposition of its business.
FUTURE SALES OF COMMON STOCK BY TUMBLEWEED STOCKHOLDERS COULD DEPRESS
TUMBLEWEED'S STOCK PRICE.
Tumbleweed cannot predict if future sales of its common stock, or the
availability of its common stock for sale, will depress the market price for its
common stock or its ability to raise capital by offering equity securities. In
particular, in the months of April and May 2000, Hikari Tsushin sold a total of
approximately 2,363,000 shares and may choose to sell additional shares of
Tumbleweed common stock. In addition, on August 1, 2000, Tumbleweed completed a
public offering of 3,000,000 shares of its common stock of which 1,500,000
shares were sold by stockholders of Tumbleweed including Hikari Tsushin. Sales
of substantial amounts of common stock, or the perception that these sales could
occur, may depress prevailing market prices for the common stock.
TUMBLEWEED'S PROPOSED ACQUISITION OF INTERFACE MAY NOT CLOSE AND ITS
EXPECTATIONS MAY NOT BE REALIZED, WHICH COULD HARM ITS PROSPECTS.
In connection with Tumbleweed's proposed acquisition of Interface, as of
June 30, 2000, it expected to expense up to $2.0 million of acquired in-process
research and development, and to record unearned compensation and goodwill and
other intangibles of approximately $66.1 million to be amortized over periods
ranging from one to three years. Tumbleweed's expectations with respect to these
amounts, adjustments and periods are preliminary and therefore subject to
substantial subsequent adjustment. Any such adjustment could adversely affect
Tumbleweed's historical or future operating results.
The transaction will result in significant one-time charges, whether
completed or not, and, if completed, will substantially increase Tumbleweed's
operating expenses in future periods. The acquisition is subject to customary
closing conditions, including approval by the shareholders of Interface. As a
result, the acquisition may not close on a timely basis or at all, or may close
on terms that differ from the terms currently proposed.
THE INTERFACE BUSINESSES OTHER THAN L2I COMPRISED A SUBSTANTIAL MAJORITY OF
THE OPERATING RESULTS OF INTERFACE, AND TUMBLEWEED INTENDS TO DIVEST THESE
BUSINESSES.
The Interface businesses other than L2i comprised a substantial majority of
the historical operating results of Interface. Specifically, the revenue from
these businesses comprised approximately $16.8 million or 83% of the revenues of
Interface for the year ended September 30, 1999 and $1.7 million or 56% of the
revenues of Interface for the three months ended March 31, 2000. In the event
that these businesses are successfully divested, the operations of the ongoing
business of Interface will be substantially less than the historical operating
results that include these businesses. Tumbleweed expects that the amount
realized from the sale of these businesses, if successfully completed, will be
limited. By contrast, if Tumbleweed does not successfully divest these
businesses, it will be required to maintain or wind-down these businesses. The
costs of doing so could be substantial and would adversely affect future
operating results through ongoing realization of unanticipated expenses and
one-time disposition charges.
28
<PAGE>
TUMBLEWEED MAY BE UNABLE TO SUCCESSFULLY INTEGRATE INTERFACE INTO ITS
BUSINESS OR ACHIEVE THE EXPECTED BENEFITS OF THE ACQUISITION.
The acquisition of Interface will require integrating Tumbleweed's business
with Interface's, including integrating product lines, technologies and distinct
corporate cultures. Tumbleweed may not be able to successfully assimilate the
personnel, operations and customers of Interface into its business.
Additionally, Tumbleweed may fail to maintain the customers it has and those of
Interface after the acquisition. Tumbleweed may also fail to achieve the
anticipated synergies from the acquisition of Interface, including product
development and other operational synergies. The integration process may further
strain its existing financial and managerial controls and reporting systems and
procedures. This may result in the diversion of management and financial
resources from its core business objectives. Tumbleweed may not be able to
retain various individuals who provide services to Interface that it intends to
hire in connection with the acquisition. Tumbleweed's failure to successfully
manage the Interface acquisition could seriously harm its operating results.
INTERFACE HAS RECENTLY BEEN NAMED A DEFENDANT IN SEVERAL PURPORTED
SECURITIES CLASS ACTION LAWSUITS.
On July 7, 2000, three complaints were filed by David H. Zimmer,
Congressional Securities, Inc. and other plaintiffs against Interface and
various additional defendants, including Interface's President and Chief
Executive Officer, Robert A. Nero and Fiserv Correspondent Services, Inc., in
the United States District Court for the Southern District of New York. The
three cases contain substantially similar allegations of false and misleading
representations by various defendants allegedly designed to inflate Interface's
stock price. The complaints seek relief under the federal securities laws on
behalf of purported classes of persons who purchased, held, or sold shares of
Interface stock, and under various other causes of action. Recently, all three
of the complaints were amended.
Tumbleweed cannot fully assess the merits of the lawsuits at this time and,
in any event, the costs in defending these complaints could harm future
operating results assuming the Interface merger is consummated.
29
<PAGE>
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Tumbleweed transacts business in various foreign currencies. Accordingly,
Tumbleweed is subject to exposure from adverse movements in foreign currency
exchange rates. This exposure is primarily related to revenue and operating
expenses denominated in each subsidiary's respective local currency. To date,
Tumbleweed has not entered into any derivative financial instruments or hedging
activities.
Tumbleweed currently does not use financial instruments to hedge operating
expenses in the United Kingdom or Japan dominated in the respective local
currency. Tumbleweed assesses the need to utilize financial instruments to hedge
currency exposures on an ongoing basis.
Tumbleweed does not use derivative financial instruments for speculative
trading purposes, nor does Tumbleweed hedge its foreign currency exposure in a
manner that entirely offsets the effects of changes in foreign exchange rates.
Tumbleweed regularly reviews its hedging program and may as part of this review
determine at any time to change its hedging program.
INTEREST RATE SENSITIVITY
The primary objective of our investment activities is to preserve principal
while at the same time maximizing the income we receive from our investments
without significantly increasing risk. Some of the securities that we have
invested in may be subject to market risk. This means that a change in
prevailing interest rates may cause the principal amount of the investment to
fluctuate. For example, if we hold a security that was issued with a fixed rate
equal to the then-prevailing interest rate and the prevailing interest rate
later rises, the fair value of our investment will decline. To minimize this
risk, we maintain our portfolio of cash equivalents in commercial paper and
money market funds. In general, money market funds are not subject to market
risk because the interest paid on these funds fluctuates with the prevailing
interest rate.
The following table presents the amounts of our cash equivalents that are
subject to market risk by range of expected maturity and weighted-average
interest rates as of June 30, 2000. This table does not include money market
funds because these funds are not subject to market risk.
<TABLE>
<CAPTION>
MATURING IN
-------------------------------
90 DAYS 90 DAYS OVER
OR LESS TO 1 YEAR ONE YEAR TOTAL FAIR VALUE
-------- --------- -------- -------- ----------
<S> <C> <C> <C> <C> <C>
Included in cash and cash equivalents........... $9,945 None None $9,945 $9,945
Weighted-average interest rate.................. 6.24%
</TABLE>
30
<PAGE>
PART II--OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
On March 3, 1999, we sued The docSpace Company, Inc. alleging infringement
of our U.S. Patent No. 5,790,790. In its answer, docSpace raised counterclaims
alleging, among other things, antitrust violations and unfair competition. On
May 3, 1999, docSpace filed a summary judgment motion of non-infringement. On
May 27, 1999, the court granted Tumbleweed's request to continue docSpace's
summary judgment motion pending further discovery and indicated that docSpace's
motion would be rescheduled. On July 14, 1999, the court issued a scheduling
order stating that it would conduct a hearing on the proper interpretation of
the claims of Tumbleweed's patent, and would afterwards hold a hearing on any
motions for summary judgment on the issue of infringement. The court also
ordered that discovery on all issues other than claim construction and
infringement would be stayed pending resolution of these issues.
The court held the claim interpretation hearing on November 19, 1999. On
December 9, 1999, the court issued an order based on the claims construction
hearing essentially adopting Tumbleweed's interpretation of the patent claims.
Critical Path, Inc. acquired docSpace on March 9, 2000. On April 24, 2000,
Tumbleweed filed a motion for summary judgment that all versions of the docSpace
"Express" system infringe our patent. On the same day, docSpace filed a motion
for summary judgment that its current version of "Express" does not infringe our
patent. On July 10, 2000, the court held a hearing on the parties' summary
judgment motions.
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
On August 11, 1999, we completed an initial public offering of our common
stock, $0.001 par value. The shares of common stock sold in the offering were
registered under the Securities Act of 1933, as amended, on a Registration
Statement on Form S-1 (No. 333-79687). The Registration Statement was declared
effective by the Securities and Exchange Commission on August 5, 1999. From the
date our Registration Statement was declared effective, until June 30, 2000, we
financed our operations from cash available prior to our initial public
offering, and did not use any of the net proceeds from our initial public
offering. Our temporary investments were in cash, cash equivalents and
investment grade, short-term interest bearing securities.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 15, 2000, we held our Annual Meeting of Stockholders. The
stockholders voted on the following matters:
1). Election of directors: Jeffrey C. Smith, Pehong Chen and Kenneth R. Klein
were nominated and elected as Class I directors for a term expiring in 2003.
The votes were counted as follows:
<TABLE>
<CAPTION>
BROKER
FOR AGAINST WITHHELD ABSTAINING NON-VOTES
---------- -------- -------- ---------- ---------
<S> <C> <C> <C> <C> <C>
Jeffrey C. Smith............................. 19,099,880 None 53,694 None None
Pehong Chen.................................. 19,099,605 None 53,969 None None
Kenneth R. Klein............................. 19,100,118 None 53,456 None None
</TABLE>
2). Approval of an amendment to our 1999 Omnibus Stock Incentive Plan to (a)
increase the number of shares reserved for issuance thereunder and
(b) qualify such plan for purposes of Sections 162(m) and 422 of the
Internal Revenue Code of 1986, as amended. The amendment was approved by a
vote of 12,482,683 for and 4,164,919 votes against, with 9,352 votes
withheld or abstaining and 2,496,620 shares non-voting.
31
<PAGE>
3). Ratification of the selection of KPMG LLP as our independent auditors for
the fiscal year ending December 31, 2000. The selection of KPMG LLP was
ratified by a vote of 19,126,356 for and 16,555 votes against, with 10,663
votes withheld or abstaining and no shares non-voting.
ITEM 6. EXHIBITS
Exhibit 2.1(1) Agreement and Plan of Merger, dated as of June 28, 2000, among
Tumbleweed Communications Corp., Maize Acquisition Sub, Inc. and
Interface Systems, Inc.
Exhibit 10.1(1) Stock Option Agreement dated as of June 28, 2000 between
Tumbleweed Communications Corp. and Interface Systems, Inc.
Exhibit 10.2(1) Form of Interface Voting Agreement dated as of June 28, 2000
Exhibit 10.3(2) 1999 Omnibus Stock Incentive Plan, as Amended
Exhibit 10.4(2) 2000 NSO Incentive Stock Plan
Exhibit 10.5(1) Convertible Subordinated Note Purchase Agreement and Form of
Convertible Subordinated Note dated as of June 28, 2000,
between Tumbleweed Communications Corp. and Interface
Systems, Inc.
Exhibit 27.1 Financial Data Schedule (available in EDGAR format only)
(1) Previously filed in Tumbleweed's Current Report on Form 8-K, filed
July 6, 2000, and incorporated herein by reference.
(2) Previously filed in Tumbleweed's Registration Statement on Form S-1,
filed July 11, 2000 (File No. 333-41188), as amended and incorporated
herein by reference.
32
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, hereunto duly authorized:
TUMBLEWEED COMMUNICATIONS CORP.
Date: August 11, 2000
<TABLE>
<S> <C>
By: /s/ JEFFREY C. SMITH
-------------------------------------------
Jeffrey C. Smith
Chairman of the Board, President and
Chief Executive Officer
(Principal Executive Officer)
</TABLE>
Date: August 11, 2000
<TABLE>
<S> <C>
By: /s/ JOSEPH C. CONSUL
-------------------------------------------
Joseph C. Consul
Vice President-Finance and
Chief Financial Officer
(Principal Financial Officer and
Principal Accounting Officer)
</TABLE>
33
