<PAGE>
Filed Pursuant to Rule 424(b)(4)
Registration No. 333-69699
3,250,000 Shares
[LOGO OF TERAYON APPEARS HERE]
Common Stock
------------
Terayon Communication Systems, Inc. is offering 1,750,000 shares. The
selling stockholders identified in this prospectus are offering an additional
1,500,000 shares. Terayon will not receive any of the proceeds from the sale
of shares by the selling stockholders.
Terayon's Common Stock is traded on the Nasdaq National Market under the
symbol "TERN." On January 21, 1999, the last reported sale price for the
Common Stock on the Nasdaq National Market was $42.25 per share.
Investing in the Common Stock involves risks.
See "Risk Factors" beginning on page 6.
<TABLE>
<CAPTION>
Per Share Total
--------- ------------
<S> <C> <C>
Public offering price................................. $38.00 $123,500,000
Underwriting discount................................. $ 1.90 $ 6,175,000
Proceeds, before expenses, to Terayon................. $36.10 $ 63,175,000
Proceeds, before expenses, to the selling
stockholders......................................... $36.10 $ 54,150,000
</TABLE>
Neither the Securities and Exchange Commission nor any other regulatory body
has approved or disapproved of these securities or passed upon the accuracy or
adequacy of this prospectus. Any representation to the contrary is a criminal
offense.
Terayon and certain selling stockholders have granted the underwriters the
right to purchase up to 487,500 additional shares at the public offering price
to cover any over-allotments.
----------------
The underwriters are severally underwriting the shares being offered. The
underwriters expect to deliver the shares against payment in Baltimore,
Maryland on January 27, 1999.
BT Alex. Brown
Hambrecht & Quist
Lehman Brothers
Salomon Smith Barney
January 21, 1999
<PAGE>
Terayon's Broadband Roadmap
Graphic consisting of a depiction of the following components of broadband
communications solutions:
S-CDMA Cable Modem System
Standards-Based DOCSIS Modem System
Technology Leadership
Set-Top Boxes
IP and Circuit Telephony
TeraComm, TeraLink, TeraPro, TeraView and Terayon are our trademarks. All
other trademarks or service marks appearing in this prospectus are the property
of their respective owners.
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<PAGE>
[Gatefold]
Terayon Cable Modem Systems:
Broadband Innovation
Internet Cable Headend Coax or HFC Corporate Office
Private Backbone TeraLink Gateway Coax or HFC TeraPro Cable Modem
Network
TeraLink Master Coax or HFC Small Business
Controller
TeraView Element Residential
Management Software
[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, high capacity communications over more cable systems than
alternative broadband access technologies.
Standards-Based Roadmap. Terayon has been selected by CableLabs to co-author
an enhanced version of the DOCSIS cable modem specification based in part on
Terayon's S-CDMA technology.
Flexible Architecture. The Terayon system can be deployed on any cable
infrastructure, from pure coaxial systems to hybrid fiber/coax ("HFC") upgraded
systems, providing cable operators fast time to market for cost-effective
broadband access.
Economic Advantage. The Terayon system does not require costly cable
infrastructure upgrades, allowing cable operators to provide broadband access
services at low start-up costs. The system also supports tiered levels of
service, which provide additional revenue opportunities for cable operators.
<PAGE>
PROSPECTUS SUMMARY
You should read the following summary together with the more detailed
information and financial statements and notes thereto appearing elsewhere in
this prospectus. Except as otherwise specified, all information in this
prospectus assumes no exercise of the Underwriters' overallotment option.
This prospectus contains forward-looking statements. The outcome of the
events described in these forward-looking statements is subject to risks and
actual results could differ materially. The sections entitled "Risk Factors,"
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Business" contain a discussion of some of the factors that
could contribute to those differences.
Terayon
We develop, market and sell cable modem systems that enable cable operators
to cost-effectively deploy reliable two-way broadband access services. Our
TeraComm system is designed to enable cable operators to maximize the capacity
and reliability of broadband access services over any cable plant. This allows
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 can provide additional revenue-generating services to end
users. This enables 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 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 TeraComm system is based on our Synchronous Code Division Multiple Access
or "S-CDMA" technology. 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. Our S-CDMA technology
enables reliable two-way broadband communications over both pure coaxial and
hybrid fiber/coax cable infrastructure. It does this by maximizing resistance
to noise that interferes with data transmissions over previously unusable
frequency spectrum. In November 1998, CableLabs selected us to co-author an
enhanced version of the DOCSIS cable modem specifications based in part on our
S-CDMA technology.
Our 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 our strategy include the following:
. supply leading cable operators worldwide;
. advance industry standards;
. extend technology leadership and achieve rapid time to market;
3
<PAGE>
. reduce manufacturing costs;
. provide superior customer service and support; and
. increase our presence in existing and new markets.
We sell our products to cable operators through direct sales forces in North
America, Latin America and Europe. We also distribute our products via
distributors and systems integrators. Companies currently using or distributing
our TeraComm system include Shaw Communications Inc., TCA Cable TV, Inc.,
Cablevision Systems, Inc., and Crossbeam Networks Corporation, a wholly owned
subsidiary of Sumitomo Corporation.
Our Company was incorporated in California in January 1993 and reincorporated
in Delaware in July 1998. References in the prospectus to "Terayon," "we,"
"our," "us" and the "Company" refer to Terayon Communication Systems, Inc., a
Delaware corporation, and its subsidiaries. Our executive offices are located
at 2952 Bunker Hill Lane, Santa Clara, California 95054 and our telephone
number is (408) 727-4400. Our Web site is located at www.terayon.com.
Information contained on our Web site does not constitute part of this
prospectus.
4
<PAGE>
The Offering
<TABLE>
<C> <S>
Shares offered by Terayon.................... 1,750,000 shares
Shares offered by the selling stockholders... 1,500,000 shares
Shares to be outstanding after the offering.. 18,208,121 shares(1)
Use of proceeds.............................. For general corporate purposes,
including capital expenditures
and research and development
Nasdaq National Market symbol................ TERN
</TABLE>
Summary Consolidated Financial Data
(in thousands, except per share data)
<TABLE>
<CAPTION>
Years Ended December 31,
---------------------------------------------
1994 1995 1996 1997 1998
------ ------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Consolidated Statement of
Operations Data:
Revenues........................ $ 140 $ -- $ -- $ 2,118 $ 31,696
Cost of goods sold.............. -- 676 -- 6,462 34,518
------ ------- -------- -------- --------
Gross profit (loss)............. 140 (676) -- (4,344) (2,822)
------ ------- -------- -------- --------
Operating expenses:
Research and development...... 235 2,028 8,020 11,319 10,685
Sales and marketing........... 17 205 1,141 4,468 6,947
General and administrative.... 84 825 1,789 2,546 3,223
------ ------- -------- -------- --------
Total operating expenses..... 336 3,058 10,950 18,333 20,855
------ ------- -------- -------- --------
Loss from operations............ (196) (3,734) (10,950) (22,677) (23,677)
Net interest income............. -- 68 253 128 449
------ ------- -------- -------- --------
Net loss........................ (196) (3,666) (10,697) (22,549) (23,228)
Series F convertible preferred
stock dividend(2).............. -- -- -- -- (23,910)
------ ------- -------- -------- --------
Net loss applicable to common
stockholders................... $ (196) $(3,666) $(10,697) $(22,549) $(47,138)
====== ======= ======== ======== ========
Historical basic and diluted net
loss per share applicable to
common stockholders(3)......... $(0.10) $ (1.02) $ (2.64) $ (5.26) $ (5.25)
====== ======= ======== ======== ========
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 8,986
====== ======= ======== ======== ========
Pro forma basic and diluted net
loss per share applicable to
common stockholders(3)......... $ (2.07) $ (3.41)
======== ========
Shares used in pro forma basic
and diluted net loss per share
applicable to common
stockholders(3)................ 10,873 13,804
======== ========
</TABLE>
<TABLE>
<CAPTION>
December 31, 1998
------------------------
Actual As Adjusted(4)
-------- --------------
<S> <C> <C>
Consolidated Balance Sheet Data:
Cash, cash equivalents and short-term investments..... $ 28,880 $ 91,355
Working capital....................................... 24,422 86,897
Total assets.......................................... 42,146 104,621
Long-term debt (less current portion)................. 10 10
Accumulated deficit................................... (84,301) (84,301)
Total stockholders' equity............................ $ 28,103 $ 90,578
</TABLE>
- -------
(1) Based on number of shares outstanding on December 31, 1998. Excludes
2,771,607 shares of common stock reserved for issuance pursuant to our
employee benefit plans and options to purchase 2,691,234 shares outstanding
as of December 31, 1998. Also excludes 3,019,191 shares issuable upon
exercise of outstanding warrants.
(2) See Note 10 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 reflects the estimated net proceeds from the sale of the
1,750,000 shares of common stock offered by Terayon in this offering, after
deducting the underwriting discount and estimated offering expenses. See
"Use of Proceeds."
5
<PAGE>
RISK FACTORS
This offering involves a high degree of risk. You should carefully consider
the risks and uncertainties described below and the other information in this
prospectus before deciding whether to invest in shares of our common stock. If
any of the following risks actually occur, our business, financial condition
or operating results could be materially adversely affected. This could cause
the trading price of our common stock to decline, and you may lose part or all
of your investment.
This prospectus also contains certain forward-looking statements that
involve risks and uncertainties. These statements relate to our future plans,
objectives, expectations and intentions. These statements may be identified by
the use of words such as "expects," "anticipates," "intends," "plans" and
similar expressions. Our actual results could differ materially from those
discussed in these statements. Factors that could contribute to these
differences include those discussed below and elsewhere in this prospectus.
We Have a Limited Operating History and a History of Losses.
We have a very limited operating history, and it is difficult to predict our
future operating results. We were incorporated in January 1993 and began
shipping products commercially in June 1997. We have only been shipping
products in volume since the first quarter of 1998. As of December 31, 1998,
we had an accumulated deficit of $84.3 million. We believe that we will
continue to experience net losses for the foreseeable future. Most of our
expenses are fixed in advance, and we generally are unable to reduce our
expenses significantly in the short term to compensate for any unexpected
delay or decrease in anticipated revenues. We expect to increase expense
levels in each of the next several quarters to support increased sales and
marketing and technical support costs. Any significant delay in our
anticipated revenues or commercialization of new products would have an
immediate adverse effect on our business, operating results and financial
condition. The revenue and profit potential of our business and our industry
are unproven. We have had negative gross margins since our inception until the
fourth quarter of 1998, and any future revenue growth may not result in
positive gross margins or operating profits in future periods.
Our Operating Results May Fluctuate.
Our quarterly revenues are likely to fluctuate significantly in the future
due to a number of factors, many of which are outside our control. Factors
that could affect our revenues include the following:
. variations in the timing of orders and shipments of our products;
. variations in the size of the orders by our customers;
. new product introductions by competitors;
. delays in introducing new products;
. delays of orders forecasted by our customers;
. delays by our customers in the completion of upgrades of cable
infrastructure;
. variations in capital spending budgets of cable operators; and
. delays in obtaining regulatory approval for commercial deployment of
cable modem systems.
Our 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 we begin development of new products and as our
development programs move to wafer fabrication, which results in higher
engineering expenses.
We have 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 our products. Any delay in the product
deployment schedule of one or more of the cable operators that we target would
6
<PAGE>
have an adverse effect on our operating results for a particular period. In
addition, due to the large dollar size of a typical transaction in comparison
to our total revenues, any delay in the closing of a transaction could have a
significant impact on our operating results for a particular period.
A variety of factors affect our gross margin, including the following:
. the sales mix of our products;
. the volume of products manufactured;
. the type of distribution channel through which we sell our products;
. the average selling prices or "ASPs" of our products; and
. the effectiveness of our cost reduction measures.
We anticipate that unit ASPs of our products will decline in the future. This
could cause a decrease in the gross margins for these products. In addition,
the maturity of TeraComm system deployments affects our gross margin. New
deployments of the TeraComm system involve the sale of headend equipment (which
has higher margins) and generally involve smaller quantities of product. New
deployments typically are sold at higher margins than the larger volume sales
of product associated with more mature deployments of the TeraComm system. The
sales mix of TeraLink 1000 Master Controllers, TeraLink Gateways and TeraPro
cable modems also affects our gross margin. The TeraPro cable modems have
significantly lower margins than the TeraLink 1000 Master Controller and
TeraLink Gateway headend products. We expect to achieve only nominal margins on
the TeraPro cable modems for the foreseeable future. Further, we expect that
sales of TeraPro cable modems will continue to constitute a significant portion
of our revenues for the foreseeable future.
We Are Dependent on a Small Number of Customers.
Three customers accounted for approximately 73% of our revenues in 1997 and
three customers accounted for approximately 70% of our revenues in 1998. Of our
total revenues in 1997, Telegate Ltd. accounted for approximately 30%, Sumitomo
Corporation accounted for approximately 29% and NET Brasil S.A. accounted for
approximately 14%. Of our total revenues in 1998, Shaw Communications Inc.
accounted for approximately 40%, Cablevision Systems, Inc. accounted for
approximately 16% and Sumitomo Corporation accounted for approximately 14%. We
believe that a substantial majority of our revenues will continue to be derived
from sales to a relatively small number of customers for the foreseeable
future. In addition, we believe that sales to these customers will be focused
on a small number of projects. The cable industry is undergoing significant
consolidation in the United States and internationally, and a limited number of
cable operators controls an increasing number of cable systems. As a result,
our sales will be largely dependent upon product acceptance by the leading
cable operators. Ten cable operators in the United States owned and operated
facilities passing approximately 74% of total homes passed in 1997. The timing
and size of each customer's order is critical to our operating results. Our
major customers are likely to have significant negotiating leverage and may
attempt to change the terms, including pricing, upon which we do business with
them. These customers also may require longer payment terms than we anticipate,
which could require us to raise additional capital to meet our working capital
requirements. Our success will depend on our cable modems being widely deployed
and our ability to sell to new customers.
The Sales Cycle for Our Products Is Lengthy.
The sales cycle associated with our products typically is lengthy, often
lasting six months to a year. Our customers typically conduct significant
technical evaluations of competing technologies prior to the commitment of
capital and other resources. In addition, purchasing decisions may be delayed
because
7
<PAGE>
of our customers' internal budget approval procedures. 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, our operating results for that quarter could be materially
adversely affected.
There are Many Risks Associated with Our Participation in Co-Authoring the
DOCSIS 1.2 Specification.
In November 1998, CableLabs selected us to co-author a technical
specification for DOCSIS 1.2, an enhanced version of the DOCSIS cable modem
standard based in part on our S-CDMA technology. Our agreement to co-author the
DOCSIS 1.2 specification will require us to contribute some aspects of our S-
CDMA technology to a royalty-free intellectual property pool. As a result, any
of our competitors who join the DOCSIS intellectual property pool will have
access to some aspects of our technology and will not be required to pay us any
royalties or other compensation. Further, some of our competitors have been
successful in reverse engineering the technology of other companies, and our
contribution to the DOCSIS 1.2 intellectual property pool would expose some
aspects of our technology to those competitors. If a competitor is able to
duplicate the functionality and capabilities of our technology, we could lose
all or some of the time-to-market advantage we might otherwise have.
CableLabs may select additional authors to contribute to the DOCSIS 1.2
proposal. Any vendors that participate in the drafting process, including us,
must contribute any of their technology that is essential to implement the
DOCSIS 1.2 specification to the DOCSIS intellectual property pool on a royalty-
free basis. If the DOCSIS Certification Board includes our proposal in the
DOCSIS 1.2 draft specification, it will then be made available for comment by
the organizations that participate in the DOCSIS specification process. The
DOCSIS Certification Board may decide not to proceed with our proposal.
Further, the comment process may take considerably longer than expected and may
delay the publication of a DOCSIS 1.2 standard, currently anticipated to occur
in 2000. If our draft proposal is not approved by the DOCSIS Certification
Board, we may not be able to develop DOCSIS 1.2-compliant cable modems in a
timely fashion or at all.
We believe the adoption of DOCSIS 1.2 will result in increased competition in
the North American cable modem market. This competition could come from
existing competitors or from new competitors who enter the market as a result
of the adoption of DOCSIS 1.2. This increased competition is likely to result
in lower ASPs of cable modem systems and likely will adversely affect our gross
margin. Because our competitors will be able to incorporate some aspects of our
technology into their products, our current customers may choose alternate
cable modem suppliers or choose to purchase DOCSIS 1.2-compliant cable modems
from multiple suppliers. We may be unable to produce DOCSIS 1.2-compliant cable
modems more quickly or at lower cost than our competitors. The inclusion of our
S-CDMA technology in DOCSIS 1.2 could result in increased competition for the
services of our existing employees who have experience with S-CDMA. The loss of
these employees to one or more competitors could adversely affect our business.
DOCSIS standards have not yet been accepted in Europe and Asia. Sales to
customers outside of the United States and Canada accounted for 78% of our
revenues in 1997 and 33% of our revenues in 1998. If standards that are not
compatible with DOCSIS standards ultimately achieve widespread acceptance
outside of the United States and Canada, we could be required to redesign our
products for use in those markets. Even if we were able to successfully
redesign our products, this would likely delay the deployment of our products
in markets outside of the United States and Canada.
We Need to Develop New Products.
Our future success will depend in part on our ability to develop, introduce
and market new products in a timely manner. We must also respond to competitive
pressures, evolving industry standards and technological advances. Our current
products are not DOCSIS-compliant, and we do not
8
<PAGE>
expect to sell our DOCSIS 1.2-compliant products until 2000. As 2000
approaches, existing or potential customers may delay purchases of our current
cable modem system in order to purchase systems that comply with the DOCSIS 1.2
standard. In addition, potential new customers could decide to purchase DOCSIS
1.2-compliant products from one or more of our competitors rather than from us.
As a result, in the second half of 1999 and early 2000, our product sales may
be lower than we anticipate. As 2000 approaches, we may be required to reduce
the price of our current products for sales to existing customers. This would
have an adverse effect on our operating results and gross margin.
It is expected that the DOCSIS 1.2 specifications will be based upon both S-
CDMA and advanced TDMA technology. In that event, we will have to incorporate
advanced TDMA technology into our DOCSIS 1.2-compliant products. If we are
unable to do this effectively or in a timely manner, we will lose some or all
of the time-to-market advantage we might otherwise have had.
Average Selling Prices of Cable Equipment Typically Decrease.
The cable equipment systems industry has been characterized by erosion of
average selling prices. We expect this to continue. This erosion is due to a
number of factors, including competition, rapid technological change and price
performance enhancements. The average selling prices for our products may be
lower than expected as a result of competitive pricing pressures, our
promotional programs and customers who negotiate price reductions in exchange
for longer term purchase commitments. We anticipate that ASPs and gross margins
for our products will decrease over product life cycles. In addition, we
believe that the widespread adoption of industry standards is likely to further
erode ASPs, particularly for cable modems. It is likely that the adoption of
industry standards will result in increased retail distribution of cable
modems, which could put further price pressure on our modems. Decreasing ASPs
could result in decreased revenue even if the number of units sold increases.
As a result, we may experience substantial period-to-period fluctuations in
future operating results due to ASP erosion. Therefore, we must continue to
develop and introduce on a timely basis next-generation products with enhanced
functionalities that can be sold at higher gross margins. Our failure to do
this could cause our revenues and gross margin to decline.
We Must Achieve Cost Reductions.
Certain of our competitors currently offer cable modems at prices lower than
ours. Market acceptance of our products will depend in part on reductions in
the unit cost of our products. We expect that as headend equipment becomes more
widely deployed, the price of cable modems and other products will decline. In
particular, we believe that the adoption of industry standards such as DOCSIS
will cause increased price competition for cable modems. However, we may be
unable to reduce the cost of our modems sufficiently to enable us to compete
with other cable modem suppliers. Our cost reduction efforts may not allow us
to keep pace with competitive pricing pressures or lead to improved gross
margins.
Many of our competitors are larger and manufacture products in significantly
greater quantities than we intend to for the foreseeable future. Consequently,
these competitors have more leverage in obtaining favorable pricing from
suppliers and manufacturers. In order to remain competitive, we must
significantly reduce the cost of manufacturing our cable modems through design
and engineering changes. We may not be successful in redesigning our products.
Even if we are successful, our redesign may be delayed or may contain
significant errors and product defects. In addition, any redesign may not
result in sufficient cost reductions to allow us to significantly reduce the
list price of our products or improve our gross margin. Reductions in our
manufacturing costs will require us to use more highly integrated components in
future products and may require us to enter into high volume or long-term
purchase or manufacturing agreements. Volume purchase or manufacturing
agreements may not be available on acceptable terms. We could incur expenses
without related revenues if we enter into a high
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<PAGE>
volume or long-term purchase or manufacturing agreement and then decide that we
cannot use the products or services offered by such agreement.
We Must Keep Pace with Rapid Technological Change to Remain Competitive.
The markets for our products are characterized by rapid technological change,
evolving industry standards, changes in end user requirements and frequent new
product introductions and enhancements. Our future success will depend upon our
ability to enhance our existing products and to develop and introduce new
products that achieve market acceptance. Cable operators may adopt alternative
technologies or they may deploy alternative services that are incompatible with
our products.
The demand for broadband access services has resulted in the development of
several competing modulation technologies. Our products utilize a modulation
technology known as Synchronous Code Division Multiple Access or "S-CDMA,"
while several of our competitors utilize modulation technologies known as Time
Division Multiple Access or "TDMA" and Frequency Division Multiple Access or
"FDMA." Our 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 products from multiple suppliers may be reluctant to
purchase our products. Although our technology may be incorporated into a
future version of industry standards, we cannot be certain that major cable
operators will adopt these standards. Major cable operators may not adopt
products or technologies based on our current proprietary S-CDMA technology or
on any future industry standard S-CDMA technology. Further, major cable
operators may adopt products or standards technologies based on competing
modulation technologies. If competitors using other modulation technologies can
incorporate functionality and capabilities currently found in S-CDMA, the value
of our S-CDMA technology would be diminished.
Cable Modems Have Not Achieved Widespread Market Acceptance and Many Competing
Technologies Exist.
Our success will depend upon the widespread commercial acceptance of cable
modems by cable operators and end users of broadband access services. Cable
operators have only recently begun to deploy broadband access services based on
cable modem technology, and the market for these services is not fully
developed. We cannot accurately predict the future growth rate or the ultimate
size of the cable modem market. Potential users of our products may have
concerns regarding the security, reliability, cost, ease of installation and
use and capability of cable modems in general.
The general market for cable modems may be affected by the development of
alternative technologies that provide broadband access services. These include
the following:
. Digital Subscriber Line technologies known as "xDSL";
. Integrated Service Digital Network or "ISDN";
. data transmission over fiber optic cable;
. direct broadcast satellite;
. Local Multipoint Distribution Service; and
. Multichannel Multipoint Distribution Service.
Broadband access services based on some of these competing technologies are
already available and could significantly limit acceptance of cable modem-based
services.
We Need to Develop Additional Distribution Channels.
We presently market our products to cable operators and systems integrators.
We believe that much of the North American cable modem market may shift to a
retail distribution model. Accordingly, we
10
<PAGE>
may need to redirect our future marketing efforts to sell our cable modems
directly to retail distributors and end users. This shift would require us to
establish new distribution channels for our products. We may be unable to
establish these additional distribution channels. If we do establish them, we
may be unable 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, we may not successfully establish a retail
distribution presence. 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.
We May Be Unable to Market Effectively to Cable Operators.
Our growth and future success will be substantially dependent upon our
ability to convince cable operators to adopt our technologies, purchase our
products and effectively market our 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. This
reluctance could result in lengthy product testing and acceptance cycles for
our products. Consequently, the impediments to our initial sales may be even
greater than those to later sales. No established distribution network in the
cable modem industry exists that would provide us with easy access to smaller
or geographically diverse cable operators. Therefore, our initial sales to
larger, more established cable operators are critical to our business. Although
we intend to establish strategic relationships with leading distributors
worldwide, we may not succeed in establishing these relationships. Even if we
do establish these relationships, the distributors may not succeed in marketing
our products to cable operators. Some of our competitors have already
established relationships with certain cable operators, such as Motorola Inc.'s
relationships with Tele-Communications, Inc. or "TCI," Time Warner Cable,
Comcast Corporation and Cox Communications, Inc. These established
relationships may further limit our ability to sell products to those cable
operators. We do not have long, well-established relationships with those cable
operators. If we were to sell our products to those cable operators, it would
likely not be based on long-term contracts and those customers would be able to
terminate their relationships with us at any time. In addition, one or more of
our current customers could cancel its relationship with us at any time.
We Are Dependent on Cable Operators and Other Service Providers.
We depend on cable operators to purchase our cable modem systems and to
provide our cable modems to end users. Cable operators have a limited amount of
available bandwidth over which they can offer robust data services, and they
may not choose to provide these data services to their customers. If cable
operators choose to provide these services, we also will depend upon them to
market these services to cable customers, to install our equipment and to
provide support to end users. In addition, we will be highly dependent on cable
operators to continue to maintain their cable infrastructure in a manner that
allows us to provide consistently high performance and reliable services. Our
success also will depend upon the acceptance of our products by other providers
of services to the cable industry, such as At Home Corporation's @Home Network
and Road Runner, a joint venture between MediaOne Group, Inc. and Time Warner
Cable.
We Are Dependent on the Cable Industry to Upgrade to Two-Way Cable
Infrastructure.
Demand for our 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. If
cable operators fail to complete these upgrades of their cable infrastructures
in a timely and satisfactory manner, the market for our products could be
limited. In addition, few businesses in the United States currently have cable
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access. Cable operators may not choose to upgrade existing residential cable
systems or to install new cable systems to serve business locations.
The success and future growth of our business will be subject to economic and
other factors affecting the cable television industry generally, particularly
its ability to finance substantial capital expenditures. Capital spending
levels in the cable industry in the United States have fluctuated significantly
in the past, and we believe that such fluctuations will occur in the future.
The capital spending patterns of cable operators are dependent on a variety of
factors, including the following:
. the availability of financing;
. cable operators' annual budget cycles, as well as the typical reduction
in upgrade projects during the winter months;
. the status of federal, local and foreign government regulation and
deregulation of the telecommunications industry;
. 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.
In recent periods, the United States cable market has been characterized by
the acquisition of smaller and independent cable operators by large cable
operators. We cannot 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 our business of further industry consolidation
also is uncertain.
We Have Limited Manufacturing Experience and We Are Dependent on Contract
Manufacturers.
We have had limited experience manufacturing our products and we depend
heavily upon the manufacturing capabilities of Solectron Corporation, our
contract manufacturer. We only began shipping our products in volume in the
first quarter of 1998, and we may encounter difficulties as we increase the
volume of our manufacturing operations. Our limited operating history and the
early stage of the cable modem market make it difficult for us to accurately
forecast demand for our products. Our inability to accurately forecast the
actual demand for our products could result in supply, manufacturing or testing
capacity constraints. These constraints could result in delays in the delivery
of our products or the loss of existing or potential customers, either of which
could have a material adverse effect on our business, operating results or
financial condition. In addition, we had unconditional purchase obligations of
approximately $10.3 million as of December 31, 1998, primarily to Solectron, to
purchase minimum quantities of materials and components used to manufacture our
products. We must fulfill these obligations even if demand for our products is
lower than we anticipate.
We Are Dependent on Key Suppliers.
We manufacture all of our 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. All of our sales
are from products containing one or more components that are available only
from single supply sources. In addition, some of the components are custom
parts produced to our specifications. For example, we currently rely on VLSI
Technology, Inc. to supply a custom ASIC that is used in our products. Other
components, such as the radio frequency 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 our ability
to meet our scheduled product deliveries to customers. Delays in key component
or product deliveries may occur due to shortages resulting from a
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limited number of suppliers, the financial or other difficulties of such
suppliers or a limitation in component product availability. We are dependent
on semiconductor manufacturers and are affected by worldwide conditions in the
semiconductor market. If we are unable to obtain a sufficient supply of
components from our current sources, we 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. Further, a significant increase in the price of one or
more of these components could have a material adverse effect on our gross
margin or operating results.
We Must Transition to New Semiconductor Process Technologies.
Our future success will depend in part upon our ability to develop products
that utilize new semiconductor process technologies. These technologies change
rapidly and require us to spend significant amounts on research and
development. We continuously evaluate the benefits of redesigning our
integrated circuits using smaller geometry process technologies to improve
performance and reduce costs. The transition of our products to integrated
circuits with increasingly smaller geometries will be important to our
competitive position. Other companies have experienced difficulty in migrating
to new semiconductor processes and, consequently, have suffered reduced yields,
delays in product deliveries and increased expense levels. Moreover, we depend
on our relationship with our third-party manufacturers to migrate to smaller
geometry processes successfully. We may be unable to migrate to new
semiconductor process technologies successfully or on a timely basis.
We Are Dependent on Contract Manufacturers to Assemble and Test Our Products.
Most of our products are assembled and tested by Solectron using testing
equipment that we provide. As a result of our dependence on Solectron for
assembly and testing of our products, we do 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 our products. In addition, as manufacturing volume increases, we will need
to procure and assemble additional testing equipment and provide it to
Solectron. The production and assembly of testing equipment typically requires
significant time. We could experience significant delays in the shipment of our
products if we are unable to provide this testing equipment to Solectron in a
timely manner.
There Are Many Risks Associated with International Operations.
Sales to customers outside of the United States accounted for approximately
88% of our revenues in 1997 and approximately 74% of our revenues in 1998. We
expect sales to customers outside of the United States to continue to represent
a significant percentage of our revenues for the foreseeable future.
International sales are subject to a number of risks, including the following:
. 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.
If our customers are impacted by currency devaluations or general economic
crises, such as the economic crisis currently affecting many Asian and Latin
American economies, their ability to purchase our products could be materially
adversely affected. Payment cycles for international customers typically are
longer than those for customers in the United States. Foreign markets for our
products may develop more slowly than currently anticipated. Foreign countries
may decide not to construct cable infrastructure or may prohibit, terminate or
delay the construction of new cable plants for a variety of
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reasons. These reasons include environmental issues, economic downturns, the
availability of favorable pricing for other communications services or the
availability and cost of related equipment. Any action like this by foreign
countries would reduce the market for our products.
We anticipate that our foreign sales generally will be invoiced in U.S.
dollars, and we currently do not plan to engage in foreign currency hedging
transactions. However, as we commence and expand our international operations,
we may be paid in foreign currencies and exposure to losses in foreign currency
transactions may increase. We may choose to limit our exposure by the purchase
of forward foreign exchange contracts or through similar hedging strategies. No
currency hedging strategy can fully protect against exchange-related losses. In
addition, if the relative value of the U.S. dollar in comparison to the
currency of our foreign customers should increase, the resulting effective
price increase of our products to those foreign customers could result in
decreased sales.
We May Be Unable to Provide Adequate Customer Support.
Our ability to achieve our planned sales growth and retain current and future
customers will depend in part upon the quality of our customer support
operations. Our customers generally require significant support and training
with respect to the TeraComm system, particularly in the initial deployment and
implementation stage. To date, we have sold a limited number of products, and
our sales have been concentrated in a small number of customers. We have
limited experience with widespread deployment of our products to a diverse
customer base. We may not have adequate personnel to provide the levels of
support that our customers may require during initial product deployment or on
an ongoing basis. Our inability to provide sufficient support to our customers
could delay or prevent the successful deployment of our products. In addition,
our failure to provide adequate support could have an adverse impact on our
reputation and relationship with our customers and could prevent us from
gaining new customers.
Our Industry is Highly Competitive with Many Established Competitors.
The market for broadband access systems is extremely competitive and is
characterized by rapid technological change. Our direct competitors in the
cable modem arena include Cisco Systems, Inc., Com21, Inc., General Instrument
Corporation, Hayes Corporation, Hybrid Networks, Inc., Matsushita Electric
Industrial Co., Ltd. (which markets products under the brand name "Panasonic"),
Motorola, Nortel Networks, Inc., Phasecom Inc., Thomson Consumer Electronics,
Inc. (which markets products under the brand name "RCA"), Samsung Corporation,
Scientific-Atlanta, Inc., Sony Corporation, 3Com Corporation, Toshiba
Corporation and Zenith Electronics Corporation. We also compete with companies
that develop integrated circuits for broadband access products, such as
Broadcom Corporation. As cable modem standards such as DOCSIS 1.2 are adopted,
other companies may enter the cable modem market. In addition, Com21, Hybrid,
Motorola and Nortel introduced cable modems before we did, and they have
established relationships and have worked with customers for a longer period of
time than we have. The principal competitive factors in our market include the
following:
. 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; and
. compliance with industry standards.
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Some of these factors are outside of our control. The existing conditions in
the broadband access market could change rapidly and significantly as a result
of technological changes. The development and market acceptance of alternative
technologies could decrease the demand for our products or render them
obsolete. Our competitors may introduce broadband access products that are less
costly, provide superior performance or achieve greater market acceptance than
our products.
We also sell products that compete with existing data access and transmission
systems utilizing the telecommunications networks, such as those of 3Com.
Additionally, our controller and headend system products face intense
competition from well-established companies such as Cisco, Nortel and 3Com.
Many of our 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 we
do. The anticipated widespread adoption of DOCSIS is likely to cause increased
price competition in the North American market. The adoption of DOCSIS also
could result in lower sales of our headend products in the North American
market. Any increased price competition or reduction in sales of our headend
products would result in downward pressure on our gross margin. We cannot
accurately predict how the competitive pressures that we face will affect our
business.
Our Business Is Dependent on the Internet and the Development of the Internet
Infrastructure.
The commercial market for products designed for the Internet has only
recently begun to develop. Our 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 remain
unresolved and are likely to affect the development of the market for our
products. These issues include security, reliability, cost, ease of access and
Quality of Service. 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, we depend 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. This has required 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 our
products. Potentially increased performance provided by our products and the
products of others ultimately is limited by and reliant upon the speed and
reliability of the Internet backbone itself. Consequently, the emergence and
growth of the market for our products will depend on improvements being made to
the entire Internet infrastructure to alleviate overloading and congestion.
Our Failure to Manage Growth Could Adversely Affect Us.
The growth of our business has placed, and is expected to continue to place,
a significant strain on our limited personnel, management and other resources.
Our management, personnel, systems, procedures and controls may be inadequate
to support our existing and future operations. To manage any future growth
effectively, we will need to attract, train, motivate, manage and retain
employees successfully, to integrate new employees into our overall operations
and to continue to improve our operational, financial and management systems.
We have hired some key employees and officers only recently, including our
Chief Financial Officer and Vice President, Manufacturing Operations. As a
result, some members of our management team have worked together for a brief
time.
We Are Dependent on Key Personnel.
Due to the specialized nature of our business, we are highly dependent on the
continued service of, and on the ability to attract and retain qualified
engineering, sales, marketing and senior management
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personnel. The competition for this personnel is intense. The loss of any of
these persons, particularly our Chairman, President and Chief Technical
Officer, Shlomo Rakib, and our Chief Executive Officer, Zaki Rakib, would have
a material adverse effect on our business and operating results. In addition,
if we are unable to hire additional qualified personnel as needed, we may not
be able to adequately manage and complete our existing sales commitments and to
bid for and execute additional sales. Further, we must train and manage our
growing employee base, which is likely to require increased levels of
responsibility for both existing and new management personnel. Our current
management personnel and systems may be inadequate, and we may fail to
assimilate new employees successfully. Highly skilled employees with the
education and training that we require, especially employees with significant
experience and expertise in both data networking and radio frequency design,
are in high demand. We may not be able to continue to attract and retain the
qualified personnel necessary for the development of our business. We do not
have "key person" insurance coverage for the loss of any of our employees. Any
officer or employee of our company can terminate his or her relationship with
us at any time. None of our employees are bound by any noncompetition
agreements with us.
Our Business Is Subject to the Risks of Product Returns, Product Liability and
Product Defects.
Products as complex as ours frequently contain undetected errors or failures,
especially when first introduced or when new versions are released. Despite
testing, errors may occur. The occurrence of errors could result in product
returns and other losses to our company or our customers. This occurrence also
could result in the loss of or delay in market acceptance of our products. Due
to the recent introduction of our products, we have limited experience with the
problems that could arise with this generation of products. Our purchase
agreements with our customers typically contain provisions designed to limit
our exposure to potential product liability claims. However, the limitation of
liability provision contained in our 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. We have not
experienced any product liability claims to date, but the sale and support of
our products entails the risk of such claims. In addition, any failure by our
products to properly perform could result in claims against us by our
customers. We maintain insurance to protect against certain claims associated
with the use of our products, but our insurance coverage may not adequately
cover any claim asserted against us. In addition, even claims that ultimately
are unsuccessful could result in our expenditure of funds in litigation and
management time and resources.
We May Not Be Able to Adequately Protect or Enforce Our Intellectual Property
Rights.
We rely on a combination of patent, trade secret, copyright and trademark
laws and contractual restrictions to establish and protect proprietary rights
in our products. Our pending patent applications may not be granted. Even if
they are granted, the claims covered by the patents may be reduced from those
included in our applications. Any patent might be subject to challenge in court
and, whether or not challenged, might not be broad enough to prevent third
parties from developing equivalent technologies or products. We have entered
into confidentiality and invention assignment agreements with our employees,
and we enter into non-disclosure agreements with some of our suppliers,
distributors and appropriate customers so as to limit access to and disclosure
of our proprietary information. These statutory and contractual arrangements
may not prove sufficient to prevent misappropriation of our technology or to
deter independent third-party development of similar technologies. In addition,
the laws of some foreign countries might not protect our products or
intellectual property rights to the same extent as do the laws of the United
States. Protection of our intellectual property might not be available in every
country in which our products might be manufactured, marketed or sold.
Upon the completion and acceptance of the DOCSIS 1.2 cable modem
specification that we co-author, we would contribute some aspects of our S-CDMA
technology to the DOCSIS 1.2 intellectual property pool. We would contribute
our technology pursuant to a proposed license agreement between
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us and CableLabs that we would execute at that time. Under the terms of the
proposed license agreement, we would grant to CableLabs a license for some
aspects of our S-CDMA technology that are essential for compliance with the
DOCSIS 1.2 cable modem standard. This license would allow CableLabs to utilize
and incorporate the licensed technology for the limited use of making and
selling products or systems that comply with the DOCSIS 1.2 cable modem
specification. As a party to the license agreement, we would have access to the
DOCSIS 1.2 intellectual property pool and would have the right to develop
products that comply with the DOCSIS 1.2 cable modem specification. As a
result, any of our competitors who join the DOCSIS intellectual property pool
will have access to some aspects of our technology and will not be required to
pay us any royalties or other compensation. Further, some of our competitors
have been successful in reverse engineering the technology of other companies,
and our contribution to the DOCSIS 1.2 intellectual property pool would expose
some aspects of our technology to those competitors. If a competitor is able to
duplicate the functionality and capabilities of our technology, we could lose
all or some of the time-to-market advantage we might otherwise have. Under the
terms of the proposed license agreement, if we sue certain parties to the
proposed license agreement on claims of infringement of any copyright or patent
right or misappropriation of any trade secret, those parties may terminate our
license to the patents or copyrights they contributed to the DOCSIS 1.2
intellectual property pool. If such termination were to occur, we would
continue to have access to certain aspects of the DOCSIS 1.2 intellectual
property pool, but we would not be able to develop products that fully comply
with the DOCSIS 1.2 cable modem specification. Therefore, we may find it
difficult to enforce our intellectual property rights against certain
companies. CableLabs may sublicense the DOCSIS 1.2 intellectual property pool
if the sublicensee complies with certain conditions. The sublicensee's rights
to some of the DOCSIS 1.2 intellectual property pool could be terminated if it
sues certain companies for infringement of any copyright, patent right or trade
secret.
We expect that developers of cable modems increasingly will be subject to
infringement claims as the number of products and competitors in our industry
segment grows. We have received letters from two individuals claiming that our
technology infringes patents held by these individuals. We have reviewed the
allegations made by these individuals and, after consulting with our patent
counsel, we do not believe that our technology infringes any valid claim of
these individuals' patents. If the issues are submitted to a court, the court
could find that our products infringe these patents. In addition, these
individuals may continue to assert infringement. If we are found to have
infringed these individuals' patents, we could be subject to substantial
damages and/or an injunction preventing us from conducting our business. In
addition, other third parties may assert infringement claims against us in the
future. An infringement claim, whether meritorious or not, could be time-
consuming, result in costly litigation, cause product shipment delays or
require us to enter into royalty or licensing agreements. These royalty or
licensing agreements may not be available on terms acceptable to us or at all,
which could have a material adverse effect upon our business, operating results
and financial condition. Litigation also may be necessary to enforce our
intellectual property rights.
Our Business Is Subject to Communications Industry Regulations.
Our business and our customers are subject to varying degrees of federal,
state and local regulation. The jurisdiction of the Federal Communications
Commission extends to the communications industry, including our broadband
access products. 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 our operations to date, future regulations applicable to our
business or our customers could be adopted by the FCC or other regulatory
bodies. For example, FCC regulatory policies affecting the availability of
cable services and other terms on which cable companies conduct their business
may impede our 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. In addition, the increasing demand for
communications systems has exerted pressure on regulatory bodies worldwide to
adopt new standards for such products and
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services. This process generally involves 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 our customers.
If other countries begin to regulate the cable modem industry more heavily or
introduce standards or specifications with which our products do not comply, we
will be unable to offer products in those countries until our products comply
with those standards or specifications. In addition, we may have to incur
substantial costs to comply with those standards or specifications. For
instance, should the DAVIC standards for ATM-based digital video be established
internationally, we will need to conform our cable modems to compete. Further,
many countries do not have regulations for installation of cable modem systems
or for upgrading existing cable network systems to accommodate our products.
Whether we currently operate in such a country or enter into the market in a
country where no such regulations exist, new regulations could be proposed at
any time. The imposition of regulations like this could place limitations on
the country's cable operators' ability to upgrade to support our products.
Cable operators in these countries may not be able to comply with these
regulations, and compliance with these regulations may require a long, costly
process. For example, we experienced delays in product shipments to a customer
in Brazil due to delays in certain regulatory approvals in Brazil. Similar
delays could occur in other countries in which we market or plan to market our
products. In addition, our customers in certain parts of Asia, such as Japan,
are required to obtain licenses prior to selling our products, and delays in
obtaining such licenses could have an adverse impact on our ability to sell
products to these customers.
Our Business Is Subject to Other Regulatory Approvals and Certifications.
In the United States, in addition to complying with FCC regulations, our
products are required to meet certain safety requirements. For example, we are
required to have our products certified by Underwriters Laboratory in order to
meet federal requirements relating to electrical appliances to be used inside
the home. Outside the United States, our products are subject to the regulatory
requirements of each country in which the products are manufactured or sold.
These requirements are likely to vary widely. We may not be able to obtain on a
timely basis or at all the regulatory approvals that may be required for the
manufacture, marketing and sale of our products. In addition to regulatory
compliance, some cable industry participants may require certification of
compatibility.
Our Business Could Be Adversely Impacted by Year 2000 Compliance Issues.
The Year 2000 issue is the result of computer programs written using two
digits rather than four to define the applicable year. Computer programs that
have this date-sensitive software may recognize a date using "00" as the year
1900 rather than the year 2000. This could result in a system failure or
miscalculations causing disruptions of operations, including, among other
things, a temporary inability to process transactions, send invoices or engage
in similar normal business activities.
We are heavily dependent upon the proper functioning of our own computer or
data-dependent systems. This includes, but is not limited to, our systems in
information, business, finance, operations, manufacturing and service. Any
failure or malfunctioning on the part of these or other systems could adversely
affect our business in ways that are not currently known, discernable,
quantifiable or otherwise anticipated by us.
In 1998, we formed an internal task force to evaluate those areas of our
business that may be affected by the Year 2000 issue. The task force will
devise a plan for us to become Year 2000 compliant in a timely manner. Our plan
will include independent validation of our Year 2000 assessment procedures,
initiating formal communications with all of our significant suppliers, large
customers and development partners to determine the extent to which we are
vulnerable to those third parties' failure
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to remedy their own Year 2000 issues. We also will develop contingency plans to
address situations that may result if we are unable to achieve Year 2000
readiness of our critical operations. We anticipate addressing the critical
Year 2000 issues by mid-1999, prior to any anticipated impacts on our operating
systems. We expect that we may address non-critical Year 2000 issues beyond the
Year 2000.
To date, we have not incurred incremental material costs associated with our
efforts to become Year 2000 compliant, as the majority of the costs have
occurred as a result of normal upgrade procedures. Furthermore, we believe that
future costs associated with our Year 2000 compliance efforts will not be
material.
We currently have only limited information on the Year 2000 compliance of key
suppliers and customers. The operations of our key suppliers and customers
could be adversely affected in the event they do not successfully and timely
achieve Year 2000 compliance. Our business and results of operations could
experience material adverse effects if our key suppliers were to experience
Year 2000 issues that caused them to delay manufacturing or shipment of key
components to us. In addition, our results of operations could be materially
adversely affected if any of our key customers encounter Year 2000 issues that
cause them to delay or cancel substantial purchase orders or delivery of our
product.
We may be unable to develop a plan to address the Year 2000 Issue in a timely
manner or to upgrade any or all of our major systems in accordance with our
plan. Even if we do make upgrades, they may not effectively address the Year
2000 issue. If required upgrades are not completed timely or are not
successful, we may be unable to conduct our business or manufacture our
products, which would have a material impact on our operations. The systems of
other companies on which our systems rely may not be timely converted. A
failure to convert by another company, or a conversion that is incompatible
with our systems would have a material adverse effect on our business. We
intend to, but have not yet established a contingency plan detailing actions
that will be taken in the event that the assessment of the Year 2000 issue is
not successfully completed on a timely basis.
We Are Controlled by Certain Stockholders and Management.
Upon completion of this offering, our executive officers, directors and
principal stockholders and their affiliates will own approximately 9,856,743
shares or 45.4% of the outstanding shares of common stock. As a result, they
may have the ability to effectively control our company and direct our affairs
and business, including the election of directors and approval of significant
corporate transactions. This concentration of ownership also may have the
effect of delaying, deferring or preventing a change in control of our company
and may make some transactions more difficult or impossible without the support
of these stockholders.
Management Will Have Broad Discretion Over the Proceeds of the Offering.
We currently have no specific plans for a significant portion of our net
proceeds from this offering. Consequently, our management will have the
discretion to allocate the net proceeds to uses that stockholders may not deem
desirable. We may not be able to yield a significant return on any investment
of the proceeds. Substantially all of our proceeds from the offering will be
invested in short-term, interest-bearing, investment grade securities
immediately following the offering.
Our Stock Price Has Been and May Continue to Be Volatile.
The trading price of our common stock has been and is likely to be highly
volatile. Our stock price could be subject to wide fluctuations in response to
a variety of factors, including the following:
. actual or anticipated variations in quarterly operating results;
. announcements of technological innovations;
. new products or services offered by us or our competitors;
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. changes in financial estimates by securities analysts;
. conditions or trends in the broadband access services industry;
. changes in the economic performance and/or market valuations of
Internet, online service or broadband access service industries;
. changes in the economic performance and/or market valuations of other
Internet, online service or broadband access service companies;
. our announcement of significant acquisitions, strategic partnerships,
joint ventures or capital commitments;
. additions or departures of key personnel;
. sales of common stock; and
. other events or factors that may be beyond our control.
In addition, the stock markets in general, and the Nasdaq National Market and
the market for broadband access services and technology companies in
particular, have experienced extreme price and volume fluctuations recently.
These fluctuations often have been unrelated or disproportionate to the
operating performance of these companies. The trading prices of many technology
companies' stocks are at or near historical highs and these trading prices and
multiples are substantially above historical levels. These trading prices and
multiples may not be sustained. These broad market and industry factors may
materially adversely affect the market price of our common stock, regardless of
our actual operating performance. In the past, following periods of volatility
in the market price of a company's securities, securities class action
litigation often has been instituted against that company. Litigation like
this, if instituted, could result in substantial costs and a diversion of
management's attention and resources.
Some Anti-Takeover Provisions May Affect the Price of Our Common Stock.
The Board of Directors has the authority to issue up to 5,000,000 shares of
preferred stock and to determine the preferences, rights and privileges of
those shares without any further vote or action by the stockholders. The rights
of the holders of common stock may be adversely affected by the rights of the
holders of any preferred stock that may be issued in the future. Some
provisions of our certificate of incorporation and bylaws could have the effect
of making it more difficult for a third party to acquire a majority of the
outstanding voting stock of the Company. These include provisions that provide
for a classified Board of Directors, prohibit stockholders from taking action
by written consent and restrict the ability of stockholders to call special
meetings.
A Significant Number of Shares Are Eligible for Sale and Their Sale Could
Depress Our Stock Price.
Sales of substantial amounts of our common stock (including shares issued
upon the exercise of outstanding options) in the public market after this
offering could adversely affect the market price of our common stock. These
sales also might make it more difficult for us to sell equity or equity-related
securities in the future at a time and price that we deem appropriate. Upon
completion of this offering, we will have outstanding 18,208,121 shares of
common stock (based upon shares outstanding as of December 31, 1998), assuming
no exercise of the Underwriters' over-allotment option and no exercise of
outstanding options after December 31, 1998. Of these shares, the 3,250,000
shares sold in this offering, together with the 3,000,000 shares sold in our
initial public offering in August 1998, are freely tradable. Of the remaining
11,958,121 shares, the following 10,812,244 shares are eligible for sale in the
public market as follows:
<TABLE>
<CAPTION>
Number of Shares Date
---------------- ----------------------------------------
<C> <S>
456,247 January 21, 1999
462,820 February 14, 1999
9,893,177 91 days from the date of this prospectus
</TABLE>
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<PAGE>
We May Need to Raise Additional Capital.
We believe that the proceeds of this offering, together with our existing
capital resources, will be sufficient to meet our capital requirements for at
least the next 24 months. We expect to use our proceeds from this offering
primarily for research and development and to expand sales and marketing
activities. Our capital requirements depend on several factors, including the
rate of market acceptance of our products, the ability to expand our client
base and the growth of sales and marketing. If our capital requirements are
materially different from those currently planned, we may require additional
financing sooner than anticipated. If additional funds are raised through the
issuance of equity securities, the percentage ownership of our stockholders
will be reduced and such securities may have rights, preferences or privileges
senior to those of our common stock. Additional financing may not be available
on favorable terms or at all. If adequate funds are not available or are not
available on acceptable terms, we may be unable to develop or enhance our
products and services, take advantage of future opportunities or respond to
competitive pressures.
You Will Experience Immediate and Substantial Dilution in the Net Tangible Book
Value of the Stock You Purchase.
The assumed public offering price is substantially higher than the book value
per share of common stock. Purchasers of our common stock will incur immediate,
substantial dilution of $33.03 per share in the net tangible book value of our
common stock from the public offering price. Additional dilution will occur
upon the exercise of outstanding options and warrants.
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; the inclusion of the
Company's S-CDMA technology in the DOCSIS 1.2 standard; the adoption of DOCSIS
1.2 as an industry standard; demand for broadband access services; the ability
of the Company to achieve cost reductions; the compliance of future products
with various industry standards, including DOCSIS 1.2; 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 1,750,000 shares of
Common Stock offered by the Company, at the public offering price of $38.00 per
share, are estimated to be approximately $62,475,000, 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 capital expenditures and research and
development. 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. The Company will
not receive proceeds from the sale of the common stock sold by the selling
stockholders. See "Principal and Selling Stockholders."
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.
PRICE RANGE OF COMMON STOCK
The Company's Common Stock is traded on the Nasdaq National Market under the
Symbol "TERN." Public trading of the Common Stock commenced on August 18, 1998.
Prior to that, there was no public market for the Common Stock. The following
table sets forth, for the periods indicated, the high and low per share sale
prices of the Common Stock, as reported by the Nasdaq National Market.
<TABLE>
<CAPTION>
1998 High Low
<S> <C> <C>
Third Quarter (from August 18, 1998)........................ $15.186 $7.000
Fourth Quarter.............................................. $40.500 $9.250
<CAPTION>
1999
<S> <C> <C>
First Quarter (through January 21, 1999).................... $50.125 $36.875
</TABLE>
On January 21, 1999, the last reported sale price for the Common Stock, as
reported by the Nasdaq National Market, was $42.25. As of December 31, 1998,
the Company had 130 holders of record of the Common Stock.
22
<PAGE>
CAPITALIZATION
The following table sets forth the capitalization of the Company as of
December 31, 1998, (i) on an actual basis and (ii) as adjusted to reflect the
sale of 1,750,000 shares of Common Stock offered by the Company at the public
offering price of $38.00 per share and the receipt of the estimated net
proceeds therefrom.
<TABLE>
<CAPTION>
December 31, 1998
---------------------
Actual As Adjusted
-------- -----------
(in thousands)
<S> <C> <C>
Current portion of long-term debt........................ $ 29 $ 29
======== ========
Long-term debt, less current portion..................... $ 10 $ 10
Stockholders' equity (1):
Preferred Stock, $.001 par value; 5,000,000 shares
authorized actual and as adjusted; no shares issued and
outstanding actual and as adjusted..................... -- --
Common Stock, $.001 par value; 30,000,000 shares
authorized actual and as adjusted; 16,458,121 shares
issued and outstanding actual; 18,208,121 shares issued
and outstanding as adjusted............................ 16 18
Additional paid in capital............................... 114,594 177,067
Accumulated deficit...................................... (84,301) (84,301)
Deferred compensation.................................... (2,184) (2,184)
Stockholders' notes receivable........................... (22) (22)
-------- --------
Total stockholders' equity............................. 28,103 90,578
-------- --------
Total capitalization................................... $ 28,113 $ 90,588
======== ========
</TABLE>
- --------
(1) Excludes (i) approximately 2,691,234 shares issuable upon exercise of
options outstanding at a weighted average exercise price of $4.54 per
share, (ii) 3,019,191 shares issuable upon exercise of outstanding
warrants with a weighted average exercise price of $6.46 per share and
(iii) approximately 2,771,607 shares reserved under the Company's employee
benefit plans. See "Management--Employee Benefit Plans" and Note 10 of
Notes to Consolidated Financial Statements.
23
<PAGE>
DILUTION
The net tangible book value of the Company at December 31, 1998 was
approximately $28,103,000 or $1.71 per share. 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 sale by the Company of the 1,750,000 shares of Common
Stock offered hereby at the public offering price of $38.00 per share, after
deducting underwriting discounts and commissions and estimated offering
expenses, the net tangible book value of the Company as of December 31, 1998
would have been $90,578,000 or $4.97 per share. This represents an immediate
increase in net tangible book value of $3.26 per share to existing stockholders
and an immediate dilution in net tangible book value of $33.03 per share to new
investors purchasing shares at the public offering price. The following table
illustrates this per share dilution:
<TABLE>
<S> <C> <C>
Public offering price per share.............................. $38.00
------
Net tangible book value per share as of December 31, 1998.. $1.71
Increase per share attributable to this offering........... 3.26
-----
Net tangible book value per share after offering............. 4.97
------
Dilution per share to new investors.......................... $33.03
======
</TABLE>
The following table sets forth, as of December 31, 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 the public offering price of $38.00
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... 16,458,121 90.4% $ 92,651,000 58.2% $ 5.63
New investors........... 1,750,000 9.6 66,500,000 41.8 38.00
------------ ------- ------------ -----
Total................. 18,208,121 100.0% $159,151,000 100.0%
============ ======= ============ =====
</TABLE>
- --------
(1) The foregoing computations assume no exercise of outstanding stock options.
As of December 31, 1998, options were outstanding to purchase 2,691,234
shares at a weighted average exercise price of $4.54 per share and warrants
were outstanding to purchase 3,019,191 shares at a weighted average
exercise price of $6.46 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 10 of Notes to
Consolidated Financial Statements.
24
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The consolidated statement of operations data for the years ended December
31, 1996, 1997 and 1998 and the consolidated balance sheet data as of December
31, 1997 and 1998, 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 years ended December 31, 1994 and 1995 and the
consolidated balance sheet data as of December 31, 1994, 1995 and 1996 have
been derived from the audited consolidated financial statements of the Company
not included herein. 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>
Years Ended December 31,
-----------------------------------------------
1994 1995 1996 1997 1998
-------- ------- -------- -------- --------
(in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Consolidated Statement of
Operations Data:
Revenues.................. $ 140 $ -- $ -- $ 2,118 $ 31,696
Cost of goods sold........ -- 676 -- 6,462 34,518
-------- ------- -------- -------- --------
Gross profit (loss)....... 140 (676) -- (4,344) (2,822)
-------- ------- -------- -------- --------
Operating expenses:
Research and
development............. 235 2,028 8,020 11,319 10,685
Sales and marketing...... 17 205 1,141 4,468 6,947
General and
administrative.......... 84 825 1,789 2,546 3,223
-------- ------- -------- -------- --------
Total operating
expenses................ 336 3,058 10,950 18,333 20,855
-------- ------- -------- -------- --------
Loss from operations...... (196) (3,734) (10,950) (22,677) (23,677)
Net interest income....... -- 68 253 128 449
-------- ------- -------- -------- --------
Net loss.................. (196) (3,666) (10,697) (22,549) (23,228)
Series F convertible
preferred stock
dividend(1).............. -- -- -- -- (23,910)
-------- ------- -------- -------- --------
Net loss applicable to
common stockholders...... $ (196) $(3,666) $(10,697) $(22,549) $(47,138)
======== ======= ======== ======== ========
Historical basic and
diluted net loss per
share applicable to
common stockholders(2)... $ (0.10) $ (1.02) $ (2.64) $ (5.26) $ (5.25)
======== ======= ======== ======== ========
Shares used in computing
historical basic and
diluted net loss per
share applicable to
common stockholders(2)... 2,000 3,589 4,054 4,289 8,986
======== ======= ======== ======== ========
Pro forma basic and
diluted net loss per
share applicable to
common stockholders(2)... $ (2.07) $ (3.41)
======== ========
Shares used in pro forma
basic and diluted net
loss per share applicable
to common
stockholders(2).......... 10,873 13,804
======== ========
</TABLE>
<TABLE>
<CAPTION>
December 31,
------------------------------------------------
1994 1995 1996 1997 1998
-------- -------- -------- -------- --------
(in thousands)
<S> <C> <C> <C> <C> <C>
Consolidated Balance
Sheet Data:
Cash, cash equivalents
and short-term
investments............ $ 27 $ 8,620 $ 12,864 $ 1,987 $ 28,880
Working capital
(deficit).............. (492) 6,934 9,971 (4,847) 24,422
Total assets............ 435 10,202 15,978 8,778 42,146
Long-term debt (less
current portion)....... 98 439 1,255 44 10
Accumulated deficit..... (251) (3,917) (14,614) (37,163) (84,301)
Total stockholders'
equity (net capital
deficiency)............ $ (201) $ 7,955 $ 11,405 $ (1,174) $ 28,103
</TABLE>
- -------
(1) See Note 10 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 $31.7 million
in the year ended December 31, 1998. The Company generally recognizes product
revenues upon shipment of products to customers. While the Company's existing
agreements do not contain price protection provisions and certain return
rights, future agreements may 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
1998, sales to Shaw, Cablevision and Sumitomo represented approximately 40%,
16% and 14%, 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--We Are Dependent on a Small Number of Customers," "--We May Be
Unable to Market Effectively to Cable Operators" and "--We Are Dependent on
the Cable Industry to Upgrade to Two-Way Cable Infrastructure."
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 had negative gross margins from inception until the fourth quarter of
1998. The Company achieved a positive gross margin for the first time in the
quarter ended December 31, 1998. 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
26
<PAGE>
TeraLink 1000 Master Controllers, TeraLink Gateways and TeraPro cable modems,
as the TeraPro modems have significantly lower margins than the 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 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--Average Selling Prices of Cable Equipment
Typically Decrease," "--We Must Achieve Cost Reductions," "--Cable Modems Have
Not Achieved Widespread Market Acceptance and Many Competing Technologies
Exist," "--We Have Limited Manufacturing Experience and We Are Dependent on
Contract Manufacturers" and "--Our Industry is Highly Competitive with Many
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 California, Inc. ("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--We Have Limited Manufacturing Experience
and We Are Dependent on Contract Manufacturers."
The Company sustained net losses applicable to common stockholders of
$10.7 million, $22.5 million and $47.1 million for the years ended December 31,
1996, 1997 and 1998, respectively. As a result, the Company had an accumulated
deficit of $84.3 million as of December 31, 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. Operating results 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 $15.0 million on
research and development during the 12 months ended December 31, 1999.
Anticipated capital expenditures consist of purchases of additional test
equipment to support higher levels of production and computer hardware,
software and
27
<PAGE>
equipment for newly hired employees. The Company intends to use the proceeds
from this offering to fund such requirements. 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--We Have a
Limited Operating History and a History of Losses," "--Our Operating Results
May Fluctuate" and "--The Sales Cycle for Our Products is Lengthy."
Results of Operations
Years Ended December 31, 1997 and 1998
Revenues. The Company's revenues increased from $2.1 million in 1997 to
$31.7 million in 1998. Revenues consist primarily of sales of cable modems and
headend equipment to new and existing customers. The Company did not commence
selling its products until June 1997 and did not commence selling its products
in volume until the first quarter of 1998.
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. In 1997, the Company incurred
$6.5 million in cost of goods sold, which included the cost of the
manufacturing group for the entire period as it readied the Company's products
for commercialization, compared to $34.5 million in 1998, which included the
costs of the manufacturing group and a charge of $1.3 million relating to the
write-off of obsolete inventory and the transition of manufacturing operations
to Solectron.
Gross Loss. The Company incurred a gross loss of $4.3 million in 1997 due to
costs associated with the Company's manufacturing operations group. The
Company incurred a gross loss of $2.8 million in 1998. The decrease in gross
loss compared to 1997 was primarily due to a reduced negative margin on cable
modems, which was partially offset by a charge of $1.3 million relating to the
write-off of obsolete inventory and the transition of manufacturing operations
to Solectron.
The Company completed the transition to a lower cost single-board modem
product in the fourth quarter of 1998. Primarily as a result of this lower
cost product, the Company achieved a positive gross margin of $425,000 in the
fourth quarter of 1998. The Company anticipates that decreases in the average
sales price of its cable modems will partially, if not completely, offset the
benefits obtained from the cost-reduced modem, particularly if the Company is
unable to reduce further the cost of its modems to sufficiently offset
declines in the average selling prices of such modems.
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 $11.3 million in 1997 to $10.7 million in
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 and commissions for sales, marketing and support personnel, and costs
related to tradeshows, consulting and travel. Sales and marketing expenses
increased from $4.5 million in 1997 to $6.9 million in 1998, primarily due to
increased payroll costs related to additional sales and support personnel for
commercial trials and deployment of the Company's products and increased
commissions related to higher sales in 1998. The Company expects sales and
marketing expenses to continue to increase as the Company expands its customer
base.
28
<PAGE>
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 $2.5 million in 1997 to $3.2 million in
1998. The increase was primarily 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. The Company
expects that general and administrative expenses will continue to increase in
the near term as a result of these factors.
Net Interest Income. Net interest income was $128,000 in 1997 compared to
$449,000 in 1998. The increase was primarily the result of higher average cash
balances subsequent to the Company's initial public offering in August 1998.
Series F Convertible Preferred Stock Dividend. The Company recorded a
dividend of $23.9 million in 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, 1996 and 1997
Revenues. The Company did not recognize any revenues from product sales in
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. 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 Loss. 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
$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.
29
<PAGE>
Sales and Marketing. Sales and marketing 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 $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. 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 in 1997.
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 eight quarters
ended December 31, 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, Sept. 30, Dec. 31,
1997 1997 1997 1997 1998 1998 1998 1998
--------- -------- --------- -------- --------- -------- --------- --------
(in thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Revenues................ $ -- $ 93 $ 662 $ 1,363 $ 2,444 $ 6,932 $ 9,400 $12,920
Cost of goods sold...... 178 304 1,761 4,219 4,134 7,383 10,506 12,495
------- ------- ------- ------- ------- -------- ------- -------
Gross profit (loss)... (178) (211) (1,099) (2,856) (1,690) (451) (1,106) 425
------- ------- ------- ------- ------- -------- ------- -------
Operating expenses:
Research and
development.......... 2,580 3,306 2,695 2,738 2,305 2,618 2,779 2,983
Sales and marketing... 529 994 1,192 1,753 1,140 1,829 1,846 2,132
General and
administrative....... 461 644 610 831 505 777 813 1,128
------- ------- ------- ------- ------- -------- ------- -------
Total operating
expenses............ 3,570 4,944 4,497 5,322 3,950 5,224 5,438 6,243
------- ------- ------- ------- ------- -------- ------- -------
Loss from operations.... (3,748) (5,155) (5,596) (8,178) (5,640) (5,675) (6,544) (5,818)
Net interest income
(expense).............. 91 32 7 (2) (64) 32 58 423
------- ------- ------- ------- ------- -------- ------- -------
Net loss................ (3,657) (5,123) (5,589) (8,180) (5,704) (5,643) (6,486) (5,395)
Series F convertible
preferred stock
dividend............... -- -- -- -- -- (23,910) -- --
------- ------- ------- ------- ------- -------- ------- -------
Net loss applicable to
common stockholders.... $(3,657) $(5,123) $(5,589) $(8,180) $(5,704) $(29,553) $(6,486) $(5,395)
======= ======= ======= ======= ======= ======== ======= =======
</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 experienced significant negative gross margins 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
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<PAGE>
$480,000 of product development revenues related to the Company's development
of a telephony module for a telecommunications system manufacturer. Gross
margins fluctuated in the first three quarters of 1998 as a result of changes
in the volume of sales in a particular quarter, changes in unit manufacturing
costs and pricing arrangements with customers. Gross margin improved in the
fourth quarter of 1998 due largely to the introduction of the lower cost
single-board modem. Operating expenses varied from quarter to quarter in the
five quarters ended December 31, 1998, due to the timing of research and
development projects, significant trade shows in the fourth quarter of 1997 and
the second quarter of 1998, increased infrastructure to support the Company's
expanded activities and costs associated with being a public company. 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--Our Operating Results May Fluctuate."
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 1998 have been
established to reflect these uncertainties.
At December 31, 1998, the Company had federal and state net operating loss
carryforwards of $50.6 million and $21.0 million, respectively, and federal and
state tax credit carryforwards of $1.2 million and $733,000, respectively, that
will expire at various dates beginning in 1999 through 2018, 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 1998, the Company had
recorded deferred compensation of $2.6 million as of December 31, 1998. The
Company amortized approximately $12,000 of the deferred compensation in 1997
and $421,000 in 1998. The remainder will be amortized over the related vesting
period of the stock options. See Note 10 of Notes to Consolidated Financial
Statements.
31
<PAGE>
Liquidity and Capital Resources
Since its inception through December 31, 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, and an initial public
offering of 3,000,000 shares of common stock at a price of $13.00 per share,
which was completed in August 1998. The net proceeds from the offering were
approximately $35.1 million.
The Company has used cash in operating activities of $50.6 million since its
inception through December 31, 1998. Cash used in operating activities in 1996,
1997 and 1998 was $9.4 million, $20.8 million and $18.1 million, respectively.
In 1996 and the 1998, cash used in investing activities was $6.5 million and
$16.1 million, respectively. Investment activities in 1996 and 1998 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. Cash provided by financing activities in 1996, 1997 and 1998
was $15.6 million, $12.6 million and $47.0 million, respectively. Cash provided
by financing activities consisted primarily of proceeds from private sales of
preferred stock in 1996, 1997 and 1998 and proceeds from the Company's initial
public offering of common stock in 1998.
At December 31, 1998, the Company had approximately $14.3 million in cash and
cash equivalents, $14.5 million in short-term investments and a $10.0 million
revolving line of credit. There were no outstanding borrowings under the line
of credit and approximately $3.0 million was available at December 31, 1998.
The Company's cash equivalents and short-term investments are subject to
market risk, primarily interest rate and credit risk. The Company's investments
are managed by outside professional managers within guidelines established by
the Company. The guidelines, which include security type, credit quality and
maturity, are intended to limit market risk by restricting the Company's
investments to high quality debt instruments with short-term maturities. Due to
the relatively short-term duration of the Company's investments at December 31,
1998, a 1% (100 basis point) increase in short-term interest rates would not
have a significant impact on the market value of the Company's investments. The
Company's investment in debt securities are classified as available-for-sale;
therefore, no gains or losses are recognized by the Company due to changes in
interest rates unless such securities are sold prior to maturity. The Company
generally holds securities until maturity and carries the securities at
amortized cost, which approximates market value.
As of December 31, 1998, the Company had approximately $10.3 million of
unconditional purchase obligations. The Company anticipates that it will pay
these obligations by May 1999. 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 24 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--We May Need to Raise Additional Capital."
Year 2000
The Year 2000 issue is the result of computer programs written using two
digits rather than four to define the applicable year (the "Year 2000 Issue").
Computer programs that have such date-sensitive software may recognize a date
using "00" as the year 1900 rather than the year 2000. This could result
32
<PAGE>
in a system failure or miscalculations causing disruptions of operations,
including, among other things, a temporary inability to process transactions,
send invoices or engage in similar normal business activities.
The Company is heavily dependent upon the proper functioning of its own
computer or data-dependent systems. This includes, but is not limited to, its
systems in information, business, finance, operations, manufacturing and
service. Any failure or malfunctioning on the part of these or other systems
could adversely affect the Company in ways that are not currently known,
discernible, quantifiable or otherwise anticipated by the Company.
In 1998, the Company formed an internal task force to evaluate those areas of
the Company that may be affected by the Year 2000 Issue. The task force will
devise a plan for the Company to become Year 2000 compliant in a timely manner
(the "Plan"). The Plan will include independent validation of the Company's
Year 2000 assessment procedures, initiating formal communications with all of
its significant suppliers, large customers and development partners to
determine the extent to which the Company is vulnerable to those third parties'
failure to remedy their own Year 2000 issues and the development of contingency
plans to address situations that may result if the Company is unable to achieve
Year 2000 readiness of its critical operations. The Company anticipates
addressing the critical Year 2000 issues by mid-1999, prior to any anticipated
impacts on its operating systems. The Company expects that it may address non-
critical Year 2000 issues beyond the Year 2000.
To date, the Company has not incurred significant costs associated with its
efforts to become Year 2000 compliant, as the majority of the costs have
occurred as a result of normal upgrade procedures. Furthermore, the Company
believes that future costs associated with its Year 2000 compliance efforts
will not be material.
The Company currently has only limited information on the Year 2000
compliance of its key suppliers and customers. The operations of the Company's
key suppliers and customers could be adversely affected in the event they do
not successfully and timely achieve Year 2000 compliance. The Company's
business and results of operations could experience material adverse effects if
its key suppliers were to experience Year 2000 issues that caused them to delay
manufacturing or shipment of key components to the Company. In addition, the
Company's results of operations could be materially adversely affected if any
of the Company's key customers encounter Year 2000 issues that cause them to
delay or cancel substantial purchase orders or delivery of the Company's
product.
There can be no assurance that the Company will be able to develop a plan to
address the Year 2000 Issue in a timely manner or to upgrade any or all of its
major systems in accordance with such plan. In addition, there can be no
assurance that any such upgrades will effectively address the Year 2000 Issue.
If required upgrades are not completed timely or are not successful, the
Company may be unable to conduct its business or manufacture its products,
which would have a material impact on the operations of the Company.
Furthermore, there can be no guarantee that the systems of other companies on
which the Company's systems rely will be timely converted, or that a failure to
convert by another company, or a conversion that is incompatible with the
Company's systems, would not have a material adverse effect on the Company. The
Company intends to, but has not yet established a contingency plan detailing
actions that will be taken in the event that the assessment of the Year 2000
Issue is not successfully completed on a timely basis.
Recent Financial Accounting Pronouncement
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" ("FAS 133"). FAS 133 provides a comprehensive and
consistent standard for the recognition and measurement of derivatives and
hedging activities. FAS 133 is effective for fiscal years beginning after June
15, 1999 and the Company believes that the adoption of FAS 133 will not have a
significant impact on the Company's operating results or cash flows.
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 enable cable operators
to maximize the capacity and reliability of broadband access services over any
cable plant. This allows 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 technology 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. In November 1998, Terayon was selected by CableLabs to co-author an
enhanced version of the DOCSIS cable modem specification based in part on the
Company's S-CDMA technology. 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 other 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 potential 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 there will be over
500,000 North American homes with data-over-cable services at the end of 1998.
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 Challenges 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 at substantial cost. An upgrade to an HFC system includes
replacing a
35
<PAGE>
substantial portion 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 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 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.
Deploy industry standard technology. The Company believes that cable
operators strive to deploy cable modems based on technology that conforms to
industry standards. Because cable modems must be interoperable with the
headend controller equipment, the purchase of a headend that is based on
proprietary technology requires the purchase of cable modems for that headend
from the same supplier. Industry standard technology allows multiple suppliers
to offer similar products, enhancing competition and lowering equipment prices
for cable operators, simplifying the purchasing decision and reducing
interoperability problems.
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
maximize the capacity and reliability of broadband access services over any
cable plant. This allows cable operators to
36
<PAGE>
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 Terayon system provides important advantages for any cable plant. Under
any given noise condition, S-CDMA provides higher reliability and a higher
capacity upstream channel than can be provided by current TDMA technology. S-
CDMA's reliability and capacity advantages exist even in fully upgraded HFC
plants. These advantages are particularly important for providing advanced
services such as telephony. The Company's S-CDMA technology offers cable
operators the following advantages:
Minimize upfront 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 initial
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. S-
CDMA allows operators to more closely match their network upgrades with the
offering of additional revenue opportunities.
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 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 ability to
respond 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
37
<PAGE>
plants in a wide range of conditions, thus reducing ongoing 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.
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 provides services to a
majority of subscribers in a specific region and thus influences 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. are deploying the TeraComm system
commercially.
Advance industry standards. In November 1998, CableLabs selected the Company
to co-author an enhanced version of the DOCSIS cable modem specification based
in part on the Company's S-CDMA technology. This enhanced version of the DOCSIS
specification will be known as DOCSIS 1.2. In order to advance the
standardization of cable modem technology, the Company has agreed to contribute
some aspects of its S-CDMA technology to the DOCSIS intellectual property pool
upon completion and acceptance of a specification that includes the Company's
S-CDMA technology. The Company intends to develop future products that are
DOCSIS 1.2-compliant and is actively participating in the development of
additional industry standards.
Extend technology leadership and achieve rapid time to market. The Company
believes the inclusion of its S-CDMA technology in DOCSIS 1.2 would give it an
advantage over its competitors, who will have to adapt their products to be
DOCSIS 1.2-compliant. Terayon's team of engineers has extensive experience in
many areas of broadband access system design, including communication systems,
ASICs, data networking, radio frequency, software and hardware. The Company
intends to leverage its engineering capabilities to expand the features and
functionality of its S-CDMA technology. The Company will strive to use its
technical expertise to achieve a significant time-to-market advantage over
competing cable modem suppliers in offering advanced features, such as IP
telephony and videoconferencing. In addition, Terayon intends to apply S-CDMA
to additional applications such as wireless communications and LMDS.
Reduce manufacturing costs. A key component of Terayon's strategy is to
decrease the cost of manufacturing its products to improve its gross margins.
For example, the Company recently introduced a cable modem that uses a single-
board design, which has higher gross margins than its original dual-board cable
modem. The Company intends to engage in other cost-reduction efforts, including
the further integration of ASIC components, other design changes and the
potential use of a second contract manufacturer.
Provide superior customer service and support. Terayon 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.
38
<PAGE>
Increase presence in existing and new markets. Terayon believes that the
market for cable modem systems is global and it intends to increase its
presence in new and existing markets throughout North America, Europe, Asia
and Latin America. The Company currently sells its products in over 20
countries worldwide. In order to increase its market penetration and to
capitalize on new opportunities, Terayon plans to continue to expand its
sales, marketing and customer support capabilities through both direct sales
and marketing staff as well as relationships with distributors. The Company
believes that a physical presence in key customer locations provides an
important advantage in developing and maintaining new and existing customer
relationships.
Technology
Terayon's products are based on the Company's S-CDMA technology. S-CDMA,
like asynchronous 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. In
asynchronous 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 asynchronous CDMA.
S-CDMA technology 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 technology 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
technology 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
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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.
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.
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The following diagram illustrates the TeraComm system:
The TeraComm System
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. In October 1998, the
Company began volume shipments of its cable modems in a new single-board
design.
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.
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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
The Company currently is designing and developing a DOCSIS 1.2-compliant
system. In addition to a cable modem, this system will include a headend
controller, the Teralink 2000 Master Controller. These products are in the
early stages of development and the Company does not anticipate commercial
deployment of these products until 2000.
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 provides services to a majority of subscribers in a specific
region and thus influences 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. 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 55,000 cable modem users.
Shaw has selected Terayon to supply cable modem systems for Shaw's @Home
service deployments in various cities throughout Canada.
Sumitomo. The Company has a distribution agreement with Sumitomo under which
its subsidiary, Crossbeam Networks Corporation ("Crossbeam") is distributing
the TeraComm system to several of Japan's leading cable operators, including
Jupiter Communications, a joint venture between Sumitomo and TCI
International. 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.
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TCA. 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 certain
metropolitan areas in 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.
Three customers accounted for approximately 73% of the Company's revenues in
1997 and for approximately 70% of the Company's revenues in 1998. In 1997,
sales to Telegate, Sumitomo and NET Brasil represented approximately 30%, 29%
and 14%, respectively, of the Company's revenues. In 1998, sales to Shaw,
Cablevision and Sumitomo represented approximately 40%, 16% and 14%,
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 will be focused
on a small number of projects. See "Risk Factors--We Are Dependent on a Small
Number of Customers."
Research and Development
The Company believes that its future success will depend on 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, in October 1998, the Company introduced
a single-board modem, which provides cost savings over its original 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 DOCSIS-compliant 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 DOCSIS 1.2-
compliant system, which will include a cable modem and an accompanying headend
controller, the TeraLink 2000 Master Controller. These products are in the
early stages of development and the Company does not anticipate commercial
deployment of these products until 2000. See "Risk Factors--There Are Many
Risks Associated with Our Participation in Co-Authoring the DOCSIS-1.2
Specification," "--We Need to Develop New Products," "--We Must Achieve Cost
Reductions" and "We Must Keep Pace with Rapid Technological Change to Remain
Competitive."
As of December 31, 1998, the Company had 56 employees engaged in research
and development. The Company's total research and development expenses for
1996, 1997 and 1998 were $8.0 million, $11.3 million and $10.7 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 several 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
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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 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
December 31, 1998, the TSS organization consisted of 17 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. As part of its efforts to reduce
costs, the Company began volume shipments in October 1998 of its single-board
cable modem, which has higher gross margins than the Company's original dual-
board cable modem. The Company anticipates that it will need to reduce further
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--We
Must Achieve Cost Reductions" and "--We Have Limited Manufacturing Experience
and We Are Dependent on Contract Manufacturers."
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 Technology, Inc. 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.
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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 Cisco, Com21, Hayes, Hybrid, Matsushita,
Motorola, Nortel, Phasecom, RCA, Samsung, Scientific-Atlanta, Sony, 3Com,
Toshiba and Zenith and there are many other potential market entrants. In
addition, Com21, Hybrid, Motorola and Nortel 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 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 Cisco, Nortel
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 --Our Industry is
Highly Competitive with Many 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
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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 have an adverse impact on the Company's
operating results. See "Risk Factors -- Our Business is Subject to
Communications Industry Regulations."
In the United States, in addition to complying with FCC regulations, the
Company's products are required to meet certain safety requirements. For
example, the Company is 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 are
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 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 -- Our Business is Subject to Other Regulatory Approvals and
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 four issued patents and ten
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.
Upon the completion and acceptance of the DOCSIS 1.2 cable modem
specification co-authored by the Company, the Company would contribute some
aspects of its S-CDMA technology to the DOCSIS 1.2 intellectual property pool.
The Company's technology would be contributed pursuant to a proposed license
agreement between the Company and CableLabs (the "License Agreement") to be
executed at that time. Under the terms of the License Agreement, the Company
would grant to CableLabs a license for some aspects of its S-CDMA technology
(the "Licensed Technology"). This license would allow CableLabs to utilize and
incorporate the Licensed Technology only for the limited use of making and
selling products or systems that comply with the DOCSIS 1.2 cable modem
specification. As a party to
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the License Agreement, the Company would have access to the DOCSIS 1.2
intellectual property pool and would have the right to develop products that
comply with the DOCSIS 1.2 cable modem specification.
CableLabs would have the right to sublicense the DOCSIS 1.2 intellectual
property on a royalty-free non-exclusive basis to other companies for the sole
purpose of allowing them to build products that are certified to be fully
compliant with DOCSIS 1.2 or its successor specifications. This sublicense
generally would be granted to any company that requested it, unless that
company were involved in an intellectual property dispute with another company
that was already a DOCSIS sublicensee.
Under the terms of the License Agreement, if the Company sues certain parties
to the License Agreement on claims of infringement of any copyright or patent
right or misappropriation of any trade secret, those parties may terminate the
Company's license to the patents or copyrights they contributed to the DOCSIS
1.2 intellectual property pool. If such termination were to occur, the Company
would continue to have access to certain aspects of the DOCSIS 1.2 intellectual
property pool, but it would not be able to develop products that fully comply
with the DOCSIS 1.2 cable modem specification. Therefore, the Company may find
it difficult to enforce its intellectual property rights against certain
companies.
CableLabs may sublicense the DOCSIS 1.2 intellectual property pool if the
sublicensee complies with certain conditions. Such sublicensee's rights to
certain of the DOCSIS 1.2 intellectual property may be terminated if it sues
certain companies on claims of infringement of any copyright, patent right or
trade secret.
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 letters from two
individuals claiming that the Company's technology infringes patents held by
such individuals. The Company has reviewed the allegations made by such
individuals and, after consulting with its patent counsel, does not believe
that the Company's technology infringes any valid claim of such individuals'
patents. 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
patents, nor that the individuals will not continue to assert infringement. If
the Company is found to have infringed such individuals' 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 by the Company could have a
material adverse effect on the Company's business, operating results and
financial condition.
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.
Employees
As of December 31, 1998, Terayon had 130 employees, of which 56 were in the
engineering group, 32 were in marketing, sales and customer support, 21 were in
operations and 21 were in general and
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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 38,000 square foot facility located in
Santa Clara, California. 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.
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MANAGEMENT
Directors, Executive Officers and Key Employees
Certain information regarding the Company's directors, executive officers and
key employees as of December 31, 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.................... 53 Chief Financial Officer
Dennis J. Picker................ 51 Chief Operating Officer
Michael D'Avella................ 40 Director
Christopher J. Schaepe(1)(2).... 35 Director
Lewis Solomon(2)................ 65 Director
Mark A. Stevens(1).............. 38 Director
Key Employees
Brian Bentley................... 37 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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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; and Artesyn Technologies, Inc.,
a power supply and power converter supply company. 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 telecommunications equipment supplier. 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.
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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 beneficially 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
Board is be divided into three classes, Class I, Class II and Class III, with
each class serving staggered three-year terms. The Class I directors,
currently Messrs. Solomon and Stevens, will stand for reelection or election
at the 1999 annual meeting of stockholders. The Class II directors, currently
Mr. D'Avella and Shlomo Rakib, will stand for reelection or election at the
2000 annual meeting of stockholders. The Class III directors, currently 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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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 Group, Inc.; George Harte, the Director of Telecom Technology for
Rogers Communications Inc.; Wilt Hildenbrand, the Vice President of Technology
for Cablevision; Isao Momota, the President of Crossbeam; 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 and Selling 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. Certain directors have been granted options to purchase Common
Stock in the past, and options may be granted to directors of the Company in
the future. Mr. Stevens, Mr. D'Avella and entities affiliated with Weiss, Peck
and Greer L.L.C., of which Mr. Schaepe is a partner, have each received options
to purchase 30,000 shares of Common Stock at exercise prices of $1.25, $6.50
and $1.25 per share, respectively.
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,
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
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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 entered 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, 1998 to the Company's
Chief Executive Officer and four other most highly compensated officers whose
annual salary and bonus exceeded $100,000 in fiscal 1998 (hereinafter, the
"Named Executive Officers").
Summary Compensation Table
<TABLE>
<CAPTION>
Long-Term
Compensation
Annual Compensation Awards
---------------------------------- ------------
Securities
Name and Principal Other Annual Underlying
Position Year Salary($) Bonus($) Compensation($) Options (#)
------------------ ---- --------- -------- --------------- ------------
<S> <C> <C> <C> <C> <C>
Dr. Zaki Rakib............ 1998 172,500 -- -- --
Chief Executive Officer
Shlomo Rakib.............. 1998 172,500 -- -- --
President and Chief
Technical Officer
Dennis Picker............. 1998 153,000 -- -- 40,000
Chief Operating Officer
Gary Law.................. 1998 136,750 32,500 -- 5,000
Vice President, Marketing
and Business Development
Brian Bentley............. 1998 125,650 -- 93,974(1) 10,000
Vice President, Worldwide
Sales
</TABLE>
- --------
(1) Represents sales commissions earned in 1998.
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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, 1998 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............ -- -- -- -- -- --
Dennis Picker........... 40,000 3.38% $6.50 05/27/08 $ 423,513 $ 674,373
Gary Law................ 5,000 0.42% $6.50 05/27/08 $ 52,939 $ 84,297
Brian Bentley........... 10,000 0.84% $6.50 05/27/08 $ 105,878 $ 168,593
</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 1,185,081 options granted to employees,
consultants and directors, including the Named Executive Officers, of the
Company during the fiscal year ended December 31, 1998.
(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 1998 and December 31, 1998 Option Values
There were no exercises of options by any Named Executive Officer in the
fiscal year ended December 31, 1998.
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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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. Pursuant to Section 162(m) of the Code, no person may be granted
options under the 1997 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 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.
55
<PAGE>
As of December 31, 1998, 62,469 shares of Common Stock had been issued upon
the exercise of options granted under the 1997 Plan, options to purchase
1,434,633 shares of Common Stock were outstanding and 1,802,898 shares
remained available for future grant. The 1997 Plan will terminate in March
2007 unless terminated by the Board before then. As of December 31, 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 December 31, 1998, 897,063 shares had been issued upon the exercise of
options under the 1995 Plan, 1,158,975 shares of Common Stock were subject to
outstanding options and 58,709 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 August 1998, 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 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
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<PAGE>
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.
As of December 31, 1998, 93 employees have the right to purchase shares of
Common Stock under the Purchase Plan.
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 was $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
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.
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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 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. Pursuant to its
terms the note accelerated upon the completion of the Company's initial public
offering. In October 1998, the Board approved an extension of the repayment of
such note until August 1999. The note is secured by 20,000 shares of Common
Stock held by Mr. Rakib.
In 1998, the Company sold products to Shaw for an aggregate of approximately
$12.5 million. In addition, in April 1998, the Company issued Shaw a warrant
("Common Stock 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
Common Stock Warrant is equal to the fair market value of the Company's Common
Stock at the time the Common Stock Warrant was granted, as determined by the
Company's Board of Directors. 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 shares of the
Company's Common Stock. As of December 31, 1998, Shaw had the right to receive
19,191 shares pursuant to the Anti-Dilution Warrant. 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."
In July 1998, the Company entered 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."
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.
Certain holders of Common Stock are entitled to certain registration rights
with respect to such Common Stock. See "Description of Capital Stock --
Registration Rights."
59
<PAGE>
PRINCIPAL AND SELLING STOCKHOLDERS
The following table sets forth certain information with respect to the
beneficial ownership of the Company's Common Stock as of December 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 stockholder who is known by the Company to own
beneficially more than 5% of the Company's Common Stock, (iv) each stockholder
of the Company who is selling shares of Common Stock in this offering
("Selling Stockholders") and (v) all current directors and executive officers
as a group.
<TABLE>
<CAPTION>
Shares Beneficially Shares Beneficially
Owned Prior to the Owned After the
Offering (1) Offering (1)
------------------- -------------------
Number
of Shares
Being
Beneficial Owner Number Percent Offered Number Percent
- ---------------- ------ ------- --------- ------ -------
<S> <C> <C> <C> <C> <C>
Shaw Communications
Inc. (2).............. 3,596,114 18.5% 200,000 3,396,114 16.0%
630 Third Avenue S.W.,
Suite 900
Calgary, Alberta T2P
4L4
Dr. Zaki Rakib (3)..... 2,000,000 12.2% 256,833 1,743,167 9.6%
Shlomo Rakib (3)....... 2,000,000 12.2% 256,834 1,743,166 9.6%
Entities associated
with Weiss, Peck &
Greer (4) ............ 1,461,300 8.9% 214,695 1,246,605 6.8%
555 California Street,
Suite 3130
San Francisco,
California 94104
Entities associated
with Sequoia Capital
(5)................... 1,431,974 8.7% 214,695 1,217,279 6.7%
3000 Sand Hill Road
Suite 280, Building 4
Menlo Park, California
94025
Entities associated
with Walden Ventures
(6)................... 714,528 4.3% 107,178 607,350 3.3%
Sierra Ventures V,
L.P................... 405,568 2.5% 60,835 344,733 1.9%
Michael D'Avella
(2)(7)................ 3,632,114 18.6% 0 3,432,114 16.1%
Christopher J. Schaepe
(4)................... 1,461,300 8.9% 0 1,246,605 6.8%
Mark Stevens (5)(8).... 1,440,260 8.8% 1,875 1,223,690 6.7%
Lewis Solomon (9)...... 90,000 * 10,000 80,000 *
Brian Bentley (10)..... 120,000 * 16,500 103,500 *
Gary Law (11).......... 120,000 * 0 120,000 *
Dennis Picker (12)..... 240,000 1.4% 31,999 208,001 1.1%
All directors and
executive officers as
a group (8 persons)
(13).................. 11,043,674 55.4% -- 9,856,743 45.4%
Other selling
stockholders (51
persons) (14)......... 1,688,143 9.5% 128,556 1,559,587 8.0%
</TABLE>
- --------
* Less than 1%.
(1) Percentage of beneficial ownership is based on 16,458,121 shares of
Common Stock outstanding as of December 31, 1998.
(2) Shares beneficially owned includes 3,019,191 shares issuable pursuant to
warrants exercisable within 60 days of December 31, 1998. Shaw may sell
up to an additional 50,000 shares if the Underwriters' over-allotment
option is exercised.
(3) The address for Messrs. Rakib is c/o Terayon Communication Systems, Inc.,
2952 Bunker Hill Lane, Santa Clara, CA 95054. Zaki Rakib and Shlomo Rakib
may sell up to an additional 43,167 and 43,166 shares, respectively, if
the Underwriters' over-allotment option is exercised.
(4) Shares beneficially owned includes 797,870 shares held by WPG Enterprise
Fund II, LLC 8,600, of which are subject to a right of repurchase and
663,430 shares held by Weiss, Peck & Greer Venture Associates III, LLC,
7,151 of which are subject to a right of repurchase. 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.
60
<PAGE>
(5) Shares beneficially owned includes (i) 1,302,483 shares held by Sequoia
Capital VI; (ii) 71,565 shares held by Sequoia Technology Partners VI;
(iii) 53,431 shares held by Sequoia XXIV; (iv) 2,296 shares held by
Sequoia 1995; (v) 792 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 all shares held by Sequoia except to the extent of his
pecuniary interest therein.
(6) Shares beneficially owned includes (i) 333,430 shares held by Walden
Israel Ventures, L.P.; (ii) 333,430 shares held by Walden SBIC, L.P.; and
(iii) 47,668 shares held by Walden Technology Ventures II, L.P.
(7) Shares beneficially owned includes 3,596,114 shares held by Shaw
Communications Inc. Mr. D'Avella, a director of the Company, is the Senior
Vice President, Planning for Shaw. Also includes 33,750 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.
(8) Shares beneficially owned includes 11,250 shares subject to repurchase by
the Company within 60 days of December 31, 1998.
(9) Shares beneficially owned includes 20,000 shares issuable upon the early
exercise of options vesting through May 2000, 8,333 of which will be fully
vested and no longer subject to repurchase within 60 days of December 31,
1998.
(10) Shares beneficially owned includes 120,000 shares issuable upon the early
exercise of options vesting through April 2003, 44,000, of which will be
fully vested and no longer subject to repurchase within 60 days of
December 31, 1998.
(11) Shares beneficially owned includes 120,000 shares issuable upon the early
exercise of options vesting through May 2003, 44,083, of which will be
fully vested and no longer subject to repurchase within 60 days of
December 31, 1998.
(12) Shares beneficially owned includes 240,000 shares issuable upon the early
exercise of options vesting through May 2003, 110,000 of which will be
fully vested and no longer subject to repurchase within 60 days of
December 31, 1998.
(13) Shares beneficially owned includes (i) 473,750 shares issuable upon the
early exercise of options vesting through May 2003, 162,416 of which will
be fully vested and no longer subject to repurchase within 60 days of
December 31, 1998 and (ii) 3,019,191 shares issuable pursuant to warrants
exercisable within 60 days of December 31, 1998.
(14) Includes the following stockholders and the shares to be sold by such
stockholders in the offering: Newton Antoniuk (851), Constance Arasmith
(1,445), Robert Arasmith (255), Yehuda Azenkot (4,209), BancBoston
Robertson Stephens (2,004), Manachem Barlev (2,083), Chabela Barrie (122),
Bayview Investors, Ltd. (2,841), Jaime Bello (28), Zvi Bernstein (1,020),
James Beatson (1,324), Matthew Carbonara (2,450), Pik Fai Chan (136),
Jeffrey DeLazaro (1,263), Kevin Durkee (450), Sandra Eovino (1,500),
Alexander Fertelmeister (2,000), Daniel Garcia (255), Timothy Geyer (600),
Tannaz Goodlett (41), Aviv Goren (467), Michael Grimwood (1,362),
Zhenzhong Gu (1,500), John Hamburger (2,406), Alexander Hubris (3,000),
Adrian Jones (6,000), Gary Lauder (26,319), Aiman Kabakibo (3,034),
Kistler Associates (3,800), James Knittel (895), Avraham Kopelman (3,400),
Korea Technology Banking Corporation (5,251), Yosef Krispin (2,000), Paul
Lind (12,500), Joseph Liotta (325), Thomas Macall (1,000), Asaf Matatyaou
(267), Moshe Matatyaou (418), Paul Miyashiro (390), George Mosqueda (750),
Bruce Newman (638), Hector Pacheco (41), Paul Richardson (728), Gershon
Schatzberg (5,850), Mark Schaub (500), Robert Sims (1,939), Mark Stalica
(1,308), Margaret Stattler (991), Jason Suen (500), James Sussbauer
(2,703), Nathalie Tal (2,898), Tower Financial Ltd. (5,632), Ronen Vainesh
(1,014), Andrea Vollerson (474), James Watkins (778), David Weiss (335),
Brian Wilkerson (1,276). In addition, Habiba Rakib, the mother of Zaki
Rakib, the Company's Chief Executive Officer and a director of the
Company, and Shlomo Rakib, the Company's Chairman of the Board, President
and Chief Technical Officer, is selling 990 shares in the offering. Shares
beneficially owned includes 1,328,387 shares issuable upon the early
exercise of options vesting through June 2003, 560,505 of which will be
fully vested and no longer subject to repurchase within 60 days of
December 31, 1998.
61
<PAGE>
DESCRIPTION OF CAPITAL STOCK
The authorized capital stock of the Company consists 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 December 31, 1998, there were 16,458,121 shares of Common Stock
outstanding held of record by 130 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. No shares of Preferred Stock currently are
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 the Common Stock Warrant, which
gives Shaw the right 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 the Anti-Dilution Warrant, which gives Shaw the right 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 shares of the Company's Common Stock. As of December 31, 1998,
Shaw had the right to receive 19,191 shares pursuant to the Anti-Dilution
Warrant.
Registration Rights
Pursuant to an agreement between the Company and the holders (or their
permitted transferees) of approximately 11,767,948 shares of Common Stock
("Holders"), the Holders are entitled to certain rights with respect to
registration of such shares for sale in the public market. The
62
<PAGE>
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 February 14,
1999. 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 in August 2005.
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--Some Anti-Takeover Provisions May
Affect the Price of Our Common Stock."
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 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 is the transfer agent and registrar for the Company's Common
Stock.
63
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Upon the completion of this offering, the Company will have outstanding
18,208,121 shares of Common Stock, based on the number of shares of Common
Stock outstanding as of December 31, 1998, assuming the issuance by the
Company of an aggregate of 1,750,000 shares of Common Stock and no exercise of
outstanding options, warrants or other obligations in connection with this
offering. The 3,250,000 shares sold in this offering will be freely tradable
without restriction under the Securities Act. Of the shares outstanding upon
completion of the offering, 11,118,132 shares of Common Stock held by existing
stockholders are restricted securities in that they may be sold in the public
market only if registered or if they qualify for an exemption from
registration under the Securities Act or Rules 144, 144(k) or 701 or
Regulation S as promulgated under the Securities Act. As of the date of this
Prospectus, holders, including all officers and directors, of 12,318,943
shares of the Company's Common Stock and an additional 3,443,683 shares
issuable upon exercise of warrants and options have agreed, subject to certain
exceptions, not to offer, pledge, sell, contract to sell, sell any option or
contract to purchase, purchase any option or contract to sell, grant any
option, right or warrant to purchase, or otherwise transfer or dispose of,
directly or indirectly, any shares of Common Stock or any securities
convertible into or exercisable or exchangeable for Common Stock (whether such
shares or any such securities are then owned by such person or are thereafter
acquired directly from the Company), or to enter into any swap or similar
arrangement that transfers, in whole or in part, the economic risks of
ownership of the Common Stock, without the prior written consent of BT Alex.
Brown Incorporated, until February 14, 1999, and holders of 11,329,390 shares
of the Company's Common Stock and an additional 3,583,784 shares issuable upon
exercise of warrants and vested options have agreed to the same sale
restrictions for a period of 90 days after the date of this Prospectus (the
"Lock-Up Agreements"). As a result of such contractual restrictions and the
provisions of Rule 144 or Regulation S, additional shares will be available
for sale in the public market, subject to presentation of evidence
satisfactory to the Company, including an opinion of counsel acceptable to the
Company, that such sales may be made without registration pursuant to the
Securities Act as follows: (i) 456,247 shares of Common Stock currently
outstanding will be eligible for sale as of the date of this Prospectus; (ii)
462,820 shares of Common Stock currently outstanding and 78,359 shares of
Common Stock issuable upon exercise of currently outstanding options or
warrants will be eligible for sale on February 14, 1999; (iii) 9,893,177
shares of Common Stock currently outstanding and 564,593 shares of Common
Stock issuable upon exercise of currently outstanding options or warrants will
be eligible for sale 91 days after the date of this Prospectus; and (iv) the
remainder of the restricted securities will be eligible for sale from time to
time thereafter upon expiration of their respective one-year holding periods.
In general, under Rule 144 as currently in effect, beginning 90 days after
the Company's initial public offering, any holder, including an affiliate of
the Company, of restricted securities as to which at least one year has
elapsed since the later of the date of the holder's acquisition of such shares
from the Company or from an affiliate, would be entitled within any three-
month period to sell a number of shares that does not exceed the greater of 1%
of the then outstanding shares of Common Stock (approximately 182,081 shares
immediately after the closing of this offering) or the average weekly trading
volume of the Common Stock on the Nasdaq National Market during the four
calendar weeks preceding the date on which notice of the sale is filed with
the Commission. Sales under Rule 144 are subject to certain requirements
relating to manner of sale, notice and availability of current public
information about the Company. However, a person (or persons whose shares are
aggregated) who is not deemed to have been an affiliate of the Company at any
time during the 90 days immediately preceding the sale and who beneficially
owns restricted securities is entitled to sell such shares under Rule 144(k)
without regard to the limitations described above, provided that at least two
years have elapsed since the later of the date the shares were acquired from
the Company or from an affiliate of the Company. The foregoing is a summary of
Rule 144 and is not intended to be a complete description of that rule.
64
<PAGE>
Subject to certain limitations on the aggregate offering price of a
transaction and other conditions, Rule 701 may be relied upon with respect to
the resale of securities originally purchased from the Company by its
employees, directors, officers, consultants or advisers prior to the closing of
the Company's initial public offering, pursuant to written compensatory benefit
plans or written contracts relating to the compensation of such persons. In
addition, the Commission has indicated that Rule 701 will apply to stock
options granted by the Company before the initial public offering, along with
the shares acquired upon exercise of such options. Securities issued in
reliance on Rule 701 are deemed to be restricted securities and, beginning 90
days after the date of the Company's initial public offering (unless subject to
the contractual restrictions described above), may be sold by persons other
than affiliates, subject only to the manner of sale provisions of Rule 144 and
by affiliates under Rule 144 without compliance with its one-year minimum
holding period requirements.
The Company has filed a registration statement on Form S-8 under the
Securities Act covering shares of Common Stock reserved for issuance under the
1995 Stock Option Plan, 1997 Equity Incentive Plan, 1998 Non-Employee Directors
Plan, 1998 Non-Employee Stock Purchase Plan and Non-Plan options. See
"Management--Employee Benefit Plans." Accordingly, shares registered under such
registration statement are, subject to limitations applicable to affiliates of
the Company, available for sale in the open market, unless such shares are
subject to vesting restrictions with the Company or other contractual lock-up
restrictions. As of December 31, 1998, an aggregate of 87,373 shares of Common
Stock had been issued upon exercise of options under the Company's option plans
subsequent to the Company's initial public offering, and options to purchase
2,691,234 additional shares of Common Stock were issued and outstanding. See
"Management--Employee Benefit Plans."
There can be no assurance that an active public market for the Common Stock
will continue after this offering or that the market price of the Common Stock
will not decline below the public offering price. Future sales of substantial
amounts of Common Stock in the public market could adversely affect market
prices prevailing from time to time. As described above, only a limited number
of shares will be available for sale shortly after this offering because of
certain contractual and legal 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.
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 Salomon Smith Barney Inc., have severally agreed
to purchase from the Company and the Selling Stockholders the following
respective number of shares of Common Stock at the 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........................................ 975,001
Hambrecht & Quist LLC.............................................. 758,333
Lehman Brothers Inc................................................ 758,333
Salomon Smith Barney Inc. ......................................... 758,333
---------
Total............................................................ 3,250,000
=========
</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 and the Selling Stockholders have been advised by Representatives
that the Underwriters propose to offer the shares of Common Stock directly to
the public at the 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 $1.10
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
public offering of the shares, the offering price and other selling terms may
be changed by the Representatives.
Certain Selling Stockholders have granted to the Underwriters an option,
exercisable no later than 30 days after the date of this Prospectus, to
purchase up to 487,500 additional shares of Common Stock at the 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 certain Selling
Stockholders 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 3,250,000 shares
are being offered.
The following table summarizes the compensation to be paid to the
Underwriters by the Company and the Selling Stockholders.
<TABLE>
<CAPTION>
Total
-----------------------------
Without With
Per Share Over-allotment Over-allotment
--------- -------------- --------------
<S> <C> <C> <C>
Underwriting Discounts and Commissions
paid by the Company.................. $1.90 $3,325,000 $3,992,217
Underwriting Discounts and Commissions
paid by Selling Stockholders......... $1.90 $2,850,000 $3,109,033
</TABLE>
The Company and the Selling Stockholders have 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.
66
<PAGE>
The Company's officers, directors and certain stockholders have agreed not to
offer, sell or otherwise dispose of any shares of Common Stock for a period of
90 days after the date of this Prospectus without the prior written consent of
BT Alex. Brown Incorporated. Such consent may be given at any time without any
public notice. The Company has entered into a similar agreement, except that it
may issue, and grant option or warrants to purchase, shares of Common Stock or
any securities convertible into, exercisable for or exchangeable for shares of
Common Stock, pursuant to the exercise of outstanding options and warrants and
the Company's issuance of options and stock granted under the existing stock
purchase plans.
The Representatives have advised the Company that, pursuant to Regulation M
under the Securities Exchange Act of 1934, as amended, certain persons
participating in the offering may engage in transactions, including stabilizing
bids, syndicate covering transactions and the imposition of penalty bids, which
may have the effect of stabilizing or maintaining the market price of the
Common Stock at a level above that which might otherwise prevail in the open
market. A "stabilizing bid" is a bid for or the purchase of the Common Stock on
behalf of the Underwriters for the purpose of fixing or maintaining the price
of the Common Stock. A "syndicate covering transaction" is the bid for or the
purchase of the Common Stock on behalf of the Underwriters to reduce a short
position incurred by the Underwriters in connection with the offering. A
"penalty bid" is an arrangement permitting the Representatives to reclaim the
selling concession otherwise accruing to an Underwriter or syndicate member in
connection with the offering if the Common Stock originally sold by such
Underwriter or syndicate member is purchased by the Representatives in a
syndicate covering transaction and has therefore not been effectively placed by
such Underwriter or syndicate member. The Representatives have advised the
Company that such transactions may be effected on the Nasdaq National Market or
otherwise and, if commenced, may be discontinued at any time.
In connection with this offering, certain Underwriters and selling group
members (if any) who are qualified market makers on the Nasdaq National Market
may engage in passive market making transactions in the Common Stock on the
Nasdaq National Market in accordance with Rule 103 of Regulation M under the
Securities Exchange Act of 1934, as amended. During the business day prior to
the pricing of the offering before the commencement of offers or sales of the
Common Stock. Passive market makers must comply with applicable volume and
price limitations and must be identified as such. In general, a passive market
maker must display its bid at a price not in excess of the highest independent
bid of such security; if all independent bids are lowered below the passive
market maker's bid, however, such bid must then be lowered when certain
purchase limits are exceeded.
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.
The Company estimates that the total expenses of the offering, excluding
underwriting discounts and commissions, will be approximately $700,000.
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
Ernst & Young LLP, independent auditors, have audited our consolidated
financial statements at December 31, 1997 and 1998, and for each of the three
years in the period ended December 31, 1998, included in our Prospectus and
Registration Statement, as set forth in their report, which is included in our
Prospectus and Registration Statement, and are included in reliance on their
report, given on their authority as experts in accounting and auditing.
ADDITIONAL INFORMATION
The Company has filed with the Securities and Exchange Commission
("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 that 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>
DOCSIS...................... Data Over Cable Service Interface Specification.
The cable modem specifications set by the MCNS
group of North American cable operators.
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.
</TABLE>
G-2
<PAGE>
<TABLE>
<C> <S>
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.
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.
S-CDMA...................... Sychronous Code Division Multiple Access. An
enhancement of CDMA that synchronizes multiple
subscriber end-stations to the headend receiver
unit to achieve high channel capacity.
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-7
Notes to Consolidated Financial Statements............................ F-9
</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, 1997 and 1998, 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, 1998. 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, 1997 and 1998, and the
consolidated results of its operations and its cash flows for each of the three
years in the period ended December 31, 1998, in conformity with generally
accepted accounting principles.
/s/ Ernst & Young LLP
San Jose, California
January 15, 1999
F-2
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
<TABLE>
<CAPTION>
December 31,
------------------
1997 1998
-------- --------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................ $ 1,569 $ 14,342
Short-term investments................................... 418 14,538
Accounts receivable, less allowance for doubtful accounts
of $20 in 1997 and $594 in 1998......................... 574 2,090
Accounts receivable from related parties................. 362 1,549
Inventory................................................ 1,322 3,950
Other current assets..................................... 690 1,856
-------- --------
Total current assets....................................... 4,935 38,325
Property and equipment, net................................ 3,615 3,593
Officer note receivable.................................... 100 100
Other assets............................................... 128 128
-------- --------
Total assets............................................... $ 8,778 $ 42,146
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable......................................... $ 2,232 $ 8,600
Accrued payroll and related expenses..................... 1,052 2,475
Other accrued liabilities................................ 1,526 2,799
Advance from related party............................... 2,000 --
Deferred revenue......................................... 95 --
Current portion of long-term debt........................ 2,812 --
Current portion of capital lease obligations............. 65 29
-------- --------
Total current liabilities.............................. 9,782 13,903
Long-term portion of capital lease obligations............. 44 10
Deferred rent.............................................. 126 130
Commitments and contingencies
Redeemable common stock, $.001 par value:
Authorized shares--included in common stock authorized
Issued and outstanding shares--10,000 in 1997 and none in
1998.................................................... 13 --
Redeemable common stockholder's note receivable.......... (13) --
-------- --------
Total redeemable common stock.......................... -- --
Stockholders' equity (net capital deficiency):
Preferred stock, $.001 par value:
Authorized shares--5,000,000
Issued and outstanding shares--none...................... -- --
Convertible preferred stock, $.001 par value:
Authorized shares--10,000,000 in 1997 and none in 1998
Issued and outstanding shares--7,131,161 in 1997 and none
in 1998................................................. 35,807 --
Common stock, $.001 par value:
Authorized shares--30,000,000
Issued and outstanding shares--4,620,447 in 1997 and
16,458,121 in 1998...................................... 458 16
Additional paid in capital............................... -- 114,594
Accumulated deficit...................................... (37,163) (84,301)
Deferred compensation.................................... (216) (2,184)
Stockholders' notes receivable........................... (60) (22)
-------- --------
Total stockholders' equity (net capital deficiency).... (1,174) 28,103
-------- --------
Total liabilities and stockholders' equity (net capital
deficiency)........................................... $ 8,778 $ 42,146
======== ========
</TABLE>
See accompanying notes.
F-3
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------
1996 1997 1998
-------- -------- --------
<S> <C> <C> <C>
Revenues:
Product revenues............................... $ -- $ 1,021 $ 19,150
Related party product revenues................. -- 617 12,546
Contract consulting and technology development
revenues...................................... -- 480 --
-------- -------- --------
Total revenues............................... -- 2,118 31,696
Cost of goods sold:
Cost of product revenues....................... -- 3,904 22,296
Cost of related party product revenues......... -- 2,558 12,222
-------- -------- --------
Total cost of goods sold..................... -- 6,462 34,518
-------- -------- --------
Gross loss ...................................... -- (4,344) (2,822)
Operating expenses:
Research and development....................... 8,020 11,319 10,685
Sales and marketing............................ 1,141 4,468 6,947
General and administrative..................... 1,789 2,546 3,223
-------- -------- --------
Total operating expenses..................... 10,950 18,333 20,855
-------- -------- --------
Loss from operations............................. (10,950) (22,677) (23,677)
Interest income.................................. 393 396 808
Interest expense................................. (140) (268) (359)
-------- -------- --------
Net loss......................................... (10,697) (22,549) (23,228)
Series F convertible preferred stock dividend
(Note 10)....................................... -- -- (23,910)
-------- -------- --------
Net loss applicable to common stockholders....... $(10,697) $(22,549) $(47,138)
======== ======== ========
Historical basic and diluted net loss per share
applicable to common stockholders............... $ (2.64) $ (5.26) $ (5.25)
======== ======== ========
Shares used in computing historical basic and
diluted net loss per share applicable to common
stockholders.................................... 4,054 4,289 8,986
======== ======== ========
Pro forma basic and diluted net loss per share
applicable to common stockholders............... $ (2.07) $ (3.41)
======== ========
Shares used in computing pro forma basic and
diluted net loss per share applicable to common
stockholders.................................... 10,873 13,804
======== ========
</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,
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 applicable to
common stockholders and
comprehensive net loss
applicable to common
stockholders........... -- -- -- -- -- (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 applicable to
common stockholders and
comprehensive net loss
applicable to common
stockholders........... -- -- -- -- -- (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 ....... 114,089 1,454 -- -- -- -- -- -- 1,454
Conversion of advance
from related party to
Series D preferred
stock ................. 153,846 2,000 -- -- -- -- -- -- 2,000
Net cash proceeds from
issuance of Series F
preferred stock and a
warrant ............... 384,615 844 -- 4,089 -- -- -- -- 4,933
Dividends on Series F
convertible preferred
stock ................. -- -- -- 23,910 -- -- -- -- 23,910
Value of preferred stock
warrant issued to
Series D preferred
stockholder ........... -- 19 -- -- -- -- -- -- 19
Exercise of options for
cash to purchase common
stock ................. -- -- 205,276 56 -- -- -- -- 56
Exercise of option for
note receivable to
purchase common stock
....................... -- -- 24,375 9 -- -- -- (9) --
Value of common stock
warrant ............... -- -- -- 35 -- -- -- -- 35
</TABLE>
See accompanying notes.
F-5
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)--
(continued)
(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>
Cash proceeds from
payment on a
stockholder note
receivable ........ -- $ -- -- $ -- $ -- $ -- $ -- $ 47 $ 47
Unearned
compensation
related to stock
options ........... -- -- -- 1,849 -- -- (1,849) -- --
Transfer to
additional paid in
capital as a result
of reincorporation
................... -- (40,116) -- (30,401) 70,517 -- -- -- --
Conversion of
preferred stock
into common stock
upon the initial
public offering ... (7,783,711) (8) 7,783,711 8 -- -- -- -- --
Issuance of common
stock in connection
with the initial
public offering,
net of issuance
costs ............. -- -- 3,000,000 3 35,133 -- -- -- 35,136
Conversion of
redeemable
preferred stock to
common stock upon
the initial public
offering .......... -- -- 576,924 -- 7,500 -- -- -- 7,500
Conversion of
redeemable common
stock upon the
initial public
offering .......... -- -- 10,000 -- 13 -- -- -- 13
Exercise of common
stock warrant for
cash............... -- -- 50,000 -- 500 -- -- -- 500
Issuance of common
stock in legal
settlement to an
employee .......... -- -- 13,000 -- 169 -- -- -- 169
Exercise of options
for cash to
purchase common
stock ............. -- -- 174,388 -- 222 -- -- -- 222
Unearned
compensation
related to stock
options............ -- -- -- -- 540 -- (540) -- --
Amortization of
unearned
compensation
related to stock
options............ -- -- -- -- -- -- 421 -- 421
Net loss applicable
to common
stockholders and
comprehensive net
loss applicable to
common stockholders
................... -- -- -- -- -- (47,138) -- -- (47,138)
---------- -------- ---------- -------- -------- -------- ------- ---- --------
Balance at December
31, 1998........... -- $ -- 16,458,121 $ 16 $114,594 $(84,301) $(2,184) $(22) $ 28,103
========== ======== ========== ======== ======== ======== ======= ==== ========
</TABLE>
See accompanying notes.
F-6
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------
1996 1997 1998
-------- -------- --------
<S> <C> <C> <C>
Operating activities:
Net loss applicable to common stockholders...... $(10,697) $(22,549) $(47,138)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization................. 830 1,563 1,992
Amortization of unearned compensation related
to stock options............................. -- 12 421
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) (1,516)
Accounts receivable from related parties..... -- (362) (1,187)
Inventory.................................... -- (1,322) (2,628)
Other current assets......................... (177) (391) (1,166)
Other assets................................. (118) 15 --
Accounts payable............................. 8 1,550 6,368
Accrued payroll and related expenses......... 346 482 1,423
Other accrued liabilities.................... 263 1,076 1,442
Deferred revenue............................. -- (330) (95)
Deferred rent................................ 102 24 4
Other noncurrent liabilities................. 24 (24) --
-------- -------- --------
Net cash used in operating activities........... (9,382) (20,830) (18,116)
Investing activities:
Purchases of short-term investments............. (6,863) (10,995) (32,959)
Proceeds from sales and maturities of short-term
investments.................................... 2,355 15,085 18,839
Purchases of property and equipment............. (1,892) (2,606) (1,970)
Proceeds from sale of assets.................... 42 -- --
Officer note receivable......................... (100) -- --
-------- -------- --------
Net cash provided by (used in) investing
activities..................................... (6,458) 1,484 (16,090)
</TABLE>
See accompanying notes.
F-7
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS--(continued)
(in thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------
1996 1997 1998
-------- -------- --------
<S> <C> <C> <C>
Financing activities:
Principal payments on capital leases............ $ (124) $ (144) $ (70)
Principal payments on long-term debt............ (273) (909) (2,812)
Proceeds from long-term debt.................... 1,843 1,654 --
Exercise of options and warrant to purchase
common stock................................... 11 140 778
Advance from related party...................... -- 2,000 --
Proceeds from issuance of preferred stock....... 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
Proceeds from issuance of common stock.......... -- -- 35,136
-------- -------- --------
Net cash provided by financing activities.... 15,576 12,559 46,979
-------- -------- --------
Net increase (decrease) in cash and cash
equivalents.................................... (264) (6,787) 12,773
Cash and cash equivalents at beginning of year.. 8,620 8,356 1,569
-------- -------- --------
Cash and cash equivalents at end of year........ $ 8,356 $ 1,569 14,342
======== ======== ========
Supplemental disclosures of cash flow
information:
Cash paid for interest.......................... $ 140 $ 268 $ 359
Supplemental noncash investing and financing
activities:
Property and equipment acquired under capital
leases......................................... $ 137 $ -- $ --
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
Issuance of common stock in legal settlement to
an employee.................................... $ -- $ -- $ 169
Conversion of preferred stock to common stock... $ -- $ -- $ 8
Conversion of redeemable preferred stock to
common stock .................................. $ -- $ -- $ 7,500
Conversion of redeemable common stock to common
stock ......................................... $ -- $ -- $ 13
</TABLE>
See accompanying notes.
F-8
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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.
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.
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, 1996,
1997 and 1998 was not significant.
Research and Development Costs
Research and development costs are charged to expense as incurred.
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. The Company accounts for
investments in accordance with Statement of Financial Accounting Standards No.
115, "Accounting for Certain Investments in Debt and Equity Securities".
Management determines the appropriate classification of debt securities at the
time of purchase and reevaluates such designation as of each balance sheet
date. The Company's short-term investments, which consist primarily of
commercial paper and government agency obligations with maturities of one year
or less, are classified as available-for-sale and are carried at amortized cost
which approximates fair market value. The amortized cost of debt securities in
this category is adjusted for amortization of premiums and accretion of
discounts to maturity. Such amortization, as well as any interest on the
securities, is included in interest income. Realized gains and
F-9
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
losses and declines in value judged to be other-than-temporary on available-
for-sale securities are included in interest income. The cost of securities
sold is based on the specific identification method. The Company had no
investments in equity securities at December 31, 1998.
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 14).
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 governmental
agencies, and corporations with credit ratings of AA/AA- or better or A1/P1 or
better, respectively. 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.
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,
-------------
1997 1998
------ ------
<S> <C> <C>
Inventory:
Finished goods............................................. $ 163 $3,355
Work-in-process............................................ 366 170
Raw materials.............................................. 793 425
------ ------
$1,322 $3,950
====== ======
</TABLE>
During the year ended December 31, 1998 the Company was required to purchase
inventory components 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
F-10
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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. 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.
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 occurred in any of the years
presented.
Property and equipment are as follows (in thousands):
<TABLE>
<CAPTION>
December 31,
----------------
1997 1998
------- -------
<S> <C> <C>
Software and computers..................................... $ 3,695 $ 4,411
Furniture and equipment.................................... 2,421 3,567
Leasehold improvements..................................... 89 197
------- -------
6,205 8,175
Accumulated depreciation and amortization.................. (2,590) (4,582)
------- -------
Property and equipment, net................................ $ 3,615 $ 3,593
======= =======
</TABLE>
Revenue Recognition
Revenues related to product sales are generally recognized when the products
are shipped to the customer. A provision is made for estimated product returns
as product shipments are made. 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 were expensed
as incurred and were included in cost of goods sold in prior years. Revenues
under technology development agreements 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 milestones under an agreement in the fourth
quarter of the year ended December 31, 1997 and recognized the related revenue
(see Note 4).
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.
F-11
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Stock-Based Compensation
As described in Note 10, 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).
Comprehensive Income
The Company has adopted Statement of 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. The Company's comprehensive net loss was the same
as its net loss for the years ended December 31, 1996, 1997 and 1998.
Segments of an Enterprise
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 131, "Disclosures about Segments of an Enterprise and
Related Information" (FAS 131). FAS 131 superseded Statement of Financial
Accounting Standards No. 14, "Financial Reporting for Segments of a Business
Enterprise". FAS 131 establishes standards for the way that public business
enterprises report information about operating segments in annual financial
statements and requires that those enterprises report selected information
about operating segments in interim financial reports. FAS 131 also establishes
standards for related disclosures about products and services, geographic
areas, and major customers. The adoption of FAS 131 did not affect the
Company's results of operations or financial position, and did not affect the
disclosure of segment information (see Note 12).
Net Loss Per Share Applicable to Common Stockholders
Historical basic and diluted net loss per share applicable to common
stockholders was computed using the weighted average number of common shares
outstanding. Options, warrants, restricted stock and preferred stock were not
included in the computation of historical diluted net loss per share applicable
to common stockholders because the effect would be antidilutive.
Pro forma net loss per share applicable to common stockholders was computed
as described above and also gives effect, even if antidilutive, to common
equivalent shares from preferred stock that automatically converted upon the
closing of the Company's initial public offering (using the as-if-converted
method).
F-12
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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>
Years ended December 31,
----------------------------
1996 1997 1998
-------- -------- --------
<S> <C> <C> <C>
Net loss......................................... $(10,697) $(22,549) $(23,228)
Series F convertible preferred stock dividend
(Note 10)....................................... -- -- (23,910)
-------- -------- --------
Net loss applicable to common stockholders....... $(10,697) $(22,549) $(47,138)
======== ======== ========
Shares used in computing historical basic and
diluted net loss per share applicable to common
stockholders.................................... 4,054 4,289 8,986
Historical basic and diluted net loss per share
applicable to common stockholders............... $ (2.64) $ (5.26) $ (5.25)
======== ======== ========
Shares used in computing historical basic and
diluted net loss per share applicable to common
stockholders.................................... 4,289 8,986
Adjustment to reflect the effect of the assumed
conversion of weighted average shares of
convertible preferred stock outstanding
applicable to common stockholders............... 6,584 4,818
-------- --------
Shares used in computing pro forma basic and
diluted net loss per share applicable to common
stockholders.................................... 10,873 13,804
======== ========
Pro forma basic and diluted net loss per share
applicable to common stockholders............... $ (2.07) $ (3.41)
======== ========
</TABLE>
Impact of Recently Issued Accounting Standards
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133, "Accounting for Derivative Instruments
and Hedging Activities" (FAS 133). FAS 133 provides a comprehensive and
consistent standard for the recognition and measurement of derivatives and
hedging activities. FAS 133 is effective for fiscal years beginning after June
15, 1999 and the Company believes that the adoption of FAS 133 will not have a
significant impact on the Company's operating results or cash flows.
F-13
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
2. Fair Value of Financial Instruments
The following estimated fair value amounts have been determined using
available market information and appropriate valuation methodologies. However,
considerable judgment is required in interpreting market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts that the Company could realize in a
current market exchange.
<TABLE>
<CAPTION>
December 31, 1998
-----------------------------------------
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Short-term investments Cost Gains Losses Value
- ---------------------- --------- ---------- ---------- ---------
(in thousands)
<S> <C> <C> <C> <C>
Commercial paper..................... $ 8,426 $-- $-- $ 8,426
Government agency obligations........ 6,112 -- -- 6,112
------- --- --- -------
Total.............................. $14,538 $-- $-- $14,538
======= === === =======
<CAPTION>
December 31, 1997
-----------------------------------------
Gross Gross Estimated
Amortized Unrealized Unrealized Fair
Short-term investments Cost Gains Losses Value
- ---------------------- --------- ---------- ---------- ---------
(in thousands)
<S> <C> <C> <C> <C>
U.S. treasury obligations............ $ 418 $-- $-- $ 418
------- --- --- -------
Total.............................. $ 418 $-- $-- $ 418
======= === === =======
</TABLE>
Realized gains and losses were insignificant for each of the three years in
the period ended December 31, 1998.
3. Officer Note Receivable
In March 1996, the Company loaned an officer $100,000 pursuant to a
promissory note. The note does not bear interest, matured in August 1998, and
is full recourse, including being collateralized by 20,000 shares of the
Company's common stock. The note was amended in 1998 extending the maturity
date of the note until August 1999.
4. Technology Development Agreement
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. 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. In March 1998, the
F-14
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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.
5. 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 $542,000, $850,000, and $853,000 for the years ended
December 31, 1996, 1997, and 1998, respectively. 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. 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, 1997 and 1998. Related accumulated amortization was
approximately $337,000 and $375,000 at December 31, 1997 and 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.
Future minimum lease payments under noncancelable operating leases and
capital leases are as follows (in thousands):
<TABLE>
<CAPTION>
December 31, 1998
-----------------
Operating Capital
Leases Leases
--------- -------
<S> <C> <C>
1999....................................................... $ 713 $33
2000....................................................... 726 11
2001....................................................... 746 4
2002....................................................... 178 --
------ ---
Total minimum payments..................................... $2,363 48
======
Less amount representing interest.......................... 9
---
39
Less current portion....................................... 29
---
$10
===
</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 December 31, 1998, the Company
had approximately $10,281,000 of unconditional purchase obligations ($784,000
at December 31, 1997).
6. Debt Obligations
In August 1998, the Company entered into a credit agreement with a bank to
provide a line of credit in an amount up to $10,000,000 based on the higher of
$3,000,000 or 80% of eligible accounts receivable.
F-15
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The credit agreement provides for interest at a rate equal to prime (7.75% at
December 31, 1998) and matures one year from the date of the agreement. At
December 31, 1998, there were no outstanding borrowings under this credit
agreement and approximately $3,000,000 was available.
Outstanding borrowings under the credit agreement are secured by certain
Company assets. The credit agreement contains affirmative and negative
covenants and requires, among other things, that the Company maintain its
primary banking relationship with the bank. The credit agreement also limits,
among other things, 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 minimum tangible net worth and prohibits certain
acquisitions, mergers, consolidations, or similar transactions without the
prior consent of the bank.
At December 31, 1997 the Company had approximately $2,812,000 of debt
outstanding under four term loans with a bank. The Company paid all debt
outstanding under the four term loans and terminated the agreements in August
1998.
The Company incurred interest expense related to the debt obligations of
approximately $88,000, $205,000 and $256,000 for the years ended December 31,
1996, 1997, and 1998, respectively.
7. Contingencies
During 1997, the Company placed a noncancelable purchase order (subject to
specific delivery date requirements) with a contract manufacturer. As delivery
of the initial shipments was delayed by the manufacturer, the Company
subsequently canceled the purchase order without the consent of the contract
manufacturer. The Company has received notification from the contract
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 contract 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 been accrued and
will not have a material adverse effect on the Company's financial position or
results of operations.
8. Initial Public Offering
In August 1998, the Company completed its initial public offering and issued
3,000,000 shares of its common stock to the public at a price of $13.00 per
share. The Company received net proceeds of approximately $35,136,000 in cash.
Upon the closing of the offering, all of the outstanding shares of convertible
preferred stock, redeemable convertible preferred stock, and redeemable common
stock outstanding were converted into an aggregate of 8,360,635 shares of
common stock.
F-16
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
9. Redeemable Stock
In 1998, the Company issued 384,616 shares of Series D redeemable convertible
preferred stock resulting in proceeds of approximately $5,000,000 and also
issued 192,308 shares of Series F redeemable convertible preferred stock
resulting in proceeds of approximately $2,500,000. The Series D and F
redeemable preferred stockholders had options ("Put Rights") to sell the
Company some or all of the Series D and F redeemable convertible preferred
stock at $13.00 per share. The Put Rights expired upon the completion of the
Company's initial public offering in August 1998.
In conjunction with the Series D redeemable convertible preferred stock
agreement, the Company issued a warrant to purchase 38,462 shares of Series D
convertible preferred stock. The Company recorded expense of $19,000 to reflect
the value of the warrant. In August 1998, the Company completed its initial
public offering (see Note 8) which caused the termination of the unexercised
warrant.
In September 1997, the Company issued common stock to an employee in return
for a full recourse note receivable for $13,000. The note bore an interest rate
of 5.81% per annum and was due in September 1998. The note was paid in full in
January 1998. Pursuant to the stock purchase agreement, the employee had 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
expired 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. In August
1998, the Company completed its initial public offering (see Note 8) which
caused the termination of the option and the conversion of the redeemable
common stock into the Company's common stock. The Company expensed
approximately $29,000 and $88,000 for the years ended December 31, 1997 and
1998, respectively, representing the difference between the common stock's per
share price and the Put Price over the option's vesting period.
10. Stockholders' Equity (Net Capital Deficiency)
Common Stock
In 1998, the Company's stockholders approved an increase in the authorized
number of common shares from 20,000,000 shares to 30,000,000 shares.
Preferred Stock
In 1998, the Company's Certificate of Incorporation was 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.
Delaware Reincorporation
In July 1998, the Company's stockholders approved the Company's
reincorporation in Delaware. The par value of the preferred and common stock is
$.001 per share. The Company's reincorporation has been reflected in the
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-17
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Convertible Preferred Stock
The following is a summary of convertible preferred stock issued and
outstanding, including redeemable convertible preferred stock at December 31,
1997:
<TABLE>
<CAPTION>
Shares
Shares Issued and
Series Authorized Outstanding
------ ---------- -----------
<S> <C> <C>
A................................................... 4,162,093 4,162,093
B................................................... 896,834 896,834
B-1................................................. 448,417 448,417
C................................................... 814,830 814,830
D................................................... 1,500,000 808,987
E................................................... 2,000,000 --
Undesignated........................................ 177,826 --
---------- ---------
10,000,000 7,131,161
========== =========
</TABLE>
Below are the rights and preferences of the preferred stock and redeemable
preferred stock outstanding at December 31, 1997 before their conversion upon
the closing of the initial public offering in August 1998.
Convertible preferred stockholders and redeemable convertible preferred
stockholders had the same voting rights as common stockholders. In addition,
the Series A, B, B-1, C, D and E voted as a single class. In the event of any
voluntary or involuntary liquidation of the Company, Series A, B, B-1, C, D and
E stockholders were entitled to a per share liquidation preference of $0.9545,
$8.92, up to $17.84, $12.50, up to $19.50, and up to $22.50, respectively, plus
accrued dividends, if any. The holders of Series A, B, B-1, C, D and E stock
were entitled to per share noncumulative dividends of $0.0764, $0.7136,
$0.7136, $1.00, $1.04 and $1.20 per annum, respectively, when and if declared
by the Board of Directors.
Common Stock Warrants
In conjunction with a Series F convertible preferred stock financing in April
1998, the Company issued a warrant to purchase 3,000,000 shares of the
Company's common stock at an exercise price of $6.50 per share to Shaw
Communications, Inc. (the "Shaw Warrant"). The Shaw 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. The Anti-Dilution Warrant is exercisable at the option of Shaw
Communications, Inc. ("Shaw") during the period that Shaw owns equity
securities of the Company (purchased in April 1998) and in the event the
Company issues new equity securities at below the current market price as
defined in the Anti-Dilution Warrant. The aggregate exercise price is $1.00. In
June 1998, the Company issued certain equity securities that, as of December
31, 1998, require the Company to issue an additional 19,191 shares of common
stock pursuant to the Anti-Dilution Warrant.
The Company recorded a dividend of $23,910,000 in the quarter ended June 30,
1998, representing the fair value of 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 the
convertible preferred stock (the "Shaw Financing") is based on management's
conclusion that the sale of convertible 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 the convertible preferred stock
and the Shaw Warrant in April 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
F-18
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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 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 was exercised in August
1998. The Company recorded an expense of $35,000 to reflect the value of the
warrant in the year ended December 31, 1998.
Common Stock Reserved
Common stock reserved for issuance is as follows:
<TABLE>
<CAPTION>
December 31,
1998
------------
<S> <C>
Common stock options............................................ 4,762,841
Common stock warrants........................................... 3,019,191
Employee stock purchase plan.................................... 700,000
---------
8,482,032
=========
</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. In June
1998, the Company's Board of Directors authorized the adoption of the amended
1997 Equity Incentive Plan, increasing the aggregate number of shares
authorized for issuance under the 1997 Plan to 3,300,000 shares (2,250,000
additional shares). However, each year on January 1, starting with January 1,
1999, the aggregate number of shares that are available for issuance under the
1997 Plan will automatically be increased to a number equal to 5% of the
Company's outstanding shares of common stock on such date. In addition, in June
1998, the Company's Board of Directors authorized 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. At December 31, 1998, the total authorized number of
shares under the 1995, 1997 and 1998 plans was 2,114,747, 3,300,000 and
200,000, 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.
During the years ended December 31, 1997 and 1998, the Company recorded
aggregate deferred compensation of approximately $228,000 and $2,389,000,
respectively, representing the difference
F-19
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
between the grant price and the deemed fair value of the Company's 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 years
ended December 31, 1997 and 1998, the amortized expense was approximately
$12,000 and $421,000, 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>
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............................ 2,520,000 -- --
Options granted............................... (1,185,081) 1,185,081 $9.45
Options exercised............................. -- (404,039) $0.69
Options canceled.............................. 426,992 (426,992) $2.79
---------- ---------
Balance at December 31, 1998.................... 2,071,607 2,691,234 $4.54
========== =========
</TABLE>
In addition, the following table summarizes information about stock options
that were outstanding and exercisable at December 31, 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........... 763,777 $ 0.40 7.24
$ 0.51 -- $ 2.99........... 712,645 $ 1.25 8.35
$ 3.00 -- $ 5.00........... 158,920 $ 4.10 8.98
$ 5.01 -- $13.00........... 960,798 $ 8.40 9.47
$13.01 -- $29.50........... 95,094 $24.31 9.90
---------
Total.................... 2,691,234 $ 4.54 8.53
=========
</TABLE>
At December 31, 1998, approximately 136,000 shares of common stock
outstanding were subject to repurchase by the Company. Common stock subject to
repurchase represents any unvested shares of
F-20
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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.
In June 1998, the Board of Directors approved, and the Company adopted, the
1998 Employee Stock Purchase Plan (the "ESPP"), which is designed to allow
eligible employees of the Company to purchase shares of common stock at
semiannual intervals through periodic payroll deductions. An aggregate of
700,000 shares of common stock has been reserved for the ESPP, and no shares
have been issued through December 31, 1998. The Purchase Plan is implemented
in a series of successive offering periods, each with a maximum duration of 24
months. Eligible employees can have up to 15% of their base salary deducted
that is to be used to purchase shares of the common stock on specific dates
determined by the Board of Directors (up to a maximum of $25,000 per year
based upon the fair market value of the shares at the beginning date of the
offering). 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 specified purchase date.
The Company has elected to follow APB Opinion No. 25 and related
interpretations in accounting for its employee stock plans because, as
discussed below, the alternative fair value accounting provided for under FAS
123 requires the use of valuation models that were not developed for use in
valuing employee stock instruments. 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, 1996, 1997 and 1998 and for its
ESPP shares to be issued under the fair value method of FAS 123. The fair
value for employee stock options granted was estimated at the date of grant
using the following weighted average assumptions: risk-free interest rates of
6.22%, 5.75% and 5.39% for 1996, 1997, and 1998, respectively; no dividend
yield, a volatility factor of .75 (no volatility factor of the expected market
price of the Company's common stock for options granted prior to the Company's
initial public offering in August 1998 as the minimum value method was used);
and a weighted average expected life of the option of five years. The fair
value for employee stock purchase plan shares to be issued was estimated using
the following weighted average assumptions: risk-free interest rate of 5.19%,
no dividend yield, a volatility factor of .75, and a weighted average expected
life of the shares of six months.
As discussed above, the 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, 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
instruments.
F-21
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
For purposes of pro forma disclosures, the estimated fair value of the
options granted and ESPP shares to be issued is amortized to expense over their
respective vesting periods. 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 plans consistent with the method of FAS 123, the
Company's net loss applicable to common stockholders and net loss per share
applicable to common stockholders would have been increased to the pro forma
amounts indicated below (in thousands, except per share data):
<TABLE>
<CAPTION>
Years Ended December 31,
----------------------------
1996 1997 1998
-------- -------- --------
<S> <C> <C> <C>
Pro forma net loss applicable to common
stockholders................................ $(10,718) $(22,627) $(48,597)
======== ======== ========
Pro forma basic and diluted net loss per
share applicable to common stockholders..... $ (2.64) $ (5.28) $ (5.41)
======== ======== ========
</TABLE>
The pro forma impact of options granted and ESPP shares to be issued on the
net loss applicable to common stockholders for the years ended December 31,
1996, 1997, and 1998 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 $0.11, $0.41, and $3.20 for options
granted during 1996, 1997, and 1998, respectively. The weighted average grant
date fair value of ESPP shares to be issued was $27.76 for the year ended
December 31, 1998.
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 was due in February 1998, and was paid subsequent to year-
end.
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.
F-22
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
11. 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, 1996, 1997, and 1998.
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, 1997 and 1998 are as
follows (in thousands):
<TABLE>
<CAPTION>
Years Ended
December 31,
------------------
1997 1998
-------- --------
<S> <C> <C>
Deferred Tax Assets:
Net operating loss carryforwards....................... $ 11,323 $ 18,448
Tax credit carryforwards............................... 2,531 1,956
Capitalized research and development................... 1,373 1,776
Other, net............................................. 1,158 2,364
-------- --------
Total deferred tax assets............................ 16,385 24,544
Valuation allowance...................................... (16,385) (24,544)
-------- --------
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,
1997 and 1998, has been established to reflect these uncertainties. The change
in the valuation allowance was a net increase of approximately $4,444,000,
$10,329,000, and $8,159,000 for the years ended December 31, 1996, 1997, and
1998, respectively.
As of December 31, 1998, the Company had federal and California net operating
loss carryforwards of approximately $50,600,000 and $21,000,000, respectively.
The Company also had federal and California research and development tax credit
carryforwards of approximately $1,223,000 and $733,000, respectively. The net
operating loss and credit carryforwards will expire at various dates beginning
in the years 1999 through 2018, 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, 1996, 1997, and 1998 is as
follows (in thousands):
<TABLE>
<CAPTION>
Years Ended December 31,
--------------------------
1996 1997 1998
------- ------- --------
<S> <C> <C> <C>
Tax provision (benefit) at U.S. statutory
rate.......................................... $(3,638) $(7,667) $(16,027)
Loss for which no tax benefit is currently
recognizable.................................. 3,638 7,667 7,898
Nondeductible preferred stock dividend......... -- -- 8,129
------- ------- --------
$ -- $ -- $ --
======= ======= ========
</TABLE>
F-23
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
12. Segments of an Enterprise and Related Information
The Company operates in one business segment, the sale of cable modem access
systems, which it sells primarily to customers within the cable and
communications industries. The TeraPro and TeraLink are sold together as part
of an entire system, and the Company accordingly does not report revenue
derived from these components.
The Chief Executive Officer has been identified as the Chief Operating
Decision Maker (CODM) because he has final authority over resource allocation
decisions and performance assessment. The CODM does not receive discrete
financial information about the individual components.
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., Cablevision
Systems Corporation and Sumitomo Corporation, accounted for 40%, 16% and 14% of
revenues for the year ended December 31, 1998, respectively. No other customer
accounted for more than 10% of revenues during these years.
Total net export revenues to regions outside of the United States were
approximately $1,855,000 and $23,383,000 for the years ended December 31, 1997
and 1998, respectively. Revenues by geographic region were as follows (in
thousands):
<TABLE>
<CAPTION>
Years Ended
December 31,
--------------
1997 1998
------ -------
<S> <C> <C>
Revenues:
United States............................................... $ 263 $ 8,313
Canada...................................................... 198 13,032
Asia........................................................ 617 4,614
South America............................................... 326 1,350
Europe and Israel........................................... 714 4,387
------ -------
Total..................................................... $2,118 $31,696
====== =======
</TABLE>
13. 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, 1996, 1997, and 1998.
14. 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 Sumitomo
Corporation, a significant stockholder in the Company as of December 31, 1997.
During the year ended December 31, 1998, Sumitomo Corporation's ownership
interest was diluted as a result of subsequent Company financings, including
the Company's initial public offering, and Sumitomo is no longer considered a
related party. Accounts receivable from Sumitomo Corporation totaled
approximately $362,000 and accounts payable were not significant at December
31, 1997.
During the year ended December 31, 1998, the Company recognized revenue of
$12,546,000 in connection with product shipments made to Shaw Communications,
Inc., a significant stockholder with
F-24
<PAGE>
TERAYON COMMUNICATIONS SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
a position on the Company's Board of Directors as of December 31, 1998.
Accounts receivable from Shaw Communications, Inc. totaled approximately
$1,549,000 and accounts payable were not significant at December 31, 1998.
In September 1997, the Company received $2,000,000 from Sumitomo Corporation
in connection with a stock option agreement. As of December 31, 1997, the
Company recorded the amount received as an advance from the related party. The
stock option agreement allowed 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 which were subsequently converted into shares of
the Company's common stock at the completion of the Company's initial public
offering in August 1998.
F-25
<PAGE>
[Inside Back Cover]
Graphic consisting of a depiction of the following:
Terayon's new single-board cable modem
<PAGE>
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You may rely on the information contained in this prospectus. We have not au-
thorized anyone to provide information different from that contained in this
prospectus. Neither the delivery of this prospectus nor sale of common stock
means that information contained in this prospectus is correct after the date
of this prospectus. This prospectus is not an offer to sell or solicitation of
an offer to buy these shares of the common stock in any circumstances under
which the offer or solicitation is unlawful.
----------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Prospectus Summary....................................................... 3
Risk Factors............................................................. 6
Information Regarding Forward-Looking Statements......................... 21
Use of Proceeds.......................................................... 22
Dividend Policy.......................................................... 22
Price Range of Common Stock.............................................. 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............................................................... 49
Certain Transactions..................................................... 59
Principal and Selling Stockholders....................................... 60
Description of Capital Stock............................................. 62
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>
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3,250,000 Shares
[LOGO OF TERAYON COMMUNICATION SYSTEMS]
Common Stock
------------
PROSPECTUS
------------
BT Alex. Brown
Hambrecht & Quist
Lehman Brothers
Salomon Smith Barney
January 21, 1999
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