<PAGE>
Filed Pursuant to Rule 424(b)(4)
Registration No. 333-56911
3,000,000 SHARES
[LOGO OF TERAYON COMMUNICATION SYSTEMS]
COMMON STOCK
------------
All of the 3,000,000 shares of Common Stock of Terayon Communication Systems,
Inc. ("Terayon" or the "Company") are being sold by the Company. Prior to this
offering, there has been no public market for the Common Stock. See
"Underwriting" for information relating to the method of determining the initial
public offering price. The Common Stock has been approved for quotation on the
Nasdaq National Market under the symbol "TERN."
------------
THE COMMON STOCK OFFERED HEREBY INVOLVES A HIGH DEGREE OF RISK.
SEE "RISK FACTORS" BEGINNING ON PAGE 5.
------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND
EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE
SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION
PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY
REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
<TABLE>
<CAPTION>
================================================================================
UNDERWRITING
PRICE TO DISCOUNTS AND PROCEEDS TO
PUBLIC COMMISSIONS(1) COMPANY(2)
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Per Share................... $13.00 $0.91 $12.09
- --------------------------------------------------------------------------------
Total(3).................... $39,000,000 $2,730,000 $36,270,000
================================================================================
</TABLE>
(1) See "Underwriting" for information relating to indemnification of the
Underwriters and other matters.
(2) Before deducting expenses payable by the Company, estimated at $1,400,000.
(3) The Company has granted to the Underwriters a 30-day option to purchase up
to 450,000 additional shares of Common Stock solely to cover over-
allotments, if any. To the extent that the option is exercised, the
Underwriters will offer the additional shares at the Price to Public as
shown above. If the option is exercised in full, the total Price to Public,
Underwriting Discounts and Commissions and Proceeds to Company will be
$44,850,000, $3,139,500 and $41,710,500, respectively. See "Underwriting."
------------
The shares of Common Stock are offered by the several Underwriters, subject
to prior sale, when, as and if delivered to and accepted by them, and subject
to the right of the Underwriters to reject any order in whole or in part. It is
expected that delivery of the shares of Common Stock will be made at the
offices of BT Alex. Brown Incorporated, Baltimore, Maryland, on or about August
21, 1998.
BT ALEX. BROWN
HAMBRECHT & QUIST
LEHMAN BROTHERS
SALOMON SMITH BARNEY
The date of this Prospectus is August 17, 1998.
<PAGE>
Graphic consisting of a depiction of the following components of broadband
communications solutions:
S-CDMA Cable Modem System
Standards-Based Modem System
Technology Leadership
Set-Top Boxes
IP Circuit Telephony
TeraComm, TeraLink, TeraPro, TeraView and Terayon are trademarks of the
Company. All other trademarks or service marks appearing in this prospectus are
the property of their respective owners.
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK OF
THE COMPANY, INCLUDING OVER-ALLOTMENT, ENTERING STABILIZING BIDS, EFFECTING
SYNDICATE COVERING TRANSACTIONS OR IMPOSING PENALTY BIDS, IN CONNECTION WITH
THE OFFERING. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING."
<PAGE>
[Gatefold]
TERAYON CABLE MODEM SYSTEMS:
BROADBAND INNOVATION
<TABLE>
<S> <C> <C> <C>
INTERNET CABLE HEADEND COAX OR HFC CORPORATE OFFICE
PRIVATE TERALINK GATEWAY COAX OR HFC TERAPRO
BACKBONE CABLE MODEM
NETWORK
TERALINK MASTER COAX OR HFC SMALL BUSINESS
CONTROLLER
TERAVIEW RESIDENTIAL
ELEMENT MANAGEMENT
SOFTWARE
</TABLE>
[graphic depicting the components of the
TeraComm system and potential users of the system]
Captions:
S-CDMA, CORE TECHNOLOGY. Terayon's S-CDMA technology allows cable operators to
provide reliable two-way broadband communications, utilizing more of the
existing upstream bandwidth than alternative broadband access technologies.
FLEXIBLE ARCHITECTURE. The Company's system can be deployed on any cable
infrastructure, from pure coaxial systems to hybrid fiber/coax ("HFC") upgraded
systems, providing cable operators with a cost-effective broadband access
solution.
ECONOMIC ADVANTAGE. The Terayon system does not require costly cable
infrastructure upgrades, filters or new cable drops, allowing cable operators
to provide broadband access services with low start-up costs.
RESIDENTIAL AND COMMERCIAL SERVICES. Terayon's system allows cable operators to
provide tiered levels of service--from lower margin residential Internet access
to higher margin commercial services.
<PAGE>
PROSPECTUS SUMMARY
The following summary is qualified in its entirety by the more detailed
information and the consolidated financial statements and notes thereto
appearing elsewhere in this Prospectus. Except as set forth in the consolidated
financial statements or as otherwise indicated herein, information in this
Prospectus (i) gives effect to the reincorporation of the Company from
California to Delaware in July 1998, (ii) gives effect to the conversion of all
of the Company's outstanding shares of Preferred Stock into shares of Common
Stock, which will occur automatically upon the closing of this offering and
(iii) assumes that the Underwriters' over-allotment option is not exercised.
See "Description of Capital Stock" and "Underwriting." This Prospectus contains
forward-looking statements that involve risks and uncertainties. Actual events
or results could differ materially from those expressed in or implied by these
forward-looking statements as a result of a number of factors, including those
set forth under "Risk Factors" and elsewhere in this Prospectus.
THE COMPANY
Terayon develops, markets and sells cable modem systems that enable cable
operators to cost-effectively deploy reliable two-way broadband access
services. The Company's TeraComm system is designed to allow cable operators to
minimize time-consuming and costly network infrastructure upgrades, achieve
reduced time to market and provide a wide range of service levels to
residential and commercial end users. Cable operators using the TeraComm system
are able to provide additional revenue-generating services to end users,
enabling cable operators to compete effectively in the emerging market for
broadband access services.
In recent years, the volume of bandwidth intensive data, voice and video
traffic across the Internet, corporate intranets and other public networks has
increased dramatically. International Data Corporation ("IDC") estimates that
the number of Internet users will increase from approximately 69 million at the
end of 1997 to approximately 320 million by the end of 2002. IDC also estimates
that the number of home office households will increase from approximately 35
million at the end of 1997 to approximately 50 million by the end of 2002.
Although various technologies have emerged to address the need for broadband
access, the existing cable infrastructure currently provides the highest
available two-way transmission speeds and "always-on" availability. In
addition, the existing cable infrastructure currently passes more than 95% of
homes in the U.S. and a large number of small businesses.
The Company's TeraComm system, comprised of the TeraPro cable modem, the
TeraLink 1000 Master Controller, the TeraLink Gateway and the TeraView Element
Management and Provisioning Software, is based on Terayon's Synchronous Code
Division Multiple Access ("S-CDMA") technology. S-CDMA enables reliable two-way
broadband communications over both pure coaxial and hybrid fiber/coax ("HFC")
cable infrastructure by maximizing resistance to noise that interferes with
data transmissions over previously unusable frequency spectrum. Cable operators
utilizing cable modems based on alternative technologies such as Time Division
Multiple Access must typically upgrade their networks to an HFC architecture.
The TeraComm system is designed to allow cable operators to minimize these
costly and time-consuming network upgrades.
Terayon's objective is to be the leading provider of cable modem systems to
cable operators seeking to provide broadband access services to residential and
commercial end users. Key elements of the Company's strategy are to supply
leading cable operators worldwide, establish relationships with industry
leaders, expand worldwide distribution channels, provide superior customer
service and support, adopt and advocate industry standards, and leverage its S-
CDMA technology.
Terayon sells its products to cable operators through direct sales forces in
North America, Latin America and Europe. The Company also distributes its
products via distributors and systems integrators. Companies currently using or
distributing the TeraComm system include Shaw Communications Inc., TCA Cable
TV, Inc., Cablevision Systems, Inc. and Crossbeam Networks Corporation, a
wholly owned subsidiary of Sumitomo Corporation.
Terayon was incorporated in California in January 1993 and reincorporated in
Delaware in July 1998. The Company's executive offices are located at 2952
Bunker Hill Lane, Santa Clara, California 95054 and its telephone number is
(408) 727-4400.
RISK FACTORS
The Common Stock offered hereby involves a high degree of risk. Risks related
to this offering include the Company's early stage of development and history
of losses; the Company's significant future capital requirements; fluctuations
in the Company's operating results; market acceptance of cable modems and the
availability of competing technologies; the evolving market for the Company's
products, rapid technological change, market acceptance of S-CDMA; the
Company's ability to achieve cost reductions; the Company's limited
manufacturing experience and dependence upon its contract manufacturer;
evolving industry standards; the Company's dependence on a small number of
customers and on cable operators and other service providers. See "Risk
Factors."
3
<PAGE>
THE OFFERING
<TABLE>
<C> <S>
Common Stock offered by the Company........ 3,000,000 shares
Common Stock outstanding after the
offering.................................. 16,220,733 shares (1)
Use of proceeds............................ Capital expenditures, research
and development, working capital
and other general corporate
purposes
Nasdaq National Market symbol.............. TERN
</TABLE>
SUMMARY CONSOLIDATED FINANCIAL DATA
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SIX MONTHS
ENDED
YEARS ENDED DECEMBER 31, JUNE 30,
------------------------------------ -----------------
1994 1995 1996 1997 1997 1998
------- ------- -------- -------- ------- --------
<S> <C> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT
OF OPERATIONS DATA:
Revenues................ $ 140 $ -- $ -- $ 2,118 $ 93 $ 9,376
Cost of goods sold...... -- 676 -- 6,462 482 11,517
------- ------- -------- -------- ------- --------
Gross profit (loss)..... 140 (676) -- (4,344) (389) (2,141)
------- ------- -------- -------- ------- --------
Operating expenses:
Research and develop-
ment.................. 235 2,028 8,020 11,319 5,886 4,923
Sales and marketing.... 17 205 1,141 4,468 1,523 2,969
General and administra-
tive.................. 84 825 1,789 2,546 1,105 1,282
------- ------- -------- -------- ------- --------
Total operating ex-
penses................ 336 3,058 10,950 18,333 8,514 9,174
------- ------- -------- -------- ------- --------
Loss from operations.... (196) (3,734) (10,950) (22,677) (8,903) (11,315)
Net interest income (ex-
pense)................. -- 68 253 128 123 (32)
------- ------- -------- -------- ------- --------
Net loss................ (196) (3,666) (10,697) (22,549) (8,780) (11,347)
Series F convertible
preferred stock divi-
dend(2)................ -- -- -- -- -- (23,910)
------- ------- -------- -------- ------- --------
Net loss applicable to
common stockholders.... $ (196) $(3,666) $(10,697) $(22,549) $(8,780) $(35,257)
======= ======= ======== ======== ======= ========
Historical basic and di-
luted net loss per
share applicable to
common stockholders(3). $ (0.10) $ (1.02) $ (2.64) $ (5.26) $ (2.10) $ (7.65)
======= ======= ======== ======== ======= ========
Shares used in computing
historical basic and
diluted net loss per
share applicable to
common stockholders(3). 2,000 3,589 4,054 4,289 4,182 4,611
======= ======= ======== ======== ======= ========
Pro forma basic and di-
luted net loss per
share applicable to
common stockholders(3). $ (2.07) $ (2.91)
======== ========
Shares used in pro forma
basic and diluted net
loss per share applica-
ble to common stock-
holders(3)............. 10,873 12,132
======== ========
</TABLE>
<TABLE>
<CAPTION>
JUNE 30, 1998
-----------------------
ACTUAL AS ADJUSTED(4)
-------- -------------
<S> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash and cash equivalents.............................. $ 6,030 $ 40,900
Working capital........................................ 194 35,064
Total assets........................................... 16,634 51,504
Long-term debt (less current portion).................. 24 24
Accumulated deficit.................................... (72,420) (72,420)
Total stockholders' equity (net capital deficiency).... $ (3,871) $ 38,512
</TABLE>
- --------
(1) Based on number of shares outstanding on June 30, 1998. Excludes (i)
2,483,292 shares issuable upon exercise of options outstanding at a
weighted average exercise price of $2.50 per share, (ii) 3,107,851 shares
issuable upon exercise of outstanding warrants with a weighted average
exercise price of $6.60 per share, (iii) 2,453,937 shares reserved for
future grants under the Company's stock option plans, and (iv) 700,000
shares reserved for issuance pursuant to the Company's 1998 Employee Stock
Purchase Plan. See "Management--Employee Benefit Plans" and Note 8 of Notes
to Consolidated Financial Statements.
(2) See Note 8 of Notes to Consolidated Financial Statements for an explanation
of the convertible preferred stock dividend.
(3) See Note 1 of Notes to Consolidated Financial Statements for an explanation
of the method employed to determine the number of shares used to compute
per share amounts.
(4) As adjusted to reflect (i) the sale of 3,000,000 shares of Common Stock
offered by the Company, based on an initial public offering price of $13.00
per share and the application of the estimated net proceeds therefrom and
(ii) the conversion of all outstanding shares of Preferred Stock into
shares of Common Stock upon the closing of this offering. See "Use of
Proceeds."
4
<PAGE>
RISK FACTORS
The shares offered hereby involve a high degree of risk. The following risk
factors should be considered carefully in addition to the other information in
this Prospectus before purchasing the shares of Common Stock offered hereby.
The discussion in this Prospectus contains certain forward-looking statements
that involve risks and uncertainties, such as statements of the Company's
plans, objectives, expectations and intentions. The cautionary statements made
in this Prospectus should be read as being applicable to all related forward-
looking statements wherever they appear in this Prospectus. The Company's
actual results could differ materially from those discussed herein. Factors
that could cause or contribute to such differences include those discussed
below as well as those discussed elsewhere herein. See "Information Regarding
Forward-Looking Statements."
Early Stage of Development; History of Losses. The Company was incorporated
in January 1993, began shipping products commercially in June 1997 and has
only been shipping products in volume since the first quarter of 1998. Most
commercial shipments of the Company's products through December 1997 were in
limited quantities to customers deploying cable modems in pre-commercial
trials. Accordingly, the Company has a very limited operating history, which
makes the prediction of future operating results difficult. The Company has
incurred significant losses since inception, including losses of $3.7 million,
$10.7 million, $22.5 million and $35.3 million for 1995, 1996, 1997 and for
the six months ended June 30, 1998, respectively. At June 30, 1998, the
Company had an accumulated deficit of $72.4 million. The Company believes that
it will continue to experience net losses for the foreseeable future. Because
a majority of the Company's expenses are fixed in advance, the Company
generally is unable to reduce its expenses significantly in the short term to
compensate for any unexpected delay or decrease in anticipated revenues. As
the Company increases its commercialization activities, it expects to increase
expense levels in each of the next several quarters primarily to support
increased sales and marketing and technical support costs. Accordingly, any
significant delay in the Company's anticipated revenues or commercialization
of new products would have an immediate adverse effect on the Company's
business, operating results and financial condition. In addition, the Company
has had negative gross margins since inception, and there can be no assurance
that any growth in revenues will result in positive gross margins or operating
profits.
The revenue and profit potential of the Company's business and industry are
unproven, and the Company's limited operating history makes its future
operating results difficult to predict. The Company has had limited experience
selling its products to cable operators and only a limited number of cable
operators have purchased the Company's products for commercial deployment. The
market for the Company's products has only recently begun to develop, is
rapidly changing and is characterized by an increasing number of competitors
and competing technologies, as well as evolving industry standards. See "--
Market Acceptance of Cable Modems; Competing Technologies," "--Dependence on
Small Number of Customers," "--Ability to Market Effectively to Cable
Operators," "--Highly Competitive Industry; Established Competitors" and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."
Significant Future Capital Requirements. The Company will require
substantial capital resources to continue to develop, manufacture and market
its products, to expand its product line and to fund its future operations.
The Company also may require additional capital resources to enter into
corporate partnerships, strategic alliances or joint ventures. There can be no
assurance that such financing will be available when needed, if at all, or on
terms favorable to the Company. Any additional equity financings will be
dilutive to stockholders, and debt financings, if available, will affect
operating results and may require the Company to agree to restrictive
covenants. Failure to generate or raise sufficient funds may require the
Company to delay or abandon some or all of its planned future expansion or
expenditure, which could have a material adverse effect on the Company's
business, operating results or financial condition. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations--
Liquidity and Capital Resources."
5
<PAGE>
Fluctuations in Operating Results. The Company's quarterly revenues will be
difficult to predict due to a number of factors and the Company expects to
experience significant fluctuations in its operating results on a quarterly
and an annual basis for the foreseeable future. Revenues will vary depending
on the timing of orders and shipments. Orders by the same customer can vary in
size over time, depending on whether the Company's products are intended for
trial or commercial deployment purposes, and depending on the geographic area
covered by the customer's deployment. Customers that have forecast deployment
plans and product orders may delay orders for many customer-specific reasons,
such as changes in customer marketing plans, delays in completing any
infrastructure or billing system upgrades required to offer new services,
variations in capital spending budgets and delays in obtaining regulatory
approval for commercial deployment. Customers also may delay orders for
industry-wide reasons such as the adoption of new technologies by cable
operators, telephone or wireless telecommunications companies, or changes in
U.S. and international regulations. For example, the Company's product
shipments to date to a customer in Brazil have been significantly lower than
anticipated due to delays in certain regulatory approvals in Brazil. There can
be no assurance that similar delays will not occur in other countries in which
the Company is marketing or planning to market its products. Any such delays
would have a material adverse effect on the Company's operating results for a
particular period. In addition, cable operators in certain parts of Asia are
required to obtain licenses prior to deploying data services over cable, and
delays in obtaining such licenses by the Company's customers could have an
adverse impact on the Company's operating results for a particular period.
Competitive factors may affect both Company revenues and profitability.
Customers may delay orders due to new product announcements by the Company or
its competitors. The Company's average selling prices for its products may be
lower than expected as a result of competitive pricing pressures, the
Company's promotional programs and customers who negotiate price reductions in
exchange for longer term purchase commitments. The Company's expenses
generally will vary from quarter to quarter depending on the level of actual
and anticipated business activities. Research and development expenses will
vary as the Company commences development of new products and as development
programs move to wafer fabrication, which results in higher engineering
expenses.
The timing and volume of customer orders are difficult to forecast because
cable operators require a long sales cycle before placing orders. In addition,
cable operators typically require delivery of products within 90 days.
Accordingly, the Company has a limited backlog of orders, and net sales for
any future quarter are difficult to predict. Supply, manufacturing or testing
constraints could result in delays in the delivery of the Company's products.
Further, sales generally are made pursuant to purchase orders, which can be
rescheduled, reduced or cancelled with little or no penalty. Any delay in the
product deployment schedule of one or more of the cable operators targeted by
the Company would have an adverse effect on the Company's operating results
for a particular period. In addition, due to the relatively large dollar size
of the Company's typical transaction, any delay in the closing of a
transaction could have a significant impact on the Company's operating results
for a particular period. See "--Limited Manufacturing Experience and
Dependence on Contract Manufacturer" and "--Lengthy Sales Cycle."
A variety of factors affect the Company's gross margin, including average
selling prices ("ASPs") of the Company's products, the sales mix of products,
type of distribution channel, the volume of products manufactured and cost
reduction measures. Historically, ASPs in the data communications industry
have decreased over the life of individual products and technologies. The
Company anticipates that unit ASPs of its products will decline in the future,
which could cause a decrease in the gross margins for these products. As a
result, the Company's gross margin also is affected by the maturity of
TeraComm deployments in any quarter, because new deployments of the TeraComm
system involve the sale of headend equipment (which has higher margins) and
generally involve smaller quantities of product, which typically are sold at
higher margins than the larger volume sales of product associated with more
mature deployments of the TeraComm system. The Company's gross margin also is
affected by the sales mix of TeraLink 1000 Master Controllers, TeraLink
Gateways and TeraPro cable modems, as the
6
<PAGE>
TeraPro cable modems have significantly lower margins than the TeraLink 1000
Master Controller and TeraLink Gateway headend products. The Company expects
to achieve only nominal margins on the TeraPro cable modems and expects that
sales of TeraPro cable modems will continue to constitute a significant
portion of its revenues for the foreseeable future. See "--Erosion of Average
Selling Prices" and "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Overview."
Market Acceptance of Cable Modems; Competing Technologies. The Company's
future success, operating results and financial condition will be
substantially dependent upon whether cable modems gain widespread commercial
acceptance by cable operators and end users of broadband access services.
Because cable operators have only recently begun to deploy broadband access
services based on cable modem technology, the market for services based on
such technology has not yet developed and the Company cannot accurately
predict the future growth rate, if any, or the ultimate size of the cable
modem market. Critical issues concerning the use of cable modems, including
security, reliability, cost, ease of deployment and administration, and
Quality of Service, remain largely unresolved and may adversely affect the
Company's growth and the market acceptance of its products. The market for
cable modems may be affected by the development of other technologies that
enable the provisioning of broadband access services. Examples of such
technologies include technologies that increase the efficiency of digital
transmission over telephone companies' existing copper infrastructure, such as
various Digital Subscriber Line technologies ("xDSL"), as well as Integrated
Service Digital Network ("ISDN"). Similarly, broadband access services may be
deployed over a number of other media, including fiber optic cable, direct
broadcast satellite ("DBS"), Local Multipoint Distribution Service ("LMDS"),
Multichannel Multipoint Distribution Service ("MMDS") and other wireless
technologies. Broadband access services based on some of these competing
technologies are already available and could materially limit acceptance of
cable modem-based services. The Company also anticipates competition from all-
digital systems, which may be offered from telecommunications or other service
providers, such as the recently announced Integrated On-Demand Network from
Sprint Corporation. The Company is unable to predict the effect of all-digital
networks on competition among service providers who are introducing broadband
access, and therefore the effect on the Company. The failure of broadband
access services based on cable modem technology to gain widespread commercial
acceptance by cable operators and end users of broadband access services would
have a material adverse effect on the Company's business, operating results
and financial condition. See "Business--Industry Background."
Evolving Market; Rapid Technological Change; Market Acceptance of S-
CDMA. The markets for the Company's products are characterized by rapid
technological change, evolving industry standards, changes in end-user
requirements and frequent new product introductions and enhancements, all of
which are outside the control of the Company. The Company believes that its
future success will depend upon its ability to enhance its existing products
and to develop and introduce new products that meet a wide range of evolving
cable operator and end-user needs and achieve market acceptance. There can be
no assurance that the Company's potential customers, specifically cable
operators, will not adopt alternative technologies or deploy alternative
services that are incompatible with the Company's products, since the
Company's products currently are not interoperable with other suppliers'
products. The occurrence of either of the foregoing events would have a
material adverse affect on the Company's business, operating results and
financial condition.
The demand for broadband access services has resulted in the development of
several competing modulation techniques. The Company's products utilize a
proprietary modulation technique known as Synchronous Code Division Multiple
Access ("S-CDMA"), while several of the Company's competitors utilize
modulation technologies known as Time Division Multiple Access ("TDMA") and
Frequency Division Multiple Access ("FDMA"). The Company's headend equipment
and cable modem products currently are not interoperable with the headend
equipment and modems of other suppliers of broadband access products. As a
result, potential customers who wish to purchase broadband access
7
<PAGE>
products from multiple suppliers may be reluctant to purchase the Company's
products. While the Company believes that S-CDMA offers superior capabilities
over TDMA and FDMA, there can be no assurance that major cable operators will
adopt the Company's proprietary modulation technology. If major cable operators
do not adopt products or technologies based on S-CDMA at all, or in the time
frame anticipated by the Company, or if they adopt technologies based on
competing modulation technologies rather than the Company's S-CDMA technology,
the Company's business, operating results and financial condition would be
materially adversely affected. Further, to the extent that competitors using
TDMA or FDMA modulation technologies can incorporate functionality and
capabilities currently found in S-CDMA, the value of the Company's proprietary
S-CDMA technology would be diminished. See "Business--Industry Background."
Ability to Achieve Cost Reductions. Certain of the Company's competitors
currently offer cable modems at prices lower than those of the Company's cable
modems. Market acceptance of the Company's products, and the Company's future
success, will depend in part on reductions in the unit cost of the Company's
products. The Company expects that as headend equipment becomes more widely
deployed, the price of cable modems and other products will decline. In
particular, the Company believes that the adoption of industry standards such
as Data Over Cable Service Interface Specifications ("DOCSIS") will cause
increased price competition for cable modems. However, there can be no
assurance that the Company will be able to reduce the cost of its modems
sufficiently to enable it to compete with other cable modem suppliers. While
the Company has initiated cost reduction programs to offset pricing pressures
on its products, there can be no assurance that these cost reduction efforts
will keep pace with competitive pricing pressures or lead to improved gross
margins. If the Company is unable to obtain cost reductions, its gross margin
and profitability will be adversely affected. Many of the Company's competitors
are larger and manufacture products in significantly greater quantities than
the Company intends to for the foreseeable future. Consequently, such
competitors are likely to have more leverage in obtaining favorable pricing
from suppliers and manufacturers. In order to remain competitive, the Company
expects that it will have to significantly reduce the cost of manufacturing its
cable modems through design and engineering changes. Reductions in such
manufacturing costs will require the Company to utilize more highly integrated
components in future products and may require the Company to enter into high
volume or long-term purchase or manufacturing agreements. For example, the
Company has developed and intends to introduce a single-board modem by the end
of 1998, which the Company anticipates will provide cost savings over its
current dual-board modem. There can be no assurance that the Company will be
successful in redesigning its products, that any such redesign will be made on
a timely basis and without introducing significant errors and product defects,
or that any such redesign, including the single-board modem, would result in
sufficient cost reductions to allow the Company to significantly reduce the
list price of its products or improve its gross margin. Moreover, there can be
no assurance that volume purchase or manufacturing agreements will be available
on terms that the Company considers acceptable. To the extent that the Company
enters into a high volume or long-term purchase or manufacturing agreement and
then decides that it cannot use the products or services offered by such
agreement, the Company's business, operating results or financial condition
could be materially adversely affected. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Overview."
Limited Manufacturing Experience and Dependence on Contract Manufacturer. In
the first quarter of 1998, the Company commenced volume shipments of its
products and transitioned substantially all of its manufacturing operations
from CMC California, Inc. ("CMC") to Solectron Corporation ("Solectron"). Any
interruption in Solectron's operations could adversely affect the Company's
ability to meet its scheduled product deliveries to customers. The Company has
had only limited experience manufacturing its products to date, and there can
be no assurance that the Company, Solectron or any other manufacturer of the
Company's products will be successful in increasing the volume of its
manufacturing efforts. In addition, given the Company's lack of manufacturing
experience, together with the complexity of the manufacturing process, there
can be no assurance that the Company will not encounter difficulty
8
<PAGE>
in manufacturing its products in volume. The Company's limited operating
history and the early stage of the cable modem market make it difficult for
the Company to accurately forecast demand for its products. The Company's
inability to accurately forecast the actual demand for its products could
result in supply, manufacturing or testing capacity constraints. Such
constraints could result in delays in the delivery of the Company's products
or the loss of existing or potential customers, either of which could have a
material adverse effect on the Company's business, operating results or
financial condition. In addition, the Company has unconditional purchase
obligations of approximately $15.2 million as of June 30, 1998, primarily to
Solectron, to purchase minimum quantities of materials and components used to
manufacture the Company's products. If demand for the Company's products is
lower than anticipated, the fulfillment of these obligations by the Company
could adversely affect the Company's business, operating results or financial
conditions. See "Business--Manufacturing" and Note 4 of Notes to Consolidated
Financial Statements.
Dependence on Component Availability and Key Suppliers. The Company
manufactures all of its products using components or subassemblies procured
from third-party suppliers. Certain of these components are available from a
single source and others are available from limited sources. In addition, some
of the components are custom parts produced to the Company's specifications.
For example, the Company currently relies on VLSI Technology, Inc. ("VLSI") to
supply a custom ASIC that is used in its products. Other components, such as
the radio frequency ("RF") tuner and some surface acoustic wave filters are
procured from sole source suppliers. Any interruption in the operations of
vendors of sole sourced parts could adversely affect the Company's ability to
meet its scheduled product deliveries to customers. There can be no assurance
that delays in key component or product deliveries will not occur in the
future due to shortages resulting from a limited number of suppliers, the
financial or other difficulties of such suppliers or the possible limitation
in component product availability due to significant worldwide demand for such
components. For example, in the second half of 1997, the Company did not
receive the full shipment of cable modems anticipated from its subcontract
manufacturer because of problems experienced with one component that was not
functioning according to its specifications. There can be no assurance that
the Company will not experience similar supply problems in the future. In
addition, all of the Company's sales are from products containing one or more
components that are available from single supply sources. The Company also is
dependent on semiconductor manufacturers and is affected by worldwide
conditions in the semiconductor market. If the Company were unable to obtain a
sufficient supply of components from its current sources, it could experience
difficulties in obtaining alternative sources or in altering product designs
to use alternative components. Resulting delays or reductions in product
shipments could damage customer relationships and could adversely affect the
Company's business, operating results or financial condition. Further, a
significant increase in the price of one or more of these components could
have a material adverse effect on the Company's gross margin or operating
results. See "Business--Manufacturing."
Transition to New Manufacturing Process Technologies. The Company's future
success will depend in part upon its ability to develop products that utilize
new manufacturing process technologies. Manufacturing process technologies are
subject to rapid change and require significant expenditures for research and
development. The Company continuously evaluates the benefits of redesigning
its integrated circuits using smaller geometry process technologies in order
to improve performance and reduce costs. The Company believes that the
transition of its products to integrated circuits with increasingly smaller
geometries will be important to its competitive position. Other companies have
experienced difficulty in migrating to new manufacturing processes and,
consequently, have suffered reduced yields, delays in product deliveries and
increased expense levels. Moreover, the Company is dependent on its
relationships with its third-party manufacturers to migrate to smaller
geometry processes successfully. There can be no assurance that the Company
will be able to migrate to new manufacturing process technologies successfully
or on a timely basis. Any such failure by the Company could have a material
adverse effect on its business, operating results or financial condition.
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Dependence on Contract Manufacturer for Assembly and Testing. Substantially
all of the Company's products are assembled and tested by Solectron using
testing equipment produced by the Company. As a result of its dependence on
Solectron for assembly and testing of its products, the Company does not
directly control product delivery schedules or product quality. Any product
shortages or quality assurance problems could increase the costs of
manufacture, assembly or testing of the Company's products and could have a
material adverse effect on the Company's business, financial condition or
results of operation. In addition, as manufacturing volume increases, the
Company will need to procure and assemble additional testing equipment and
provide it to Solectron. Due to the amount of time typically required to
produce and assemble the testing equipment, the Company could experience
significant delays in the shipment of its products if it is unable to provide
such testing equipment to Solectron in a timely manner. Any delays in delivery
of the Company's products could have a material adverse effect on the
Company's business, operating results or financial condition. See "Business--
Manufacturing."
Evolving Industry Standards. Market acceptance of the Company's products may
be affected by the emergence and evolution of industry standards. Standards
efforts currently under way include those of the Digital Audio Video
Interactive Council ("DAVIC") in Europe and, in the United States, the
Institute of Electrical and Electronics Engineers, Inc. ("IEEE") 802.14
Committee and the Multimedia Cable Network System ("MCNS") consortium. MCNS
has created a cable modem standard based on TDMA technology and known as
DOCSIS, which was adopted as an international standard by the International
Telecommunications Union in March 1998. The Company is developing a next-
generation product, the Universal Cable Modem ("UCM"), to be compliant with
the DOCSIS standard. There can be no assurance that the Company will develop
an DOCSIS-compliant product at all or in a timely manner. The Company believes
that the broad adoption of DOCSIS will cause increased competition in the
North American market, which is likely to negatively affect the Company's
gross margin. There can be no assurance that competitors will not develop
DOCSIS-compliant products more quickly than the Company. Current customers of
the Company that move to the DOCSIS platform could choose alternative cable
modem suppliers or choose to purchase DOCSIS-compliant cable modems from
multiple suppliers. Further, there can be no assurance that the DOCSIS
standard will gain industry-wide acceptance. If the Company fails to deliver a
DOCSIS-compliant product by the time DOCSIS gains industry-wide acceptance or
if DOCSIS does not gain industry-wide acceptance, the Company's business
operating results or financial condition could be adversely affected.
In addition to the current DOCSIS standard, the MCNS consortium has begun
work on DOCSIS 2.0, a next-generation standard that is intended to enhance the
current standard to include functionality already found in S-CDMA. The Company
is actively working with MCNS, and other standards committees such as the IEEE
802.14 Committee, to advocate the inclusion of S-CDMA as the platform for
DOCSIS 2.0. There can be no assurance that the Company will be successful in
advocating S-CDMA's use in the next-generation standard. If the next-
generation standard emerges without S-CDMA as part of the standard, and if the
standard emerges based on competing modulation technologies, S-CDMA could be
isolated as a proprietary technology. This could result in customers selecting
competitors' products that comply with the DOCSIS 2.0 modulation technology
rather than the Company's products, and could require the Company to develop
new products that comply with the standard. If this occurs, the Company's
business, operating results and financial condition would be materially
adversely affected. Preliminary specifications for DOCSIS 2.0 may be released
formally or informally during 1998. If S-CDMA is not part of these preliminary
specifications, the Company's customers may cancel or delay orders even if the
standards committees are still considering including S-CDMA as part of the
final version of DOCSIS 2.0.
Dependence on Small Number of Customers. The Company's sales are highly
concentrated, with three customers accounting for approximately 73% of the
Company's revenues in 1997 and three customers accounting for approximately
64% of the Company's revenues in the first six months of 1998.
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In 1997, sales to Telegate Ltd. ("Telegate"), Sumitomo Corporation
("Sumitomo") and NET Brasil S.A. ("NET Brasil") represented approximately 30%,
29% and 14%, respectively, of the Company's total revenues. In the first six
months of 1998, sales to Shaw Communications Inc. ("Shaw"), Sumitomo and
Cablevision Systems, Inc. ("Cablevision") represented approximately 40%, 14%
and 10%, respectively, of the Company's total revenues. The Company believes
that a substantial majority of its revenues will continue to be derived from
sales to a relatively small number of customers for the foreseeable future. In
addition, the Company believes that sales to these customers will be focused
on a small number of projects. Ten cable operators in the United States own
and operate facilities passing approximately 74% of total homes passed in
1997. Due to the concentration of the Company's market, any reduction, delay
or loss of orders from a significant customer or customers would have a
material adverse effect on the Company's business, operating results and
financial condition. Major customers also are likely to have significant
negotiating leverage and may attempt to change the terms, including pricing,
upon which the Company and such customers do business. In addition, these
customers may require longer payment terms than the Company has anticipated,
which could require the Company to raise additional capital to meet its
working capital requirements. There can be no assurance that any such capital
would be available to the Company as required on reasonable terms or at all.
The Company markets its products to cable operators in the United States and
internationally. Due to the consolidation affecting the cable industry, with a
limited number of cable operators controlling an increasing number of cable
systems, the Company believes that its sales will be largely dependent upon
product acceptance by leading cable operators. If the Company's products are
not widely deployed, its business, operating results and financial condition
will be materially adversely affected. The Company's ability to increase its
revenues in the future will also depend in part upon its ability to make sales
to new customers. In the event that such sales do not occur, or if one or more
of the Company's customers elect to purchase and market competing technologies
or products, the Company's business, operating results and financial condition
would be adversely affected.
Dependence on Cable Operators and Other Service Providers. The Company
depends on cable operators to purchase its cable modem systems and to provide
its cable modems to end users. Cable operators have a limited amount of
available bandwidth over which they can offer robust data services, and there
can be no assurance that they will choose to provide Internet access. If cable
operators choose to provide such services, the Company will also be dependent
on them to market such services to cable customers, to install the Company's
equipment and to provide support to end-users. In addition, the Company will
be highly dependent on cable operators to continue to maintain their cable
infrastructure in such a manner that the Company will be able to provide
consistently high performance and reliable services. The Company's success
will also be dependent upon the acceptance of its products by other providers
of services to the cable industry, such as At Home Corporation ("@Home") and
Time Warner Cable's Road Runner ("Road Runner"). If cable operators and other
cable system service providers are unable to provide robust, high performance
and reliable services, the Company's business, operating results and financial
condition could be materially adversely affected. See "Business--Industry
Background" and "--Customers."
Dependence on the Cable Industry to Upgrade to Two-Way Cable
Infrastructure. Demand for the Company's products will depend to a significant
degree upon the magnitude and timing of capital spending by cable operators
for implementation of access systems for data transmission over cable
networks. This involves the enabling of two-way transmission over existing
coaxial cable networks and the eventual upgrade to HFC in areas of higher
penetration of data services. In addition, few businesses in the United States
currently have cable access. There can be no assurance that cable operators
will choose to upgrade existing residential cable systems or install new cable
systems to serve business locations. The success and future growth of the
Company's business will also be subject to economic and other factors
affecting the cable television industry generally, particularly its ability to
finance substantial capital expenditures. The capital spending patterns of
cable operators are dependent on a variety of factors, including availability
of financing, cable operators' annual budget cycles, the status of
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federal, local and foreign government regulation and deregulation, overall
demand for cable services, competitive pressures (including the availability
of alternative data transmission and access technologies), discretionary
consumer spending patterns and general economic conditions. The failure of
cable operators to complete these upgrades in a timely and satisfactory
manner, or at all, would limit the market for the Company's products and would
have a material adverse effect on the Company's business, operating results
and financial condition. In addition, cable spending can be subject to the
effects of seasonality, with fewer upgrade projects typically occurring in the
winter months. Capital spending levels in the cable industry in the United
States have fluctuated significantly in the past, and the Company believes
that such fluctuations will occur in the future. In recent periods, the United
States cable market has been characterized by the acquisition of smaller and
independent cable operators by large cable operators. The Company is unable to
predict the effect, if any, that consolidation in the United States cable
industry will have on overall capital spending patterns by cable operators.
The effect on the Company of further industry consolidation also is uncertain.
See "Business--Industry Background."
Ability to Market Effectively to Cable Operators. The Company believes that
its growth and future success will be substantially dependent upon its ability
to convince cable operators to adopt the Company's technologies, purchase the
Company's products and effectively market the Company's products to end users.
Cable operators are likely to prefer purchasing products from established
manufacturing companies that can demonstrate the capability to supply large
volumes of products on short notice. In addition, many cable operators may be
reluctant to adopt technologies that have not gained acceptance among other
cable operators, and such reluctance could result in lengthy product testing
and acceptance cycles for the Company's products. Consequently, the
impediments to the Company's initial sales may be even greater than those to
later sales, if any. No established distribution network in the cable modem
industry exists that would provide easy access by the Company to smaller or
geographically diverse cable operators. Therefore, the Company's initial sales
to larger, more established cable operators are critical to the Company's
business. Although the Company intends to establish strategic relationships
with leading distributors worldwide, there can be no assurance that Company
will be successful in establishing such relationships or that such
distributors will be successful in marketing the Company's products to cable
operators. Some competitors of the Company have already established
relationships with certain cable operators, such as Motorola Inc.'s
("Motorola") relationships with Tele-Communications, Inc. ("TCI"), Time Warner
Cable, Comcast Corporation and Cox Communications, Inc., which may further
limit the Company's ability to sell products to such cable operators. It is
likely that any such sales to cable operators will not be based on long-term
contracts and that such customers will be able to terminate their
relationships with the Company at any time. If the Company is unable to market
and sell its products to a significant number of cable operators, or if one or
more of the Company's current customers should cancel any relationship with
the Company, the Company's business, operating results and financial condition
would be materially adversely affected. See "Business--Strategy," "--
Customers" and "--Sales and Marketing."
Dependence on Products Under Development. The Company's future success will
depend in part on its ability to develop, introduce and market new products or
enhancements to existing products in a timely manner and to respond to
competitive pressures, evolving industry standards or technological advances.
For example, in November 1997, the Company announced the planned development
of its next-generation product, the UCM. The UCM is in the early stages of
design and development, and the Company does not anticipate shipment until
1999. The current design of the UCM requires ASIC fabrication at 0.2 micron
line widths, which has only recently been used by wafer fabrication facilities
for commercial production, increasing the risk that the Company's
semiconductor device will require a time-consuming redesign at a larger
geometry. The failure of the UCM or other future products to perform
acceptably in testing and development could result in major engineering
changes, increased development costs and significant delays in market
introduction. In addition, it is possible that customers may delay purchasing
the Company's current products in favor of next-generation products, which
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would have an adverse impact on the Company's operating results in the near
term. There can be no assurance that the Company's engineering and product
design efforts will be successful or that the Company will be successful in
developing new products or commercializing its current or any future products.
Any failure to release new products or to upgrade or redesign products on a
timely basis could have a material adverse effect on the Company's business,
operating results or financial condition. See "--Transition to New
Manufacturing Process Technologies" and "Business--Products."
Erosion of Average Selling Prices. The cable equipment systems industry has
been characterized, and is likely to continue to be characterized by, erosion
of average selling prices due to a number of factors, including competition,
rapid technological change and price performance enhancements. The Company
anticipates that ASPs and gross margins for its products will decrease over
product life cycles, due to competitive pressures and volume pricing
agreements. Decreasing ASPs could cause the Company to experience decreased
revenue even though the number of units sold could increase. As a result, the
Company may experience substantial period-to-period fluctuations in future
operating results due to ASP erosion. Therefore, the Company must continue to
develop and introduce on a timely basis next-generation products with enhanced
functionalities that could be sold at higher gross margins. Failure to achieve
the foregoing could cause the Company's revenues and gross margin to decline,
which would have a material adverse effect on the Company's business,
operating results and financial condition. See "Management's Discussion and
Analysis of Financial Condition and Results of Operations--Overview."
Ability to Provide Customer Support. The Company's ability to achieve its
planned sales growth and retain current and future customers will depend in
part upon the quality of its customer support operations. The Company's
customers generally require significant support and training with respect to
the Company's TeraComm system, particularly in the initial deployment and
implementation stage. To date, the Company has sold a limited number of
products, and such sales have been concentrated in a small number of
customers. The Company does not have any experience with widespread deployment
of its products to a diverse customer base, and there can be no assurance that
it will have adequate personnel to provide the levels of support that its
customers may require during initial product deployment or on an ongoing
basis. An inability to provide sufficient support to its customers could delay
or prevent the successful deployment of the Company's products. In addition,
failure to provide adequate support could have an adverse impact on the
Company's reputation and relationship with its customers, could prevent the
Company from gaining new customers and could have a material adverse effect on
the Company's business, operating results or financial condition. See
"Business--Customer Service and Technical Support."
Need to Develop Additional Distribution Channels. The Company presently
markets its products to cable operators and systems integrators. The Company
believes that much of the North American cable modem market may shift to a
retail distribution model. Accordingly, the Company anticipates that it may
need to redirect its marketing efforts in the future to sell its cable modems
directly to retail distributors and end users, which would require the
establishment of new distribution channels for its products. There can be no
assurance that the Company will be able to establish such additional
distribution channels or that, if the Company does establish additional
channels, it will have the capital required or the ability to hire the
additional personnel necessary to foster and enhance such distribution
channels. In addition, if the cable modem market shifts to a retail
distribution model, there can be no assurance that the Company will
successfully establish a retail distribution presence. Failure by the Company
to establish such distribution channels could have a material adverse affect
on the Company's business, operating results or financial condition. To the
extent that large consumer electronics companies enter the cable modem market,
their well established retail distribution capabilities would provide them
with a significant competitive advantage.
Lengthy Sales Cycle. The sales cycle associated with the Company's products
is typically lengthy, often lasting six months to a year. The Company's
customers typically conduct significant technical evaluations of competing
technologies prior to the commitment of capital and other resources. In
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addition, customers' internal procedures required to approve large capital
expenditures and test, accept and deploy new technologies often delay
purchasing decisions. Sales also generally are subject to customer trials,
which typically last three months. Because of the lengthy sales cycle and the
large size of customers' orders, if orders forecasted for a specific customer
for a particular quarter do not occur in that quarter, the Company's operating
results for that quarter could be materially adversely affected. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations--Overview."
Highly Competitive Industry; Established Competitors. The market for
broadband access systems is extremely competitive and is characterized by
rapid technological change. The Company's direct competitors in the cable
modem arena include Bay Networks, Inc. ("Bay Networks"), Com21, Inc.
("Com21"), Hayes Microcomputer Products, Inc. ("Hayes"), Hybrid Networks, Inc.
("Hybrid"), Matsushita Electric Industrial Co., Ltd. (which markets products
under the brand name "Panasonic") ("Matsushita"), Motorola, Phasecom Inc.
("Phasecom"), Thomson Consumer Electronics, Inc. (which markets products under
the brand name "RCA"), Samsung Corporation ("Samsung"), Scientific-Atlanta,
Inc. ("Scientific-Atlanta"), Sony Corporation ("Sony"), 3Com Corporation
("3Com"), Toshiba Corporation ("Toshiba") and Zenith Electronics Corporation
("Zenith"), and there are many other potential market entrants. In addition,
Bay Networks, Com21, Hybrid and Motorola introduced cable modems prior to the
Company, and have established relationships and have worked with customers for
a longer period of time than the Company. The principal competitive factors in
this market include: product performance, features and reliability; price;
size and stability of operations; breadth of product line; sales and
distribution capability; technical support and service; relationships with
cable operators; standards compliance; and general industry and economic
conditions. Certain of these factors are outside of the Company's control. The
existing conditions in the broadband access market could change rapidly and
significantly as a result of technological changes, and the development and
market acceptance of alternative technologies could decrease the demand for
the Company's products or render them obsolete. There can be no assurance that
these companies and other competitors will not introduce broadband access
products that will be less costly, provide superior performance or achieve
greater market acceptance than the Company's products.
The Company sells products that also compete with existing data access and
transmission systems utilizing the telecommunications networks, such as those
of 3Com. Additionally, the Company's controller and headend system products
face intense competition from well-established companies such as Bay Networks,
Cisco Systems, Inc. ("Cisco") and 3Com. Many of the Company's current and
potential competitors have significantly greater financial, technical,
marketing, distribution, customer support and other resources, as well as
greater name recognition and access to customers than the Company. The
anticipated widespread adoption of DOCSIS is likely to cause increased price
competition in the North American market. Further, such adoption could result
in lower sales of headend products by the Company in the North American
market. Any such increased price competition or reduction in sales of headend
products would result in downward pressure on the Company's gross margin,
which could have a material adverse effect on the Company's business,
operating results or financial condition. There can be no assurance that the
Company will be able to compete successfully against current or future
competitors or that the competitive pressures faced by the Company will not
have a material adverse effect on its business, operating results and
financial condition. See "--Market Acceptance of Cable Modems; Competing
Technologies."
Dependence on Effective Management of Growth. The growth in the Company's
business has placed, and is expected to continue to place, a significant
strain on the Company's limited personnel, management and other resources.
There can be no assurance that the Company's management, personnel, systems,
procedures and controls will be adequate to support the Company's existing and
future operations. The Company's ability to manage any future growth
effectively will require it to attract, train, motivate, manage and retain
employees successfully, to integrate new employees into its overall operations
and to continue to improve its operational, financial and management systems.
The Company has hired certain key employees and officers only recently,
including its Chief Financial Officer
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and Vice President, Manufacturing Operations, and the Company filled the
position of Chief Operating Officer in February 1998. As a result, the
Company's entire management team has worked together for a brief time. The
failure to manage its growth effectively could have a material adverse effect
on the Company's business, operating results or financial condition. See
"Business--Employees" and "Management."
Dependence on the Internet and Internet Infrastructure Development. The
commercial market for products designed for the Internet has only recently
begun to develop, and the Company's success will depend in large part on
increased use of the Internet to increase the need for high speed broadband
access networks. Critical issues concerning the commercial use of the Internet,
including security, reliability, cost, ease of access and Quality of Service,
remain unresolved and are likely to affect the development of the market for
the Company's products. The adoption of the Internet for commerce and
communications, particularly by enterprises that have historically relied upon
alternative means of commerce and communications, generally requires the
acceptance of a new method of conducting business and exchanging information.
In addition, the Company is dependent on the growth of the use of the Internet
by businesses, particularly for applications that utilize multimedia content
and thus require high bandwidth. The recent growth in the use of the Internet
has caused frequent periods of performance degradation, requiring the upgrade
of routers, telecommunications links and other components forming the
infrastructure of the Internet by Internet service providers and other
organizations with links to the Internet. Any perceived degradation in the
performance of the Internet as a whole could undermine the benefits of the
Company's products. Potentially increased performance provided by the products
of the Company and others is ultimately limited by and reliant upon the speed
and reliability of the Internet backbone itself. Consequently, the emergence
and growth of the market for the Company's products will be dependent on
improvements being made to the entire Internet infrastructure to alleviate
overloading and congestion. If the Internet as a commercial or business medium
fails to develop or develops more slowly than expected, the Company's business,
operating results and financial condition could be materially adversely
affected. See "Business--Industry Background."
Risks of Product Returns, Product Liability and Product Defects. Products as
complex as those offered by the Company frequently contain undetected errors or
failures, especially when first introduced or when new versions are released.
There can be no assurance that, despite testing by the Company, errors will not
occur. The occurrence of such errors could result in product returns and other
losses to the Company or its customers. Such occurrence could also result in
the loss of or delay in market acceptance of the Company's products, which
could have a material adverse effect on the Company's business, operating
results and financial condition. Due to the recent introduction of the
Company's products, the Company has limited experience with the problems that
could arise with this generation of products. The Company's purchase agreements
with its customers typically contain provisions designed to limit the Company's
exposure to potential product liability claims, however, it is possible that
the limitation of liability provision contained in the Company's purchase
agreements may not be effective as a result of federal, state or local laws or
ordinances or unfavorable judicial decisions in the United States or other
countries. Although the Company has not experienced any product liability
claims to date, the sale and support of the Company's products entails the risk
of such claims. In addition, any failure by the Company's products to properly
perform could result in claims against the Company by its customers. The
Company maintains insurance to protect against certain claims associated with
the use of its products, but there can be no assurance that its insurance
coverage would adequately cover any claim asserted against the Company. A
successful claim brought against the Company that is in excess of, or excluded
from, its insurance coverage, could have a material adverse effect on the
Company's business, operating results or financial condition. In addition, even
claims that ultimately are unsuccessful could result in the Company's
expenditure of funds in litigation and management time and resources. There can
be no assurance that the Company will not be subject to material claims in the
future, that such claims will not result in liability in excess of its
insurance coverage, that the Company's
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insurance will cover such claims or that appropriate insurance will continue
to be available to the Company in the future at commercially reasonable rates.
Dependence on Proprietary Technology; Protection of Intellectual Property
Rights. The Company relies on a combination of patent, trade secret, copyright
and trademark laws and contractual restrictions to establish and protect
proprietary rights in its products. There can be no assurance that the
Company's patent applications will be granted or, if granted, that the claims
covered by the patents will not be reduced from those included in the
Company's applications. Any patent might be subject to challenge in court and,
whether or not challenged, might not be sufficiently broad to prevent third
parties from developing equivalent technologies or products. The Company has
entered into confidentiality and invention assignment agreements with its
employees, and enters into non-disclosure agreements with certain of its
suppliers, distributors and appropriate customers so as to limit access to and
disclosure of its proprietary information. There can be no assurance that
these statutory and contractual arrangements will prove sufficient to prevent
misappropriation of the Company's technology or to deter independent third-
party development of similar technologies. In addition, the laws of certain
foreign countries might not protect the Company's products or intellectual
property rights to the same extent as do the laws of the United States, and
protection of such intellectual property might not be available in every
country in which the Company's products might be manufactured, marketed or
sold.
The Company expects that developers of cable modems will increasingly be
subject to infringement claims as the number of products and competitors in
the Company's industry segment grows. The Company has received a letter from
an individual claiming that the Company's technology infringes a patent held
by such individual. The Company has reviewed the allegations made by such
individual and, after consulting with its patent counsel, does not believe
that the Company's technology infringes any valid claim of such individual's
patent. There can be no assurance that, if the issue were to be submitted to a
court, such a court would not find that the Company's products infringe the
patent, nor that the individual will not continue to assert infringement. If
the Company is found to have infringed such individual's patent, the Company
could be subject to substantial damages and/or an injunction preventing it
from conducting its proposed business. In addition, there can be no assurance
that other third parties will not assert infringement claims against the
Company in the future. Any such claim, whether meritorious or not, could be
time-consuming, result in costly litigation, cause product shipment delays or
require the Company to enter into royalty or licensing agreements. Such
royalty or licensing agreements may not be available on terms acceptable to
the Company or at all, which could have a material adverse effect upon the
Company's business, operating results and financial condition. Litigation may
also be necessary to enforce the Company's intellectual property rights. Any
infringement claim or other litigation against or by the Company could have a
material adverse effect on the Company's business, operating results or
financial condition. See "Business--Technology" and "--Intellectual Property."
Risks of Doing Business in International Markets. Sales to customers outside
of the United States accounted for approximately 88% and 79% of revenues in
1997 and the first six months of 1998, respectively, and the Company expects
sales to customers outside of the United States to continue to represent a
significant percentage of the Company's revenues for the foreseeable future.
International sales are subject to a number of risks, including changes in
foreign government regulations and communications standards, export license
requirements, tariffs and taxes, other trade barriers, difficulty in
collecting accounts receivable, difficulty in managing foreign operations and
political and economic instability. To the extent the Company's customers may
be impacted by currency devaluations or general economic crises such as the
economic crisis currently affecting many Asian and Latin American economies,
the ability of such customers to purchase the Company's products could be
materially adversely affected. Payment cycles for international customers are
typically longer than those for customers in the United States. There also can
be no assurance that foreign markets for the Company's products will not
develop more slowly than currently anticipated. Foreign countries may decide
not to construct cable infrastructure, place moratoria on building cable
plants or terminate or delay construction
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of such facilities for a variety of reasons, including environmental issues,
economic downturns, the availability of favorable pricing for other
communications services or the availability and cost of related equipment. Any
such action by foreign countries would reduce the market for the Company's
products, which would materially adverse affect the Company's business,
operating results and financial condition.
The Company anticipates that its foreign sales generally will be invoiced in
U.S. dollars and, accordingly, the Company currently does not plan to engage
in foreign currency hedging transactions. However, as the Company commences
and expands its international operations, it may be paid in foreign currencies
and exposure to losses in foreign currency transactions may increase. The
Company may choose to limit such exposure by the purchase of forward foreign
exchange contracts or through similar hedging strategies. There can be no
assurance that any currency hedging strategy would be successful in avoiding
exchange-related losses. In addition, if the relative value of the U.S. dollar
in comparison to the currency of the Company's foreign customers should
increase, the resulting effective price increase of the Company's products to
such foreign customers could result in decreased sales, which could have a
material adverse impact on the Company's business, operating results or
financial condition. See "Business--Customers."
Dependence on Key Personnel; Competitive Market for Personnel. Due to the
specialized nature of the Company's business, the Company is highly dependent
on the continued service of, and on the ability to attract and retain,
qualified engineering, sales, marketing and senior management personnel,
particularly the Company's Chairman, President and Chief Technical Officer,
Shlomo Rakib, and its Chief Executive Officer, Zaki Rakib. The competition for
such personnel is intense and the loss of any such persons would have a
material adverse effect on the Company's business and operating results. In
addition, an inability to hire additional qualified personnel as needed could
impair the Company's ability to adequately manage and complete its existing
sales commitments and to bid for and execute additional sales. Further, the
Company must train and manage its growing employee base, which is likely to
require increased levels of responsibility for both existing and new
management personnel. There can be no assurance that the management personnel
and systems currently in place will be adequate or that the Company will be
able to assimilate new employees successfully. Highly skilled employees with
the education and training required by the Company, especially employees with
significant experience and expertise in both data networking and radio
frequency design, are in high demand. There can be no assurance that the
Company will be able to continue to attract and retain the qualified personnel
necessary for the development of its business. The Company does not have "key
person" insurance coverage for the loss of any of its employees. Any officer
or employee of the Company can terminate his or her relationship with the
Company at any time and are not bound by any non-competition agreements with
the Company. See "Business--Employees" and "Management."
Regulation of the Communications Industry. The Company and its customers are
subject to varying degrees of federal, state and local regulation. The
jurisdiction of the Federal Communications Commission ("FCC") extends to the
communications industry, including broadband access products such as those of
the Company. The FCC has promulgated regulations that, among other things, set
installation and equipment standards for communications systems. Although FCC
regulations and other governmental regulations have not materially restricted
the Company's operations, there can be no assurance that future regulations
adopted by the FCC or other regulatory bodies will not have a material adverse
effect on the Company. Further, regulation of the Company's customers may
adversely impact the Company's business, operating results and financial
condition. For example, FCC regulatory policies affecting the availability of
cable services and other terms on which cable companies conduct their
business, may impede the Company's penetration of certain markets. In
addition, regulation of cable television rates may affect the speed at which
cable operators upgrade their cable infrastructures to two-way HFC. Changes
in, or the failure by the Company to comply with, applicable domestic and
international regulations could have a material adverse effect on the
Company's business, operating results and financial condition. In addition,
the increasing demand for communications systems has
17
<PAGE>
exerted pressure on regulatory bodies worldwide to adopt new standards for
such products and services, generally following extensive investigation of and
deliberation over competing technologies. The delays inherent in this
governmental approval process have in the past, and may in the future, cause
the cancellation, postponement or rescheduling of the installation of
communications systems by the Company's customers, which in turn may have a
material adverse effect on the sale of products by the Company to such
customers.
If other countries begin to regulate the cable modem industry more heavily
or introduce standards or specifications with which the Company's products do
not comply, the Company will be unable to offer products in those countries
until its products comply with such standards or specifications and the
Company may have to incur substantial costs in order to comply with such
standards or specifications. For instance, should the DAVIC standards for ATM-
based digital video be established internationally, the Company will be
required to conform its cable modems in order to compete. Further, many
countries do not have regulations for installation of cable modem systems or
for upgrading existing cable network systems to accommodate the Company's
products. Whether the Company currently operates in such a country or enters
into the market in a country where no such regulations exist, there can be no
assurance that such regulations will not be proposed at any time, and if
imposed, that they would not place limitations on the country's cable
operators' ability to upgrade to support the Company's products. There can be
no assurance that the cable operators in such countries would be able to
comply with such regulations or that compliance with such regulations would
not require a long, costly process. For example, the Company experienced
delays in product shipments to a customer in Brazil due to delays in certain
regulatory approvals in Brazil, and there can be no assurance that similar
delays will not occur in other countries in which the Company markets or plans
to market its products. In addition, the Company's customers in certain parts
of Asia, such as Japan, are required to obtain licenses prior to selling the
Company's products, and delays in obtaining such licenses could have an
adverse impact on the Company's operating results. See "Business--Regulation."
Other Regulatory Approvals or Certifications. In the United States, in
addition to complying with FCC regulations, the Company's products will be
required to meet certain safety requirements. For example, the Company will be
required to have its products certified by Underwriters Laboratory ("UL") in
order to meet federal requirements relating to electrical appliances to be
used inside the home. Outside of the United States, the Company's products
will be subject to the regulatory requirements of each country in which the
products are manufactured or sold. These requirements are likely to vary
widely, and there can be no assurance that the Company will be able to obtain
on a timely basis or at all such regulatory approvals as may be required for
the manufacture, marketing and sale of its products. In addition to regulatory
compliance, some cable industry participants may require certification of
compatibility. Any delay in or failure to obtain such approvals or
certifications could have a material adverse effect on the Company's business,
operating results and financial condition. See "Business--Regulation."
Year 2000 Compliance. Many existing computer systems and applications and
other control devices use only two digits to identify a year in the date
field, without considering the impact of the upcoming change in the century.
As a result, in less than two years, computer systems and applications used by
many companies may need to be upgraded to comply with Year 2000 requirements.
Significant uncertainty exists in the computer industry concerning the
potential effects associated with such compliance. The Company relies on
computer systems in operating and monitoring many significant aspects of its
business, including financial systems (such as general ledger, accounts
payable, accounts receivable, inventory and order management), customer
services, infrastructure and network and telecommunications equipment. The
Company also relies directly and indirectly on the systems of external
business enterprises such as customers, suppliers, creditors, financial
organizations and domestic and international governments. The Company
currently estimates that its costs associated with Year 2000 compliance,
including any costs associated with the consequences of incomplete or untimely
resolution of Year 2000 compliance issues, will not have a material adverse
effect on the Company's business,
18
<PAGE>
financial condition or results of operations in any given year. However, the
Company has not extensively investigated and does not believe that it has
fully identified the impact of Year 2000 compliance and has not concluded that
it can resolve any issues that may arise in connection with Year 2000
compliance without disruption of its business or without incurring significant
expense. In addition, even if the Company's internal systems are not
materially affected by Year 2000 compliance issues, the Company could be
affected through disruption in the operation of the enterprises with which the
Company interacts. There can be no assurance that the Company's products will
be Year 2000 compliant, that third-party products with which the Company's
products interface will be Year 2000 compliant or that any changes to third-
party products made in response to Year 2000 compliance issues will not render
the Company's products incompatible with such third-party products.
Control by Existing Stockholders and Management. Following the closing of
this offering, the Company's directors, officers and their respective
affiliates will beneficially own approximately 51.0% of the Company's
outstanding Common Stock (49.5% if the Underwriters' over-allotment option is
exercised in full). As a result, the Company's directors, officers and their
respective affiliates, if they voted together, would be able to exercise
significant influence over the election of members of the Company's Board of
Directors and other corporate actions requiring stockholder approval have a
significant impact on the management and direction of the Company. See
"Principal Stockholders."
Management's Broad Discretion Over Use Of Proceeds of the Offering. Although
the Company intends to use the net proceeds of this offering for working
capital and general corporate purposes, including capital expenditures, the
Company currently has no specific plans for a significant portion of such
proceeds. Consequently, the Company's management will have the discretion to
allocate the net proceeds to uses that stockholders may not deem desirable,
and there can be no assurance that the net proceeds can or will be invested to
yield a significant return. Substantially all of the proceeds of the offering
will be invested in short-term, interest-bearing, investment grade securities
immediately following the offering. See "Use of Proceeds."
Absence of Prior Trading Market; Potential Volatility of Stock Price. Prior
to this offering, there has been no public market for the Common Stock. There
can be no assurance that an active trading market will develop or, if one
develops, that it will be maintained. The market price of the shares of Common
Stock could be subject to significant fluctuations in response to the
Company's operating results and other factors, including general economic and
market conditions. In addition, the stock market in recent years has
experienced and continues to experience extreme price and volume fluctuations,
which have affected the market price of the stock of many companies and which
have often been unrelated or disproportionate to the operating performance of
these companies. These fluctuations, as well as a shortfall in sales or
earnings compared to securities analysts' expectations, changes in analysts'
recommendations or projections or general economic and market conditions, may
adversely affect the market price of the Common Stock. In the past, securities
class action litigation has often been instituted following periods of
volatility in the market price for a company's securities. Such litigation
could result in substantial costs and a diversion of management attention and
resources, which could have a material adverse effect on the Company's
business, operating results and financial condition.
Anti-Takeover Provisions. The Company's Certificate of Incorporation (the
"Certificate") authorizes the Board of Directors to issue up to 5,000,000
shares of Preferred Stock and to determine the powers, designations,
preferences, rights, qualifications, limitations and restrictions, including
voting rights, of those shares without any further vote or action by the
stockholders. The rights of the holders of Common Stock will be subject to,
and may be adversely affected by, the rights of the holders of any Preferred
Stock that may be issued in the future. The Certificate and Bylaws, among
other things, provide for a classified Board of Directors, require that
stockholder actions occur at duly called meetings of the stockholders, limit
who may call special meetings of stockholders and require advance notice of
stockholder proposals and director nominations. These and other provisions
could have the effect of making it more difficult for a third party to acquire
a majority of the outstanding voting stock of the
19
<PAGE>
Company, discourage a hostile bid or delay, prevent or deter a merger,
acquisition or tender offer in which the Company's stockholders could receive
a premium for their shares, or a proxy contest for control of the Company or
other change in the Company's management. See "Management" and "Description of
Capital Stock."
Shares Eligible for Future Sale. The sale of a substantial number of shares
of Common Stock in the public market following this offering could adversely
affect the market price of the Common Stock. Upon the closing of this
offering, the Company will have outstanding an aggregate of 16,220,733 shares
of Common Stock, based on the number of shares outstanding as of June 30, 1998
and assuming no exercise of outstanding options and warrants. The 3,000,000
shares of Common Stock sold in this offering will be freely tradable without
restriction under the Securities Act of 1933, as amended (the "Securities
Act"). The remaining 13,220,733 shares of Common Stock are "Restricted Shares"
and are subject to restrictions under the Securities Act. All of these
Restricted Shares are subject to lock-up agreements pursuant to which the
holders have agreed not to sell or otherwise dispose of any of their shares
for a period of 180 days after the date of this Prospectus without the prior
written consent of BT Alex. Brown Incorporated or, in certain instances, the
Company. All or a portion of such shares may be released at any time and
without notice. The Company has agreed with BT Alex. Brown Incorporated not to
release any stockholder from any lock-up agreement between the Company and the
stockholder without the prior written consent of BT Alex. Brown Incorporated.
Approximately 12,145,105 Restricted Shares subject to lock-up agreements will
become available for sale in the public market immediately following
expiration of the 180-day lock-up period, subject to the volume and other
limitations of Rule 144 and Rule 701 under the Securities Act, and the
remaining Restricted Shares subject to lock-up agreements and other
contractual restrictions will become eligible for sale at various times
thereafter following the expiration of their respective one-year holding
periods under Rule 144. In addition, certain stockholders of the Company have
the right to register shares of Common Stock for sale in the public market,
and the Company intends to register shares of Common Stock authorized for
issuance under the Company's equity incentive plans shortly following the
closing of this offering. See "Shares Eligible for Future Sale" and
"Description of Capital Stock--Registration Rights."
Dilution; Absence of Cash Dividends. Purchasers of the shares of Common
Stock offered hereby will experience immediate and substantial dilution in the
net tangible book value of $10.63 per share, from the initial public offering
price of $13.00 per share. Additional dilution will occur upon exercise of
outstanding options and warrants. See "Dilution" and "Shares Eligible for
Future Sale." The Company has never paid any dividends and does not anticipate
paying cash dividends in the foreseeable future. See "Dividend Policy."
20
<PAGE>
INFORMATION REGARDING FORWARD-LOOKING STATEMENTS
When used in this Prospectus, the words "expects," "anticipates,"
"estimates," and similar expressions are intended to identify forward-looking
statements. Such statements, which include but are not limited to statements
under the captions "Risk Factors," "Use of Proceeds," "Management's Discussion
and Analysis of Financial Condition and Results of Operations," "Business" and
elsewhere in this Prospectus as to the timing of availability of products under
development; the Company's ability to commercialize new products; the
acceptance and performance of the Company's products; demand for broadband
access services; the ability of the Company to achieve cost reductions; the
compliance of future products with various industry standards; the Company's
ability to make sales to new customers; the Company's ability to develop,
introduce and market new products in a timely manner; the Company's ability to
provide sufficient customer support; the adequacy of capital resources; future
fluctuations in operating expenses; future capital expenditures; the
sufficiency of existing and potential cash resources and the use of the
proceeds of this offering are subject to risks and uncertainties that could
cause actual results to differ materially from those projected. The cautionary
statements made in this Prospectus should be read as being applicable to all
related forward-looking statements wherever they appear in this Prospectus. The
Company assumes no obligation to update such forward-looking statements or to
update the reasons actual results could differ materially from those
anticipated in such forward-looking statements.
21
<PAGE>
USE OF PROCEEDS
The net proceeds to the Company from the sale of the 3,000,000 shares of
Common Stock offered by the Company, at an initial public offering price of
$13.00 per share, are estimated to be approximately $34,870,000 ($40,310,500 if
the Underwriters' over-allotment option is exercised in full), after deducting
underwriting discounts and commissions and estimated offering expenses payable
by the Company. The Company expects to use the net proceeds for general
corporate purposes, including approximately $12.0 million for research and
development, $7.5 million for capital expenditures and the remainder for
working capital, including the settlement of $15.2 million of outstanding
purchase obligations. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Liquidity and Capital Resources." The
amounts and timing of the Company's actual expenditures will depend upon
numerous factors, including the status of the Company's product development and
commercialization efforts, the amount of cash generated by the Company's
operations, competition and sales and marketing activities. Pending application
of the net proceeds as described above, the Company intends to invest the net
proceeds of the offering in short-term, investment-grade, interest-bearing
securities.
DIVIDEND POLICY
The Company has never paid any cash dividends on its capital stock. The
Company currently anticipates that it will retain earnings to support
operations and to finance the growth and development of the Company's business
and does not anticipate paying cash dividends for the foreseeable future. In
addition, the Company's credit agreement prohibits the payment of cash
dividends without the lender's written consent.
22
<PAGE>
CAPITALIZATION
The following table sets forth the capitalization of the Company as of June
30, 1998, (i) on an actual basis and (ii) as adjusted to reflect the
conversion of all outstanding shares of Preferred Stock into Common Stock and
the sale of 3,000,000 shares of Common Stock offered by the Company, at an
initial public offering price of $13.00 per share and the receipt of the
estimated net proceeds therefrom.
<TABLE>
<CAPTION>
JUNE 30, 1998
----------------------
ACTUAL(1) AS ADJUSTED
--------- -----------
(IN THOUSANDS)
<S> <C> <C>
Current portion of long-term debt...................... $ 2,180 $ 2,180
======== =======
Long-term debt, less current portion................... $ 24 $ 24
Redeemable convertible preferred stock, $.001 par
value; authorized shares included in convertible
preferred stock authorized actual, no shares
authorized as adjusted; 576,924 shares issued and
outstanding actual; no shares issued and outstanding
as adjusted........................................... 7,500 --
Redeemable common stock, $0.001 par value; authorized
shares included in common stock authorized actual, no
shares authorized as adjusted; 10,000 shares issued
and outstanding actual; no shares issued and
outstanding as adjusted............................... 13 --
Stockholders' equity (net capital deficiency) (2):
Preferred Stock, $.001 par value; 4,600,903 shares
authorized actual and 5,000,000 shares authorized as
adjusted; no shares issued and outstanding actual and
as adjusted.......................................... -- --
Convertible Preferred Stock, $.001 par value;
10,399,097 shares authorized actual; no shares
authorized as adjusted; 7,783,711 shares issued and
outstanding, actual; no shares issued and
outstanding, as adjusted............................. 8 --
Common Stock, $.001 par value; 35,000,000 shares
authorized actual; 30,000,000 shares authorized as
adjusted; 4,850,098 shares issued and outstanding
actual; 16,220,733 shares issued and outstanding as
adjusted............................................. 5 16
Additional paid in capital............................. 70,517 112,897
Accumulated deficit.................................... (72,420) (72,420)
Deferred compensation.................................. (1,959) (1,959)
Stockholders' notes receivable......................... (22) (22)
-------- -------
Total stockholders' equity (net capital deficiency).. (3,871) 38,512
-------- -------
Total capitalization................................. $ 3,666 $38,536
======== =======
</TABLE>
- --------
(1) Reflects the Company's reincorporation in Delaware in July 1998.
(2) Excludes (i) approximately 2,483,292 shares issuable upon exercise of
options outstanding at a weighted average exercise price of $2.50 per
share, (ii) 3,107,851 shares issuable upon exercise of outstanding
warrants with a weighted average exercise price of $6.60 per share, (iii)
approximately 2,453,937 shares reserved for future grants under the
Company's stock option plans and (iv) 700,000 shares reserved for issuance
pursuant to the Company's 1998 Employee Stock Purchase Plan. See
"Management--Employee Benefit Plans" and Note 8 of Notes to Consolidated
Financial Statements.
23
<PAGE>
DILUTION
The pro forma net tangible book value of the Company at June 30, 1998 was
approximately $3,642,000 or $0.28 per share. Pro forma net tangible book value
per share is determined by dividing the Company's tangible net worth (tangible
assets less liabilities) by the number of shares of Common Stock outstanding,
after giving effect to the conversion of Preferred Stock upon completion of
this offering. After giving effect to the sale by the Company of the 3,000,000
shares of Common Stock offered hereby at an initial public offering price of
$13.00 per share, after deducting underwriting discounts and commissions and
estimated offering expenses, the pro forma net tangible book value of the
Company as of June 30, 1998 would have been $38,512,000 or $2.37 per share.
This represents an immediate increase in net tangible book value of $2.09 per
share to existing stockholders and an immediate dilution in net tangible book
value of $10.63 per share to new investors purchasing shares at the initial
public offering price. The following table illustrates this per share
dilution:
<TABLE>
<S> <C> <C>
Initial public offering price per share...................... $13.00
------
Pro forma net tangible book value per share as of June 30,
1998...................................................... $0.28
Increase per share attributable to this offering........... 2.09
-----
Pro forma net tangible book value per share after offering... 2.37
------
Dilution per share to new investors.......................... $10.63
======
</TABLE>
The following table summarizes, on a pro forma basis as of June 30, 1998,
the difference between the number of shares of Common Stock purchased from the
Company, the total consideration paid and the average price per share paid by
the existing stockholders and by the new investors at an initial public
offering price of $13.00 per share for shares purchased in this offering,
before deducting underwriting discounts and commissions and estimated offering
expenses:
<TABLE>
<CAPTION>
SHARES PURCHASED(1) TOTAL CONSIDERATION
------------------------------------------ AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
------------ --------------------- ------- -------------
<S> <C> <C> <C> <C> <C>
Existing stockholders... 13,220,733 81.5% $53,047,000 57.6% $ 4.01
New investors........... 3,000,000 18.5 39,000,000 42.4 13.00
------------ ------- ----------- -----
Total................. 16,220,733 100.0% $92,047,000 100.0%
============ ======= =========== =====
</TABLE>
- --------
(1) The foregoing computations assume no exercise of outstanding stock
options. As of June 30, 1998, options were outstanding to purchase
2,483,292 shares at a weighted average exercise price of $2.50 per share
and warrants were outstanding to purchase 3,107,851 shares at a weighted
average exercise price of $6.60 per share. To the extent that outstanding
options and warrants are exercised, there will be further dilution to new
investors. See "Management--Employee Benefit Plans" and Note 8 of Notes to
Consolidated Financial Statements.
24
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The consolidated statement of operations data for the years ended December
31, 1995, 1996 and 1997 and the consolidated balance sheet data as of December
31, 1996 and 1997, have been derived from the audited consolidated financial
statements of the Company included elsewhere in this Prospectus that have been
audited by Ernst & Young LLP, independent auditors. The consolidated statement
of operations data for the year ended December 31, 1994 and the consolidated
balance sheet data as of December 31, 1994 and 1995 have been derived from the
audited consolidated financial statements of the Company not included herein.
The consolidated statement of operations data for the period from January 20,
1993 (inception) to December 31, 1993 and the consolidated balance sheet data
at December 31, 1993 have been derived from unaudited financial statements of
the Company not included herein. The consolidated statement of operations data
for the six months ended June 30, 1997 and 1998 and the consolidated balance
sheet data at June 30, 1998 are derived from unaudited financial statements
included elsewhere in this Prospectus and contain all adjustments, consisting
of normal recurring accruals, necessary for a fair presentation of the
financial position and results of operations for such periods. The results of
operations for the six months ended June 30, 1998 are not necessarily
indicative of results to be expected for the full fiscal year. The data set
forth below should be read in conjunction with the consolidated financial
statements of the Company, including the notes thereto, and with "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
included elsewhere in this Prospectus.
<TABLE>
<CAPTION>
PERIOD FROM SIX MONTHS
JANUARY 20, ENDED
1993 (INCEPTION) YEARS ENDED DECEMBER 31, JUNE 30,
TO DECEMBER 31, ------------------------------------- -----------------
1993 1994 1995 1996 1997 1997 1998
---------------- -------- ------- -------- -------- ------- --------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT
OF OPERATIONS DATA:
Revenues................ $ 128 $ 140 $ -- $ -- $ 2,118 $ 93 $ 9,376
Cost of goods sold...... -- -- 676 -- 6,462 482 11,517
------ -------- ------- -------- -------- ------- --------
Gross profit (loss)..... 128 140 (676) -- (4,344) (389) (2,141)
------ -------- ------- -------- -------- ------- --------
Operating expenses:
Research and develop-
ment.................. 157 235 2,028 8,020 11,319 5,886 4,923
Sales and marketing.... -- 17 205 1,141 4,468 1,523 2,969
General and administra-
tive.................. 26 84 825 1,789 2,546 1,105 1,282
------ -------- ------- -------- -------- ------- --------
Total operating ex-
penses................ 183 336 3,058 10,950 18,333 8,514 9,174
------ -------- ------- -------- -------- ------- --------
Loss from operations.... (55) (196) (3,734) (10,950) (22,677) (8,903) (11,315)
Net interest income (ex-
pense)................. -- -- 68 253 128 123 (32)
------ -------- ------- -------- -------- ------- --------
Net loss................ (55) (196) (3,666) (10,697) (22,549) (8,780) (11,347)
Series F convertible
preferred stock
dividend(1)............ -- -- -- -- -- -- (23,910)
------ -------- ------- -------- -------- ------- --------
Net loss applicable to
common stockholders.... $ (55) $ (196) $(3,666) $(10,697) $(22,549) $(8,780) $(35,257)
====== ======== ======= ======== ======== ======= ========
Historical basic and di-
luted net loss per
share applicable to
common stockholders(2). $(0.03) $ (0.10) $ (1.02) $ (2.64) $ (5.26) $ (2.10) $ (7.65)
====== ======== ======= ======== ======== ======= ========
Shares used in computing
historical basic and
diluted net loss per
share applicable to
common stockholders(2). 1,750 2,000 3,589 4,054 4,289 4,182 4,611
====== ======== ======= ======== ======== ======= ========
Pro forma basic and di-
luted net loss per
share applicable to
common stockholders(2). $ (2.07) $ (2.91)
======== ========
Shares used in pro forma
basic and diluted net
loss per share
applicable to common
stockholders(2)........ 10,873 12,132
======== ========
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------------------------------ JUNE 30,
1993 1994 1995 1996 1997 1998
-------- -------- -------- -------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
CONSOLIDATED BALANCE
SHEET DATA:
Cash, cash equivalents
and short-term invest-
ments.................. $ -- $ 27 $ 8,620 $ 12,864 $ 1,987 $ 6,030
Working capital (defi-
cit)................... 3 (492) 6,934 9,971 (4,847) 194
Total assets............ 3 435 10,202 15,978 8,778 16,634
Long-term debt (less
current portion)....... -- 98 439 1,255 44 24
Accumulated deficit..... (55) (251) (3,917) (14,614) (37,163) (72,420)
Total stockholders' eq-
uity (net capital defi-
ciency)................ $ (6) $ (201) $ 7,955 $ 11,405 $ (1,174) $ (3,871)
</TABLE>
- -------
(1) See Note 8 of Notes to Consolidated Financial Statements for an explanation
of the convertible preferred stock dividend.
(2) See Note 1 of Notes to Consolidated Financial Statements for an explanation
of the method employed to determine the number of shares used to compute
per share amounts.
25
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with
"Selected Consolidated Financial Data" and the Company's Consolidated
Financial Statements and Notes included elsewhere in this Prospectus. The
discussion in this Prospectus contains forward-looking statements that involve
risks and uncertainties, such as statements of the Company's plans,
objectives, expectations and intentions. The cautionary statements made in
this Prospectus should be read as being applicable to all related forward-
looking statements wherever they appear in this Prospectus. The Company's
actual results could differ materially from those discussed here. Factors that
could cause or contribute to such differences include those discussed in "Risk
Factors," as well as those discussed elsewhere herein. See "Risk Factors" and
"Information Regarding Forward-Looking Statements."
OVERVIEW
Terayon develops, markets and sells cable modem systems based upon its S-
CDMA technology. Since its inception in January 1993, the Company has focused
on the development of its S-CDMA technology, as well as certain other core
technologies, to enable broadband transmission of data over cable networks.
The Company commenced the specifications and design of its first ASIC in
October 1994 and produced the first version of this ASIC in June 1996. The
Company concurrently developed an end-to-end broadband access system, the
TeraComm system, around the ASIC. During late 1996 and through 1997, the
Company commenced limited field trials of the TeraComm system with several
cable operators. In the first quarter of 1998, the Company commenced volume
shipments to a small number of cable operators. The Company recognized
revenues of $2.1 million in the year ended December 31, 1997 and $9.4 million
for the six months ended June 30, 1998. The Company generally recognizes
product revenues upon shipment of products to customers. Future agreements
with certain distribution partners may contain price protection provisions and
certain return rights. The Company's existing agreements currently do not
contain such provisions.
The Company sells its products both in the United States and internationally
and markets its products primarily to cable operators and distributors. To
date, a small number of customers has accounted for all of the Company's
sales. In 1997, sales to Telegate, Sumitomo and NET Brasil represented
approximately 30%, 29% and 14%, respectively, of the Company's revenues. In
the first six months of 1998, sales to Shaw, Sumitomo and Cablevision
represented approximately 40%, 14% and 10%, respectively, of the Company's
revenues. The Company expects that sales to a limited number of customers will
continue to account for a substantial portion of the Company's sales for the
foreseeable future. If orders from significant customers are delayed,
cancelled or otherwise fail to occur in any particular period, or if any
significant customer delays payment or fails to pay, the Company could
experience significant operating losses in such period. As a result, the
Company expects to experience significant fluctuations in its operating
results on a quarterly and annual basis. See "Risk Factors--Dependence on
Small Number of Customers," "--Dependence on Cable Industry to Upgrade to Two-
Way Cable Infrastructure" and "--Ability to Market Effectively to Cable
Operators."
The market for broadband access products and services is intensely
competitive and is characterized by rapid technological change, new product
development and product obsolescence, evolving industry standards and
significant price erosion of products over time. The Company has experienced
and expects to continue to experience downward pressure on its unit ASPs. The
Company has had negative gross margins since inception. While the Company has
initiated cost reduction programs to offset pricing pressures on its products,
there can be no assurance that these cost reduction efforts will continue to
keep pace with competitive price pressures or lead to improved gross margin.
If the Company is unable to reduce costs efficiently, its gross margin and
profitability will continue to be adversely affected. The Company's gross
margin also is affected by the sales mix of TeraLink 1000 Master Controllers,
TeraLink Gateways and TeraPro cable modems, as the TeraPro modems have
significantly lower margins than the
26
<PAGE>
TeraLink 1000 Master Controllers and TeraLink Gateway headend products. As a
result, the Company's gross margin also is affected by the maturity of TeraComm
deployments in any quarter, because new deployments of the TeraComm system
involve the sale of headend equipment (which has higher margins) and generally
involve smaller quantities of product, which typically are sold at higher
margins than the larger volume sales of product associated with more mature
deployments of the TeraComm system. For the foreseeable future, the Company
expects to achieve negative or nominal margins on TeraPro cable modems and
expects that sales of TeraPro cable modems will continue to constitute a
significant portion of its revenues. As a result of these factors, the
Company's gross margins and operating results are likely to be adversely
affected in the near term. The Company's components are sold together as part
of an entire system, and the Company accordingly does not report revenue
derived from each component. In addition, because the relationship of each
component to the other components is likely to vary depending on the specific
arrangement with each of the Company's customers, the quantification of revenue
according to each component is not necessarily indicative of the percentage of
revenue that each component might represent in future quarters. See "Risk
Factors--Market Acceptance of Cable Modems; Competing Technologies," "--Ability
to Achieve Cost Reductions," "--Limited Manufacturing Experience and Dependence
on Contract Manufacturer," "--Erosion of Average Selling Prices" and "--Highly
Competitive Industry; Established Competitors."
The Company's ability to generate revenues also depends on guaranteeing the
availability of supplies from its sole sources, increasing the manufacturing
and testing capacity of its products by a contractor while ensuring product
quality, and continuing deployment of its products by existing and new
customers. In the first quarter of 1998, the Company transitioned its
manufacturing operations from CMC to Solectron. The Company recorded a charge
of $1.3 million in the first quarter of 1998 relating to the write-off of
inventory as a result of transitioning manufacturing operations to Solectron. A
portion of the charge consisted of $750,000 of raw material components that
were deemed obsolete due to a design change in the Company's bill of materials
during the quarter ended March 31, 1998. The charge also consisted of a
$550,000 write down of parts repurchased from CMC and then resold to Solectron,
as Solectron could purchase the related parts at a lower cost than the Company
had valued the inventory. Therefore, the Company wrote down the inventory to
the lower of cost or market as part of selling the inventory to Solectron. The
Company currently tests and assembles the TeraLink 1000 Master Controller and
the TeraLink Gateway headend equipment at its Santa Clara facility. Finished
TeraPro cable modems are drop shipped by Solectron to Terayon customers. See
"Risk Factors--Limited Manufacturing Experience and Dependence on Contract
Manufacturer."
The Company sustained net losses of $3.7 million, $10.7 million, $22.5
million and $35.3 million for the years ended December 31, 1995, 1996 and 1997
and for the six months ended June 30, 1998, respectively. As a result, the
Company had an accumulated deficit of $72.4 million as of June 30, 1998. The
Company's operating expenses are based in part on its expectations of future
sales, and the Company expects that a significant portion of its expenses will
be committed in advance of sales. As a result, net income may be adversely
affected by a reduction in sales if the Company is unable to adjust expenses
quickly in response to any decrease in sales. The Company expects to increase
significantly expenditures in technical development, sales and marketing and
manufacturing as it engages in activities related to product enhancement, cost
reduction and commercialization of new products. Additionally, the Company
expects to increase capital expenditures and other operating expenses in order
to support and expand the Company's operations. The Company anticipates that it
will spend approximately $4.0 million on capital expenditures and approximately
$12.0 million on research and development during the twelve months ended June
30, 1999. Anticipated capital expenditures consist of purchases of additional
test equipment to support higher levels of production, a customer demonstration
and training center, computer hardware, software and equipment for newly hired
employees and enhancements to the Company's operating systems to support its
activities as a public company. The Company intends to use the proceeds from
this offering, together with capital lease arrangements, to fund such
requirements. In the event this offering is not completed, the Company will
reduce its anticipated expenditures and
27
<PAGE>
will use capital leases as the primary source of financing. As a result of
these anticipated increased operating expenses, the Company expects to
continue to incur losses for the foreseeable future. There can be no assurance
that the Company will achieve or sustain profitability in the future. See
"Risk Factors--Early Stage of Development; History of Losses," "--Fluctuations
in Operating Results" and "--Lengthy Sales Cycle."
RESULTS OF OPERATIONS
SIX MONTHS ENDED JUNE 30, 1997 AND 1998
Revenues. The Company had revenues of $93,000 for the six months ended June
30, 1997, as the Company did not commence selling its products until June
1997. For the six months ended June 30, 1998, the Company had revenues of $9.4
million, primarily due to sales of cable modems, headend controllers and, to a
lesser extent, telephony modules.
Cost of Goods Sold. Cost of goods sold consists of direct product costs as
well as the cost of the Company's manufacturing operations group, which cost
consists of assembly, test and quality assurance for products, warranty costs
and associated costs of personnel and equipment. For the six months ended June
30, 1997, the Company incurred $482,000 in cost of goods sold primarily
related to the costs of the manufacturing operations group as it prepared for
commercialization of the Company's products. The Company incurred $11.5
million in cost of goods sold for the six months ended June 30, 1998, which
included a charge of $1.3 million relating to the write-off of obsolete
inventory and the transition of manufacturing operations to Solectron.
Gross Profit (Loss). The Company incurred a gross loss of $389,000 for the
six months ended June 30, 1997 due to costs associated with the Company's
manufacturing operations group. The Company incurred a gross loss of $2.1
million for the six months ended June 30, 1998, primarily due to manufacturing
costs spread over low volumes of products sold, together with a charge of $1.3
million relating to the write-off of obsolete inventory and the transition of
manufacturing operations to Solectron.
Research and Development. Research and development expenses consist
primarily of personnel costs, as well as design expenditures, equipment and
supplies required to develop and enhance the Company's products. Research and
development expenses decreased from $5.9 million in the six months ended June
30, 1997 to $4.9 million in the six months ended June 30, 1998 as a result of
timing of the Company's development projects. The Company intends to continue
to increase investment in research and development programs in future periods
for the purpose of enhancing current products, reducing the cost of current
products and developing new products.
Sales and Marketing. Sales and marketing expenses consist primarily of
salaries for sales, marketing and support personnel, and costs related to
tradeshows, consulting and travel. Sales and marketing expenses increased from
$1.5 million in the six months ended June 30, 1997 to $3.0 million in the six
months ended June 30, 1998, primarily due to increased payroll costs related
to additional sales and support personnel for commercial trials and deployment
of the Company's products. The Company expects sales and marketing expenses to
increase in the future as the Company expands its customer base.
General and Administrative. General and administrative expenses primarily
consist of salary and benefits for administrative officers and support
personnel, travel expenses, legal, accounting and consulting fees. General and
administrative expenses increased from $1.1 million in the six months ended
June 30, 1997 to $1.3 million in the six months ended June 30, 1998. The
Company expects that general and administrative expenses will increase as a
result of the additional reporting requirements imposed on the Company as a
public company and increased infrastructure to support expanded activities of
the Company.
28
<PAGE>
Net Interest Income (Expense). Net interest income was $123,000 in the six
months ended June 30, 1997 compared to net interest expense of $32,000 in the
six months ended June 30, 1998. The decrease primarily was a result of lower
interest income on lower average cash balances and higher interest expense on
term debt in the six months ended June 30, 1998.
Series F Convertible Preferred Stock Dividend. The Company recorded a
dividend of $23.9 million in the six months ended June 30, 1998, representing
the fair value of the warrant to purchase 3,000,000 shares of the Company's
common stock (the "Shaw Warrant") under EITF No. 96-13, "Accounting for
Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock." The Company's accounting conclusion with respect to the
Shaw Warrant issued in connection with the sale of $5.0 million of convertible
preferred stock to Shaw (the "Shaw Financing") is based on management's
conclusion that the sale of preferred stock was, in substance, a financing
transaction and not the issuance of equity instruments in exchange for goods
or services. When the Company issued $5.0 million of convertible preferred
stock and the Shaw Warrant on April 6, 1998, its singular objective was to
obtain sufficient liquidity to continue as a going concern. At the time of the
Shaw Financing, the Company's ability to continue as a going concern was in
serious doubt. At March 31, 1998, the Company had only $109,000 in cash, but
was using cash of approximately $1.0 million, net, per month in operations;
further, the Company had a deficit in working capital of $8.8 million.
YEARS ENDED DECEMBER 31, 1995, 1996 AND 1997
Revenues. The Company did not recognize any revenues from product sales in
1995 or 1996, as the Company did not commence selling its products until June
1997. The Company recognized product revenues of $1.6 million in 1997,
primarily due to sales of headend controllers and cable modems. A majority of
the products shipped during 1997 were for customer trial purposes. During
1997, the Company also recognized $480,000 of technology development revenues
pursuant to a technology development agreement (the "Development Agreement")
to provide telephony modules to a telecommunications systems manufacturer. The
Company does not expect significant revenues to be recognized pursuant to the
Development Agreement in the future.
Cost of Goods Sold. In 1995, the Company incurred $676,000 in cost of goods
sold as a result of technology development costs incurred pursuant to the
Development Agreement. The Company did not incur any cost of goods sold in
1996. The Company incurred $6.5 million in cost of goods sold in 1997,
reflecting the costs of the Company's manufacturing operations group for the
full year and direct product costs related to sales that occurred primarily in
the last six months of 1997.
Gross Profit (Loss). The Company incurred a gross loss of $676,000 in 1995
due to technology development costs incurred pursuant to the Development
Agreement. The Company did not realize any gross profit or loss in 1996. The
Company incurred a gross loss of $4.3 million in 1997, primarily due to
manufacturing costs for the full year spread against revenues recognized
primarily in the last six months of 1997. The manufacturing costs incurred in
the first six months of 1997 consisted of pre-production activities related to
preparation for commercialization of the Company's products.
Research and Development. Research and development expenses increased from
$2.0 million in 1995 to $8.0 million in 1996, primarily due to increased
number of personnel and related labor costs and approximately $1.5 million of
prototype and non-recurring engineering costs related to the development of
the Company's initial products. Research and development expenses increased
from $8.0 million in 1996 to $11.3 million in 1997 due to increased staffing
and associated engineering costs related to new and existing product
development.
Sales and Marketing. Sales and marketing expenses increased from $205,000 in
1995 to $1.1 million in 1996, primarily as a result of increased number of
personnel and related labor costs and costs related to promotional activities
and early trials of the Company's products. Sales and marketing
29
<PAGE>
expenses increased from $1.1 million in 1996 to $4.5 million in 1997,
primarily due to increased payroll costs related to additional sales and
support personnel for commercial and market trials and the commercial launch
of the Company's products.
General and Administrative. General and administrative expenses increased
from $825,000 in 1995 to $1.8 million in 1996, primarily due to increased
hiring and higher legal and travel expenses related to preparations for the
commercial release of the Company's products. General and administrative
expenses increased from $1.8 million in 1996 to $2.5 million in 1997, due to
increased number of personnel and related payroll costs and higher legal and
executive travel expenses.
Net Interest Income (Expense). Net interest income increased from $68,000 in
1995 to $253,000 in 1996, as a result of increased cash balances during 1996
resulting from the Company's financing activities during those periods. Net
interest income decreased from $253,000 in 1996 to $128,000 in 1997, primarily
as a result of higher interest expense due to larger loan balances.
QUARTERLY RESULTS OF OPERATIONS
The following table sets forth selected unaudited consolidated statement of
operations data for each of the three-month periods in the six quarters ended
June 30, 1998. The data set forth below have been derived from unaudited
consolidated financial statements of the Company and have been prepared on the
same basis as the audited consolidated financial statements contained in this
Prospectus, and in the opinion of management, include all adjustments,
consisting only of normal recurring accruals, necessary for a fair
presentation of such information for the periods presented. Such consolidated
statement of operations data should be read in conjunction with the
Consolidated Financial Statements and Notes thereto appearing elsewhere in
this Prospectus. Results of operations in any period should not be considered
indicative of the results to be expected in any future period.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
--------------------------------------------------------------
MARCH 31, JUNE 30, SEPT. 30, DEC. 31, MARCH 31, JUNE 30,
1997 1997 1997 1997 1998 1998
--------- -------- --------- -------- --------- ---------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Revenues................ $ -- $ 93 $ 662 $ 1,363 $ 2,444 $ 6,932
Cost of goods sold...... 178 304 1,761 4,219 4,134 7,383
-------- -------- -------- -------- -------- ---------
Gross profit (loss)... (178) (211) (1,099) (2,856) (1,690) (451)
-------- -------- -------- -------- -------- ---------
Operating expenses:
Research and
development.......... 2,580 3,306 2,695 2,738 2,305 2,618
Sales and marketing... 529 994 1,192 1,753 1,140 1,829
General and
administrative....... 461 644 610 831 505 777
-------- -------- -------- -------- -------- ---------
Total operating
expenses........... 3,570 4,944 4,497 5,322 3,950 5,224
-------- -------- -------- -------- -------- ---------
Loss from operations.... (3,748) (5,155) (5,596) (8,178) (5,640) (5,675)
Net interest income (ex-
pense)................. 91 32 7 (2) (64) 32
-------- -------- -------- -------- -------- ---------
Net loss................ (3,657) (5,123) (5,589) (8,180) (5,704) (5,643)
Series F convertible
preferred stock divi-
dend................... -- -- -- -- -- (23,910)
-------- -------- -------- -------- -------- ---------
Net loss applicable to
common stockholders.... $ (3,657) $ (5,123) $ (5,589) $ (8,180) $ (5,704) $ (29,553)
======== ======== ======== ======== ======== =========
</TABLE>
Revenues increased in each of the consecutive three month periods due to
commencement of commercial shipment of the Company's products in June 1997.
The Company incurred increasing gross
30
<PAGE>
losses and declining gross margin in the second half of 1997 as the Company
commenced sales of cable modems which, due to low volume production quantities
and resulting high manufacturing costs and per-unit overhead allocations, were
sold at negative margins. Revenues for the fourth quarter of 1997 include
$480,000 of product development revenues related to the Company's development
of a telephony module for a telecommunications system manufacturer. Gross
margin improved in the first and second quarters of 1998 as unit volume sales
increased and unit manufacturing costs declined. Gross margin also improved in
the period due to a change in product mix, with a higher ratio of higher margin
headend products sold relative to lower margin cable modems. Operating expenses
varied in the last four quarters ended June 30, 1998 due to the timing of
research and development projects and due to significant trade shows in the
fourth quarter of 1997 and the second quarter of 1998. Net loss applicable to
common stockholders increased in the second quarter of 1998 due to the
recording of a dividend charge of $23.9 million representing the fair value of
the Shaw Warrant.
The Company has experienced, and expects to continue to experience,
fluctuations in its operating results on a quarterly and an annual basis.
Historically, the Company's quarterly revenues have been unpredictable due to a
number of factors. Factors that have influenced and will continue to influence
the Company's operating results include: a long sales cycle for the Company's
products; competitive pricing pressures; the effects of extended payment terms,
promotional pricing, service, marketing or other terms offered to customers;
accuracy of customer forecasts of end user demand; personnel changes; quality
control of products sold; and regulatory changes or delays in obtaining
required regulatory approvals. For example, the Company's product shipments to
date to a customer in Brazil have been significantly lower than anticipated,
due to delays in certain regulatory approvals in Brazil. There can be no
assurance that similar delays will not occur in other countries in which the
Company is marketing or plans to market its products. Any such delays would
have an adverse effect on the Company's operating results for a particular
period. Factors that may influence the Company's operating results in the
future include: the size and timing of customer orders and subsequent
shipments; customer order deferrals in anticipation of new products or
technologies; timing of product introductions or enhancements by the Company or
its competitors; market acceptance of new products; technological changes in
the cable, wireless and telecommunications industries; changes in the Company's
operating expenses; customers' capital spending; delays of orders by customers;
customers' delay in or failure to pay accounts receivable; and general economic
conditions. See "Risk Factors--Fluctuations in Operating Results."
INCOME TAXES
The Company has not generated any net income to date and therefore has not
accrued any income taxes since its inception. The Company accounts for income
taxes under Statement of Financial Accounting Standards No. 109. Realization of
deferred tax assets is dependent on future earnings, if any, the timing and
amount of which are uncertain. Accordingly, valuation allowances in amounts
equal to the net deferred tax assets as of December 31, 1997 and 1996 have been
established to reflect these uncertainties.
At December 31, 1997, the Company had federal and state net operating loss
carryforwards of $31.0 million and $15.0 million, respectively, and federal and
state tax credit carryforwards of $1.7 million and $1.2 million, respectively,
that will expire at various dates beginning in 1999 through 2012, if not
utilized. Utilization of net operating loss and tax credit carryforwards may be
subject to a substantial annual limitation due to the ownership change
limitations provided by the Internal Revenue Code of 1986, as amended, and
similar state provisions. The annual limitation may result in the expiration of
net operating loss and tax credit carryforwards before full utilization.
STOCK-BASED COMPENSATION
With respect to certain stock option grants in 1997 and the first six months
of 1998, the Company had recorded deferred compensation of $2.1 million as of
June 30, 1998. The Company amortized approximately $12,000 of the deferred
compensation in 1997 and $106,000 in the first six months of
31
<PAGE>
1998, and will amortize the remainder over the related vesting period of the
stock options. See Note 8 of Notes to Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception through June 30, 1998 the Company met its liquidity needs
primarily through private sales of preferred stock for aggregate proceeds of
$52.7 million, before deduction of issuance costs.
Since its inception, the Company has used cash in operating activities of
$41.0 million through June 30, 1998. Cash used in operating activities in 1995,
1996, 1997 and the first six months of 1998 was $2.3 million, $9.4 million,
$20.8 million and $8.5 million, respectively. In 1995, 1996 and the first six
months of 1998, cash used in investing activities was $1.3 million, $6.5
million and $309,000, respectively. Investment activities in 1995 and the first
six months of 1998 consisted primarily of the purchase of hardware, software
and test equipment and in 1996 consisted primarily of the purchase of short-
term investments. Cash provided by investing activities, primarily from the
sales of short-term investments, was $1.5 million in 1997.
At June 30, 1998 the Company had approximately $6.0 million in cash and cash
equivalents and a $10.0 million revolving line of credit. At June 30, 1998, the
Company was in violation of certain covenants under its line of credit,
including (i) realization of operating profit, (ii) maintenance of a minimum
quick ratio of 1.0 to 1.0, (iii) a minimum tangible net worth of $6.0 million
and (iv) a maximum total liabilities to net worth ratio of 1.6 to 1.0. The
Company is currently in negotiations with another bank to establish a new
credit facility, which would be used to repay and terminate the existing line
of credit. As of June 30, 1998, the Company did not have any funds available
under its current line of credit.
As of June 30, 1998, the Company had approximately $15.2 million of
unconditional purchase obligations. The Company anticipates that it will pay
approximately $10.1 million and $5.1 million of such obligations by September
30, 1998 and December 31, 1998, respectively. The Company intends to make these
payments out of available working capital.
The Company believes that its cash balances, together with the proceeds of
this offering, will be sufficient to satisfy its cash requirements for at least
the next 12 months. There can be no assurance, however, that the Company will
not require additional financing prior to such time to fund its operations and
it may seek to raise such additional funds through the sale of public or
private equity or debt financing or from other sources. The sale of additional
equity or debt securities may result in additional dilution to the Company's
stockholders. There can be no assurance that any additional financing will be
available to the Company on acceptable terms, or at all, when required by the
Company. See "Risk Factors--Significant Future Capital Requirements."
YEAR 2000
Many existing computer systems and applications and other control devices use
only two digits to identify a year in the date field, without considering the
impact of the upcoming change in the century. As a result, in less than two
years, computer systems and applications used by many companies may need to be
upgraded to comply with Year 2000 requirements. Significant uncertainty exists
in the computer industry concerning the potential effects associated with such
compliance. The Company relies on computer systems in operating and monitoring
many significant aspects of its business, including financial systems (such as
general ledger, accounts payable, accounts receivable, inventory and order
management), customer services, infrastructure and network and
telecommunications equipment. The Company also relies directly and indirectly
on the systems of external enterprises such as customers, suppliers, creditors,
financial organizations and domestic and international governments. The Company
32
<PAGE>
currently estimates that its costs associated with Year 2000 compliance,
including any costs associated with the consequences of incomplete or untimely
resolution of Year 2000 compliance issues, will not have a material adverse
effect on the Company's business, financial condition or results of operations
in any given year. However, the Company has not extensively investigated and
does not believe that it has fully identified the impact of Year 2000
compliance and has not concluded that it can resolve any issues that may arise
in connection with Year 2000 compliance without disruption of its business or
without incurring significant expense. In addition, even if the Company's
internal systems are not materially affected by Year 2000 compliance issues,
the Company could be affected through disruption in the operation of the
enterprises with which the Company interacts. There can be no assurance that
the Company's products will be Year 2000 compliant, that third-party products
with which the Company's products interface will be Year 2000 compliant or
that any changes to third-party products made in response to Year 2000
compliance issues will not render the Company's products incompatible with
such third-party products.
RECENT FINANCIAL ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued
Statement No. 130, Reporting Comprehensive Income. This statement requires
that all items that are to be required to be recognized under accounting
standards as components of comprehensive income be reported in a financial
statement that is displayed with the same prominence as other financial
statements. This statement is effective for fiscal years beginning after
December 15, 1997, and will be adopted by the Company for the year ended
December 31, 1998.
In June 1997, FASB issued Statement No. 131, Disclosures About Segments of
an Enterprise and Related Information. This statement replaces Statement No.
14, Financial Reporting for Segments of a Business Enterprise, and changes the
way public companies report segment information. This statement is effective
for fiscal years beginning after December 15, 1997 and will be adopted by the
Company for the year ended December 31, 1998.
33
<PAGE>
BUSINESS
OVERVIEW
Terayon develops, markets and sells cable modem systems that enable cable
operators to cost-effectively deploy reliable two-way broadband access
services. The Company's TeraComm system is designed to allow cable operators to
minimize time-consuming and costly network infrastructure upgrades, achieve
reduced time to market and provide a wide range of service levels to
residential and commercial end users. Cable operators using the TeraComm system
are able to provide additional revenue-generating services to end users,
enabling cable operators to compete effectively in the emerging market for
broadband access services.
The Company's TeraComm system, comprised of the TeraPro cable modem, the
TeraLink 1000 Master Controller, the TeraLink Gateway and the TeraView Element
Management and Provisioning Software, is based on Terayon's S-CDMA technology.
S-CDMA enables reliable two-way broadband communications over both pure coaxial
and HFC cable infrastructure by maximizing resistance to noise that interferes
with data transmissions over previously unusable frequency spectrum. See "--
Technology."
INDUSTRY BACKGROUND
DEMAND FOR BROADBAND ACCESS
In recent years, the volume of bandwidth intensive data, voice and video
traffic across the Internet, corporate intranets and other public networks has
increased dramatically. This demand has been driven by the proliferation of
residential and commercial computer users that are accessing networks in a
variety of applications, including communications via the Internet, electronic
commerce and telecommuting. These applications often require the transmission
of large, multimedia-intensive files. IDC estimates that the number of Internet
users will increase from approximately 69 million at the end of 1997 to
approximately 320 million by the end of 2002. IDC also estimates that the
number of home office households will increase from approximately 35 million at
the end of 1997 to approximately 50 million by the end of 2002.
Despite significant advances in the performance of computer processors and
data backbone networks, high speed data transmission has been limited by the
existing local access network infrastructure (the local loop), which is not
optimized for distribution of data-intensive multimedia content. Users of dial-
up analog modems with maximum data rates of only 28.8 Kbps to 56 Kbps often
experience frustration, as they encounter frequent and lengthy delays or
complete failures in transmission. In response to the growing demand for
increased bandwidth, the communications industry has begun to deploy new
broadband access technologies that can deliver megabit per second ("Mbps") or
better performance to end users.
ADVANTAGES OF CABLE MODEMS OVER ALTERNATIVE BROADBAND ACCESS TECHNOLOGIES
As residential and commercial demand for faster Internet access continues to
grow, particularly for applications such as streaming audio and video, IP
telephony and interactive two-way video, service providers are investing in
enabling infrastructure and technologies. Various technologies have emerged to
address the need for broadband access. The leading technologies include ISDN,
ADSL and xDSL technologies being marketed by telecommunications companies, and
cable infrastructure technologies such as cable modems being marketed by cable
operators. These digital technologies offer substantial performance increases
over traditional analog 56 Kbps dial-up modem technologies.
34
<PAGE>
The following chart depicts the maximum available throughput of various
broadband access technologies:
COMPARISON OF ALTERNATIVE BROADBAND TECHNOLOGIES
<TABLE>
<CAPTION>
MAXIMUM
AVAILABLE THROUGHPUT
------------------------
TECHNOLOGY DESCRIPTION DOWNSTREAM UPSTREAM
- ----------------------------------------------------------------------------
<C> <S> <C> <C>
Cable Modems High speed digital technology over 27.0 to 36.0 2.0 to 14.0
HFC and pure coaxial systems Mbps Mbps
- ----------------------------------------------------------------------------
ADSL High speed digital technology over 1.5 to 6.1 640 Kbps
existing copper wire Mbps
- ----------------------------------------------------------------------------
ISDN High speed digital technology over 128 Kbps 128 Kbps
existing copper wire
- ----------------------------------------------------------------------------
Dial-up Digital-to-analog conversion 56 Kbps 33 Kbps
Analog Access utilizing existing copper wire
- ----------------------------------------------------------------------------
</TABLE>
Of the digital technologies, cable modems currently provide the highest
available two-way transmission speeds and their "always on" availability
eliminates the tedious and unreliable dial-up process of other technologies.
The existing cable infrastructure offers other important advantages over
alternative broadband architectures. Currently, the cable infrastructure passes
over 95% of homes in the United States and a large number of small businesses.
In addition, the cable infrastructure has the capacity to offer a wide range of
broadband services, such as digital TV, Internet access and IP telephony. Many
cable operators have recognized the need to expand beyond broadcast and video
TV services to diversify their business and remain competitive. A growing
number of cable operators have already expanded their business to include data-
over-cable services through affiliations with service providers such as @Home
and Road Runner, and several cable operators are exploring voice-over-cable
services as well. Kinetic Strategies Inc. estimates that over 200,000 North
American homes currently have data-over-cable services.
LIMITATIONS OF EXISTING CABLE INFRASTRUCTURE
Most cable networks were designed to provide one-way video broadcast from the
cable headend to subscribers. Data-over-cable and other two-way services
require cable operators to provide an upstream return path from subscribers to
the headend. Noise interferes with upstream signal transmissions, potentially
resulting in corrupted information or service outages. Common noise problems
are (i) "ingress noise," a relatively constant level of interference resulting
from home appliances and consumer electronics leaking noise into the cable
system through imperfections in the cable plant, such as faulty connections or
cracked cable shielding and (ii) "impulse noise," which is transient,
unpredictable interference that results from home appliances switching on and
off. Noise is a particular problem in the upstream return path because each
home's noise is aggregated into the headend. In addition, the 5 to 42 MHz
frequency spectrum reserved for subscriber-to-headend transmissions is highly
susceptible to ingress and impulse noise.
CABLE OPERATOR OBJECTIVES IN DEPLOYING BROADBAND ACCESS SERVICES
In order to successfully exploit the opportunities offered by the increasing
demand for broadband access, cable operators face a number of challenges.
Cost-effectively manage system noise. Cable modems based on current-
generation TDMA technologies typically require a Signal-to-Noise Ratio ("SNR")
of 20dB or better for reliable operation. To respond to ingress noise, cable
operators using cable modems based on TDMA often must upgrade their networks to
an HFC architecture. An upgrade to an HFC system includes replacing a
substantial portion
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of the existing coaxial network with optical fiber, replacing the headend
transmission equipment with optical transmission systems and providing
additional interface layers between the optical fiber and the coaxial
connection into the home.
To further address ingress noise and attempt to prevent impulse noise
interference, cable operators must often completely rebuild their HFC network.
This entails dividing the network into smaller segments, to isolate noise and
therefore limit the aggregate noise arriving at the headend, as well as
replacing coaxial drops in the homes of subscribers for data services and
placing filters on non-subscriber homes. In addition, many TDMA-based systems
employ a frequency-agile scheme where the transmission system will shift
transmission to a pre-reserved backup channel if the primary channel is
affected by a noise event. Despite these expenditures, cable operators using
TDMA may still be required to increase routine maintenance procedures in order
to provide reliable service and to restrict two-way services to a limited
portion of the 5 to 42 MHz frequency spectrum where noise events are less
likely to occur. To reduce these costs and improve the quality of their
service, cable operators require new upstream transmission technologies that
address both ingress and impulse noise.
Minimize network capital equipment costs. Noise levels are directly related
to the number of homes passed by a network, regardless of the number of
subscribers on such network. As a result, the number of homes that can be
supported by a single TDMA-based cable modem headend is limited, even in the
early phase of deployment, when the number of subscribers may be very small.
Cable operators using TDMA technology are often required to deploy a large
number of headends to create a large service area "footprint." Minimizing
initial investments and attaining "pay-as-you-go" capability that allows
revenues to support incremental investment are vital to the ability of cable
operators to enter the broadband access market.
Time to market. As telecommunications operators move quickly to offer
broadband services, the Company believes that a cable operator's success in a
particular geographic market will be determined by being first to market with
broadband access services. Therefore, the Company believes that cable
operators will need the ability to accelerate cable modem deployments in order
to enhance their competitive position.
Ability to offer tiered services. The Company believes that cable operators
can benefit from having a network capable of offering tiered services that
allow them to maximize revenue from bandwidth allocated to those services. For
example, a residential end user who only utilizes e-mail or Internet access
may only be willing to pay a small premium over the cost of a dial-up
connection, while commercial end users may be willing to pay a substantial
premium for guaranteed bandwidth. In order to offer multiple tiers of service
with varied access speeds and priority connections, cable operators need the
ability to assign a portion of shared bandwidth to individual end users.
To meet these challenges, cable operators require a highly reliable
broadband access solution that can be deployed rapidly at low initial costs,
that enables cable operators to maximize revenues from available bandwidth
capacity, and that scales as the number of broadband access subscribers
increases.
THE TERAYON SOLUTION
The Company's TeraComm system is designed to enable cable operators to
minimize time-consuming and costly network infrastructure upgrades, achieve
reduced time to market and provide a wide range of service levels to
residential and commercial end users. Cable operators using the TeraComm
system are able to provide additional revenue-generating services to end
users, enabling cable operators to compete effectively in the emerging market
for broadband access services. The Company's system is based on its spread
spectrum technology, S-CDMA, which offers cable operators the following
advantages:
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Minimize cable infrastructure upgrades. Terayon's S-CDMA technology operates
at extremely low SNRs (-13dB), which enables Terayon's cable modems to be
deployed on pure coaxial or HFC-upgraded systems, with minimal system
upgrades. TDMA-based systems, which generally demand higher SNRs for operation
(20dB), often require costly system upgrades or complete rebuilds to high
quality HFC in order to support comparable broadband access services.
Reduce time to market. Activating two-way transmission by installing the
TeraComm system does not require the time-consuming network upgrades or
rebuilds usually required to support TDMA-based transmission equipment. As a
result, cable operators can accelerate cable modem deployment and reduce their
time to market with broadband access services, thereby enhancing their
competitive position.
Minimize initial headend capital equipment costs. By deploying the TeraComm
system, cable operators can minimize the initial capital expense for headend
equipment. The noise-resistant properties of S-CDMA allow more cable segments
to be aggregated to form a single shared upstream channel. These properties
provide cable operators with a cost-effective solution during initial stages
of deployment even with a limited number of users. As the number of users
increases, additional Terayon equipment can be installed for a smooth
transition to a larger-scale network. For large deployments, the routed
architecture of Terayon's system will support a large number of headends,
enabling cable operators to effectively manage thousands of subscribers as a
single IP network with multiple logical sub-networks. In contrast, TDMA-based
systems only support a smaller number of homes passed per headend due to
susceptibility to noise-related service problems.
Increase signal transmission reliability. Cable operators who plan to offer
broadband access services must demonstrate the ability to provide reliable and
continuous service. S-CDMA enables cable operators to maintain signal
transmission even in high noise environments. Further, S-CDMA's rate-adaptive
response to sudden changes in plant conditions prevents even short service
outages, unlike alternative systems that utilize a frequency-agile scheme,
which can result in a loss of service.
Maximize spectrum usage. The TeraComm system is designed to operate
effectively in the lowest frequency ranges of the upstream spectrum, where
noise is too severe to allow the operation of TDMA-based systems. As a result,
cable operators who employ the TeraComm system can utilize more of the
existing upstream bandwidth than alternative broadband access technologies.
Generate additional revenue through tiered services. The high capacity and
dynamic bandwidth management capabilities of the TeraComm system are designed
to enable cable operators to offer a wide range of services at tiered prices.
Cable operators can emulate high margin commercial-service offerings such as
T-1, frame-relay and leased lines in the same network as lower margin,
residential, Internet access.
Reduce ongoing cable infrastructure maintenance costs. Cable operators
utilizing the TeraComm system can capitalize on S-CDMA's noise-resistant
properties, which enable cable operators to operate plants in a wide range of
conditions, thus reducing on-going maintenance costs and minimizing service
problems. For example, while all cable operators monitor their networks on a
regular basis, cable operators using TDMA-based systems are generally required
to take more frequent corrective action than cable operators using S-CDMA-
based systems to prevent normal "wear and tear" on the cable system from
impacting service.
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STRATEGY
The Company's objective is to be the leading provider of cable modem systems
to cable operators seeking to provide broadband access services to residential
and commercial end users. Key elements of the Company's strategy are as
follows:
Supply leading cable operators worldwide. The Company's initial target
market is the ten largest cable companies in each major geographic area. In
most markets, a small number of large cable operators often provide services
to a majority of subscribers in a specific region and thus influence the
purchase decisions of smaller cable operators. In the United States, ten cable
operators together own and operate facilities passing approximately 74% of
total homes passed. To date, three of the largest North American cable
operators, Cablevision, Shaw and TCA Cable TV, Inc. ("TCA"), are deploying the
TeraComm system commercially. The Company operates on a purchase order basis
with each of these customers and does not have agreements in place for the
future purchases of products by any of such customers.
Establish relationships with industry leaders. The Company seeks to provide
cable operators with a complete broadband access solution by establishing
relationships with networking companies, systems integrators and other
industry leaders. For example, the Company has a co-development agreement with
Cisco to create an integrated headend solution. Additionally, the Company and
@Home have integrated the Company's products with @Home's service. The Company
will continue to pursue strategic relationships to expand the capabilities of
its system.
Expand worldwide distribution channels. The Company intends to continue to
increase its direct sales efforts and to establish strategic relationships
with leading distributors worldwide. The Company's distribution strategy is to
customize its sales and distribution efforts to address the specific needs of
each market. For example, the Company has an agreement with Sumitomo, through
its subsidiary Crossbeam Networks Corporation ("Crossbeam"), to distribute the
Company's products in Japan. In Latin America, Europe and other parts of Asia
the Company has appointed local distributors with expertise in their specific
geographic regions. In the United States, the Company has begun to establish
distribution relationships to provide broadband access solutions to smaller
cable operators.
Provide superior customer service and support. The Company believes that its
ability to provide consistent high quality service and support will be a key
factor in attracting and retaining customers. In addition to assigning a field
applications engineer to each customer account, the Company provides its
customers with technical support and training through customer support
representatives and representatives of distributors. The Company provides
service and support to its customers 24 hours a day, 7 days a week.
Adopt and advocate industry standards. The rapidly evolving market in which
the Company participates has recently adopted DOCSIS for cable modem
standards, and the industry has commenced discussion of a next-generation
cable modem standard, DOCSIS 2.0. The Company is developing a next-generation
product, known as the UCM, which is intended to offer a mode of operation
compliant with DOCSIS. The Company is actively participating in industry
standard-setting efforts and intends to work with the MCNS consortium to
incorporate S-CDMA into the DOCSIS 2.0 standard.
Leverage S-CDMA technology. The Company believes that its S-CDMA technology
provides significant advantages over alternative broadband access
technologies. The Company's team of engineers has extensive experience in many
areas of broadband access system design, including communication systems,
ASICs, data networking, RF, software and hardware. The Company intends to
leverage these engineering capabilities to expand the features and
functionality of its S-CDMA technology, and to apply S-CDMA to additional
applications such as IP telephony, wireless communications and LMDS.
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TECHNOLOGY
Terayon's products are based on the Company's S-CDMA technology. S-CDMA,
like asynchronous Code Division Multiple Access ("CDMA") technology commonly
used in wireless communications, is a form of spread spectrum technology,
enabling the transmission of information as a group of codes from multiple
transmitters to a single headend receiver. In spread spectrum systems, data is
transmitted by spreading the information across a range of frequencies and
across a period of time, limiting the amount of interference caused by foreign
signals as compared to TDMA systems. However in CDMA transmissions, the codes
can arrive at the headend at slightly different times, or "unaligned," which
can result in interference among the codes, creating inefficiency and
requiring the use of signal modulation techniques that sacrifice capacity in
order to cancel the interference. The Company has developed a technique to
synchronize the arrival of codes at the headend to eliminate the interference
among the codes, allowing the use of signal modulation techniques that do not
sacrifice capacity. As a result, the Company's S-CDMA technology provides
better channel efficiency (more bandwidth per Hertz) than CDMA.
S-CDMA is integrated into a single ASIC chip, which implements the physical
("PHY") layer and media access control ("MAC") layer communication protocols
in the TeraComm system. S-CDMA is the primary differentiator between Terayon's
cable modems and those of competitors who use TDMA-based technology for the
PHY and MAC layer protocols. S-CDMA is designed to maximize resistance to
noise, optimize use of network capacity and provide cable operators with
multiple revenue streams through the ability to offer multiple Quality of
Service levels.
Maximum noise resistance through spread spectrum and rate adaptive
technologies. Spread spectrum technology was originally designed for use by
the military to provide reliable and secure communications in harsh RF
environments. The RF environment is subject to a variety of noise sources that
can interfere with the transmission of data. In spread spectrum systems such
as the Company's S-CDMA technology, data is transmitted by spreading the
information across a range of frequencies and across a period of time,
allowing sufficient information reception for the data to be reconstructed by
the receiver. Data is encoded by transmitters in unique spreading codes that
allow multiple data streams to be received and decoded by the receiver
simultaneously. Therefore, noise events that are typically specific to a
particular frequency or a period of time do not significantly interfere with
transmission
In addition to spread spectrum, S-CDMA incorporates other techniques,
including forward error correction and interleaving, that further enhance the
ability of S-CDMA to resist impulse and ingress noise. In extremely harsh
noise environments, S-CDMA incorporates a rate adaptive mode of operation that
changes modulation schemes, reducing capacity, but allowing continued reliable
transmission. This combination of techniques enables S-CDMA-based systems to
operate in SNR environments as low as 13dB at full capacity and as low as -
13dB in rate adaptive mode. In contrast, TDMA-based systems typically require
an SNR of at least 20dB for reliable operation.
Optimal capacity utilization through synchronization. In asynchronous CDMA
systems, codes arriving at the receiver are unaligned. This causes mutual
interference between the codes, which forces the use of lower order modulation
schemes resulting in significantly reduced data capacity. S-CDMA minimizes
mutual interference by ensuring that codes are synchronized with each other
through ranging, power management and adaptive equalization. The process of
ranging guarantees time alignment by ensuring all codes arrive at the receiver
at the same time. Power management and adaptive equalization compensate for
variables such as temperature and changes in network topology. These
techniques allow S-CDMA to utilize higher order modulation schemes providing a
capacity of 14 Mbps in a 5 MHz channel in both the upstream and downstream
paths. This 14 Mbps capacity is divided into 144 data streams, each of which
is represented by a unique S-CDMA spreading code.
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Efficient bandwidth management for multiple levels of Quality of
Service. The TeraComm system segments each 14 Mbps upstream and downstream
channel into 128 user data streams and 16 management and control data streams.
Separating user data from management and control ensures high channel
efficiency under heavy channel loading. Each of the 128 user data streams has
a continuous data payload capacity of 64 Kbps. The bandwidth manager software
residing in the system headend allocates data streams to cable modems
individually or in groups. Data streams can also be assigned on a permanent
basis, or can be multiplexed among multiple modems based on a fairness
algorithm in the bandwidth manager. This capability allows the TeraComm system
to provide a variety of Quality of Service levels. Constant Bit Rate ("CBR")
services can be provisioned in increments of 64 Kbps by continuous assignment
of data streams to a TeraPro cable modem. As a result, services such as leased
lines and T-1 circuits can be emulated. Unspecified Bit Rate ("UBR") services
can be supported by allowing modems to contend for data streams on an "as
requested" basis. Because all access requests and grants are communicated
through management streams, the impact on channel efficiency is minimized as
more modems contend for bandwidth. Both CBR and UBR services can co-exist on a
single channel enabling a cable operator to create multiple service levels and
maximize revenue from the available bandwidth capacity.
PRODUCTS
CURRENT PRODUCTS
The Company's TeraComm system enables cable operators to cost-effectively
deploy reliable two-way broadband access services. The TeraComm system is
comprised of the TeraPro cable modem, the TeraLink 1000 Master Controller, the
TeraLink Gateway and the TeraView Element Management and Provisioning
Software. The price of a TeraComm system depends upon a number of variables,
including a customer's basic cable system architecture, the type of routing
equipment a customer intends to use, the level and quality of service that a
cable operator desires to provide and the volume of products purchased by a
customer. The price of the TeraComm system ranges from $39,500 to $525,000.
The median price of TeraComm systems sold in the six months ended June 30,
1998 was approximately $250,000.
The following diagram illustrates the TeraComm system:
LOGO
[Diagram of the components of the TeraComm system]
THE TERACOMM SYSTEM
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TeraPro Cable Modem. The TeraPro cable modem is a data communications device
installed in a subscriber's home or business. The TeraPro cable modem connects
to the subscriber's PC via a standard 10BaseT Ethernet connector and to the
cable network via a standard coaxial cable connector. The TeraPro cable modem
automatically configures itself without user intervention, thus minimizing
modem installation time. In addition, the configuration software for the
TeraPro cable modem is downloaded remotely, allowing centralized software
upgrades directly from the headend management system.
The TeraPro cable modem delivers full two-way communication over the cable
network, with data rates of up to 14 Mbps per 5 MHz channel in both the
upstream and the downstream direction. The TeraPro cable modem operates at
full capacity at an SNR as low as 13dB, and gradually adjusts throughput to
provide transmission at an SNR as low as -13dB. This feature will permit the
TeraPro cable modem to operate across any portion of the 5 to 42 MHz upstream
RF spectrum.
TeraLink 1000 Master Controller. The TeraLink 1000 Master Controller is a
data channel controller and multiplexer located at the cable headend system or
distribution hub. The TeraLink 1000 Master Controller provides control,
management and data transport functions for TeraPro cable modems connected to
the cable network. It offers dynamic bandwidth management, high-speed traffic
concentration, access control to data networking resources, and data service
quality and integrity.
The TeraLink 1000 Master Controller is a single channel, rack-mountable
controller that supports up to 2,000 cable modems per channel. Additional
TeraLink 1000 Master Controllers can be added to scale service as performance
and subscriber needs grow. The TeraLink 1000 Master Controller, with the
TeraLink Gateway, provides a 100 BaseT interface for direct connectivity to a
private backbone or any vendor's router or switch. Alternatively, the TeraLink
1000 Master Controller, with its built-in ATM OC-3 interface, can be connected
via an ATM switch, or directly to Cisco's 7500 series routers.
TeraLink Gateway. The TeraLink Gateway is a rack-mountable edge concentrator
providing end-user clients with broadband access to a remote IP backbone
(e.g., Internet) as well as efficient communication between modems. The
TeraLink Gateway includes an ATM OC-3 interface for connectivity to up to two
TeraLink 1000 Master Controllers or an ATM switch. It also provides a 10/100
BaseT Ethernet/Fast Ethernet auto-sense interface to a headend backbone or any
IP router including the Cisco Universal Broadband Router. The TeraLink Gateway
also includes a separate 10 BaseT interface, which may be connected to a
separate management network or the headend network. The TeraLink Gateway
supports up to 2,000 cable modems per RF channel when connected to a TeraLink
1000 Master Controller. When used with the TeraLink Gateway, the TeraPro cable
modems behave as an extension of the TeraLink Gateway, providing maximum
bandwidth and privacy.
TeraView Element Management and Provisioning Software. The TeraView Element
Management and Provisioning Software is a Windows 95 and Windows NT standards-
based software application installed at the headend system or the network
operations center. The TeraView software allows cable operators to configure,
control, monitor and maintain multiple channels of the TeraComm system.
PRODUCTS UNDER DEVELOPMENT
Universal Cable Modem and TeraLink 2000 Master Controller. The Company
currently is designing and developing a next-generation system, which includes
the UCM and an accompanying headend controller, the TeraLink 2000 Master
Controller. The UCM and the TeraLink 2000 Master Controller will be designed
to be fully compliant with DOCSIS standards, while also offering additional
features and performance enabled by the use of the S-CDMA technology. The UCM
and the TeraLink 2000 Master Controller are in the early stages of development
and the Company does not anticipate commercial deployment of these products
until 1999.
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The UCM will be designed to operate in any of three modes: (i) as an
existing TeraPro cable modem to ensure backward compatibility for existing
TeraComm system users; (ii) as a DOCSIS-compliant modem that will be
compatible with multiple vendors' DOCSIS-compliant systems; and (iii) as an
advanced system. In the advanced mode the UCM will be designed to offer
DOCSIS-compliant 64/256 QAM modulation downstream channels, coupled with an
advanced S-CDMA upstream channel, offering up to 40 Mbps downstream channel
capacity and 30 Mbps upstream channel capacity.
CUSTOMERS
The Company markets its products to cable operators that seek to provide
broadband access services to both residential and commercial end users. The
Company's initial target market consists of the ten largest cable companies in
each major geographic area. In most markets, a small number of large cable
operators often provide services to a majority of subscribers in a specific
region and thus influence the purchasing decisions of smaller cable operators.
In the United States, ten cable operators together own and operate facilities
passing approximately 74% of total homes passed. The Company commenced volume
shipments of its products in the first quarter of 1998. To date, three of the
largest North American cable operators, Cablevision, Shaw and TCA, are
deploying the TeraComm system commercially.
Selected examples of the range of customers and applications for which the
TeraComm system is being commercially deployed are as follows:
Cablevision. Cablevision is the fifth largest cable operator in the United
States, with cable infrastructure passing approximately 5.1 million homes,
primarily located in New York, New Jersey, Connecticut, Ohio and
Massachusetts. Cablevision is currently deploying Terayon's products in
systems located in Long Island, New York and areas of Connecticut for its
optimum high speed data service.
Shaw Cable. Shaw is the third largest cable operator in Canada, with cable
infrastructure passing approximately 2.0 million homes. Shaw currently has the
largest cable modem deployment in Canada, with over 35,000 cable modem users.
Shaw has selected Terayon to supply cable modem systems for Shaw's @Home
service deployments in Victoria, British Columbia, Edmonton, Alberta and parts
of metropolitan Toronto, Ontario.
Sumitomo. The Company has a distribution agreement with Sumitomo under which
Crossbeam is distributing the TeraComm system to three of Japan's leading
cable operators. The TeraComm system's noise resistant properties are designed
to enable two-way broadband access over pure coaxial networks, which comprise
the majority of Japan's cable infrastructure.
TCA Cable. TCA is the 16th largest cable operator in the United States, with
cable infrastructure passing approximately 1.2 million homes, primarily in
Texas, Arkansas and Louisiana. TCA has deployed the TeraComm system in
Bryan/College Station, Texas and Amarillo, Texas. TCA provides a tiered
service offering, with prices ranging from $49.95 per month for residential
Internet access to $184.95 per month for commercial Internet access. TCA has
announced that it intends to leverage the noise resistant properties of
Terayon's products to deploy broadband access services on a pure coaxial
network in Tyler, Texas.
Three customers accounted for approximately 73% of the Company's revenues in
1997 and for approximately 64% of the Company's revenues in the first six
months of 1998. In 1997, sales to Telegate, Sumitomo and NET Brasil
represented approximately 30%, 29% and 14%, respectively, of the Company's
revenues. In the first six months of 1998, sales to Shaw, Sumitomo and
Cablevision represented approximately 40%, 14% and 10%, respectively, of the
Company's revenues. The Company believes that a substantial majority of its
revenues will continue to be derived from sales to a relatively small number
of customers for the foreseeable future. In addition, the Company believes
that sales to these customers
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will be focused on a small number of projects. See "Risk Factors--Dependence
on Small Number of Customers."
RESEARCH AND DEVELOPMENT
The Company believes that its future success will depend upon its ability to
enhance its existing products and to develop and introduce new products that
meet a wide range of evolving cable operator and end user needs. In addition,
to address competitive and pricing pressures, the Company expects that it will
have to reduce the unit cost of manufacturing its cable modems through design
and engineering changes. For example, the Company has developed and intends to
introduce a single-board modem by the end of 1998, which the Company
anticipates will provide cost savings over its current dual-board modem. There
can be no assurance that the Company will be successful in redesigning its
products, that any such redesign will be made on a timely basis and without
introducing significant errors and product defects, or that any such redesign,
including the single-board modem, would result in sufficient cost reductions
to allow the Company to significantly reduce the list price of its products or
improve its gross margin.
The Company also currently is designing and developing a next-generation
system, which includes the UCM and an accompanying headend controller, the
TeraLink 2000 Master Controller. The UCM and the TeraLink 2000 Master
Controller will be designed to be fully compliant with emerging DOCSIS
standards, while also offering additional features and performance enabled by
the use of the S-CDMA technology. The UCM and the TeraLink 2000 Master
Controller are in the early stages of development and the Company does not
anticipate commercial deployment of these products until 1999. See "Risk
Factors--Evolving Market; Rapid Technological Change; Market Acceptance of S-
CDMA," "--Ability to Achieve Cost Reductions," "--Evolving Industry Standards"
and "--Dependence on Products Under Development."
As of June 30, 1998, the Company had 51 employees engaged in research and
development. The Company's total research and development expenses for 1995,
1996 and 1997 and the first six months of 1998 were $2.0 million, $8.0
million, $11.3 million and $4.9 million, respectively.
SALES AND MARKETING
Terayon has direct sales forces in North America, Latin America and Europe.
The Company also distributes its products via distributors and systems
integrators. Terayon has signed a distribution agreement with Sumitomo under
which Crossbeam is distributing the TeraComm system to three of Japan's
leading cable operators.
The Company markets its products directly to cable operators through its
sales force, key distribution and technology partners, as well as other
marketing vehicles such as industry press, trade shows and the World Wide Web.
Through its marketing efforts, the Company strives to educate cable operators
on the technological and business benefits of its system solution, as well as
the Company's ability to provide quality support and service to the customer.
Terayon participates in the major trade shows and industry events for the
cable industry in the United States and is expanding its presence in other
markets through joint participation at local events with its international
sales and marketing partners. Industry referrals and reference accounts are
significant marketing tools developed and utilized by the Company.
CUSTOMER SERVICE AND TECHNICAL SUPPORT
The Company believes that its ability to consistently provide high quality
service and support will be a key factor in attracting and retaining
customers. The Technical Services and Support ("TSS") organization provides
support 24 hours a day, seven days per week. Prior to deployment of the
Company's systems, each cable operator's needs are assessed and proactive
solutions are implemented, including various levels of training, periodic
management and coordination meetings, and problem escalation procedures.
Terayon places a strong emphasis on technical training, both for cable
operators and systems integrators. Initial
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training is offered to cable operators and systems integrators at no cost,
both in Terayon's headquarters in Santa Clara and on a cable operator's or
system integrator's premises. At June 30, 1998, the TSS organization consisted
of 13 employees located in North America, Europe, Latin America and Asia.
In addition, Terayon has developed sophisticated tools for remote diagnosis
and monitoring of the TeraComm systems deployed by cable operators. Such tools
enable the Company to monitor cable operators' installations of the TeraLink
1000 Master Controller and to proactively suggest solutions before problems
become noticeable to end users. The Company is developing a Web-based
knowledge system to provide cable operators with access to the latest
technical support information.
MANUFACTURING
The Company outsources the materials procurement, printed circuit board
assembly, and product assembly and testing to turnkey contract manufacturers.
Currently, the Company contracts with Solectron, located in Milpitas,
California, for the manufacture of the majority of its products. CMC, located
in Santa Clara, California, also manufactures certain of the Company's
products. The Company has a limited in-house manufacturing capability at its
headquarters in Santa Clara. This facility is currently used for the assembly
and final testing of TeraLink 1000 Master Controller and TeraLink Gateways,
pilot production of new modem designs, sample testing of products received
from volume modem manufacturers, developing the manufacturing process and
documentation for new products in preparation for outsourcing. The Company
also repairs products returned from customers with its in-house manufacturing
resources.
The Company's future success will depend in significant part on its ability
to obtain high volume manufacturing at low costs. As volume increases, the
Company plans to engage additional contract manufacturers, to procure
additional manufacturing facilities and equipment, to modify existing
inventory procedures, to substantially increase its personnel and to revise
its quality assurance and testing practices. There can be no assurance that
any of these efforts will be successful. The Company anticipates that the need
to reduce the manufacturing costs of its cable modem and will continue to
evaluate the use of low cost third-party suppliers and manufacturers. See
"Risk Factors--Ability to Achieve Cost Reductions" and "--Limited
Manufacturing Experience and Dependence on Contract Manufacturer."
Subcontractors supply the Company's contract manufacturers with both
standard components and subassemblies manufactured to the Company's
specifications. The Company is dependent upon certain key suppliers for a
number of the components for its products. For example, the Company currently
relies on VLSI for the Company's S-CDMA ASIC, which is used in the Company's
headend and cable modem products. In addition, all of the Company's products
contain one or more components that are currently only available from a single
source.
COMPETITION
The market for broadband access systems is extremely competitive and is
characterized by rapid technological change. The Company's direct competitors
in the cable modem arena include Bay Networks, Com21, Hayes, Hybrid,
Matsushita, Motorola, Phasecom, RCA, Samsung, Scientific-Atlanta, Sony, 3Com,
Toshiba and Zenith and there are many other potential market entrants. In
addition, Bay Networks, Com21, Hybrid and Motorola introduced cable modems
prior to the Company, and have established relationships and have worked with
customers for a longer period of time than the Company. The principal
competitive factors in this market include: product performance, features and
reliability; price; size and stability of operations; breadth of product line;
sales and distribution capability; technical support and service;
relationships with cable operators; standards compliance; and general industry
and economic conditions. Certain of these factors are outside of the Company's
control. The existing conditions in the broadband access market could change
rapidly and significantly as a result of technological changes, and the
development and market acceptance of alternative technologies could decrease
the demand for the Company's products or render them obsolete. There can be no
assurance
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that these companies and other competitors will not introduce broadband access
products that will be less costly or provide superior performance or achieve
greater market acceptance than the Company's products.
The Company sells products that also compete with existing data access and
transmission systems utilizing the telecommunications networks, such as those
of 3Com. Additionally, the Company's controller and headend system products
face intense competition from well-established companies such as Bay Networks,
Cisco and 3Com. Many of the Company's current and potential competitors have
significantly greater financial, technical, marketing, distribution, customer
support and other resources, as well as greater name recognition and access to
customers than the Company. There can be no assurance that the Company will be
able to compete successfully against current or future competitors or that the
competitive pressures faced by the Company will not have a material adverse
effect on its business, operating results and financial condition.
The market for cable modems may be impacted by the development of other
technologies that enable the provisioning of broadband access services.
Examples of such technologies include technologies that increase the efficiency
of digital transmission over telephone companies' existing copper
infrastructure, such as various xDSL, as well as ISDN. Similarly, broadband
access services may be deployed over a number of other media, including fiber
optic cable, DBS and other wireless technologies. Broadband access services
based on some of these competing technologies are already available and could
materially limit acceptance of cable modem-based services. The failure of
broadband access services based on cable modem technology to gain widespread
commercial acceptance by cable operators and end users of broadband access
services would have a material adverse effect on the Company's business,
operating results and financial condition. See "Risk Factors -- Highly
Competitive Industry; Established Competitors."
REGULATION
The Company and its customers are subject to varying degrees of federal,
state and local regulation. The jurisdiction of the FCC extends to the
communications industry, including broadband access products such as those of
the Company. The FCC has promulgated regulations that, among other things, set
installation and equipment standards for communications systems. Although FCC
regulations and other governmental regulations have not materially restricted
the Company's operations, there can be no assurance that future regulations
adopted by the FCC or other regulatory bodies will not have a material adverse
effect on the Company. Further, regulation of the Company's customers may
adversely impact the Company's business, operating results and financial
condition. For example, FCC regulatory policies affecting the availability of
cable services and other terms on which cable companies conduct their business,
may impede the Company's penetration of certain markets. In addition,
regulation of cable television rates may affect the speed at which cable
operators upgrade their cable infrastructures to two-way HFC. Changes in, or
the failure by the Company to comply with, applicable domestic and
international regulations could have a material adverse effect on the Company's
business, operating results and financial condition. In addition, the
increasing demand for communications systems has exerted pressure on regulatory
bodies worldwide to adopt new standards for such products and services,
generally following extensive investigation of and deliberation over competing
technologies. The delays inherent in this governmental approval process have in
the past, and may in the future, cause the cancellation, postponement or
rescheduling of the installation of communications systems by the Company's
customers, which in turn may have a material adverse effect on the sale of
products by the Company to such customers. For example, the Company experienced
delays in product shipments to a customer in Brazil due to delays in certain
regulatory approvals in Brazil, and there can be no assurance that similar
delays will not occur in other countries in which the Company markets or plans
to market its products. In addition, the Company's customers in certain parts
of Asia, such as Japan, are required to obtain licenses prior to selling the
Company's products, and delays in obtaining such licenses could
45
<PAGE>
have an adverse impact on the Company's operating results. See "Risk Factors --
Regulation of the Communications Industry."
In the United States, in addition to complying with FCC regulations, the
Company's products will be required to meet certain safety requirements. For
example, the Company will be required to have its products certified by UL in
order to meet federal requirements relating to electrical appliances to be used
inside the home. Outside of the United States, the Company's products will be
subject the regulatory requirements of each country in which the products are
manufactured or sold. These requirements are likely to vary widely, and there
can be no assurance that the Company will be able to obtain on a timely basis
or at all such regulatory approvals as may be required for the manufacture,
marketing or sale of its products. Any delay in or failure to obtain such
approvals or meet such requirements could have a material adverse effect on the
Company's business, operating results and financial condition. See "Risk
Factors -- Other Regulatory Approvals or Certifications."
INTELLECTUAL PROPERTY
The Company relies on a combination of patent, trade secret, copyright and
trademark laws and contractual restrictions to establish and protect
proprietary rights in its products. The Company has two issued patents and five
patent applications pending in the United States. The Company has seven patent
applications pending internationally. There can be no assurance that the
Company's patent applications will be granted or, if granted, that the claims
covered by the patents will not be reduced from those included in the Company's
applications. Any patent might be subject to challenge in court and, whether or
not challenged, might not be sufficiently broad to prevent third parties from
developing equivalent technologies or products. The Company has entered into
confidentiality and invention assignment agreements with its employees, and
enters into non-disclosure agreements with certain of its suppliers,
distributors and appropriate customers so as to limit access to and disclosure
of its proprietary information. There can be no assurance that these statutory
and contractual arrangements will prove sufficient to prevent misappropriation
of the Company's technology or to deter independent third-party development of
similar technologies.
The Company pursues the registration of its trademarks in the United States
and has applications pending to register several of its trademarks. However,
since the laws of certain foreign countries might not protect the Company's
products or intellectual property rights to the same extent as do the laws of
the United States, effective trademark, copyright, trade secret and patent
protection might not be available in every country in which the Company's
products might be manufactured, marketed or sold.
The Company expects that developers of cable modems will increasingly be
subject to infringement claims as the number of products and competitors in the
Company's industry segment grows. The Company has received a letter from an
individual claiming that the Company's technology infringes a patent held by
such individual. The Company has reviewed the allegations made by such
individual and, after consulting with its patent counsel, does not believe that
the Company's technology infringes any valid claim of such individual's patent.
There can be no assurance that, if the issue were to be submitted to a court,
such a court would not find that the Company's products infringe the patent,
nor that the individual will not continue to assert infringement. If the
Company is found to have infringed such individual's patent, the Company could
be subject to substantial damages and/or an injunction preventing it from
conducting its proposed business, and the Company's business could be
materially and adversely affected. In addition, there can be no assurance that
other third parties will not assert infringement claims against the Company in
the future. Any such claim, whether meritorious or not, could be time-
consuming, result in costly litigation, cause product shipment delays or
require the Company to enter into royalty or licensing agreements. Such royalty
or licensing agreements may not be available on terms acceptable to the Company
or at all, which could have a material adverse effect upon the Company's
business, operating results and financial condition. Litigation also may be
necessary to enforce the Company's intellectual property rights. Any
infringement claim or other litigation against or
46
<PAGE>
by the Company could have a material adverse effect on the Company's business,
operating results and financial condition.
EMPLOYEES
As of June 30, 1998, Terayon had 106 employees, of which 51 were in the
engineering group, 27 were in marketing, sales and customer support, 15 were in
operations and 13 were in general and administrative functions. None of the
Company's employees is represented by a union. The Company believes that its
relations with its employees are good.
PROPERTIES
The Company leases an approximately 30,000 square foot facility located in
Santa Clara, California and has an option to lease approximately 10,000
additional square feet in August 1998. The current lease for the Santa Clara
facility expires in March 2002. The Company has sales offices in Denver,
Colorado; Atlanta, Georgia; Sao Paulo, Brazil; and Brussels, Belgium. The
Company believes that its existing facilities are adequate to meet its needs
for the immediate future and that future growth can be accommodated by leasing
additional or alternative space near its current facilities.
LEGAL PROCEEDINGS
The Company is not currently a party to any material legal proceedings.
47
<PAGE>
MANAGEMENT
DIRECTORS, EXECUTIVE OFFICERS AND KEY EMPLOYEES
Certain information regarding the Company's directors, executive officers and
key employees as of August 15, 1998 is set forth below.
<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<C> <C> <S>
EXECUTIVE OFFICERS AND DIRECTORS
Dr. Zaki Rakib(1)............... 40 Chief Executive Officer and Director
Shlomo Rakib.................... 41 Chairman of the Board, President and
Chief Technical Officer
Ray M. Fritz.................... 52 Chief Financial Officer
Dennis J. Picker................ 50 Chief Operating Officer
Michael D'Avella................ 39 Director
Christopher J. Schaepe(1)(2).... 34 Director
Lewis Solomon(2)................ 64 Director
Mark A. Stevens(1).............. 38 Director
KEY EMPLOYEES
Brian Bentley................... 36 Vice President, Worldwide Sales
Gary W. Law..................... 43 Vice President, Marketing and Business
Development
Linda R. Palmor................. 43 Vice President, Finance
Gershon Schatzberg.............. 43 Vice President, Customer Satisfaction
W. Lee Stalcup.................. 58 Vice President, Manufacturing Operations
</TABLE>
- --------
(1) Member of the Compensation Committee.
(2) Member of the Audit Committee.
Zaki Rakib co-founded Terayon in 1993 and has served as Chief Executive
Officer since January 1993 and as a director since February 1995. From January
1993 to July 1998, Dr. Rakib also served as Chief Financial Officer of the
Company. Prior to co-founding the Company, Dr. Rakib served as Director of
Engineering for Cadence Design Systems, an electronic design automation
software company, from 1990 to 1994. Prior to joining Cadence, Dr. Rakib was
Vice President of Engineering at Helios Software, which was acquired by Cadence
in 1990. Dr. Rakib holds B.S., M.S. and Ph.D. degrees in engineering from Ben-
Gurion University in Israel. Dr. Rakib is the brother of Shlomo Rakib, the
Company's Chairman of the Board, President and Chief Technical Officer.
Shlomo Rakib co-founded Terayon in 1993 and has served as Chairman of the
Board and President since January 1993 and as Chief Technical Officer since
February 1995. Prior to co-founding the Company, Mr. Rakib served as Chief
Engineer at PhaseCom, Inc., a communications products company, from 1981 to
1993, where he pioneered the development of data and telephony applications
over cable. Mr. Rakib is the inventor of several patented technologies in the
area of data and telephony applications over cable. Mr. Rakib holds a B.S.E.E.
degree from Technion University in Israel. Mr. Rakib is the brother of Zaki
Rakib, the Chief Executive Officer and a director of the Company.
Ray M. Fritz has served as the Company's Chief Financial Officer since July
1998. Prior to joining the Company, Mr. Fritz was Vice President of Finance and
Operations and Chief Financial Officer of GigaLabs Inc., a provider of high-
performance input/output switching solutions, from December 1997 to July 1998.
From August 1994 until August 1997, Mr. Fritz was with Clarify, Inc., a
provider of front office automation systems, as its Vice President, Finance and
Operations and Chief Financial Officer. From May 1990 to August 1994, he served
as Director, Finance of Synopsys, Inc., an electronic design automation
company, and from April 1986 to May 1990, Mr. Fritz served as Vice President
and Controller of LSI Logic Corporation, a semiconductor company. Prior to
that, he held a variety of finance positions with Xerox Corporation, The Singer
Company and Shell Oil Company. Mr. Fritz holds a B.S. degree in
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<PAGE>
finance/business administration from Benedictine College, an M.B.A. degree
from Atlanta University and an M.S. degree in tax from Golden Gate University.
Dennis J. Picker has served as Chief Operating Officer since February 1998
and served as Vice President, Standards from October 1997 to February 1998 and
Vice President, Engineering from May 1996 to October 1997. From 1994 to April
1996, Mr. Picker was Director of the Cable Data Products Business Unit of
Motorola, Inc., an electronics company, and from 1992 to 1994, he was Senior
Director of Data Networking Products at Motorola. Mr. Picker holds a B.S.
degree in electrical engineering from the University of Pennsylvania and an
M.S. degree in electrical engineering from Northwestern University.
Michael D'Avella has served as a director of the Company since April 1998.
Mr. D'Avella is the Senior Vice President, Planning for Shaw Communications
Inc. ("Shaw"), a diversified communications company and a leading cable
operator in Canada. Mr. D'Avella has held a variety of senior management
positions at Shaw since 1991. Prior to that, he held positions with the
Canadian Cable Television Association and Telesat Canada. He is a director of
several privately held companies. Mr. D'Avella holds a B.A. degree in
economics and planning from the University of Toronto in Canada.
Christopher J. Schaepe has served as a director of the Company since March
1995. Mr. Schaepe is a General Partner of Weiss, Peck & Greer Venture
Partners, L.P., a technology-focused venture capital firm, which he joined in
1991. Previously, Mr. Schaepe served in corporate finance and capital markets
roles for three years at Goldman, Sachs & Company after his employment as a
software engineer at IBM Corporation. He is a director of Galileo Technology
Ltd., a communications semiconductor company, as well as several privately
held companies. Mr. Schaepe holds B.S. and M.S. degrees in computer science
from the Massachusetts Institute of Technology and an M.B.A. degree from
Stanford Business School.
Lewis Solomon has served as a director of the Company since March 1995. Mr.
Solomon has been a principal of G&L Investments, a consulting firm, since 1989
and currently serves as the Chairman of the Board of ICTV, Inc. From 1983 to
1988, he served as Executive Vice President at Alan Patricof Associates, a
venture capital firm focused on high technology, biotechnology and
communications industries. Prior to that, Mr. Solomon served in various
capacities with General Instrument Corp., most recently as Senior Vice
President. From April 1986 to January 1997, he served as Chairman of the Board
of Cybernetic Services, Inc., an LED systems manufacturer, which commenced a
Chapter 7 bankruptcy proceeding in April 1997. Mr. Solomon serves on the
boards of Anadigics, Inc., a manufacturer of integrated circuits; Anacomp,
Inc., a manufacturer of data storage systems; Artesyn Technologies, Inc., a
power supply and power converter supply company; and Microelectronic
Packaging, Inc., an integrated circuit packaging manufacturer. Mr. Solomon
also serves on the boards of several privately held companies.
Mark A. Stevens has served as a director of the Company since March 1995.
Mr. Stevens has been a General Partner of Sequoia Capital, a venture capital
investment fund, since March 1993. Mr. Stevens currently serves on the Board
of Directors of Aspect Development, Inc., a client/server applications
software company, and several privately held companies. Prior to joining
Sequoia in 1989, he held technical sales and marketing positions at Intel
Corporation. Mr. Stevens holds a B.S.E.E. degree, a B.A. degree in economics
and an M.S. degree in computer engineering from the University of Southern
California and an M.B.A. degree from Harvard Business School.
Brian Bentley has served as Vice President, Worldwide Sales since February
1997. From 1995 to February 1997, he served as Director of TCI Sales for
Scientific-Atlanta, Inc., a satellite manufacturer. Prior to that, Mr. Bentley
served as Vice President of MSO Sales for the Multimedia Group of Motorola
from January 1995 to November 1995, and as Vice President and General Manager
for the Optical Media Group of Antec Corporation, a fiber-optic equipment
manufacturer company, from 1992 to 1995. He holds a B.S. degree in economics
from Arizona State University.
49
<PAGE>
Gary W. Law has served as Vice President, Marketing and Business Development
since March 1997. From August 1995 to March 1997, he was Vice President of
Marketing for the Networking Products Group of Adaptec, Inc., a hardware and
software manufacturer company. Prior to that, Mr. Law served as Director of
Market Development for Bay Networks, Inc. from 1989 to 1995 and held sales and
marketing management positions with Hewlett-Packard Company, an electronics
company and Ungermann-Bass Inc. between 1978 and 1988. He holds a B.S. degree
in engineering from the University of Texas.
Linda R. Palmor has served as Vice President, Finance since May 1997 and
served as Corporate Controller from February 1996 to May 1997. Prior to
joining the Company, Ms. Palmor served as the Corporate Controller of
Electronic Arts Inc., a multimedia software company, from 1995 to 1996 and
held financial positions with The Walt Disney Company, a media conglomerate,
from 1991 to 1995. Ms. Palmor is a certified public accountant and holds a
B.Sc. degree in biochemistry from Manchester University in the United Kingdom.
Gershon Schatzberg has served as the Company's Vice President, Customer
Satisfaction since April 1998 and served as Group Director of Technical
Support Services from August 1997 to April 1998. Prior to joining the Company,
he served as Director of Network Consulting for 3Com Corporation, a networking
hardware manufacturer company, running North American sales support operations
from 1996 to 1997. From 1989 to 1996, Mr. Schatzberg served as the President
and Vice President of Engineering for RAD Network Devices, Inc., a networking
and router manufacturer company. Prior to that, he held engineering positions
with various companies. Mr. Schatzberg holds a B.S.E.E. degree from Technion
University in Israel.
W. Lee Stalcup has served as the Company's Vice President, Manufacturing
Operations since May 1998. Prior to joining the Company, Mr. Stalcup was Vice
President of Operations for Magellan Systems Corporation, a global positioning
systems manufacturer, from October 1996 to May 1998. From May 1994 to October
1994, he served as Director of Operations at AST Research, Inc., a computer
and network server manufacturer, and from October 1994 to October 1996 he
served as its Vice President of Worldwide Materials. From 1990 to 1993, Mr.
Stalcup was Executive Vice President and Chief Operating Officer of Vitalrel
Microelectronics, a multi-chip module company.
The Company's Board of Directors (the "Board") currently is comprised of six
directors. Directors are elected by the stockholders at each annual meeting of
stockholders to serve until the next annual meeting of stockholders or until
their successors are duly elected and qualified. Pursuant to a voting
agreement, Messrs. Rakib, who together own 4,000,000 shares of the Company's
stock, have agreed to vote to elect a nominee of Shaw to the Company's Board
("Shaw Nominee"), currently Mr. D'Avella, until such time as Shaw owns less
than 384,615 shares of the Company's stock. The Company also has agreed with
Shaw to use its best efforts to nominate a Shaw Nominee to the Board until the
earlier of December 31, 2000 or the date upon which Shaw no longer holds at
least 384,615 shares of the Company's stock. The Company's Certificate of
Incorporation, which will become effective upon the completion of this
offering, provides that the Board will be divided into three classes, Class I,
Class II and Class III, with each class serving staggered three-year terms.
The Class I directors, initially Messrs. Solomon and Stevens, will stand for
reelection or election at the 1999 annual meeting of stockholders. The Class
II directors, initially Mr. D'Avella and Shlomo Rakib, will stand for
reelection or election at the 2000 annual meeting of stockholders. The Class
III directors, initially Mr. Schaepe and Zaki Rakib, will stand for reelection
or election at the 2001 annual meeting of stockholders.
ADVISORY BOARD
In early 1997, the Company established an Advisory Board, which consists of
representatives from the United States and international cable industries. The
Advisory Board currently consists of nine members: Steven Craddock, the Vice
President of New Media for Comcast Corporation; Michael D'Avella,
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<PAGE>
the Senior Vice President of Planning for Shaw and a member of the Company's
Board of Directors; David Fellows, the former Vice President of Technology for
MediaOne; George Harte, the Director of Telecom Technology for Rogers
Communications Inc.; Wilt Hildebrand, the Vice President of Technology for
Cablevision Systems Corporation; Isao Momota, the President of Crossbeam
Networks; Richard Rexroat, the Vice President, Engineering of TCI
International; J.C. Sparkman, a former Executive Vice President of TCI; and
Arthur Steiner, the Director of Business Development for NET Brasil.
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
Prior to February 1998, the Company did not have a Compensation Committee of
the Board of Directors, and the entire Board participated in all compensation
decisions, except that Messrs. Rakib did not participate in decisions relating
to their respective compensation. In February 1998, the Board formed the
Company's Compensation Committee to review and recommend to the Board
compensation and benefits for the Company's executive officers and administer
the Company's stock purchase and stock option plans. Each of the Company's
directors, or an affiliated entity, holds securities of the Company. See
"Certain Transactions" and "Principal Stockholders."
BOARD COMMITTEES
The Audit Committee of the Board of Directors, currently consisting of
Messrs. Schaepe and Solomon, reviews the internal accounting procedures of the
Company and consults with and reviews the services provided by the Company's
independent auditors. The Compensation Committee of the Board of Directors
currently consists of Dr. Rakib and Messrs. Schaepe and Stevens. The
Compensation Committee reviews and recommends to the Board the compensation and
benefits for the Company's executive officers, except that Dr. Rakib does not
participate in decisions relating to his compensation. The Compensation
Committee also administers the issuance of stock options and other awards under
the Company's 1995 Stock Option Plan, 1997 Equity Incentive Plan, 1998 Employee
Stock Purchase Plan and 1998 Non-Employee Directors' Stock Option Plan. See "--
Employee Benefit Plans."
DIRECTOR COMPENSATION
Lewis Solomon receives $2,000 per month for his service as a member of the
Board. No other director of the Company receives cash for services provided as
a director. From time to time, certain directors who are not employees of the
Company have received grants of options to purchase shares of the Company's
Common Stock. In July 1997, Mr. Stevens was granted an option to purchase
30,000 shares of Common Stock at an exercise price of $1.25 per share and
entities affiliated with Weiss, Peck & Greer L.L.C. ("WPG") were granted
options to purchase an aggregate of 30,000 shares of Common Stock at an
exercise price of $1.25 per share. Mr. Schaepe is a partner of WPG. In May
1998, Mr. D'Avella was granted an option to purchase 30,000 shares of Common
Stock at an exercise price of $6.50 per share.
In June 1998, the Board adopted the 1998 Non-Employee Directors' Stock Option
Plan (the "Directors' Plan") to provide for the automatic grant of options to
purchase shares of Common Stock to non-employee directors of the Company who
are not employees of or consultants to the Company or of any affiliate of the
Company (a "Non-Employee Director"). The Directors' Plan is administered by the
Board, unless the Board delegates administration to a Committee comprised of
members of the Board. See "--Employee Benefit Plans--1998 Non-Employee
Directors' Stock Option Plan."
LIMITATION ON DIRECTORS' AND OFFICERS' LIABILITY
As permitted by Section 145 of the Delaware General Corporation Law, the
Bylaws of the Company provide that (i) the Company is required to indemnify its
directors and executive officers to the fullest extent permitted by the
Delaware General Corporation Law, (ii) the Company may, in its discretion,
51
<PAGE>
indemnify other officers, employees and agents as set forth in the Delaware
General Corporation Law, (iii) to the fullest extent permitted by the Delaware
General Corporation Law, the Company is required to advance all expenses
incurred by its directors and executive officers in connection with a legal
proceeding (subject to certain exceptions), (iv) the rights conferred in the
Bylaws are not exclusive, (v) the Company is authorized to enter into
indemnification agreements with its directors, officers, employees and agents
and (vi) the Company may not retroactively amend the Bylaws provisions relating
to indemnity. The Company intends to enter into agreements to indemnify its
officers and directors. A copy of the form of such indemnification has been
filed as an exhibit to the Registration Statement.
EXECUTIVE COMPENSATION
The following table sets forth the annualized compensation awarded or paid by
the Company during the fiscal year ended December 31, 1997 to the Company's
Chief Executive Officer and four other most highly compensated officers whose
annual salary and bonus exceeded $100,000 in fiscal 1997 (hereinafter, the
"Named Executive Officers").
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
ANNUAL COMPENSATION AWARDS
---------------------------------- ------------
SECURITIES
NAME AND PRINCIPAL OTHER ANNUAL UNDERLYING
POSITION YEAR SALARY($) BONUS($) COMPENSATION($) OPTIONS (#)
------------------ ---- --------- -------- --------------- ------------
<S> <C> <C> <C> <C> <C>
Dr. Zaki Rakib............ 1997 150,000 12,500 -- --
Chief Executive Officer
and Chief Financial
Officer
Shlomo Rakib.............. 1997 150,000 12,500 -- --
President and Chief
Technical Officer
Gary Law.................. 1997 108,333 -- -- 115,000
Vice President, Marketing
and Business Development
Linda Palmor.............. 1997 108,306 10,000 -- 35,000
Vice President, Finance
Dennis Picker............. 1997 129,000 31,800 75,166(2) --
Vice President,
Standards(1)
</TABLE>
- --------
(1) Mr. Picker has served as Chief Operating Officer since February 1998.
(2) Consists of reimbursement to Mr. Picker for travel costs of which $35,140
was attributable to tax gross-up payments made by the Company.
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<PAGE>
OPTION GRANTS IN LAST FISCAL YEAR
The following table sets forth each grant of stock options made during the
fiscal year ended December 31, 1997 to each of the Named Executive Officers:
<TABLE>
<CAPTION>
INDIVIDUAL GRANTS
------------------------------------------------------------
POTENTIAL REALIZABLE
PERCENTAGE OF VALUE AT ASSUMED
TOTAL OPTIONS ANNUAL RATES OF STOCK
GRANTED TO PRICE APPRECIATION
NUMBER OF SECURITIES EMPLOYEES IN FOR OPTION TERM (4)
UNDERLYING OPTIONS FISCAL YEAR EXERCISE PRICE EXPIRATION ----------------------
NAME GRANTED (#) (1) (%) (2) ($/SH) (3) DATE 5% ($) 10% ($)
---- -------------------- ------------- -------------- ---------- ---------- -----------
<S> <C> <C> <C> <C> <C> <C>
Dr. Zaki Rakib.......... -- -- -- -- -- --
Shlomo Rakib............ -- -- -- -- -- --
Gary Law................ 115,000 8.82% $1.25 03/25/07 $234,153 $372,850
Linda Palmor............ 35,000 2.68% $1.25 05/05/07 $ 71,264 $113,476
Dennis Picker........... -- -- -- -- -- --
</TABLE>
- --------
(1) Options generally vest at a rate 20% on the first anniversary of the
vesting commencement date and 1/48th each month thereafter. The term of
each option granted is generally the earlier of (i) ten years or (ii) 90
days after termination of the optionee's services to the Company. Options
are immediately exercisable; however, the unvested shares purchasable
under such options are subject to repurchase by the Company at the
original exercise price paid per share upon the optionee's cessation of
service prior to the vesting of such shares.
(2) Based on an aggregate of 1,304,050 options granted to employees,
consultants and directors, including the Named Executive Officers, of the
Company during the fiscal year ended December 31, 1997.
(3) The exercise price per share of each option was equal to the fair market
value of the Common Stock on the date of grant as determined by the Board
of Directors after consideration of a number of factors, including, but
not limited to, the development life cycle of the Company's products, the
Company's financial performance, market conditions, the price and
preferred rights and privileges of shares of equity securities sold to or
purchased by outside investors, and third-party appraisals.
(4) The potential realizable value is calculated based on the term of the
option at its time of grant (ten years). It is calculated assuming that
the fair market value of the Company's Common Stock on the date of grant
appreciates at the indicated annual rate compounded annually for the
entire term of the option and that the option is exercised and sold on the
last day of its term for the appreciated stock price.
AGGREGATE OPTION EXERCISES IN FISCAL 1997 AND DECEMBER 31, 1997 OPTION VALUES
There were no exercises of options by any Named Executive Officer in the
fiscal year ended December 31, 1997.
EMPLOYEE BENEFIT PLANS
1997 Equity Incentive Plan. The Company's 1997 Equity Incentive Plan (the
"1997 Plan") was adopted in March 1997 and amended in December 1997 and June
1998. An aggregate of 3,300,000 shares of Common Stock currently are
authorized for issuance under the 1997 Plan. However, each year on January 1,
starting with January 1, 1999, the aggregate number of shares of Common Stock
that are available for issuance under the 1997 Plan will automatically be
increased to that number of shares of Common Stock that is equal to 5% of the
Company's outstanding shares of Common Stock on such date.
The 1997 Plan provides for the grant of incentive stock options, as defined
under the Internal Revenue Code of 1986, as amended (the "Code"), to employees
(including officers and employee directors) and non-statutory stock options,
restricted stock purchase awards and stock bonuses to employees (including
officers and employee directors), directors and consultants of the Company and
its affiliates. The 1997 Plan is administered by the Compensation Committee,
which determines the
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<PAGE>
recipients and types of awards to be granted, including the exercise price,
number of shares subject to the award and the exercisability thereof.
The terms of options granted under the 1997 Plan may not exceed 10 years. The
Compensation Committee determines the exercise price of options granted under
the 1997 Plan. However, the exercise price for an incentive stock option cannot
be less than 100% of the fair market value of the Common Stock on the date of
the option grant, and the exercise price for a non-statutory stock option
cannot be less than 85% of the fair market value of the Common Stock on the
date of the option grant. Options granted under the 1997 Plan vest at the rate
specified in the option agreement. Generally, the right to exercise 20% of the
total number of shares granted vest 12 months after the date of option grant,
with the reminder vesting monthly over four years thereafter, such that an
option is fully vested on the fifth anniversary of the date of the option
grant. Generally, the optionee may not transfer a stock option other than by
will or the laws of descent or distribution. However, an optionee may designate
a beneficiary who may exercise the option in the event of the optionee's death
or disability. Unless the terms of an optionee's option agreement provide for
an earlier termination, in the event of the optionee's cessation of his or her
relationship with the Company due to death or disability, the optionee's
beneficiary may exercise any vested options up to 18 months and 12 months,
respectively, after the date of such cessation. If such optionee's relationship
with the Company ceases for any reason other than the optionee's death or
disability or termination for cause, the optionee may exercise any vested
options during the 30 days following such cessation.
No incentive stock option (and, prior to the Company's stock being publicly
traded, no non-statutory stock option) may be granted to any person who, at the
time of the grant, owns (or is deemed to own) stock possessing more than 10% of
the total combined voting power of the Company or any affiliate of the Company,
unless the option exercise price is at lease 110% of the fair market value of
the stock subject to the option on the date of grant and the term of the option
does not exceed five years from the date of the grant. In addition, the
aggregate fair market value, determined at the time of grant, of the shares of
Common Stock with respect to which incentive stock options are exercisable for
the first time by an optionee during any calendar year (under the 1997 Plan and
all other stock plans of the Company and its affiliates) may not exceed
$100,000.
When the Company becomes subject to Section 162(m) of the Code (which denies
a deduction to publicly held corporations for certain compensation paid to
specified employees in a taxable year to the extent that the compensation
exceeds $1,000,000), no person may be granted options under the Incentive Plan
covering more than 500,000 shares of Common Stock in any calendar year.
Shares subject to stock awards that have expired or otherwise terminated
without having been exercised in full again become available for the grant of
awards under the 1997 Plan. The Compensation Committee has the authority to
reprice outstanding options or to offer optionees the opportunity to replace
outstanding options with new options for the same or a different number of
shares. Both the original and new options will count toward the Code Section
162(m) limitations set forth above.
Restricted stock purchase awards granted under the 1997 Plan may be granted
pursuant to a repurchase option in favor of the Company in accordance with a
vesting schedule and at a price determined by the Compensation Committee. Stock
bonuses may be awarded in consideration of past services without a purchase
payment. Rights under a stock bonus or restricted stock bonus agreement
generally may not be transferred other than by will or the laws of descent and
distribution during such period as the stock awarded pursuant to such an
agreement remains subject to the agreement.
If there is any sale of all or substantially all of the Company's assets, any
merger or any consolidation in which the Company is not the surviving
corporation or a like transaction involving the Company, all outstanding awards
under the 1997 Plan either will be assumed or substituted for by any surviving
entity. If the surviving entity determines not to assume or substitute for such
awards, the
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<PAGE>
vesting of stock awards held by persons still serving the Company or its
affiliate will be accelerated and such awards will terminate if not exercised
prior to the sale of assets, merger or consolidation.
As of June 30, 1998, 39,250 shares of Common Stock had been issued upon the
exercise of options granted under the 1997 Plan, options to purchase 1,010,560
shares of Common Stock were outstanding and 2,250,190 shares remained
available for future grant. The 1997 Plan will terminate in March 2007 unless
terminated by the Board before then. As of June 30, 1998, no stock awards or
restricted stock had been granted under the 1997 Plan.
1995 Stock Option Plan. The Company also has a 1995 Stock Option Plan (the
"1995 Plan"). The 1995 Plan is administered by the Board, unless the Board
delegates administration to a committee comprised of members of the Board.
Under the 1995 Plan, stock options and awards may be granted to employees,
directors and consultants. Only employees may receive incentive stock options;
employees, directors and consultants may receive non-statutory stock options
and stock awards other than incentive stock options. The exercise price of
incentive stock options granted under the 1995 Plan must be at least equal to
the fair market value of the Common Stock on the date of grant, while the
exercise price of nonstatutory options must equal at least 85% of such market
value. Generally, the right to exercise 20% of the total number of shares
granted vest 12 months after the date of option grant, with the reminder
vesting monthly over four years thereafter, such that an option is fully
vested on the fifth anniversary of the date of the option grant. Options and
awards granted under the Plan must be exercised within ten years of the date
of grant. The other terms of the 1995 Plan are substantially similar to the
terms of the 1997 Plan.
As of June 30, 1998, 778,268 shares had been issued upon the exercise of
options under the 1995 Plan, 1,332,732 shares of Common Stock were subject to
outstanding options and 3,747 shares remained available for future grant. The
1995 Plan will terminate in March 2005 unless terminated by the Board of
Directors before then.
1998 Non-Employee Directors' Stock Option Plan. In June 1998, the Board
adopted the Directors' Plan to provide for the automatic grant of options to
purchase shares of Common Stock to non-employee directors of the Company who
are not employees of or consultants to the Company or of any affiliate of the
Company (a "Non-Employee Director"). The Directors' Plan is administered by
the Board, unless the Board delegates administration to a Committee comprised
of members of the Board.
The aggregate number of shares of Common Stock that may be issued pursuant
to options granted under the Directors' Plan is 200,000 shares. Pursuant to
the terms of the Directors' Plan, after the effective date of the initial
public offering of the Company's Common Stock, each person who is elected or
appointed for the first time to be a Non-Employee Director automatically
shall, upon the date of his or her initial election or appointment to be a
Non-Employee Director by the Board or stockholders of the Company, be granted
an option to purchase 30,000 shares of Common Stock. In addition, on the day
following each Annual Meeting of Stockholders of the Company ("Annual
Meeting"), commencing with the Annual Meeting in 1999, each person who is then
serving as a Non-Employee Director automatically shall be granted an option to
purchase 12,500 shares of Common Stock, which amount shall be prorated for any
Non-Employee Director who has not continuously served as a Non-Employee
Director for the 12-month period prior to the date of such Annual Meeting. In
addition, on the day following each Annual Meeting, commencing with the Annual
Meeting in 1999, each Non-Employee Director who is then serving as a member of
a committee of the Board of Directors automatically shall be granted, for each
such committee, an option to purchase 3,000 shares of Common Stock of the
Company, which amount shall be prorated for any Non-Employee Director who has
not continuously served as a member of such committee for the 12-month period
prior to the date of such Annual Meeting.
The exercise price of the options granted under the Directors' Plan will be
equal to the fair market value of the Common Stock on the date of grant. No
option granted under the Directors' Plan may be
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<PAGE>
exercised after the expiration of 10 years from the date it was granted.
Options granted under the Directors' Plan vest and become exercisable as to
33% of the shares on the first anniversary of the date of grant and 1/36th of
the shares monthly thereafter. Options granted under the Directors' Plan
generally are non-transferable. However, an optionee may designate a
beneficiary who may exercise the option following the optionee's death. An
optionee whose service relationship with the Company or any affiliate (whether
as a Non-Employee Director of the Company or subsequently as an employee,
director or consultant of either the Company or an affiliate) ceases for any
reason may exercise vested options for the term provided in the option
agreement (3 months generally, 12 months in the event of disability, and 18
months in the event of death).
In the event of certain changes in control of the Company, all outstanding
awards under the Directors' Plan either will be assumed or substituted for by
any surviving entity. If the surviving entity determines not to assume or
substitute for such awards, the vesting and time during which such options may
be exercised shall be accelerated prior to such event and the options will
terminate if not exercised after such acceleration and at or prior to such
event. Unless terminated sooner by the Board of Directors, the Directors' Plan
will terminate in June 2008.
1998 Employee Stock Purchase Plan. In June 1998, the Company's Board of
Directors approved the 1998 Employee Stock Purchase Plan (the "Purchase
Plan"), covering an aggregate of 700,000 shares of Common Stock. The Purchase
Plan is intended to qualify as an employee stock purchase plan within the
meaning of Section 423 of the Code. Under the Purchase Plan, the Board of
Directors may authorize participation by eligible employees, including
officers, in periodic offerings following the adoption of the Purchase Plan.
The offering period for any offering will be no more than 27 months.
Under the Purchase Plan, employees are eligible to participate if they are
employed by the Company or an affiliate of the Company designated by the Board
of Directors and are employed at least 20 hours per week and five months per
year. Employees who participate in an offering will have the right to purchase
up to the number of shares of Common Stock purchasable with a percentage
designated by the Board of Directors, up to 15%, of an employee's earnings
withheld pursuant to the Purchase Plan and applied, on specified dates
determined by the Board of Directors, to the purchase of shares of Common
Stock. The price of Common Stock purchased under the Purchase Plan will be
equal to 85% of the lower of the fair market value of the Common Stock on the
commencement date of each offering period or the relevant purchase date.
Employees may end their participation in the offering at any time during the
offering period, and participation ends automatically on termination of
employment with the Company.
In the event of certain changes in control of the Company, the Company and
the Board of Directors have discretion to provide that each right to purchase
Common Stock will be assumed or an equivalent right will be substituted by the
successor corporation, or the Board may shorten the offering period and
provide for all sums collected by payroll deductions to be applied to purchase
stock immediately prior to the change in control. The Purchase Plan will
terminate at the Board's discretion or when all of the shares reserved for
issuance under the Purchase Plan have been issued.
401(k) Plan. The Company maintains the Terayon Corporation 401(k) Retirement
Plan (the "401(k) Plan") for eligible employees ("Participants"). A
Participant may contribute up to 15% of his or her total annual compensation
to the 401(k) Plan, or up to a statutorily prescribed annual limit, if less.
The annual limit for 1998 is $10,000. Each Participant is fully vested in his
or her deferred salary contributions. Participant contributions are held and
invested by the 401(k) Plan's trustee. The Company may make discretionary
contributions as a percentage of Participant contributions, subject to
established limits. To date, the Company has not made any contributions to the
401(k) Plan on behalf of the Participants. The 401(k) Plan is intended to
qualify under Section 401 of the Code, so that contributions by employees or
by the Company to the 401(k) Plan, and income earned on the 401(k) Plan
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contributions, are not taxable to employees until withdrawn from the 401(k)
Plan, and so that contributions by the Company, if any, will be deductible by
the Company when made.
EMPLOYMENT AGREEMENTS
In February 1993, the Company entered into an employment agreement with
Shlomo Rakib to serve as President and Chairman of the Board of Directors. The
employment agreement is for a specified duration of seven years, but it is
terminable at will or without cause at any time upon written notice. In
February 1993, the Company also entered into an employment agreement with Zaki
Rakib to serve as Chief Executive Officer and Chief Financial Officer. The
employment agreement is not for a specified term and is terminable at will or
without cause at any time upon written notice. Both employment agreements
further provide that the Company's Board of Directors will set each executive's
salary in accordance with the payroll policies of the Company as constituted
from time to time.
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CERTAIN TRANSACTIONS
In February 1993, the Company entered into an employment agreement with Zaki
Rakib, the Company's Chief Executive Officer and a director of the Company.
Dr. Rakib is the brother of Shlomo Rakib, the Company's Chairman of the Board,
President and Chief Technical Officer. See "Management-- Employment
Agreements."
In February 1993, the Company also entered into an employment agreement with
Shlomo Rakib, the Company's Chairman of the Board, President and Chief
Technical Officer. Mr. Rakib is the brother of Zaki Rakib, the Company's Chief
Executive Officer and a director of the Company. See "Management --Employment
Agreements."
In December 1995, in connection with the purchase by Cisco of Series B
Preferred Stock of the Company, the Company granted Cisco a right of first
offer to acquire the Company in the event the Company commences a sale of 50%
or more of its outstanding capital stock or all of its assets. The Company
also granted Cisco the right to make an offer to purchase the Company in the
event the Company commences an initial public offering of its securities.
Cisco holds more than 5% of the outstanding equity of the Company. Cisco also
has the right to elect one director to the Company's Board of Directors.
Cisco's rights terminate upon the completion of the Company's initial public
offering.
In March 1996, the Company loaned Shlomo Rakib, the Company's Chairman of
the Board, President and Chief Technical Officer, $100,000 pursuant to an
interest-free promissory note, with the principal amount due in March 2001.
The purpose of the loan was to permit Mr. Rakib to purchase a residence. The
note (i) may be extended for a longer term at the option of the Company, (ii)
is secured by 20,000 shares of Common Stock held by Mr. Rakib and (iii) will
accelerate upon termination of his employment with the Company, the initial
public offering of the Company's securities or the sale of the Company. As of
June 30, 1998 and December 31, 1997, $100,000 remained outstanding under the
note.
In December 1997, the Company entered into a strategic partnership and
distributorship agreement with Sumitomo, a greater than 5% stockholder of the
Company, whereby Sumitomo and the Company formed a strategic partner
relationship for the purpose of promoting the Company's products in Japan.
Pursuant to this agreement, the Company appointed Sumitomo as its exclusive
distributor for the Company's products in Japan and as a non-exclusive
distributor for the Company's products in the rest of the world. Sales to
Sumitomo in the first six months of 1998 were approximately $1.3 million,
which represented approximately 14% of the Company's revenues for such period.
In the six months ended June 30, 1998, the Company sold products to Shaw for
an aggregate of approximately $3.8 million. In addition, in April 1998, the
Company issued Shaw a warrant to purchase 3,000,000 shares of Common Stock at
an exercise price of $6.50 per share in connection with the issuance of
384,615 shares of Series F convertible preferred stock. The exercise price of
the warrant is equal to the fair market value of the Company's Common Stock at
the time the warrant was granted, as determined by the Company's Board of
Directors. The warrant is exercisable by Shaw at any time prior to December
31, 2003. Michael D'Avella, a director of the Company, is the Senior Vice
President of Planning for Shaw.
The Company has granted options to certain of its directors and executive
officers. See "Management -- Director Compensation."
The Company believes that the terms of the transactions described above were
no less favorable to the Company than would have been obtained from an
unaffiliated third party. Any future transactions between the Company and any
of its officers, directors or principal stockholders will be on terms no less
favorable to the Company than could be obtained from unaffiliated third
parties and will be approved by a majority of the independent and
disinterested members of the Board of Directors.
The Company intends to enter into indemnification agreements with its
directors and executive officers for the indemnification of and advancement of
expenses to such persons to the full extent permitted by law. The Company also
intends to execute such agreements with its future directors and executive
officers. See "Management -- Limitation on Directors' and Officers'
Liability."
Holders of Preferred Stock are entitled to certain registration rights with
respect to the Common Stock issued or issuable upon conversion thereof. See
"Description of Capital Stock -- Registration Rights."
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<PAGE>
PRINCIPAL STOCKHOLDERS
The following table sets forth certain information with respect to the
beneficial ownership of the Company's Common Stock as of July 31, 1998, and as
adjusted to reflect the sale of the shares of Common Stock offered hereby by
(i) each of the Company's Named Executive Officers, (ii) each of the Company's
directors, (iii) each holder of more than 5% of the Company's Common Stock,
(iv) certain other stockholders and (v) all current directors and executive
officers as a group.
<TABLE>
<CAPTION>
PERCENTAGE OF SHARES
BENEFICIALLY OWNED (1)
SHARES ----------------------
BENEFICIALLY PRIOR TO AFTER
BENEFICIAL OWNERS OWNED (1) OFFERING OFFERING
- ----------------- ------------ ----------- -----------
<S> <C> <C> <C>
Dr. Zaki Rakib (2)..................... 2,000,000 15.0% 12.3%
Shlomo Rakib (2)....................... 2,000,000 15.0% 12.3%
Entities associated with Weiss, Peck & 1,713,882 12.9% 10.5%
Greer (3).............................
555 California Street, Suite 3130
San Francisco, California 94104
Entities associated with Sequoia 1,683,882 12.7% 10.3%
Capital (4)...........................
3000 Sand Hill Road Suite 280,
Building 4
Menlo Park, California 94025
Cisco Systems, Inc..................... 896,834 6.7% 5.5%
170 West Tasman Drive
San Jose, California 95134
Entities associated with Walden 840,620 6.3% 5.2%
Ventures (5)..........................
750 Battery Street, 7th Floor
San Francisco, California 94111
Sumitomo Corporation................... 784,615 5.9% 4.8%
2-2 Hitotsubashi 1-Chome,
Chiyoda-Ku
C.P.O. Box 1524
Tokyo, 100-91 Japan
Shaw Communications Inc. (6)........... 576,923 4.3% 3.5%
Christopher J. Schaepe (3)............. 1,713,882 12.9% 10.6%
Mark Stevens (4)(7).................... 1,713,882 12.9% 10.6%
Lewis Solomon (8)...................... 100,000 * *
Michael D'Avella (6)(9)................ 611,923 4.6% 3.8%
Gary Law (10).......................... 120,000 * *
Linda Palmor (11)...................... 90,000 * *
Dennis Picker (12)..................... 240,000 1.8% 1.5%
All directors and executive officers as 8,499,687 61.9% 51.0%
a group (7 persons) (13)..............
</TABLE>
- --------
* Less than 1%.
(1) Percentage of beneficial ownership is based on 13,307,748 shares of Common
Stock outstanding on an as-converted basis as of July 31, 1998.
(2) The address for Messrs. Rakib is c/o Terayon Communication Systems, Inc.,
2952 Bunker Hill Lane, Santa Clara, CA 95054.
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<PAGE>
(3) Includes 919,400 shares held by WPG Enterprise Fund II, L.P. and 764,482
shares held by Weiss, Peck & Greer Venture Associates III, L.P. Also
includes 16,380 shares issuable to WPG Enterprise Fund II, L.P. and 13,620
shares issuable to Weiss, Peck & Greer Venture Associates III, L.P. upon
the early exercise of options vesting through July 2000. Christopher J.
Schaepe, a director of the Company, is a General Partner of WPG Venture
Partners III, L.P., a general partner of the entities associated with
Weiss, Peck & Greer. Mr. Schaepe may be deemed to have a voting and
investment power over the shares held by the entities associated with
Weiss, Peck & Greer. He disclaims beneficial ownership of such shares
except to the extent of his pecuniary interest therein.
(4) Includes (i) 1,532,333 shares held by Sequoia Capital VI; (ii) 84,195
shares held by Sequoia Technology Partners VI; (iii) 62,860 shares held by
Sequoia XXIV; (iv) 2,296 shares held by Sequoia 1995; (v) 791 shares held
by Sequoia 1997; and (vi) 1,407 shares held by SQP 1997. Mark Stevens, a
director of the Company, is a General Partner of the entities associated
with Sequoia Capital. Mr. Stevens may be deemed to have a voting and
investment power over the shares held by the entities associated with
Sequoia Capital. He disclaims beneficial ownership of such shares except
to the extent of his pecuniary interest therein.
(5) Includes (i) 392,270 shares held by Walden-Israel Ventures, L.P.; (ii)
392,270 shares held by Walden-SBIC, L.P.; and (iii) 56,080 shares held by
Walden Technology Ventures II, L.P.
(6) Does not include 3,019,389 shares issuable pursuant to warrants.
(7) Includes 18,000 shares subject to repurchase by the Company within 60 days
of July 31, 1998.
(8) Includes 20,000 shares issuable upon the early exercise of options vesting
through May 2000, 4,166 of which will be fully vested and no longer
subject to repurchase within 60 days of July 31, 1998.
(9) Includes 576,923 shares held by Shaw Communications Inc. Mr. D'Avella, a
director of the Company, is the Senior Vice President, Planning for Shaw.
Also includes 35,000 shares issuable upon the early exercise of options
vesting through April 2001. Mr. D'Avella may be deemed to have a voting
and investment power over the shares held by Shaw. He disclaims beneficial
ownership as to all shares held by Shaw.
(10) Includes 120,000 shares issuable upon the early exercise of options
vesting through May 2003, 34,500, of which will be fully vested and no
longer subject to repurchase within 60 days of July 31, 1998.
(11) Includes 90,000 shares issuable upon the early exercise of options vesting
through May 2003, 27,416 of which will be fully vested and no longer
subject to repurchase within 60 days of July 31, 1998.
(12) Includes 240,000 shares issuable upon the early exercise of options
vesting through May 2003, 93,333 of which will be fully vested and no
longer subject to repurchase within 60 days of July 31, 1998.
(13) Includes 415,000 shares issuable upon the early exercise of options
vesting through May 2003, 131,166 of which will be fully vested and no
longer subject to repurchase within 60 days of July 31, 1998.
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DESCRIPTION OF CAPITAL STOCK
Upon the completion of this offering, the authorized capital stock of the
Company will consist of 30,000,000 shares of Common Stock, par value $0.001
per share, and 5,000,000 shares of Preferred Stock, par value $0.001 per share
("Preferred Stock").
COMMON STOCK
As of June 30, 1998, there were 13,220,733 shares of Common Stock (including
shares of Preferred Stock that will be converted into Common Stock upon
completion of this offering) outstanding held of record by 102 stockholders.
The holders of Common Stock are entitled to one vote for each share held of
record on all matters submitted to a vote of the stockholders. Subject to
preferences that may be applicable to any outstanding shares of the Preferred
Stock, the holders of Common Stock are entitled to receive ratably such
dividends as may be declared by the Board of Directors out of funds legally
available therefor. See "Dividend Policy." In the event of a liquidation,
dissolution or winding up of the Company, holders of the Common Stock are
entitled to share ratably in all assets remaining after payment of liabilities
and the liquidation preferences of any outstanding shares of Preferred Stock.
Holders of Common Stock have no preemptive rights and no right to convert
their Common Stock into any other securities. There are no redemption or
sinking fund provisions applicable to the Common Stock. All outstanding shares
of Common Stock are, and all shares of Common Stock to be outstanding upon the
completion of this offering will be, fully paid and non-assessable.
PREFERRED STOCK
Pursuant to the Restated Certificate, the Board of Directors has the
authority, without further action by the stockholders, to issue up to
5,000,000 shares of Preferred Stock in one or more series and to fix the
designations, powers, preferences, privileges and relative participating,
optional or special rights and the qualifications, limitations or restrictions
thereof, including dividend rights, conversion rights, voting rights, terms of
redemption and liquidation preferences, any or all of which may be greater
than the rights of the Common Stock. The Board of Directors, without
stockholder approval, can issue Preferred Stock with voting, conversion or
other rights that could adversely affect the voting power and other rights of
the holders of Common Stock. Preferred Stock could thus be issued quickly with
terms calculated to delay, defer or prevent a change in control of the Company
or make removal of management more difficult. Additionally, the issuance of
Preferred Stock may have the effect of decreasing the market price of the
Common Stock and may adversely affect the voting and other rights of the
holders of Common Stock. Upon the completion of this offering, there will be
no shares of Preferred Stock outstanding and the Company has no current plans
to issue any shares of the Preferred Stock.
WARRANTS
In April 1998, the Company issued to Shaw a warrant ("Common Stock Warrant")
to purchase 3,000,000 shares of Common Stock at an exercise price of $6.50 per
share. The Common Stock Warrant is exercisable by Shaw at any time prior to
December 31, 2003. In addition, the Company issued to Shaw a warrant ("Anti-
Dilution Warrant") to purchase an indeterminate number of shares of Common
Stock for an aggregate price of $1.00. The Anti-Dilution Warrant is
exercisable from time to time when the Company issues certain new equity
securities until the date upon which Shaw ceases to own at least 384,615
shares of Common Stock. As of June 30, 1998, Shaw had the right to receive
19,389 shares pursuant to the Anti-Dilution Warrant.
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REGISTRATION RIGHTS
Pursuant to an agreement between the Company and the holders (or their
permitted transferees) of approximately 8,200,635 shares of Common Stock and
Preferred Stock (which Preferred Stock will automatically be converted into
Common Stock upon the completion of this offering) and of warrants to purchase
3,057,851 shares of Common Stock ("Holders"), the Holders will be entitled to
certain rights with respect to registration of such shares for sale in the
public market. The Holders are entitled to certain rights with respect to the
registration of such shares under the Securities Act. If the Company proposes
to register its Common Stock, subject to certain exceptions, under the
Securities Act, the Holders are entitled to notice of the registration and are
entitled at the Company's expense to include such shares therein, provided that
the managing underwriters have the right to limit the number of such shares
included in the registration or exclude such shares entirely. In addition,
certain of the Holders may require the Company, at the Company's expense, on no
more than six occasions, to file a registration statement under the Securities
Act with respect to their shares of Common Stock. Such rights may not be
exercised until six months after the completion of this offering. Further,
certain Holders may require the Company at the Company's expense on no more
than four occasions, to register all or portion of their shares on Form S-3
when such form becomes available to the Company, subject to certain conditions
and limitations. Such rights expire on the seventh anniversary of completion of
this offering.
ANTI-TAKEOVER EFFECTS OF PROVISIONS OF CHARTER DOCUMENTS AND DELAWARE LAW
Charter Documents
The Restated Certificate and Restated Bylaws include a number of provisions
that may have the effect of deterring hostile takeovers or delaying or
preventing changes in control or management of the Company. First, the Restated
Certificate provides that all stockholder action upon completion of this
offering must be effected at a duly called meeting of holders and not by a
consent in writing. Second, the Restated Bylaws provide that special meetings
of the holders may be called only by (i) the Chairman of the Board of
Directors, (ii) the Chief Executive Officer or (iii) Board of Directors
pursuant to a resolution adopted by a majority of the total number of
authorized directors. Third, the Certificate and the Bylaws provide for a
classified Board of Directors. The Certificate includes a provision requiring
cumulative voting for directors only if required by applicable California law.
Under cumulative voting, a minority stockholder holding a sufficient percentage
of a class of shares may be able to ensure the election of one or more
directors. As a result of the provisions of the Certificate and applicable
California and Delaware law, at any annual meeting whereby the Company had at
least 800 stockholders as of the end of the fiscal year prior to the record
date for such annual meeting, stockholders will not be able to cumulate votes
for directors. Finally, the Restated Bylaws establish procedures, including
advance notice procedures with regard to the nomination of candidates for
election as directors and stockholder proposals. These provisions of the
Restated Certificate and Restated Bylaws could discourage potential acquisition
proposals and could delay or prevent a change in control or management of the
Company. Such provisions also may have the effect of preventing changes in the
management of the Company. See "Risk Factors--Anti-Takeover Provisions."
Delaware Takeover Statute
The Company is subject to the provisions of Section 203 of the Delaware
General Corporation Law ("Section 203"). In general, Section 203 prohibits a
publicly held Delaware corporation, such as the Company shall become upon
completion of this offering, from engaging in a "business combination" with an
"interested stockholder" for a period of three years after the date of the
transaction pursuant to which the person became an interested stockholder,
unless the business combination is approved in a manner prescribed by Delaware
law. For purposes of Section 203, a "business combination" includes a merger,
asset sale or other transaction resulting in a financial benefit to the
interested stockholder, and
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<PAGE>
an "interested stockholder" is a person who, together with affiliates and
associates, owns (or within three years prior, did own) 15% or more of the
corporation's voting stock.
TRANSFER AGENT AND REGISTRAR
Boston Equiserve has been appointed as the transfer agent and registrar for
the Company's Common Stock.
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<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Prior to this offering, there has been no market for the Common Stock of the
Company, and there can be no assurance that a significant public market for the
Common Stock will develop or be sustained after this offering. Future sales of
substantial amounts of Common Stock (including shares issued upon exercise of
outstanding options and warrants) in the public market following this offering
could adversely affect market prices prevailing from time to time and could
impair the Company's ability to raise capital through sale of its equity
securities. As described below, no shares currently outstanding will be
available for sale immediately after this offering because of certain
contractual restrictions on resale. Sales of substantial amounts of Common
Stock of the Company in the public market after the restrictions lapse could
adversely affect the prevailing market price and the ability of the Company to
raise equity capital in the future.
Upon completion of this offering, the Company will have outstanding
16,220,733 shares of Common Stock, based upon shares outstanding as of June 30,
1998 and assuming no exercise of the Underwriters' over-allotment option and no
exercise of outstanding options or warrants prior to the completion of this
offering. Of these shares, the 3,000,000 shares sold in this offering will be
freely tradable without restriction under the Securities Act except for any
shares purchased by "affiliates" of the Company as that term is defined in Rule
144 under the Securities Act. The remaining 13,220,733 shares of Common Stock
held by existing stockholders are "Restricted Shares" as that term is defined
in Rule 144. All such Restricted Shares are subject to lock-up agreements
providing that, with certain limited exceptions, the stockholder will not
offer, sell, contract to sell or otherwise dispose of any Common Stock of the
Company, including any securities that are convertible into or exchangeable
for, Common Stock for a period 180 days after the date of this Prospectus
without the prior written consent of BT Alex. Brown Incorporated or the
Company. As a result of these lock-up agreements, notwithstanding possible
earlier eligibility for sale under the provisions of Rules 144, 144(k) and 701,
none of these shares will be salable until 181 days after the date of this
Prospectus. Beginning 181 days after the date of this Prospectus, 12,145,105
Restricted Shares will be eligible for sale in the public market, subject to
volume and other limitations under Rule 144. In addition, as of June 30, 1998,
there were outstanding options to purchase 2,483,292 shares and warrants to
purchase 3,107,851 shares. Of such options and warrants, 5,541,143 shares
issuable upon exercise are subject to lock-up agreements. The Company has
agreed with BT Alex. Brown Incorporated not to release any stockholder from any
lock-up agreement between the Company and the stockholder without the prior
written consent of BT Alex. Brown Incorporated. BT Alex. Brown Incorporated
may, in its sole discretion and at any time without notice, release all or any
portion of the securities subject to lock-up agreements.
In general, under Rule 144 as currently in effect, beginning 90 days after
the date of this Prospectus, a person (or persons whose shares are aggregated)
who has beneficially owned Restricted Shares for at least one year (including
the holding period of any prior owner except an affiliate) would be entitled to
sell within any three-month period a number of shares that does not exceed the
greater of: (i) 1% of the number of shares of Common Stock then outstanding
(which will equal approximately 162,207 shares immediately after this
offering); or (ii) the average weekly trading volume of the Common Stock during
the four calendar weeks preceding the filing of a Form 144 with respect to such
sale. Sales under Rule 144 are also subject to certain manner of sale
provisions and notice requirements and to the availability of current public
information about the Company. Under Rule 144(k), a person who is not deemed to
have been an affiliate of the Company at any time during the three months
preceding a sale, and who has beneficially owned the shares proposed to be sold
for at least two years (including the holding period of any prior owner except
and affiliate), is entitled to sell such shares without complying with the
manner of sale, public information, volume limitation or notice provisions of
Rule 144.
Rule 701, as currently in effect, permits resales of shares in reliance upon
Rule 144 but without compliance with certain restrictions, including the
holding period requirement, of Rule 144. Any employee, officer or director of
or consultant to the Company who purchased shares pursuant to a
64
<PAGE>
written compensatory plan or contract may be entitled to rely on the resale
provisions of Rule 701. Rule 701 permits affiliates to sell their Rule 701
shares under Rule 144 without complying with the holding period requirements of
Rule 144. Rule 701 further provides that non-affiliates may sell such shares in
reliance on Rule 144 without having to comply with the holding period, public
information, volume limitation or notice provisions of Rule 144. All holders of
Rule 701 shares are required to wait until 90 days after the date of this
Prospectus before selling such shares. However, all Rule 701 shares are subject
to lock-up agreements and will only become eligible for sale at the expiration
of the 180-day lock-up agreements or no sooner than 90 days after the offering
upon obtaining the prior written consent of BT Alex. Brown Incorporated.
Immediately after this offering, the Company intends to file a registration
statement under the Securities Act covering shares of Common Stock subject to
outstanding options under the 1995 Stock Option Plan, the 1997 Equity Incentive
Plan, the 1998 Employee Stock Purchase Plan and the 1998 Non-employee
Director's Stock Option Plan (collectively the "Incentive Stock Plans"). See
"Management--Equity Incentive Plans". Based on the number of shares subject to
outstanding options as of June 11, 1998 and currently reserved for issuance
under the Incentive Stock Plans, such registration statement would cover
approximately 5,600,000 shares. Such registration statement will automatically
become effective upon filing. Accordingly, shares registered under such
registration statement will, subject to Rule 144 volume limitations applicable
to affiliates of the Company, be available for sale in the open market
immediately after the 180-day lock-up agreements expire.
Also beginning 180 days after the date of this offering, holders of
approximately 8,200,635 Restricted Shares and holders of warrants to purchase
3,057,851 shares of Common Stock will be entitled to certain rights with
respect to registration of such shares for sale in the public market. See
"Description of Capital Stock--Registration Rights". Registration of such
shares under the Securities Act would result in such shares becoming freely
tradable without restriction under the Securities Act (except for shares
purchased by affiliates) immediately upon the effectiveness of such
registration.
65
<PAGE>
UNDERWRITING
Subject to the terms and conditions of the underwriting agreement (the
"Underwriting Agreement"), the underwriters named below (the "Underwriters"),
through their Representatives, BT Alex. Brown Incorporated, Hambrecht & Quist
LLC, Lehman Brothers Inc. and Smith Barney Inc., have severally agreed to
purchase from the Company the following respective number of shares of Common
Stock at the initial public offering price less the underwriting discounts and
commissions set forth on the cover page of this Prospectus:
<TABLE>
<CAPTION>
NUMBER OF
UNDERWRITER SHARES
----------- ---------
<S> <C>
BT Alex. Brown Incorporated........................................ 1,028,750
Hambrecht & Quist LLC.............................................. 543,750
Lehman Brothers Inc................................................ 435,000
Smith Barney Inc. ................................................. 217,500
Morgan Stanley & Co. Incorporated.................................. 75,000
NationsBanc Montgomery Securities LLC.............................. 75,000
Prudential Securities Incorporated................................. 75,000
SG Cowen........................................................... 75,000
Warburg Dillon Read LLC............................................ 75,000
GS2 Securities, Inc. .............................................. 50,000
Loewenbaum & Company Incorporated.................................. 50,000
Needham & Company, Inc. ........................................... 50,000
Brad Peery Inc. ................................................... 50,000
Punk, Ziegel & Company, L.P. ...................................... 50,000
The Seidler Companies Incorporated................................. 50,000
Soundview Financial Group, Inc. ................................... 50,000
Wedbush Morgan Securities Inc. .................................... 50,000
---------
Total............................................................ 3,000,000
=========
</TABLE>
The Underwriting Agreement provides that the obligations of the Underwriters
are subject to certain conditions precedent and that the Underwriters will
purchase all shares of the Common Stock offered hereby if any such shares are
purchased.
The Company has been advised by Representatives of the Underwriters that the
Underwriters propose to offer the shares of Common Stock directly to the public
at the initial offering price set forth on the cover page of this Prospectus
and to certain dealers at such price less a concession not in excess of $0.52
per share. The Underwriters may allow, and such dealers may reallow, a
concession not in excess of $0.10 per share to certain other dealers. After the
initial public offering of the shares, the offering price and other selling
terms may be changed by the Representatives of the Underwriters.
The Company has granted to the Underwriters an option, exercisable no later
than 30 days after the date of this Prospectus, to purchase up to 450,000
additional shares of Common Stock at the initial public offering price less the
underwriting discounts and commissions set forth on the cover page of this
Prospectus. To the extent that the Underwriters exercise such option, each of
the Underwriters will have a firm commitment to purchase approximately the same
percentage of such additional shares as the number set forth next to such
Underwriter's name in the above table bears to the total number of shares of
Common Stock offered hereby, and the Company will be obligated, pursuant to the
option, to sell such shares to the Underwriters to the extent the option is
exercised. The Underwriters may exercise such option only to cover over-
allotments made in connection with the sale of Common Stock offered hereby. If
purchased, the Underwriters will offer such additional shares on the same terms
as those on which the 3,000,000 shares are being offered.
66
<PAGE>
The Company has agreed to indemnify the Underwriters against certain
liabilities, including liabilities under the Securities Act, and to contribute
to payments the Underwriters may be required to make in respect thereof.
The Company and its officers, directors and stockholders have agreed not to
offer, sell or otherwise dispose of any shares of Common Stock for a period of
180 days after the date of this Prospectus without the prior written consent of
BT Alex. Brown Incorporated. Such consent may be given without any public
notice.
At the request of the Company, the Underwriters have reserved for sale, at
the initial offering price, up to 250,000 shares offered hereby (not including
shares subject to the Underwriters' over-allotment option) for certain parties
who have expressed an interest in purchasing such shares in this offering. The
number of shares of Common Stock available for sale to the general public will
be reduced to the extent such persons purchase such reserved shares. Any
reserved shares that are not so purchased will be offered by the Underwriters
to the general public on the same basis as the other shares offered hereby.
Prior to this offering, there has been no public market for the Common Stock
of the Company. Consequently, the initial public offering price for the Common
Stock was determined by negotiation between the Company and the Representatives
of the Underwriters. Among the factors considered in such negotiations were
prevailing market conditions, the results of operations of the Company in
recent periods, the market capitalizations and stages of development of other
companies that the Company and the Representatives of the Underwriters believe
to be comparable to the Company, estimates of the business potential of the
Company and its industry in general and the present state of the Company's
development and other factors deemed relevant.
The Company has been advised by the Representatives that during and after
this offering, the Underwriters may purchase and sell Common Stock in the open
market. These transactions may include over-allotment and stabilizing
transactions and purchases to cover syndicate short positions created in
connection with this offering. Stabilizing transactions consist of certain bids
or purchases for the purpose of preventing or retarding a decline in the market
price of the Common Stock; and syndicate short positions involve the sale by
the Underwriters of a greater number of shares of Common Stock than they are
required to purchase from the Company in this offering. The Underwriters also
may impose penalty bids, whereby selling concessions allowed to the syndicate
members or other broker-dealers in respect of the Common Stock sold in this
offering for their account may be reclaimed by the syndicate if such securities
are repurchased by the syndicate in stabilizing or short-covering transactions.
These activities may stabilize, maintain or otherwise affect the market price
of the Common Stock, which may be higher than the price that might otherwise
prevail in the open market. These transactions may be effected on the Nasdaq
National Market or otherwise and these activities, if commenced, may be
discontinued at any time.
The Representatives of the Underwriters have advised the Company that the
Underwriters do not intend to confirm orders to any account over which they
exercise discretionary authority.
67
<PAGE>
LEGAL MATTERS
The validity of the Common Stock offered hereby will be passed upon for the
Company by Cooley Godward llp ("Cooley Godward"), San Francisco, California.
Certain legal matters related to the offering will be passed upon for the
Underwriters by Wilson Sonsini Goodrich & Rosati, Professional Corporation,
Palo Alto, California. As of the date of this Prospectus, certain partners and
associates of Cooley Godward own through an investment partnership an aggregate
of 36,668 shares of Common Stock of the Company.
EXPERTS
The consolidated financial statements of Terayon Communication Systems, Inc.
at December 31, 1997 and 1996, and for each of the three years in the period
ended December 31, 1997, appearing in this Prospectus and Registration
Statement have been audited by Ernst & Young LLP, independent auditors, as set
forth in their report thereon appearing elsewhere herein, and are included in
reliance upon such report given upon the authority of such firm as experts in
accounting and auditing.
ADDITIONAL INFORMATION
The Company has filed with the Securities and Exchange Commission (the
"Commission"), Washington, D.C. 20549, a Registration Statement on Form S-1
under the Securities Act with respect to the shares of Common Stock offered
hereby. This Prospectus does not contain all the information set forth in the
Registration Statement and the exhibits and schedules thereto. For further
information with respect to the Company and such Common Stock, reference is
made to the Registration Statement and to the exhibits and schedules filed
therewith. Statements contained in this Prospectus as to the contents of any
contract or other document referred to are not necessarily complete, and in
each instance reference is made to the copy of such contract or other document
filed as an exhibit to the Registration Statement, each such statement being
qualified in all respects by such reference. A copy of the Registration
Statement may be inspected by anyone without charge at the Commission's
principal office in Washington, D.C., and copies of all or any part of the
Registration Statement may be obtained from the Public Reference Section of the
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, upon payment of
certain fees prescribed by the Commission. The Commission also maintains a
World Wide Web site that contains reports, proxy and information statements and
other information regarding registrants, such as the Company, that file
electronically with the Commission. The address of the site is
http://www.sec.gov.
The Company intends to furnish to its stockholders annual reports containing
audited financial statements certified by an independent public accounting firm
and quarterly reports containing unaudited interim financial information for
each of the first three fiscal quarters of each fiscal year of the Company.
68
<PAGE>
GLOSSARY OF TECHNICAL TERMS
<TABLE>
<C> <S>
10BASET..................... Ethernet standard which applies to the physical
layer of the OSI Reference Model for 10 Mbps
Ethernet over two pairs of category 3, 4 or 5
Unshielded Twisted Pair (UTP) wire.
100BASET.................... An extension to the 10BaseT Ethernet network
access method which operates at 100 Mbps.
56 KBPS..................... Equivalent to a single high speed telephone
service line, capable of transmitting one voice
call or 56 Kbps of data.
ADSL........................ Asymmetric Digital Subscriber Line. A high speed
technology that enables the transfer of data
over existing copper line.
ANALOG...................... A form of transmission employing a continuous
electrical signal (rather than a pulsed or
digital system) that varies in frequency and
amplitude.
ASIC........................ Application specific integrated circuit.
ASYNCHRONOUS................ A form of concurrent input and output
communication transmission with no timing
relationship between the two signals. Slower-
speed asynchronous transmission requires start
and stop bits to avoid a dependency on timing
clocks (10 bits to send an 8-bit byte).
ATM......................... Asynchronous Transfer Mode. A fixed length 53-
byte packet-based transmission technology that
may be used to transmit data, voice and video
traffic; ATM utilizes cell switching.
BANDWIDTH................... A range of signal frequencies, measured in
cycles per second or Hertz (Hz). Also refers to
the speed at which data is transmitted, measured
in bits per second (bps).
BROADBAND ACCESS............ A transmission that has a bandwidth greater than
a voice-grade line of 3KHz, usually at
transmission speeds of greater than 1.5 Mbps
(T-1).
CBR......................... Constant bit rate. A Quality of Service class
specified when service is initiated.
CDMA........................ Code Division Multiple Access. An information
transmission technology that transmits
information from multiple sources across a fixed
frequency band by encoding each in a unique
transmission code.
COAXIAL CABLE............... A large capacity data transmission medium
consisting of insulated wires grouped together
inside an insulated cable. Used for broadband
communications networks and cable TV.
DAVLC....................... Digital Audio Video Interactive Council. A
European standards setting committee.
DBS......................... Direct Broadcast Satellite. A broadband
communications technology that broadcasts
digital television programming from satellites
directly to end-user dish antennas.
</TABLE>
G-1
<PAGE>
<TABLE>
<C> <S>
DOWNSTREAM.................. The data path from service provider to end user.
DSL......................... Digital Subscriber Line. Point-to-point public
network access technologies that allow multiple
forms of data, voice and video to be carried
over twisted-pair copper wire on the local loop
between a network service provider's central
office and the customer site at limited
distances.
FCC......................... Federal Communications Commission.
FDMA........................ Frequency Division Multiple Access. A
transmission technology that multiplexes
information from multiple sources onto discrete
carrier frequencies over fixed time intervals.
FREQUENCY................... The number of identical cycles per second,
measured in hertz, of a periodic oscillation or
wave in radio propagation.
HDSL........................ High Bit Rate Digital Subscriber Line. A
technology that enables high speed transmission
of data over copper wires.
HEADEND..................... The central distribution point in a cable
system. Typically serves tens to hundreds of
thousands of homes.
HERTZ OR HZ................. Cycles per second.
HFC......................... Hybrid Fiber/Coax. Upgraded cable plant, which
uses a combination of fiber optic cable in the
backbone and coaxial cable in the subscriber
feeder plant.
HOMES PASSED................ Homes physically passed by a cable network.
IEEE........................ Institute of Electrical and Electronics
Engineers, Inc.
ISDN........................ Integrated Services Digital Network. An
internationally accepted standard for voice,
data and signaling that makes all transmission
circuits end-to-end digital and defines a
standard out-of-band signaling system.
KBPS........................ Kilobits per second. Thousand bits per second.
LMDS........................ Local Multipoint Distribution Service. A
broadband wireless communications network that
uses millimeter wave frequencies around 28 to 38
GHz to transmit video and data to residences
over a cellular-like network at distances under
a few miles.
MBPS........................ Megabits per second. Millions of bits per
second.
MCNS........................ Multimedia Cable Network System. Industry
consortium that defines the technical
requirement for interoperability of high speed
cable modem and headend equipment.
MHZ......................... Megahertz. Millions of cycles per second.
MMDS........................ Multichannel Multipoint Distribution Service. A
broadband wireless communications network that
uses microwave frequencies around 2.5 GHz to
transmit video to residences at distances up to
tens of miles.
</TABLE>
G-2
<PAGE>
<TABLE>
<C> <S>
OC-3........................ A specification of transmission of data over
optical cable at 155 megabits per second.
QAM......................... Quadrature Amplitude Modulation. A digital
modulation technique commonly used in broadband
networks.
RF.......................... Radio Frequency. The range of electro-magnetic
frequencies above the audio range and below
visible light.
RF MODULATION............... The transmission of a signal through a carrier
frequency.
SNR......................... Signal-to-noise ratio.
SYNCHRONOUS................. A form of communication transmission with a
direct timing relationship between input and
output signals. The transmitter and receiver are
in sync and signals are sent at a fixed rate.
Information is sent in multibyte packets.
TDMA........................ Time Division Multiple Access. An information
transmission technology that multiplexes
information from multiple sources onto a single
frequency carrier signal over discrete time
intervals.
UBR......................... Unspecified Bit Rate. A Quality of Service class
that provides no guarantee of a fixed data rate,
or bandwidth to the user. Bandwidth is provided
on a best effort basis.
UL.......................... Underwriter's Laboratory. A United States
regulatory body responsible for certification of
safety standards.
UPSTREAM.................... The data path from the end user to the service
provider.
XDSL........................ Other Digital Subscriber Line. Generic
representation of entire family of Digital
Subscriber Line technology spanning data rates
from 128 Kbps to 52 Mbps depending on the
distance between the central office and the
subscriber.
</TABLE>
G-3
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Ernst & Young LLP, Independent Auditors.......................... F-2
Consolidated Balance Sheets................................................ F-3
Consolidated Statements of Operations...................................... F-4
Consolidated Statements of Stockholders' Equity (Net Capital Deficiency)... F-5
Consolidated Statements of Cash Flows...................................... F-6
Notes to Consolidated Financial Statements................................. F-8
</TABLE>
F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Terayon Communication Systems, Inc.
We have audited the accompanying consolidated balance sheets of Terayon
Communication Systems, Inc. as of December 31, 1996 and 1997, and the related
consolidated statements of operations, stockholders' equity (net capital
deficiency), and cash flows for each of the three years in the period ended
December 31, 1997. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Terayon Communication Systems, Inc. at December 31, 1996 and 1997, and the
consolidated results of its operations and its cash flows for each of the
three years in the period ended December 31, 1997, in conformity with
generally accepted accounting principles.
Ernst & Young LLP
San Jose, California
February 6, 1998,
except for Note 13, as to which
the date is July 8, 1998
F-2
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
<TABLE>
<CAPTION>
UNAUDITED
DECEMBER 31, PRO FORMA
------------------ JUNE 30, STOCKHOLDERS' EQUITY
1996 1997 1998 JUNE 30, 1998
-------- -------- ----------- --------------------
(UNAUDITED)
<S> <C> <C> <C> <C>
ASSETS
Current assets:
Cash and cash
equivalents............ $ 8,356 $ 1,569 $ 6,030
Short-term investments.. 4,508 418 --
Accounts receivable,
less allowance for
doubtful accounts of
$20 in 1997 and $152 in
1998................... -- 574 2,284
Accounts receivable from
related parties........ -- 362 2,236
Other receivable........ -- -- 242
Inventory............... -- 1,322 1,521
Other current assets.... 299 690 719
-------- -------- --------
Total current assets...... 13,163 4,935 13,032
Property and equipment,
net...................... 2,572 3,615 3,371
Officer note receivable... 100 100 100
Other assets.............. 143 128 131
-------- -------- --------
Total assets.............. $ 15,978 $ 8,778 $ 16,634
======== ======== ========
LIABILITIES AND
STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable........ $ 682 $ 2,232 $ 6,642
Accrued payroll and
related expenses....... 570 1,052 1,310
Other accrued
liabilities............ 450 1,526 2,706
Advance from related
party.................. -- 2,000 --
Deferred revenue........ 425 95 --
Current portion of long-
term debt.............. 917 2,812 2,137
Current portion of
capital lease
obligations............ 148 65 43
-------- -------- --------
Total current
liabilities.......... 3,192 9,782 12,838
Long-term debt............ 1,150 -- --
Long-term portion of
capital lease
obligations.............. 105 44 24
Deferred rent............. 102 126 130
Other noncurrent
liabilities.............. 24 -- --
Commitments and
contingencies
Redeemable convertible
preferred stock, $.001
par value:
Authorized shares--
included in convertible
preferred stock
authorized
Issued and outstanding
shares--576,924 in 1998
and none pro forma;
aggregate redemption
value of $7,500;
aggregate liquidation
preference of $7,500 in
1998................... -- -- 7,500 $ --
Redeemable common stock,
$.001 par value:
Authorized shares--
included in common
stock authorized
Issued and outstanding
shares--10,000 in 1997
and 1998 and none pro
forma; aggregate
redemption value of
$13.................... -- 13 13 --
Redeemable common
stockholder's note
receivable............. -- (13) -- --
-------- -------- -------- --------
Total redeemable
common stock......... -- -- 13 --
Stockholders' equity (net
capital deficiency):
Preferred stock, $.001
par value:
Authorized shares--
4,600,903 actual and
5,000,000 pro forma
Issued and outstanding
shares--none actual and
pro forma.............. -- -- -- --
Convertible preferred
stock, $.001 par value:
Authorized shares--
10,399,097 actual and
none pro forma
Issued and outstanding
shares--6,322,174 in
1996, 7,131,161 in 1997
and 7,783,711 in 1998,
and none pro forma;
aggregate liquidation
preference--$26,158 in
1996, $36,675 in 1997
and $45,158 in 1998.... 25,989 35,807 8 --
Common stock, $.001 par
value:
Authorized shares--
35,000,000 actual and
30,000,000 pro forma
Issued and outstanding
shares--4,138,799 in
1996, 4,620,447 in
1997, 4,850,098 in 1998
and 13,220,733 pro
forma.................. 90 458 5 13
Additional paid in
capital................ -- -- 70,517 78,030
Accumulated deficit..... (14,614) (37,163) (72,420) (72,420)
Deferred compensation... -- (216) (1,959) (1,959)
Stockholders' notes
receivable............. (60) (60) (22) (22)
-------- -------- -------- --------
Total stockholders'
equity (net capital
deficiency).......... 11,405 (1,174) (3,871) $ 3,642
-------- -------- -------- ========
Total liabilities and
stockholders' equity
(net capital
deficiency).......... $ 15,978 $ 8,778 $ 16,634
======== ======== ========
</TABLE>
See accompanying notes.
F-3
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
SIX MONTHS
YEARS ENDED DECEMBER 31, ENDED JUNE 30,
--------------------------- -----------------
1995 1996 1997 1997 1998
------- -------- -------- ------- --------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
REVENUES:
Product revenues............. $ -- $ -- $ 1,021 $ 93 $ 4,279
Related party product
revenues.................... -- -- 617 -- 5,097
Contract consulting and
technology development
revenues.................... -- -- 480 -- --
------- -------- -------- ------- --------
Total revenues............. -- -- 2,118 93 9,376
COST OF GOODS SOLD:
Cost of product revenues..... -- -- 3,904 482 5,017
Cost of related party product
revenues.................... -- -- 2,558 -- 6,500
Cost of contract consulting
and technology development
revenues.................... 676 -- -- -- --
------- -------- -------- ------- --------
Total cost of goods sold... 676 -- 6,462 482 11,517
------- -------- -------- ------- --------
GROSS PROFIT (LOSS)............ (676) -- (4,344) (389) (2,141)
OPERATING EXPENSES:
Research and development..... 2,028 8,020 11,319 5,886 4,923
Sales and marketing.......... 205 1,141 4,468 1,523 2,969
General and administrative... 825 1,789 2,546 1,105 1,282
------- -------- -------- ------- --------
Total operating expenses... 3,058 10,950 18,333 8,514 9,174
------- -------- -------- ------- --------
Loss from operations........... (3,734) (10,950) (22,677) (8,903) (11,315)
Interest income................ 110 393 396 231 146
Interest expense............... (42) (140) (268) (108) (178)
------- -------- -------- ------- --------
Net loss....................... (3,666) (10,697) (22,549) (8,780) (11,347)
Series F convertible preferred
stock dividend (Note 8)....... -- -- -- -- (23,910)
------- -------- -------- ------- --------
Net loss applicable to common
stockholders.................. $(3,666) $(10,697) $(22,549) $(8,780) $(35,257)
======= ======== ======== ======= ========
Historical basic and diluted
net loss per share applicable
to common stockholders........ $ (1.02) $ (2.64) $ (5.26) $ (2.10) $ (7.65)
======= ======== ======== ======= ========
Shares used in computing
historical basic and diluted
net loss per share applicable
to common stockholders........ 3,589 4,054 4,289 4,182 4,611
======= ======== ======== ======= ========
Pro forma basic and diluted net
loss per share applicable to
common stockholders........... $ (2.07) $ (2.91)
======== ========
Shares used in computing pro
forma basic and diluted net
loss per share applicable to
common stockholders........... 10,873 12,132
======== ========
</TABLE>
See accompanying notes.
F-4
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
TOTAL
CONVERTIBLE ADDI- STOCKHOLDERS'
PREFERRED STOCK COMMON STOCK TIONAL ACCUMU- DEFERRED STOCKHOLDERS' EQUITY
------------------ ------------------ PAID-IN LATED COMPEN- NOTES (NET CAPITAL
SHARES AMOUNT SHARES AMOUNT CAPITAL DEFICIT SATION RECEIVABLE DEFICIENCY)
--------- -------- --------- -------- ------- -------- -------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
BALANCE AT DECEMBER 31,
1994................... -- $ -- 2,000,000 $ 62 -- $ (251) $ -- $(13) $ (202)
Exercise of option to
purchase common stock.. -- -- 2,000,000 -- -- -- -- -- --
Net cash proceeds from
issuance of Series A
preferred stock........ 4,077,093 3,853 -- -- -- -- -- -- 3,853
Issuance of Series A
preferred stock for
notes receivable....... 85,000 81 -- -- -- -- -- (81) --
Net cash proceeds from
issuance of Series B
preferred stock........ 896,834 7,970 -- -- -- -- -- -- 7,970
Net loss................ -- -- -- -- -- (3,666) -- -- (3,666)
--------- -------- --------- -------- ------- -------- ------- ---- --------
BALANCE AT DECEMBER 31,
1995................... 5,058,927 11,904 4,000,000 62 -- (3,917) -- (94) 7,955
Net cash proceeds from
issuance of Series B-1
preferred stock........ 448,417 3,957 -- -- -- -- -- -- 3,957
Cash proceeds from
payment on a
shareholder note
receivable............. -- -- -- -- -- -- -- 34 34
Exercise of options for
cash to purchase common
stock.................. -- -- 106,219 11 -- -- -- -- 11
Issuance of common stock
for consulting
services............... -- -- 32,580 17 -- -- -- -- 17
Net cash proceeds from
issuance of Series C
preferred stock........ 814,830 10,128 -- -- -- -- -- -- 10,128
Net loss................ -- -- -- -- -- (10,697) -- -- (10,697)
--------- -------- --------- -------- ------- -------- ------- ---- --------
BALANCE AT DECEMBER 31,
1996................... 6,322,174 25,989 4,138,799 90 -- (14,614) -- (60) 11,405
Exercise of options for
cash to purchase common
stock.................. -- -- 481,648 140 -- -- -- -- 140
Net cash proceeds from
issuance of Series D
preferred stock........ 808,987 9,818 -- -- -- -- -- -- 9,818
Unearned compensation
related to stock
options................ -- -- -- 228 -- -- (228) -- --
Amortization of unearned
compensation........... -- -- -- -- -- -- 12 -- 12
Net loss................ -- -- -- -- -- (22,549) -- -- (22,549)
--------- -------- --------- -------- ------- -------- ------- ---- --------
BALANCE AT DECEMBER 31,
1997................... 7,131,161 35,807 4,620,447 458 -- (37,163) (216) (60) (1,174)
Net cash proceeds from
issuance of Series D
preferred stock
(unaudited)............ 114,089 1,454 -- -- -- -- -- -- 1,454
Conversion of advance
from related party to
Series D preferred
stock (unaudited)...... 153,846 2,000 -- -- -- -- -- -- 2,000
Net cash proceeds from
issuance of Series F
preferred stock and a
warrant (unaudited).... 384,615 844 -- 4,089 -- -- -- -- 4,933
Dividends on Series F
convertible preferred
stock (unaudited)...... -- -- -- 23,910 -- -- -- -- 23,910
Value of preferred stock
warrant issued to
Series D preferred
stockholder
(unaudited)............ -- 19 -- -- -- -- -- -- 19
Exercise of options for
cash to purchase common
stock (unaudited)...... -- -- 205,276 56 -- -- -- -- 56
Exercise of option for
note receivable to
purchase common stock
(unaudited)............ -- -- 24,375 9 -- -- -- (9) --
Value of common stock
warrant (unaudited).... -- -- -- 35 -- -- -- -- 35
Cash proceeds from
payment on a
stockholder note
receivable (unaudited). -- -- -- -- -- -- -- 47 47
Unearned compensation
related to stock
options (unaudited).... -- -- -- 1,849 -- -- (1,849) -- --
Amortization of unearned
compensation
(unaudited)............ -- -- -- -- -- -- 106 -- 106
Transfer to additional
paid in capital as a
result of
reincorporation
(unaudited)............ -- (40,116) -- (30,401) 70,517 -- -- -- --
Net loss applicable to
common stockholders and
comprehensive net loss
applicable to common
stockholders
(unaudited)............ -- -- -- -- -- (35,257) -- -- (35,257)
--------- -------- --------- -------- ------- -------- ------- ---- --------
BALANCE AT JUNE 30, 1998
(UNAUDITED)............ 7,783,711 $ 8 4,850,098 $ 5 $70,517 $(72,420) $(1,959) $(22) $ (3,871)
========= ======== ========= ======== ======= ======== ======= ==== ========
</TABLE>
See accompanying notes.
F-5
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
SIX MONTHS ENDED
YEARS ENDED DECEMBER 31, JUNE 30,
--------------------------- -----------------
1995 1996 1997 1997 1998
------- -------- -------- ------- --------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
OPERATING ACTIVITIES:
Net loss applicable to common
stockholders................. $(3,666) $(10,697) $(22,549) $(8,780) $(35,257)
Adjustments to reconcile net
loss to net cash used in
operating activities:
Depreciation and
amortization............... 203 830 1,563 628 971
Amortization of unearned
compensation related to
stock options.............. -- -- 12 -- 106
Loss on disposal of fixed
assets..................... -- 20 -- -- --
Issuance of common stock for
consulting services........ -- 17 -- -- --
Value of common and
preferred stock warrants
issued..................... -- -- -- -- 54
Series F convertible
preferred stock dividend... -- -- -- -- 23,910
Changes in operating assets
and liabilities:
Accounts receivable........ -- -- (574) (93) (1,710)
Accounts receivable from
related party............. -- -- (362) -- (1,874)
Other receivable........... -- -- -- -- (242)
Inventory.................. -- -- (1,322) (321) (199)
Other current assets....... (97) (177) (391) (317) (29)
Other assets............... (7) (118) 15 9 (3)
Accounts payable........... 518 8 1,550 1,646 4,410
Accrued payroll and related
expenses.................. 212 346 482 242 258
Other accrued liabilities.. 168 263 1,076 (47) 1,180
Deferred revenue........... 325 -- (330) 55 (95)
Deferred rent.............. -- 102 24 14 4
Other noncurrent
liabilities............... -- 24 (24) -- --
------- -------- -------- ------- --------
Net cash used in operating
activities................... (2,344) (9,382) (20,830) (6,964) (8,516)
INVESTING ACTIVITIES:
Purchases of short-term
investments.................. -- (6,863) (10,995) (5,501) --
Proceeds from sales and
maturities of short-term
investments.................. -- 2,355 15,085 8,732 418
Purchases of property and
equipment.................... (1,301) (1,892) (2,606) (1,613) (727)
Proceeds from sale of assets.. -- 42 -- -- --
Officer note receivable....... -- (100) -- -- --
------- -------- -------- ------- --------
Net cash provided by (used in)
investing activities......... (1,301) (6,458) 1,484 1,618 (309)
</TABLE>
See accompanying notes.
F-6
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS--(CONTINUED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
SIX MONTHS
YEARS ENDED ENDED
DECEMBER 31, JUNE 30,
------------------------- ----------------
1995 1996 1997 1997 1998
------- ------- ------- ------- -------
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
FINANCING ACTIVITIES:
Principal payments on capital
leases............................ $ (82) $ (124) $ (144) $ (73) $ (42)
Principal payments on long-term
debt.............................. (16) (273) (909) (498) (675)
Proceeds from long-term debt....... 513 1,843 1,654 542 --
Exercise of option to purchase
common stock...................... -- 11 140 20 56
Advance from related party......... -- -- 2,000 -- --
Proceeds from issuance of preferred
stock............................. 11,823 14,085 9,818 -- 6,387
Proceeds from issuance of
redeemable preferred stock........ -- -- -- -- 7,500
Principal payments on redeemable
common stockholder and common
stockholder notes receivable...... -- 34 -- -- 60
------- ------- ------- ------- -------
Net cash provided by (used in)
financing activities........... 12,238 15,576 12,559 (9) 13,286
------- ------- ------- ------- -------
Net increase (decrease) in cash and
cash equivalents.................. 8,593 (264) (6,787) (5,355) 4,461
Cash and cash equivalents at
beginning of period............... 27 8,620 8,356 8,356 1,569
------- ------- ------- ------- -------
Cash and cash equivalents at end of
period............................ $ 8,620 $ 8,356 $ 1,569 $ 3,001 $ 6,030
======= ======= ======= ======= =======
SUPPLEMENTAL DISCLOSURES OF CASH
FLOW INFORMATION:
Cash paid for interest............. $ 42 $ 140 $ 268 $ 108 $ 178
SUPPLEMENTAL NONCASH INVESTING AND
FINANCING ACTIVITIES:
Property and equipment acquired
under capital leases.............. $ 176 $ 137 $ -- $ -- $ --
Maintenance agreement acquired
under capital lease............... $ 6 $ -- $ -- $ -- $ --
Issuance of convertible preferred
stock for stockholder note
receivable........................ $ 81 $ -- $ -- $ -- $ --
Sale of asset for decrease in
accounts payable.................. $ 210 $ -- $ -- $ -- $ --
Issuance of common stock for
consulting services............... $ -- $ 17 $ -- $ -- $ --
Exercise of option for note
receivable to purchase redeemable
common stock...................... $ -- $ -- $ 13 $ -- $ --
Exercise of option for note
receivable to purchase common
stock............................. $ -- $ -- $ -- $ -- $ 9
Conversion of advance from related
party to Series D preferred stock. $ -- $ -- $ -- $ -- $ 2,000
</TABLE>
See accompanying notes.
F-7
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
Terayon Communication Systems, Inc. (the Company) was incorporated under the
laws of the state of California on January 20, 1993 for the purpose of
developing, producing, and marketing broadband access system products. In
October 1997, the Company changed its legal name from Terayon Corporation. In
July 1998, the Company reincorporated in the State of Delaware. Through
December 31, 1996, the Company was active in product development, the
acquisition of equipment and facilities, and raising capital; accordingly, the
Company was in the development stage. The Company emerged from the development
stage during 1997.
Unaudited Interim Financial Information
The accompanying consolidated financial statements at June 30, 1998 and for
the six months ended June 30, 1997 and 1998 are unaudited but include all
adjustments (consisting of normal recurring accruals) which, in the opinion of
management, are necessary for a fair statement of the financial position and
the operating results and cash flows for the interim date and periods
presented. Results for the interim period ended June 30, 1998 are not
necessarily indicative of results for the entire fiscal year or future periods.
Basis of Consolidation
The consolidated financial statements include the accounts of the Company and
its majority owned subsidiaries, Terayon Communication Systems Europe and
Terayon do Brasil. The minority interests in net losses of Terayon
Communication Systems Europe and Terayon do Brasil were not significant for all
periods presented. All material intercompany balances and transactions have
been eliminated.
Use of Estimates
The preparation of the consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the amounts reported in the financial statements
and accompanying notes. Actual results could differ from those estimates.
Reclassifications
Certain prior year balances have been restated to conform with current year
presentation.
Advertising Expenses
The Company accounts for advertising costs as expense in the period in which
they are incurred. Advertising expense for the years ended December 31, 1995,
1996 and 1997 and for the six months ended June 30, 1997 and 1998 was not
significant.
Research and Development Costs
Research and development costs are charged to expense as incurred.
F-8
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
Cash Equivalents and Short-Term Investments
The Company invests its excess cash in money market accounts and debt
instruments and considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents. Investments
with an original maturity at the time of purchase of over three months but less
than a year are classified as short-term investments. At December 31, 1996 and
1997, approximately 90% and 45%, respectively, of the Company's total cash and
short-term investment balance was placed on deposit with an affiliate of a
convertible preferred stockholder (none at June 30, 1998). Management
determines the appropriate classification of debt and equity securities at the
time of purchase and reevaluates such designation at the end of each period.
At December 31, 1996 and 1997, all of the Company's investments in debt
securities were classified as available-for-sale and were obligations issued by
U.S. government agencies, maturing within one year. The amortized cost, which
approximated fair value, of debt instruments classified as cash equivalents and
short-term investments was approximately $6,436,000 and $4,508,000,
respectively, at December 31, 1996 and approximately $99,000 and $418,000,
respectively, at December 31, 1997 (none at June 30, 1998). The amount of
unrealized gains or losses was not significant at December 31, 1996 or 1997.
The estimated fair values of cash equivalents and short-term investments are
based on quoted market prices. The amount of realized gains or losses for the
years ended December 31, 1995, 1996, and 1997, and for the six months ended
June 30, 1997 and 1998 were not significant.
Concentrations of Credit Risk, Customer, Supplier, and Product
The Company operates in one business segment, the development and sale of
cable modem access products, which it sells primarily to customers within the
cable and communications industries, including related parties (see Note 12).
The Company performs ongoing credit evaluations of its customers and generally
requires no collateral. A relatively small number of customers and resellers
account for a significant percentage of the Company's revenues. The Company
expects that the sale of its products to a limited number of customers and
resellers may continue to account for a high percentage of revenues for the
foreseeable future.
Currently, the Company relies on single source suppliers of materials and
labor for the significant majority of its product inventory but is actively
pursuing additional supplier alternatives. As a result, should the Company's
current suppliers not produce and deliver inventory for the Company to sell on
a timely basis, operating results may be adversely impacted.
Substantially all of the Company's revenues have been attributable to sales
of the TeraLink and the TeraPro. These products are expected to account for a
significant part of the Company's revenues for the foreseeable future. As a
result, a decline in demand for or failure to achieve broad market acceptance
of the TeraLink or the TeraPro would adversely affect operating results.
In addition, market acceptance of the Company's products may be affected by
the emergence and evolution of industry standards. While the Company expects
its products to become compliant with industry standards, its inability to do
so may adversely affect operating results.
The Company invests its excess cash in debt instruments of the U.S. Treasury,
governmental agencies, and corporations with strong credit ratings. The Company
has established guidelines relative to diversification and maturities that
attempt to maintain safety and liquidity. The Company has not experienced any
significant losses on its cash equivalents or short-term investments.
F-9
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
Other Receivable
At June 30, 1998, the Company had a receivable of $242,000 relating to
inventory components the Company was required to purchase from its previous
contract manufacturer that were subsequently sold to its current contract
manufacturer. As a result of the transition to the Company's current contract
manufacturer, the Company also recorded a charge of approximately $1,300,000. A
portion of the charge consisted of approximately $750,000 of raw material
components that were deemed obsolete due to a design change in the Company's
bill of materials during the quarter ended March 31, 1998. The charge also
consisted of a write down of approximately $550,000 for parts repurchased from
the Company's previous contract manufacturer and then resold to the Company's
current contract manufacturer, as the Company's current contract manufacturer
could purchase the related parts at a lower cost than the Company had valued
the inventory. Therefore, the Company wrote down the inventory to the lower of
cost or market as part of selling the inventory to its current contract
manufacturer.
Inventory
Inventory is stated at the lower of cost (first-in, first-out) or market. The
components of inventory are as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31, JUNE 30,
1997 1998
------------ --------
<S> <C> <C>
Inventory:
Finished goods..................................... $ 163 $ 599
Work-in-process.................................... 366 383
Raw materials...................................... 793 539
------ ------
$1,322 $1,521
====== ======
</TABLE>
Property and Equipment
Property and equipment are carried at cost less accumulated depreciation and
amortization. Property and equipment are depreciated for financial reporting
purposes using the straight-line method over the estimated useful lives of
three to five years. Leasehold improvements are amortized using the straight-
line method over the shorter of the useful lives of the assets or the terms of
the leases. The recoverability of the carrying amount of property and equipment
is assessed based on estimated future undiscounted cash flows and if an
impairment exists the charge to operations is measured as the excess of the
carrying amount over the fair value of the assets. Based upon this method of
assessing recoverability, no asset impairment existed for all periods
presented.
Property and equipment are as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31,
---------------- JUNE 30,
1996 1997 1998
------- ------- --------
<S> <C> <C> <C>
Software and computers........................... $ 2,516 $ 3,695 $ 3,870
Furniture and equipment.......................... 1,064 2,421 2,973
Leasehold improvements........................... 19 89 89
------- ------- -------
$ 3,599 $ 6,205 $ 6,932
Accumulated depreciation and amortization........ (1,027) (2,590) (3,561)
------- ------- -------
Property and equipment, net...................... $ 2,572 $ 3,615 $ 3,371
======= ======= =======
</TABLE>
F-10
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
Revenue Recognition
Revenues related to product sales are generally recognized when the products
are shipped to the customer. The Company has also performed some research and
product development work under best efforts technology development agreements.
Due to technological risk factors, the costs of these agreements have been
expensed as incurred and are included in cost of goods sold for the year ended
December 31, 1995. Revenues are recognized when applicable customer milestones
have been met, including deliverables and, in any case, not in excess of the
amount that would be recognized using the percentage-of-completion method. The
Company met deliverables under an agreement in the fourth quarter of the year
ended December 31, 1997 and recognized the related revenue (see Note 3).
Warranty Reserves
Due to the recent introduction of the Company's products, the Company has
limited experience with warranty commitments that may arise with the current
generation of its products. The Company's products generally carry a one-year
warranty that includes factory and on-site repair services as needed for
replacement of parts. Estimated expenses for warranty obligations are accrued
as revenue is recognized. Reserve estimates are adjusted periodically to
reflect actual experience.
Stock-Based Compensation
As described in Note 8, the Company has elected to account for its employee
stock plans in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB Opinion No.25), and to adopt
the disclosure-only provisions as required under Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation"
(FAS 123).
Net Loss Per Share and Unaudited Pro Forma Stockholders' Equity (Net Capital
Deficiency)
Historical basic and diluted net loss per share are computed using the
weighted average number of common shares outstanding. Options, warrants,
restricted stock and preferred stock were not included in the computation of
diluted net loss per share because the effect would be antidilutive.
Pro forma net loss per share has been computed as described above and also
gives effect, even if antidilutive, to common equivalent shares from preferred
stock that will automatically convert upon the closing of the Company's initial
public offering (using the as-if-converted method). If the offering
contemplated by this Prospectus is consummated, all of the convertible
preferred stock and redeemable convertible preferred stock outstanding as of
the closing date will automatically be converted into an aggregate of
approximately 8,360,635 shares of common stock based on the shares of
convertible preferred stock outstanding at June 30, 1998. In addition, the
redemption feature of the 10,000 shares of redeemable Common Stock will
terminate upon the Company's initial public offering. Unaudited pro forma
stockholders' equity (net capital deficiency) at June 30, 1998, as adjusted for
the conversion of preferred stock and redeemable preferred stock, is disclosed
on the balance sheet.
F-11
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
A reconciliation of shares used in the calculation of historical and pro
forma basic and diluted net loss per share follows (in thousands, except per
share data):
<TABLE>
<CAPTION>
SIX MONTHS
YEARS ENDED DECEMBER 31, ENDED JUNE 30,
--------------------------- -----------------
1995 1996 1997 1997 1998
------- -------- -------- ------- --------
<S> <C> <C> <C> <C> <C>
Net loss....................... $(3,666) $(10,697) $(22,549) $(8,780) $(11,347)
Series F convertible preferred
stock dividend (Note 8)....... -- -- -- -- (23,910)
------- -------- -------- ------- --------
Net loss applicable to common
stockholders.................. $(3,666) $(10,697) $(22,549) $(8,780) $(35,257)
======= ======== ======== ======= ========
Shares used in computing
historical basic and diluted
net loss per share applicable
to common stockholders........ 3,589 4,054 4,289 4,182 4,611
Historical basic and diluted
net loss per share applicable
to common stockholders........ $ (1.02) $ (2.64) $ (5.26) $ (2.10) $ (7.65)
======= ======== ======== ======= ========
Shares used in computing
historical basic and diluted
net loss per share applicable
to common stockholders........ 4,289 4,611
Adjustment to reflect the
effect of the assumed
conversion of weighted average
shares of convertible
preferred stock outstanding
applicable to common
stockholders.................. 6,584 7,521
-------- --------
Shares used in computing pro
forma basic and diluted net
loss per share applicable to
common stockholders........... 10,873 12,132
======== ========
Pro forma basic and diluted net
loss per share applicable to
common stockholders........... $ (2.07) $ (2.91)
======== ========
</TABLE>
Impact of Recently Issued Accounting Standards
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130, "Reporting Comprehensive Income" (FAS
130). FAS 130 requires that all items required to be recognized under
accounting standards as components of comprehensive income be reported in a
financial statement that is displayed with the same prominence as other
financial statements. FAS 130 is effective for fiscal years beginning after
December 15, 1997 and has been adopted by the Company in 1998. The Company's
comprehensive net loss was the same as its net loss for the six months ended
June 30, 1998 and 1997.
In addition, during June 1997, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards No. 131, "Disclosures About
Segments of an Enterprise and Related Information" (FAS 131). FAS 131 replaces
FAS 14, "Financial Reporting for Segments of a Business Enterprise" and changes
the way public companies report segment information. FAS 131 is effective for
fiscal years beginning after December 15, 1997 and will be adopted by the
Company for the year ended December 31, 1998.
F-12
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
2. OFFICER NOTE RECEIVABLE
In March 1996, the Company loaned an officer $100,000 pursuant to a
promissory note. The note does not bear interest, matures in March 2001, and is
full recourse, including being collateralized by 20,000 shares of the Company's
common stock.
3. DEFERRED REVENUE
On January 4, 1995, the Company entered into a Development and Production
Agreement with a telecommunications systems manufacturer (the Manufacturer),
whereby the Company agreed to develop an enabling technology for use with
certain manufacturer technology (the Product). Pursuant to the agreement, the
Manufacturer is obligated to purchase certain minimum quantities of the
Product, and the Company has agreed to provide the Product to the Manufacturer
on favorable pricing terms for a period of four years following completion of
the Product. In addition, the Company has agreed that for the first three
months following the completion of the Product, the Company will not sell the
Product to any third party for use in the carrying of voice-over coaxial
cables.
In accordance with the agreement, the Company will receive funding from the
Manufacturer totaling $1,000,000. These payments were originally received upon
the completion of certain milestones set forth in the agreement. In March 1998,
the agreement was amended, and the Company is to receive the remaining payments
(in addition to normal Product billings) over a certain number of future unit
shipments to the Manufacturer. As of December 31, 1997, approximately $480,000
of cash advances had been received under the agreement. In the fourth quarter
of the year ended December 31, 1997, the Company delivered the Product under
the agreement and recognized the $480,000 as revenue. During the six months
ended June 30, 1998, the Company recognized approximately $163,000 in revenue
under this agreement.
4. COMMITMENTS
The Company leases its facility and certain equipment under operating leases.
The operating lease for the Company's facility expires in 2002. Rental expense
was approximately $114,000, $542,000, and $850,000 for the years ended December
31, 1995, 1996, and 1997, respectively, and approximately $351,000 and $361,000
for the six months ended June 30, 1997 and June 30, 1998, respectively. The
Company signed a promissory note of approximately $59,000 in connection with
the initial security deposit for the facility. The note did not bear interest
and was paid in April 1997.
In March 1996, the Company subleased its former facilities to a third party
through December 1997. Sublease rental income was approximately $106,000 and
$122,000 for the years ended December 31, 1996 and 1997, respectively and
approximately $73,000 for the six months ended June 30, 1997. In October 1997,
the master lease and underlying sublease for these facilities were terminated
concurrently.
The Company leases certain equipment under noncancelable lease agreements
that are accounted for as capital leases. Equipment under capital lease
arrangements and included in property and equipment aggregated approximately
$452,000 at December 31, 1996 and 1997 and June 30, 1998. Related accumulated
amortization was approximately $211,000, $337,000 and $365,000 at December 31,
1996 and 1997, and June 30, 1998, respectively. Amortization expense related to
assets under capital leases is included in depreciation expense. In addition,
the capital leases are secured by the related equipment, and the Company is
required to maintain liability and property damage insurance.
F-13
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
Future minimum lease payments under noncancelable operating leases and
capital leases are as follows (in thousands):
<TABLE>
<CAPTION>
DECEMBER 31, 1997 JUNE 30, 1998
----------------- -----------------
OPERATING CAPITAL OPERATING CAPITAL
LEASES LEASES LEASES LEASES
--------- ------- --------- -------
<S> <C> <C> <C> <C>
1998..................................... $ 610 $ 80 $ 327 $32
1999..................................... 666 34 666 34
2000..................................... 688 11 688 11
2001..................................... 708 4 708 4
2002..................................... 178 -- 178 --
------ ---- ------ ---
Total minimum payments................... $2,850 129 $2,567 81
====== ======
Less amount representing interest........ 20 14
---- ---
109 67
Less current portion..................... 65 43
---- ---
$ 44 $24
==== ===
</TABLE>
Unconditional Purchase Obligations
The Company has unconditional purchase obligations to a few of its suppliers
that support the Company's ability to manufacture its products. The obligations
require the Company to purchase minimum quantities of the suppliers' products
at a specified price. At June 30, 1998, the Company had approximately
$15,198,000 of unconditional purchase obligations ($784,000 at December 31,
1997 and none at December 31, 1996).
5. DEBT OBLIGATIONS
In April 1997, the Company amended an existing credit agreement with a bank
to provide for a revolving line of credit up to $10,000,000 and four term loans
totaling $4,250,000. Borrowings under the revolving line of credit are limited
to the lesser of a) 80% of accounts receivable less than ninety days from the
invoice date or b) $10,000,000. Borrowings under the revolving line of credit
bear interest at the bank's prime rate plus 0.50% per annum (8.75% at December
31, 1996 and 9.0% at December 31, 1997 and June 30, 1998). There were no
borrowings under the revolving line of credit at December 31, 1996 and 1997 and
June 30, 1998.
Each term loan is subject to an interest rate calculated at the bank's prime
rate plus 1.50% per annum (9.75% at December 31, 1996 and 10% at December 31,
1997 and June 30, 1998). The first term loan is payable in thirty monthly
payments consisting of six interest payments and twenty-four equal principal
and interest payments through May 1998. Borrowings under the first term loan of
approximately $303,000 and $85,000 were outstanding at December 31, 1996 and
1997. There were no borrowings under the first term loan at June 30, 1998.
The second term loan is payable in forty monthly payments of four interest
payments and thirty-six equal principal and interest payments through October
1999. Borrowings under the second term loan of approximately $944,000,
$611,000, and $444,000 were outstanding at December 31, 1996 and 1997 and June
30, 1998, respectively.
F-14
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
The third term loan is payable according to two separate payment schedules.
The first payment schedule includes thirty-six equal principal and interest
payments through November 1999. At December 31, 1996 and 1997 and June 30,
1998, borrowings under the first payment schedule were approximately $820,000,
$539,000 and $398,000, respectively. The second payment schedule consists of
thirty-one payments of one interest payment and thirty equal principal and
interest payments through December 1999. At December 31, 1997 and June 30,
1998, borrowings under the second payment schedule were approximately $119,000
and $87,000, respectively (none at December 31, 1996).
The fourth term loan is payable in forty-one monthly payments of five
interest payments and thirty-six equal principal and interest payments through
November 2000. Borrowings under the fourth term loan of approximately
$1,458,000 and $1,208,000 were outstanding at December 31, 1997 and June 30,
1998, respectively (none at December 31, 1996).
Outstanding borrowings under the credit agreement are secured by all of the
Company's assets. The credit agreement contains affirmative and negative
covenants and will, among other things, require the Company to maintain minimum
levels of investable funds and liquid assets. The credit agreement also limits
the Company's ability to incur additional debt, to pay cash dividends, or to
purchase or sell certain assets. Finally, the agreement restricts the Company
to a maximum liability to tangible net worth ratio and prohibits certain
acquisitions, mergers, consolidations, or similar transactions. At December 31,
1997 and June 30, 1998, the Company was out of compliance with certain
covenants contained within the credit agreement and therefore has classified
all outstanding borrowings as short-term at those dates.
The Company incurred interest expense related to the term loans of
approximately $18,000, $88,000, and $205,000 for the years ended December 31,
1995, 1996, and 1997, respectively and $95,000 and $128,000 for the six months
ended June 30, 1997 and 1998, respectively.
6. CONTINGENCIES
During 1997, the Company placed a noncancelable purchase order (subject to
specific delivery date requirements) with a subcontract manufacturer. As
delivery of the initial shipments was delayed by the manufacturer, the Company
subsequently canceled the purchase order without the consent of the subcontract
manufacturer. The Company has received notification from the subcontract
manufacturer that the Company is obligated to make payment for materials and
services rendered under the terms of the purchase order. While management
believes that amounts recorded on its financial statements are adequate to
cover all related risks, the subcontract manufacturer has not agreed to a
settlement with the Company. Although the ultimate outcome of this matter
cannot be determined at this time, management does not believe that the outcome
will have a material adverse effect on the Company's financial position,
results of operations, and cash flows. However, based on future developments,
the Company's estimate of the outcome of these matters could change in the near
term.
The Company has also received a letter from an individual claiming that the
Company's technology infringes a patent held by such individual. The Company
has reviewed the allegations made by such individual, and management does not
believe that the outcome will have a material adverse effect on the Company's
financial position, results of operations, or cash flows.
In the normal course of business, the Company from time to time receives
inquiries with regard to various legal proceedings. In the opinion of
management, any liability resulting from these inquiries has
F-15
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
been accrued and will not have a material adverse effect on the Company's
financial position or results of operations.
7. REDEEMABLE STOCK
In December 1997, the Company entered into a Series E redeemable convertible
preferred stock agreement ("the Agreement"). The Agreement calls for the
establishment of a $5,000,000 escrow account to fund the issuance of up to
333,334 shares of Series E redeemable convertible preferred stock ("the Stock")
for cash at $15.00 per share. The escrow account will release cash to the
Company as the Company reaches certain technological and customer base
milestones as defined under the Agreement. Upon the first closing, the Company
is also to issue a warrant to purchase up to an additional 33,334 shares of the
Stock at $15.00 per share. In the event the final closing of the Agreement does
not occur prior to the earlier of the (a) completion of the Company's initial
public offering of shares of its common stock and (b) December 31, 1998, then
any amount remaining in the escrow account will be returned to the Series E
stockholder.
In February 1998, the Company reached a milestone under the Series E
redeemable convertible preferred stock agreement and issued 100,000 shares of
Series E redeemable convertible preferred stock, resulting in cash proceeds of
approximately $1,500,000 to the Company. In conjunction with this issuance, the
Company issued a warrant to the Series E stockholder to purchase 33,334 shares
of the Company's redeemable convertible preferred stock at $15.00 per share.
In June 1998, the Company and the Series E stockholder amended the Series E
redeemable convertible preferred stock agreement (the "Amendment"). The
Amendment calls for the cancellation of all Series E redeemable convertible
preferred stock outstanding with the $1,500,000 of proceeds from the
cancellation being applied toward the issuance of 115,385 shares of Series D
redeemable convertible preferred stock. In addition, all future milestones
under the Series E redeemable convertible preferred stock agreement were
canceled under the Amendment and 269,231 additional shares of Series D
redeemable convertible preferred stock were issued resulting in additional
proceeds of approximately $3,500,000. The Amendment also cancelled the warrant
for the purchase of 33,334 shares of Series E convertible preferred stock at
$15.00 per share and issued a warrant for the purchase of 38,462 shares of
Series D convertible preferred stock with an exercise price of $13.00 per
share. The warrant is immediately exercisable and expires on the earlier of the
effective date of the Company's initial public offering or June 11, 2003. The
Company has recorded an expense of $19,000 to reflect the value of this warrant
for the six months ended June 30, 1998.
The Series D redeemable convertible preferred stockholder also has the option
to sell to the Company some or all of the 384,616 redeemable shares held by the
Series D redeemable convertible preferred stockholder (the "Put Right") any
time after July 1, 1998. The price paid by the Company to the Series D
redeemable convertible preferred stockholder for any shares purchased pursuant
to the Put Right is $13.00 per share. In the event of the exercise of the Put
Right, the Company will apply the total amount of the Put Right toward the
purchase of the Company's products. Any of the redeemable shares not sold back
to the Company by the Series D redeemable convertible preferred stockholder
will retain their Put Right until the Put Termination Date which is defined
under the Agreement as the earlier of (a) February 20, 1999 and (b) the
completion of the Company's initial public offering of shares of its common
stock. In addition, in the event that prior to the Put Termination Date either
(a) the completion of the Company's initial public offering of shares of its
common stock has not occurred or (b) an acquisition of at least ninety percent
of all of the Company's capital stock has not occurred, then the
F-16
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
Series D redeemable convertible preferred stockholder has the right to receive
a cash payment from the Company in an amount equal to ten percent of the
aggregate purchase price of the number of redeemable shares held by the Series
D redeemable convertible preferred stockholder as of the Put Termination Date.
In June 1998, the Company issued 192,308 shares of Series F redeemable
convertible preferred stock resulting in proceeds of approximately $2,500,000
to the Company. Series F redeemable convertible preferred stock also contains
an option that allows the Series F stockholder to sell some or all of the
redeemable shares back to the Company at a price of $13.00 per share any time
after June 1, 1999 to be used toward the purchase of the Company's products.
Any of the redeemable shares not sold back to the Company by the Series F
stockholder will retain the option until the completion of the Company's
initial public offering of shares of its common stock.
In September 1997, the Company issued common stock to an employee in return
for a full recourse note receivable for $13,000. The note bears an interest
rate of 5.81% per annum and is due in September 1998. Pursuant to the stock
purchase agreement, the employee has the option to sell some or all of his
shares to the Company on or after September 22, 1998 at a purchase price of
$13.00 per share (the "Put Price"). Such option expires upon the earlier of (a)
September 22, 2003 and (b) the completion of the Company's initial public
offering of shares of its common stock. The Company accrued approximately
$29,000 and $88,000 for the year ended December 31, 1997 and the six months
ended June 30, 1998, respectively, representing the difference between the note
receivable's per share price and the Put Price over the option's vesting period
and included the cumulative difference in other accrued liabilities as of June
30, 1998. The note receivable was paid in full in January 1998.
8. STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
Convertible Preferred Stock
In April 1998, the Company's Board of Directors approved an increase in the
authorized number of shares of convertible preferred stock to 10,399,097
shares.
In April 1998, the Company issued 384,615 shares of Series F convertible
preferred stock and a warrant to purchase 3,000,000 shares of the Company's
common stock at an exercise price of $6.50 per share, resulting in cash
proceeds of approximately $5,000,000 to the Company. The warrant is exercisable
at any time prior to December 31, 2003. In addition, the Company issued a
warrant (the "Anti-Dilution Warrant") to purchase an indeterminate number of
shares of common stock for an aggregate price of $1.00. The Anti-Dilution
Warrant is exercisable when the Company issues certain new equity securities.
In June 1998, the Company issued new equity securities that require the Company
to issue an additional 19,389 shares of common stock pursuant to the Anti-
Dilution Warrant.
The Company recorded a dividend of $23,910,000 for the six months ended June
30, 1998, representing the fair value of the warrant to purchase 3,000,000
shares of the Company's common stock (the "Shaw Warrant") under EITF No. 96-13,
"Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock." The Company's accounting conclusion with
F-17
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
respect to the Shaw Warrant issued in connection with the sale of $5,000,000 of
convertible preferred stock (the "Shaw Financing") is based on management's
conclusion that the sale of preferred stock was, in substance, a financing
transaction and not the issuance of equity instruments in exchange for goods or
services. When the Company issued $5,000,000 of convertible preferred stock and
the Shaw Warrant on April 6, 1998, its singular objective was to obtain
sufficient liquidity to continue as a going concern. At the time of the Shaw
Financing, the Company's ability to continue as a going concern was in serious
doubt. At March 31, 1998, the Company had only $109,000 in cash, but was using
cash of approximately $1,000,000, net, per month in operations; further, the
Company had a deficit in working capital of $8,769,000.
In April 1998, a $2,000,000 advance received from a Series D preferred
stockholder in 1997 was converted into 153,846 shares of Series D convertible
preferred stock (see Note 12).
In June 1998, the Company also issued 114,089 shares of Series D convertible
preferred stock resulting in additional net proceeds of approximately
$1,454,000 to the Company.
The following is a summary of convertible preferred stock authorized, issued,
and outstanding, including redeemable convertible preferred stock:
<TABLE>
<CAPTION>
SHARES ISSUED AND OUTSTANDING
-----------------------------------
SHARES DECEMBER 31, DECEMBER 31, JUNE 30,
SERIES AUTHORIZED 1996 1997 1998
- ------ ---------- ------------ ------------ ---------
<S> <C> <C> <C> <C>
A................................ 4,162,093 4,162,093 4,162,093 4,162,093
B................................ 896,834 896,834 896,834 896,834
B-1.............................. 448,417 448,417 448,417 448,417
C................................ 814,830 814,830 814,830 814,830
D................................ 1,500,000 -- 808,987 1,461,538
E................................ 2,000,000 -- -- --
F................................ 576,923 -- -- 576,923
---------- --------- --------- ---------
10,399,097 6,322,174 7,131,161 8,360,635
========== ========= ========= =========
</TABLE>
Convertible preferred stockholders and redeemable convertible preferred
stockholders have the same voting rights as common stockholders. In addition,
the Series A, B, B-1, C, D, E and F stockholders will vote as a single class.
In the event of any voluntary or involuntary liquidation of the Company, Series
A, B, B-1, C, D, E and F stockholders are entitled to a per share liquidation
preference of $0.9545, $8.92, up to $17.84, $12.50, up to $19.50, up to $22.50,
and up to $19.50, respectively, plus accrued dividends, if any. The holders of
Series A, B, B-1, C, D, E and F stock are entitled to per share noncumulative
dividends of $0.0764, $0.7136, $0.7136, $1.00, $1.04, $1.20 and $1.04 per
annum, respectively, when and if declared by the Board of Directors.
Each share of preferred stock and redeemable preferred stock is convertible
at the option of the holder into one share of common stock, subject to
adjustments for future dilution since the date of issuance. Preferred stock and
redeemable preferred stock are convertible into common stock at a rate
calculated by the quotient obtained by dividing the conversion rates by the
conversion prices.
F-18
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
Conversion rates for Series A, B, B-1, C, D, and F stockholders are $0.9545,
$8.92, $8.92, $12.50, $13.00 and $13.00, respectively. Conversion prices for
Series A, B, B-1, C, D, and F stockholders are $0.9545, $8.92, $8.92, $12.50,
$13.00 and $13.00, respectively. Both conversion rates and conversion prices
are subject to proportionate increases and decreases resulting from adjustments
to conversion prices for stock dividends and for combinations or subdivisions
of common stock, adjustments for reclassification and reorganization or
adjustments for the sale of shares below the conversion prices for Series C,
Series D, and Series F redeemable preferred and preferred stockholders.
Each share of Series A, B, and B-1 preferred stock automatically converts
into common stock at the then applicable conversion rate upon the earlier of
(a) the public offering of the Company's common stock with aggregate proceeds
in excess of $10,000,000 or (b) the date on which the Company obtains the
consent of at least two-thirds of the shares of Series A, B, and B-1
stockholders separately by class. Each share of Series C preferred stock
automatically converts at the earlier of (a) the public offering of the
Company's common stock at a per share price of $12.50 (b) the end of any
twenty-day period after a public offering of the Company's common stock during
which the closing sales price per share was at least $12.50, or (c) the date on
which the Company obtains the consent of at least two-thirds of the shares of
Series C stockholders, as applicable. Each share of Series D preferred and
redeemable preferred stock, Series E preferred stock, and Series F preferred
and redeemable preferred stock automatically converts at the earlier of (a) the
public offering of the Company's common stock at a per share price of $13.00 or
(b) the date on which the Company obtains the consent of at least two-thirds of
the shares of Series D, E and Series F stockholders, as applicable. The Company
has fully reserved shares of common stock for issuance upon the conversion of
the convertible preferred stock and redeemable convertible preferred stock. In
June 1998, the Company obtained waivers from the holders of more than 66 2/3%
of the Series C and Series D preferred stock, eliminating the automatic
conversion price of $12.50 and $13.00 per share, respectively, and instituted
an automatic conversion provision of aggregate proceeds in excess of
$30,000,000 from the Company's initial public offering. In addition, the Series
F automatic conversion price was reduced from $13.00 per share to $11.00 per
share.
Prior to undertaking an initial public offering of its securities or
initiating a sale of 50% or more of the Company's outstanding capital stock or
substantially all of the Company's assets to a third party, the Company must
provide written notice to one of the convertible preferred shareholders. The
investor then has the right to make the first offer to purchase the Company for
a period of up to thirty days from receipt of the Company's notice.
Common Stock Warrant
In June 1998, the Company issued a warrant to purchase 50,000 shares of the
Company's common stock at $10.00 per share. The warrant expires on the earlier
of the completion of the Company's initial public offering or December 1998.
The Company recorded an expense of $35,000 to reflect the value of the warrant
in the six months ended June 30, 1998.
F-19
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
Common Stock Reserved
Common stock reserved for issuance is as follows:
<TABLE>
<CAPTION>
DECEMBER 31, JUNE 30,
1997 1998
------------ ----------
<S> <C> <C>
Convertible preferred stock.......................... 7,131,161 7,783,711
Redeemable convertible preferred stock............... -- 576,924
Common stock options................................. 2,646,880 4,937,229
Convertible preferred stock option................... 153,846 --
Redeemable convertible preferred stock in escrow..... 333,334 --
Series D preferred stock warrant..................... -- 38,462
Common stock warrants................................ -- 3,069,389
Employee stock purchase plan......................... -- 700,000
---------- ----------
10,265,221 17,105,715
========== ==========
</TABLE>
Stock-Based Compensation
In March 1995 and February 1997, the Board of Directors approved a stock
option plan and an equity incentive plan, respectively, that authorized the
grant of options to purchase shares of the Company's common stock. At December
31, 1997, the total authorized number of shares under the 1995 and 1997 plans
was 2,114,747 and 1,050,000, respectively. The plans are administered by the
Board of Directors and provide for incentive stock options or nonqualified
stock options to be issued to employees, directors, and consultants of the
Company. Prices for incentive stock options may not be less than the fair value
of the common stock at the date of grant. Prices for nonqualified stock options
may not be less than 85% of the fair value of the common stock at the date of
grant. Options are immediately exercisable and vest over a period not to exceed
five years from the date of grant. Any unvested stock issued is subject to
repurchase by the Company at the original issuance price upon termination of
the option holder's employment. Unexercised options expire ten years after the
date of grant.
In March and July 1997, the Board of Directors authorized grants of common
stock options outside the Company's stock option plans. The options are for
70,000 shares of common stock and generally vest over a three-year period in
six equal installments occurring every six months. In May and June 1998, the
Board of Directors authorized additional grants of 70,000 shares of common
stock outside the Company's stock option plans.
In June 1998, the Company's Board of Directors authorized (i) the adoption of
the amended 1997 Equity Incentive Plan, pursuant to which 2,250,000 additional
shares (plus a number of shares equal to the difference between the number of
shares remaining available for grant and the number of shares equal to 5% of
the Company's outstanding common stock at each year end) of the Company's
common stock have been reserved for future issuance to selected employees,
directors and consultants, (ii) the adoption of the 1998 Non-Employee
Directors' Stock Option Plan, pursuant to which 200,000 shares of the Company's
common stock have been reserved for future issuance to non-employee directors
of the Company, and (iii) the adoption of the 1998 Employee Stock Purchase
Plan, pursuant to which 700,000 shares of the Company's common stock have been
reserved for future issuance to eligible employees.
During the year ended December 31, 1997 and the six months ended June 30,
1998, the Company recorded aggregate deferred compensation of approximately
$228,000 and $1,849,000, respectively, representing the difference between the
grant price and the deemed fair value of the Company's
F-20
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
common stock options granted during these periods. The amortization of deferred
compensation is being charged to operations and is being amortized over the
vesting period of the options, which is typically five years. For the year
ended December 31, 1997 and the six months ended June 30, 1998, the amortized
expense was approximately $12,000 and $106,000, respectively.
The following is a summary of additional information with respect to the 1995
Stock Option Plan, the 1997 Equity Incentive Plan, the 1998 Non-Employee
Directors' Stock Option Plan and option grants made outside the plans:
<TABLE>
<CAPTION>
OPTIONS
OUTSTANDING
AND EXERCISABLE
-------------------
WEIGHTED
OPTIONS NUMBER AVERAGE
AVAILABLE OF EXERCISE
FOR GRANT SHARES PRICE
---------- --------- --------
<S> <C> <C> <C>
Options authorized on March 8, 1995........... 1,414,747 -- $ --
Options granted............................... (1,630,500) 1,630,500 $0.10
Options canceled.............................. 396,000 (396,000) $0.03
---------- ---------
Balance at December 31, 1995.................... 180,247 1,234,500 $0.10
Options authorized............................ 700,000 -- $ --
Options granted............................... (988,500) 988,500 $0.51
Options exercised............................. -- (106,219) $0.10
Options canceled.............................. 229,831 (229,831) $0.15
---------- ---------
Balance at December 31, 1996.................... 121,578 1,886,950 $0.31
Options authorized............................ 1,120,000 -- $ --
Options granted............................... (1,304,050) 1,304,050 $1.71
Options exercised............................. -- (481,648) $0.30
Options canceled.............................. 372,168 (372,168) $0.56
---------- ---------
Balance at December 31, 1997.................... 309,696 2,337,184 $1.05
Options authorized (unaudited)................ 2,520,000 -- --
Options granted (unaudited)................... (716,610) 716,610 $6.37
Options exercised (unaudited)................. -- (229,651) $0.29
Options canceled (unaudited).................. 340,851 (340,851) $2.21
---------- ---------
Balance at June 30, 1998 (unaudited)............ 2,453,937 2,483,292 $2.50
========== =========
</TABLE>
The following table summarizes information about stock options that were
outstanding and exercisable at December 31, 1997:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING AND EXERCISABLE
-------------------------------------------
WEIGHTED AVERAGE
WEIGHTED REMAINING
NUMBER OF AVERAGE EXERCISE CONTRACTUAL LIFE
RANGE OF EXERCISE PRICES SHARES PRICE (IN YEARS)
------------------------ --------- ---------------- ----------------
<S> <C> <C> <C>
$0.10 - $0.50.............. 1,167,134 $0.34 8.13
$1.25 - $1.30.............. 974,800 $1.26 9.00
$3.00 - $5.00.............. 195,250 $4.26 9.90
---------
Total.................... 2,337,184 $1.05 8.64
=========
</TABLE>
F-21
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
In addition, the following table summarizes information about stock options
that were outstanding and exercisable at June 30, 1998:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING AND EXERCISABLE
-------------------------------------------
WEIGHTED AVERAGE
WEIGHTED REMAINING
NUMBER OF AVERAGE EXERCISE CONTRACTUAL LIFE
RANGE OF EXERCISE PRICES SHARES PRICE (IN YEARS)
------------------------ --------- ---------------- ----------------
<S> <C> <C> <C>
$0.10 -- $0.50............. 866,782 $0.40 7.75
$1.25 -- $1.30............. 816,650 $1.25 8.41
$3.00 -- $5.00............. 162,750 $4.11 9.48
$6.50 -- $10.00............ 637,110 $6.55 9.98
---------
Total.................... 2,483,292 $2.50 8.64
=========
</TABLE>
At December 31, 1997 and June 30, 1998, 103,050 and 127,152 shares,
respectively, of common stock outstanding were subject to repurchase by the
Company. Common stock subject to repurchase represents any unvested shares of
common stock held by an option holder which, upon termination of the option
holder's employment, may be repurchased by the Company. Such shares are subject
to repurchase at their original issuance price.
The Company has elected to follow APB Opinion No. 25 and related
interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under FAS
123 requires the use of option valuation models that were not developed for use
in valuing employee stock options. Under APB Opinion No. 25, when the exercise
price of the Company's employee stock options equals the market price of the
underlying stock on the date of grant, no compensation expense is recognized.
Pro forma information regarding net loss is required under FAS 123 and is
calculated as if the Company had accounted for its employee stock options
granted during the years ended December 31, 1995, 1996 and 1997 under the fair
value method of FAS 123. The fair value for these options was estimated at the
date of grant using the minimum value method with the following weighted
average assumptions: risk-free interest rates of 5.34%, 6.22%, and 5.75% for
1995, 1996, and 1997, respectively; no dividend yield or volatility factors of
the expected market price of the Company's common stock; and a weighted average
expected life of the option of five years.
As discussed above, the option valuation models used under FAS 123 were
developed for use in estimating the fair value of traded options that have no
vesting restrictions and are fully transferable. In addition, option valuation
models require the input of highly subjective assumptions, including the
expected life of the option. Because the Company's employee stock options have
characteristics significantly different from those of traded options and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its employee
stock options.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. Had
compensation cost for the Company's stock-based compensation plans been
determined based on the fair value at the grant dates for awards under those
F-22
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
plans consistent with the method of FAS 123, the Company's net loss and loss
per share would have been increased to the pro forma amounts indicated below
(in thousands, except per share data):
<TABLE>
<CAPTION>
1995 1996 1997
------- -------- --------
<S> <C> <C> <C>
Pro forma net loss............................. $(3,669) $(10,718) $(22,627)
======= ======== ========
Pro forma basic and diluted net loss per share. $ (1.02) $ (2.64) $ (5.28)
======= ======== ========
</TABLE>
The pro forma impact of options on the net loss for the years ended December
31, 1995, 1996, and 1997 is not representative of the effects on net income
(loss) for future years, as future years will include the effects of options
vesting as well as the impact of multiple years of stock option grants. The
full effect of FAS 123 will not be fully reflected until 1999.
The options' weighted average grant date fair value, which is the value
assigned to the options under FAS 123, was $0.02, $0.11, and $0.41 for options
granted during 1995, 1996, and 1997, respectively.
Stockholders' Notes Receivable
In February 1993, the Company issued common stock to a founder in return for
a full recourse note receivable for $12,500. The note bears an interest rate of
7.04% per annum and is due in February 1998.
During June and December 1995, two officers of the Company were provided cash
advances totaling $81,133 for the purpose of purchasing the Company's Series A
preferred stock. The underlying full recourse notes were paid in August 1996
and June 1998.
In January 1998, the Company issued common stock to an employee in exchange
for a full recourse note receivable for $9,375. The note bears interest at 5.7%
and is payable in three equal annual payments commencing in January 1999.
9. INCOME TAXES
Due to operating losses and the inability to recognize the benefits
therefrom, there is no provision for income taxes for the fiscal years ended
December 31, 1995, 1996, and 1997.
F-23
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of the Company's deferred tax assets as of December 31, 1996 and 1997 are as
follows (in thousands):
<TABLE>
<CAPTION>
YEARS ENDED
DECEMBER 31,
-----------------
1996 1997
------- --------
<S> <C> <C>
Deferred Tax Assets:
Net operating loss carryforwards........................ $ 4,412 $ 11,323
Tax credit carryforwards................................ 293 2,531
Capitalized research and development.................... 912 1,373
Other, net.............................................. 439 1,158
------- --------
Total deferred tax assets............................. 6,056 16,385
Valuation allowance....................................... (6,056) (16,385)
------- --------
Net deferred tax assets $ -- $ --
======= ========
</TABLE>
Realization of deferred tax assets is dependent on future earnings, if any,
the timing and the amount of which are uncertain. Accordingly, a valuation
allowance, in an amount equal to the net deferred tax asset as of December 31,
1996 and 1997, has been established to reflect these uncertainties. The change
in the valuation allowance was a net increase of approximately $1,533,000,
$4,444,000, and $10,329,000 for the years ended December 31, 1995, 1996, and
1997, respectively.
As of December 31, 1997, the Company had federal and California net operating
loss carryforwards of approximately $31,000,000 and $15,000,000, respectively.
The Company also had federal and California research and development tax credit
carryforwards of approximately $1,700,000 and $1,200,000, respectively. The net
operating loss and credit carryforwards will expire at various dates beginning
in the years 1999 through 2012, if not utilized.
Utilization of net operating loss and tax credit carryforwards may be subject
to a substantial annual limitation due to the ownership change limitations
provided by the Internal Revenue Code of 1986, as amended, and similar state
provisions. The annual limitation may result in the expiration of net operating
loss and tax credit carryforwards before full utilization.
The reconciliation of income tax expense (benefit) attributable to continuing
operations computed at the U.S. federal statutory rates to income tax expense
(benefit) for the fiscal years ended December 31, 1995, 1996, and 1997 is as
follows (in thousands):
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
----------------------------
1995 1996 1997
-------- -------- --------
<S> <C> <C> <C>
Tax provision (benefit) at U.S. statutory
rate......................................... $ (1,258) $ (3,638) $ (7,667)
Loss for which no tax benefit is currently
recognizable................................. 1,258 3,638 7,667
-------- -------- --------
$ -- $ -- $ --
======== ======== ========
</TABLE>
F-24
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
10. SIGNIFICANT CUSTOMER AND GEOGRAPHIC INFORMATION
Three of the Company's customers, Telegate Ltd., Sumitomo Corporation, and
Net Brasil S.A. accounted for 30%, 29%, and 14% of revenues, respectively, for
the year ended December 31, 1997. Shaw Communications, Inc., Sumitomo
Corporation and Cablevision Systems Corporation, accounted for 40%, 14% and 10%
of revenues for the six months ended June 30, 1998, respectively. No other
customer accounted for more than 10% of revenues during these periods.
Total net export revenues to regions outside of the United States were
approximately $1,855,000 and $7,394,000 for the year ended December 31, 1997
and the six months ended June 30, 1998, respectively. Revenues by geographic
region were as follows (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED SIX MONTHS ENDED
DECEMBER 31, JUNE 30,
1997 1998
------------ ----------------
<S> <C> <C>
Revenues:
United States................................ $ 263 $1,982
Canada....................................... 198 3,873
Asia......................................... 617 1,422
South America................................ 326 304
Europe and Israel............................ 714 1,795
------ ------
Total...................................... $2,118 $9,376
====== ======
</TABLE>
11. 401(K) PROFIT SHARING PLAN AND TRUST
During 1995, the Company adopted a 401(k) Profit Sharing Plan and Trust that
allows eligible employees to make contributions subject to certain limitations.
The Company may make discretionary contributions based on profitability as
determined by the Board of Directors. No amount was contributed by the Company
to the plan during the years ended December 31, 1995, 1996, and 1997 or for the
six months ended June 30, 1997 and 1998.
12. RELATED PARTY TRANSACTIONS
During the year ended December 31, 1997, the Company recognized revenue of
approximately $617,000 in connection with product shipments made to a Series D
preferred stockholder. In addition, during the six months ended June 30, 1998,
the Company recognized revenue of approximately $1,312,000 and $3,785,000 in
connection with product shipments made to a Series D preferred stockholder, and
a Series F redeemable preferred and preferred stockholder, respectively.
Accounts receivable from the related parties totaled approximately $362,000 and
$2,236,000 at December 31, 1997 and June 30, 1998, respectively.
In September 1997, the Company received $2,000,000 from a Series D preferred
stockholder in connection with a stock option agreement. As of December 31,
1997, the Company has recorded the amount received as an advance from the
related party. The stock option agreement allows for the purchase of 153,846
shares of Series D preferred stock for the $2,000,000, on or before April 30,
1998. In April 1998, the $2,000,000 advance was converted into 153,846 shares
of Series D convertible preferred stock.
F-25
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(CONTINUED)
(INFORMATION PERTAINING TO JUNE 30, 1998 AND THE SIX MONTH PERIODS ENDED
JUNE 30, 1997 AND 1998 IS UNAUDITED)
13. SUBSEQUENT EVENT--DELAWARE REINCORPORATION
In June 1998, the Company's Board of Directors authorized the reincorporation
of the Company in Delaware and an increase in the authorized number of shares
of common stock from 20,000,000 shares to 35,000,000 shares. In July 1998, the
Company's shareholders approved the reincorporation and the increase in
authorized number of shares, and the reincorporation was effective as of July
8, 1998. The par value of the preferred and common stock is $.001 per share.
Subsequent to the initial public offering, the Company's Certificate of
Incorporation will be amended to authorize 5,000,000 shares of preferred stock
which the Board of Directors has the authority to fix or alter the designation,
powers, preferences and rights of the shares of each such series and
qualifications, limitations or restrictions to any unissued series of preferred
stock. The Company's reincorporation has been reflected in the June 30, 1998
consolidated financial statements. The change resulted in the transfer of
$40,116,000 from convertible preferred stock and $30,401,000 from common stock
to additional paid in capital.
F-26
<PAGE>
[graphic depicts man standing on a bridge with a rainbow overhead]
[logo of Terayon appears at bottom of page]
<PAGE>
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NO PERSON HAS BEEN AUTHORIZED IN CONNECTION WITH THE OFFERING MADE HEREBY TO
GIVE ANY INFORMATION OR TO MAKE ANY REPRESENTATION NOT CONTAINED IN THIS PRO-
SPECTUS AND, IF GIVEN OR MADE, SUCH INFORMATION OR REPRESENTATION MUST NOT BE
RELIED UPON AS HAVING BEEN AUTHORIZED BY THE COMPANY OR ANY UNDERWRITER. THIS
PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR A SOLICITATION OF ANY OFFER
TO BUY ANY OF THE SECURITIES OFFERED HEREBY TO ANY PERSON OR BY ANYONE IN ANY
JURISDICTION IN WHICH IT IS UNLAWFUL TO MAKE SUCH OFFER OR SOLICITATION. NEI-
THER THE DELIVERY OF THIS PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER
ANY CIRCUMSTANCES, CREATE ANY IMPLICATION THAT THE INFORMATION CONTAINED
HEREIN IS CORRECT AS OF ANY DATE SUBSEQUENT TO THE DATE HEREOF.
----------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary........................................................ 3
Risk Factors.............................................................. 5
Information Regarding Forward-Looking Statements.......................... 21
Use of Proceeds........................................................... 22
Dividend Policy........................................................... 22
Capitalization............................................................ 23
Dilution.................................................................. 24
Selected Consolidated Financial Data...................................... 25
Management's Discussion and Analysis of Financial Condition and Results of
Operations............................................................... 26
Business.................................................................. 34
Management................................................................ 48
Certain Transactions...................................................... 58
Principal Stockholders.................................................... 59
Description of Capital Stock.............................................. 61
Shares Eligible for Future Sale........................................... 64
Underwriting.............................................................. 66
Legal Matters............................................................. 68
Experts................................................................... 68
Additional Information.................................................... 68
Glossary.................................................................. G-1
Index to Financial Statements............................................. F-1
</TABLE>
UNTIL SEPTEMBER 11, 1998 (25 DAYS AFTER THE DATE OF THIS PROSPECTUS), ALL
DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK OFFERED HEREBY, WHETHER OR
NOT PARTICIPATING IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPEC-
TUS. THIS IS IN ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS
WHEN ACTING AS UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR
SUBSCRIPTIONS.
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3,000,000 SHARES
LOGO
[LOGO OF TERAYON COMMUNICATION SYSTEMS]
COMMON STOCK
------------
PROSPECTUS
------------
BT ALEX. BROWN
HAMBRECHT & QUIST
LEHMAN BROTHERS
SALOMON SMITH BARNEY
August 17, 1998
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