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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OF 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ---------------TO ---------------.
COMMISSION FILE NUMBER: 000-24647
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TERAYON COMMUNICATION SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0328533
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
2952 BUNKER HILL LANE
SANTA CLARA, CALIFORNIA 95054
(408) 727-4400
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF THE
REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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NONE NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, par value $0.001 per share
(TITLE OF CLASS)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of the registrant's knowledge, in definitive
proxy or information statements incorporated by reference in Part III of
this Form 10-K or any amendment to this Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of
the Company, based upon the closing sale price of the Common Stock on
March 12, 1999 as reported on the Nasdaq National Market, was
approximately $482,939,757. Shares of Common Stock held by each officer
and director and by each person known to the Company who owns 5% or more
of the outstanding Common Stock have been excluded in that such persons
may be deemed to be affiliates. This determination of affiliate status
is not necessarily a conclusive determination for other purposes.
As of March 12, 1999, the Company had outstanding 20,376,482 shares of
Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
The Registrant has incorporated by reference into Part III of this Form
10-K portions of its definitive Proxy Statement for the Annual Meeting
of Stockholders to be filed by April 30, 1999
SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This report on Form 10-K contains forward-looking statements of
Terayon Communication Systems, Inc. (the Company) within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934 which are subject to the "safe harbor"
created by those sections. The forward-looking statements include, but
are not limited to: statements related to industry trends and future
growth in the markets for cable modem systems; the Company's strategies
for reducing the cost of its products; the Company's product development
efforts; the effect of GAAP accounting pronouncements on the Company's
recognition of revenues; the Company's future research and development;
the timing of the Company's introduction of new products; the timing and
extent of deployment of the Company's products by its customers; and,
future profitability. Discussions containing such forward-looking
statements may be found in "Management's Discussion and Analysis of
Financial Condition and Results of Operations." These forward-looking
statements involve certain risks and uncertainties that could cause
actual results to differ materially from those in such forward-looking
statements. The Company disclaims any obligation to update these
forward-looking statements as a result of subsequent events. The
business risks on pages 18 through 29, among other things, should be
considered in evaluating the Company's prospects and future financial
performance.
PART I
ITEM 1. BUSINESS
Overview
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 this strategy
include the following:
o supply leading cable operators worldwide;
o advance industry standards;
o extend technology leadership and achieve rapid time to market;
o reduce manufacturing costs;
o provide superior customer service and support; and
o 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 the TeraComm system include Shaw Communications
Inc., TCA Cable TV, Inc., Cablevision Systems, Inc., and Crossbeam
Networks Corporation, a wholly owned subsidiary of Sumitomo Corporation.
Our Company was incorporated in California in January 1993 and
reincorporated in Delaware in July 1998. References in this report to
"Terayon," "we," "our," "us" and the "Company" refer to Terayon
Communication Systems, Inc. and its subsidiaries.
Recent Events
On January 21, 1999, we completed a public offering of 3,250,000
shares of common stock at $38.00 per share. Of the 3,250,000 shares
offered, 1,750,000 shares were offered by us and 1,500,000 were offered
by certain selling stockholders. Our net proceeds, after underwriting
discounts of approximately $3.3 million and expenses related to the
offering of approximately $700,000, were $62.5 million. The proceeds
have been designated for general corporate purposes. On February 9,
1999, the underwriters exercised their right to purchase 487,500
additional shares to cover over-allotments. Of the 487,500 additional
shares purchased, 351,946 shares were from us and the balance were
purchased from certain selling stockholders. Our net proceeds from the
exercise of the over-allotment option were $12.7 million.
On March 11, 1999, Shaw purchased 1,500,000 shares of our common
stock at $6.50 per share, resulting in net proceeds of $9.75 million.
The shares were purchased pursuant to the exercise of a warrant to
purchase 3,000,000 shares of our common stock issued to Shaw in 1998.
On March 18, 1999, we entered into a one-year Product Development
Assistance Agreement ("Development Agreement") with Rogers
Communications Inc. Under the terms of the Development Agreement, Rogers
will provide us assistance with the characterization and testing of our
subscriber-end and head-end voice over cable equipment. In addition,
Rogers will provide us technology to assist us with our efforts to
develop high quality, field proven technology solutions that are DOCSIS-
compliant and packet cable-compliant. The Product Development
Assistance Agreement has a term of one year. In consideration of Rogers
entering into the Development Agreement, we issued to Rogers two fully
vested and non-forfeitable warrants, each to purchase 1,000,000 shares
of common stock. One warrant has an exercise price of $1.00 per share
and one warrant has an exercise price of $37.00 per share. The warrants
may be exercised in full or in part through March 31, 2000. The fair
value of the two warrants is estimated to be approximately $45,000,000
and will be a noncash charge included in operations over the term of the
Development Agreement.
In addition, on March 18, 1999, we entered into a Supply Agreement
with Rogers Cablevision Limited, a subsidiary of Rogers Communications
Inc. Under the Supply Agreement, we agreed to make available to Rogers
our current TeraLink Gateway and TeraLink 1000 Master Controller, and
TeraPro Cable Modems and specified software. We also committed to
certain product pricing and specifications.
The Supply Agreement and the Development Agreement do not constitute
a commitment by Rogers to purchase or deploy any particular volume or
quantity of our product. No such commitment will be made unless Rogers
issues us a purchase order.
Business Segments
Terayon operates in one business segment, the sale of cable modem
access systems. Our products are sold together as part of the TeraComm
system and we do not report revenue derived from these individual
components. Additional information about Terayon's operations by
business segment and geographic region is included in Management's
Discussion and Analysis of Financial Condition and Results of Operations
in Item 7 of this report and Note 12 of Notes to Consolidated Financial
Statements included in Item 8 of this report.
Products
Current Products - The TeraComm System
Our 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 is dependent on 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.
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, we began volume
shipments of our 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.
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
We currently are 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 we do not anticipate commercial
deployment of these products until 2000.
Customers
We market our products to cable operators that seek to provide
broadband access services to both residential and commercial end users.
Our 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. We commenced volume shipments of our 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 currently is deploying our 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 us to supply cable modem systems for
Shaw's @Home service deployments in various cities throughout Canada.
Sumitomo. We have 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.
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 70% of our revenues in
1998 and approximately 73% of our revenues in 1997. In 1998, sales to
Shaw represented approximately 40% of our revenues, sales to Cablevision
represented approximately 16% and sales to Sumitomo represented
approximately 14% of our revenues. In 1997, sales to Telegate
represented approximately 30% of our revenues, sales to Sumitomo
represented approximately 29% and sales to NET Brasil represented
approximately 14% of our revenues. 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.
Research and Development
We believe that our future success will depend on our ability to
enhance our 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, we expect that
we will have to reduce the unit cost of manufacturing our cable modems
through design and engineering changes. For example, in October 1998, we
introduced a single-board modem, which provides cost savings over our
original dual-board modem.
We also currently are 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 we do not anticipate
commercial deployment of these products until 2000.
As of December 31, 1998, we had 56 employees engaged in research and
development. Our total research and development expenses were $10.7
million in 1998, $11.3 million in 1997 and $8.0 million in 1996.
Sales and Marketing
We have direct sales forces in North America, Latin America and
Europe. We also distribute our products via distributors and systems
integrators. We have signed a distribution agreement with Sumitomo under
which Crossbeam is distributing the TeraComm system to several of
Japan's leading cable operators.
We market our products directly to cable operators through our 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 our marketing efforts, we strive to educate cable
operators on the technological and business benefits of our system
solution, as well as our ability to provide quality support and service
to the customer. We participate in the major trade shows and industry
events for the cable industry in the United States and we are expanding
our presence in other markets through joint participation at local
events with our international sales and marketing partners. Industry
referrals and reference accounts are significant marketing tools we
develop and utilize.
Customer Service and Technical Support
We believe that our 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 TeraComm system, 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. We place 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 at our 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 to our TSS organization, we have developed sophisticated
tools for remote diagnosis and monitoring of the TeraComm systems
deployed by cable operators. These tools allow us to monitor cable
operators' installations of the TeraLink 1000 Master Controller and to
proactively suggest solutions before problems become noticeable to end
users. We are developing a Web-based knowledge system to provide cable
operators with access to the latest technical support information.
Manufacturing
We outsource the materials procurement, printed circuit board
assembly, and product assembly and testing to turnkey contract
manufacturers. Currently, we contract with Solectron, located in
Milpitas, California, for the manufacture of the majority of our
products. CMC California, Inc.("CMC"), located in Santa Clara,
California, also manufactures some of our products. We have a limited
in-house manufacturing capability at our Santa Clara headquarters. This
facility currently is used for the assembly and final testing of
TeraLink 1000 Master Controllers and TeraLink Gateways. We also use this
facility for 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. We also repair products returned from customers with
our in-house manufacturing resources.
Our future success will depend in significant part on our ability to
obtain high volume manufacturing at low costs. As volume increases, we
plan to engage additional contract manufacturers, to procure additional
manufacturing facilities and equipment, to modify existing inventory
procedures, to substantially increase our personnel and to revise our
quality assurance and testing practices. As part of our efforts to
reduce costs, we began volume shipments in October 1998 of our single-
board cable modem, which has higher gross margins than our original
dual-board cable modem. We anticipate that we will need to reduce
further the cost to manufacture our cable modem and we will continue to
evaluate the use of low cost third-party suppliers and manufacturers.
Subcontractors supply our contract manufacturers with both standard
components and subassemblies manufactured to our specifications. We
depend upon certain key suppliers for a number of the components for our
products. For example, we currently rely on VLSI Technology, Inc. for
our S-CDMA ASIC, which is used in our headend and cable modem products.
In addition, all of our products contain one or more components that
currently only are available from a single source.
Competition
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, 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 us, and have established
relationships and have worked with customers for a longer period of time
than we have. 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. 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, and the
development and market acceptance of alternative technologies could
decrease the demand for our products or render them obsolete. In
addition, these companies and other competitors could introduce
broadband access products that will be less costly or 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.
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. Broadband access services
based on cable modem technology may fail to gain widespread commercial
acceptance by cable operators and end users.
Regulation
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 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 a country without these regulations or
enter into the market in a country these regulations do not exist, new
regulations could be proposed at any time. The imposition of regulations
like this could place limitations on a 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 required licenses could harm our
ability to sell products to these customers.
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 be unable 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.
Intellectual Property
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 are co-authoring, 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 with 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 a termination like this were to occur, we
would continue to have access to some 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. Because
of these terms, we may find it difficult to enforce our intellectual
property rights against certain companies. Under the terms of proposed
license agreement, 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. Litigation also may be necessary to enforce
our intellectual property rights.
We pursue the registration of our trademarks in the United States and
have application spending to register several of our trademarks.
However, the laws of certain foreign countries might not protect our
products or intellectual property rights to the same extent as the laws
of the United States. This means that effective trademark, copyright,
trade secret and patent protection might not be available in every
country in which our products might be manufactured, marketed or sold.
Employees
As of December 31, 1998, we 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 administrative
functions. None of our employees is represented by a union. We believe
that our relations with our employees are good.
Executive Officers of the Registrant
Certain information regarding our executive officers as of March 12, 1999
is set forth below.
<TABLE>
<CAPTION>
Name Age Position
- ------------------------- ----- ---------------------------------------
<S> <C> <C>
Dr. Zaki Rakib(1)........ 40 Chief Executive Officer and Director
Shlomo Rakib............. 42 Chairman of the Board, President and
Chief Technical Officer
Ray M. Fritz............. 53 Chief Financial Officer
Dennis J. Picker......... 51 Chief Operating Officer
</TABLE>
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 our Chief
Financial Officer. Prior to co-founding Terayon, 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, our 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 Terayon, 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 Terayon.
Ray M. Fritz has served as our Chief Financial Officer since July
1998. Prior to joining us, 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 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.
ITEM 2. PROPERTIES
Our headquarters are located in an approximately 38,000 square foot
leased facility located in Santa Clara, California. The current lease
for the Santa Clara facility expires in March 2002. We have sales
offices in Denver, Colorado; Atlanta, Georgia; Sao Paulo, Brazil; and
Brussels, Belgium. We believe that our existing facilities are adequate
to meet our needs for the immediate future and that our future growth
can be accommodated by leasing additional or alternative space near our
current facilities.
ITEM 3. LEGAL PROCEEDINGS
We are not currently a party to any material legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of security holders in the
fourth quarter of 1998.
<PAGE>
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS
Market for the Registrant's Stock
Our common stock is traded on the Nasdaq National Market under the
symbol "TERN." Public trading of our common stock commenced on August
18, 1998. Prior to that, there was no public market for our common
stock. The following table sets forth, for the periods indicated, the
high and low per share sale prices of our common stock, as reported by
the Nasdaq National Market.
<TABLE>
<CAPTION>
High Low
---------- ----------
<S> <C> <C>
1998:
Third Quarter (from August 18, 1998).............. $15.186 $7.000
Fourth Quarter.................................... $40.500 $9.250
1999:
First Quarter (through March 18, 1999).......... $50.125 $25.750
</TABLE>
As of March 12, 1999 there were 248 stockholders of record. We
currently intend to retain any earnings for use in our business and do
not anticipate paying any cash dividends in the foreseeable future.
Recent Sales of Unregistered Securities
We did not sell any unregistered securities during the fourth quarter
of 1998.
Use of Proceeds from Sales of Registered Securities
We commenced our initial public offering on August 18, 1998 pursuant
to a Registration Statement on Form S-1 (the "Registration Statement")
(File No. 333-56911). The managing underwriters of the public offering
were BT Alex. Brown, Hambrecht & Quist, Lehman Brothers and Salomon
Smith Barney (the "Underwriters"). In the offering, we sold an
aggregate of 3,000,000 shares of our common stock for an initial price
of $13.00 per share.
The aggregate proceeds from the offering were $39.0 million. We paid
expenses of approximately $3.9 million, of which approximately $2.7
million represented underwriting discounts and commissions and
approximately $1.2 million represented expenses related to the offering.
Net proceeds from the offering were $35.1 million. Of the net proceeds,
as of December 31, 1998, approximately $5.4 million had been used to
fund operating activities, $1.5 million had been used for payments on
long-term debt and capital lease obligations and $900,000 had been used
to purchase property and equipment. The use of the proceeds from the
offering does not represent a material change in the use of proceeds
described in our Registration Statement. As of December 31, 1998, we had
invested the remainder of the net proceeds in short-term, interest-
bearing, investment grade securities.
ITEM 6. SELECTED FINANCIAL DATA
<TABLE>
<CAPTION>
Years Ended December 31,
------------------------------------------------
1998 1997 1996 1995 1994
--------- --------- --------- --------- --------
(in thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Consolidated Statement of
Operations Data:
Revenues....................... $31,696 $2,118 $ -- $ -- $140
Cost of goods sold............. 34,518 6,462 -- 676 --
--------- --------- --------- --------- --------
Gross profit (loss)............ (2,822) (4,344) -- (676) 140
--------- --------- --------- --------- --------
Operating expenses:
Research and development...... 10,685 11,319 8,020 2,028 235
Sales and marketing........... 6,947 4,468 1,141 205 17
General and administra-
tive......................... 3,223 2,546 1,789 825 84
--------- --------- --------- --------- --------
Total operating expenses...... 20,855 18,333 10,950 3,058 336
--------- --------- --------- --------- --------
Loss from operations........... (23,677) (22,677) (10,950) (3,734) (196)
Net interest income (expense).. 449 128 253 68 --
--------- --------- --------- --------- --------
Net loss....................... (23,228) (22,549) (10,697) (3,666) (196)
Series F convertible preferred
stock dividend (1)........... (23,910) -- -- -- --
--------- --------- --------- --------- --------
Net loss applicable to common
stockholders.................. ($47,138) ($22,549) ($10,697) ($3,666) ($196)
========= ========= ========= ========= ========
Historical basic and diluted
net loss per share applicable
to common stockholders (2).... ($5.25) ($5.26) ($2.64) ($1.02) ($0.10)
========= ========= ========= ========= ========
Shares used in computing
historical basic and diluted
net loss per share applicable
to common stockholders (2).... 8,986 4,289 4,054 3,589 2,000
========= ========= ========= ========= ========
Pro forma basic and diluted
net loss per share applicable
to common stockholders (2).... ($3.41) ($2.07)
========= =========
Shares used in computing pro
forma basic and diluted net
loss per share applicable
to common stockholders (2).... 13,804 10,873
========= =========
<CAPTION>
December 31,
------------------------------------------------
1998 1997 1996 1995 1994
--------- --------- --------- --------- --------
(in thousands)
<S> <C> <C> <C> <C> <C>
Consolidated Balance
Sheet Data:
Cash, cash equivalents and
short-term investments........ $28,880 $1,987 $12,864 $8,620 $27
Working capital (deficit)...... 24,422 (4,847) 9,971 6,934 (492)
Total assets................... 42,146 8,778 15,978 10,202 435
Long-term debt (less
current portion).............. 10 44 1,255 439 98
Accumulated deficit............ (84,301) (37,163) (14,614) (3,917) (251)
Total stockholders' equity
(net capital deficiency)...... $28,103 ($1,174) $11,405 $7,955 ($201)
</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.
<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Overview
We develop, market and sell cable modem systems based upon our S-CDMA
technology. Since our inception in January 1993, we have focused on the
development of our S-CDMA technology, as well as certain other core
technologies, to enable broadband transmission of data over cable
networks. We commenced the specification and design of our first ASIC in
October 1994 and produced the first version of this ASIC in June 1996.
At the same time, we developed an end-to-end broadband access system,
the TeraComm system, around the ASIC. During late 1996 and through 1997,
we commenced limited field trials of the TeraComm system with several
cable operators. In the first quarter of 1998, we commenced volume
shipments to a small number of cable operators. We had revenues of $31.7
million in 1998 and $2.1 million in 1997. We generally recognize product
revenues upon shipment of products to customers. While our existing
agreements do not contain price protection provisions and certain return
rights, future agreements may contain such provisions.
We sell our products both in the United States and internationally
and we market our products primarily to cable operators and
distributors. To date, a small number of customers has accounted for all
of our sales. In 1998, sales to Shaw represented approximately 40% of
our revenues, sales to Cablevision represented approximately 16% and
sales to Sumitomo represented approximately 14% of our revenues. In
1997, sales to Telegate represented approximately 30% of our revenues,
sales to Sumitomo represented approximately 29% and sales to NET Brasil
represented 14% our revenues. We expect that sales to a limited number
of customers will continue to account for a substantial portion of our
sales for the foreseeable future. If orders from significant customers
are delayed, canceled or otherwise fail to occur in any particular
period, or if any significant customer delays payment or fails to pay,
we could experience significant operating losses in such period. As a
result, we expect to experience significant fluctuations in our
operating results on a quarterly and annual basis.
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. We have
experienced and expect to continue to experience downward pressure on
our unit ASPs. We had negative gross margins from inception until the
fourth quarter of 1998. We achieved a positive gross margin for the
first time in the quarter ended December 31, 1998. While we have
initiated cost reduction programs to offset pricing pressures on our
products, we cannot be sure that these cost reduction efforts will
continue to keep pace with competitive price pressures or lead to an
improved gross margin. If we are unable to reduce costs efficiently, our
gross margin and profitability will suffer. Our gross margin also is
affected by the sales mix of TeraLink 1000 Master Controllers to
TeraLink Gateways and to TeraPro cable modems. 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). In addition, new
deployments 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, we expect negative or nominal margins on
TeraPro cable modems and expect that sales of TeraPro cable modems will
continue to constitute a significant portion of our revenues. As a
result of these factors, our gross margins and operating results are
likely to suffer in the near term. Our components are sold together as
part of an entire system, and accordingly we do not report revenue
derived from each component.
Our ability to generate revenues also depends on guaranteeing the
availability of supplies from our sole sources, increasing the
manufacturing and testing capacity of our products by a contractor while
ensuring product quality, and continuing deployment of our products by
existing and new customers. In the first quarter of 1998, we
transitioned our manufacturing operations from CMC to Solectron. We
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 our 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. Since Solectron could purchase
the related parts at a lower cost than we had valued the inventory, we
wrote down the inventory to the lower of cost or market as part of
selling the inventory to Solectron. We currently test and assemble the
TeraLink 1000 Master Controller and the TeraLink Gateway headend
equipment at our Santa Clara facility. Finished TeraPro cable modems are
drop shipped by Solectron to our customers.
We sustained net losses applicable to common stockholders of $47.1
million $22.5 million and $10.7 million for the years ended December 31,
1998, 1997 and 1996, respectively. As a result, we had an accumulated
deficit of $84.3 million as of December 31, 1998. Our operating expenses
are based in part on our expectations of future sales, and we expect
that a significant portion of our expenses will be committed in advance
of sales. Operating results may be adversely affected by a reduction in
sales if we are unable to adjust expenses quickly in response to any
decrease in sales. We expect to increase significantly expenditures in
technical development, sales and marketing and manufacturing as we
engage in activities related to product enhancement, cost reduction and
commercialization of new products. Additionally, we expect to increase
capital expenditures and other operating expenses in order to support
and expand our operations. We anticipate that we 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 equipment for newly hired employees. As
a result of these anticipated increased operating expenses, we expect to
continue to incur losses for the foreseeable future.
Results of Operations
Years Ended December 31, 1998 and 1997
Revenues. Our revenues increased to $31.7 million in 1998 from $2.1
million in 1997. Revenues consist primarily of sales of cable modems and
headend equipment to new and existing customers. We did not commence
selling our products until June 1997 and did not commence selling our
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 our manufacturing operations group. The
cost of the manufacturing operations group includes assembly, test and
quality assurance for products, warranty costs and associated costs of
personnel and equipment. In 1998, we incurred $34.5 million in cost of
goods sold, which included the costs our manufacturing operations group
and a charge of $1.3 million relating to the write-off of obsolete
inventory and the transition of manufacturing operations. In 1997, we
incurred $6.5 million in cost of goods sold, which included the cost of
the manufacturing group for the entire period as we readied our products
for commercialization.
Gross Loss. We incurred a gross loss of $2.8 million in 1998. In
1997, we incurred a gross loss of $4.3 million due to costs associated
with our manufacturing operations group. The decrease in gross loss in
1998 compared to 1997 was primarily due to a reduced negative margin on
cable modems, which was partially offset by the $1.3 million write-off
relating to obsolete inventory and the transition of manufacturing
operations to Solectron.
We 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, we achieved a positive gross margin of $425,000 in
the fourth quarter of 1998. We anticipate that decreases in the average
sales price of our cable modems will partially, if not completely,
offset the benefits obtained from the cost-reduced modem, particularly
if we are unable to achieve cost reductions sufficient to offset further
average selling price declines.
Research and Development. Research and development expenses consist
primarily of personnel costs, as well as design expenditures, equipment
and supplies required to develop and to enhance our products. Research
and development expenses decreased to $10.7 million in 1998 from $11.3
million in 1997 as a result of the timing of our development projects.
We intend 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 trade shows, consulting and travel. Sales and
marketing expenses increased to $6.9 million in 1998 from $4.5 million
in 1997, primarily due to increased payroll costs related to additional
sales and support personnel for commercial trials and deployment of our
products and increased commissions related to higher sales in 1998. We
expect sales and marketing expenses to continue to increase as we expand
our customer base.
General and Administrative. General and administrative expenses
primarily consist of salary and benefits for administrative officers and
support personnel, travel expenses, legal, accounting and consulting
fees. General and administrative expenses increased to $3.2 million in
1998 from $2.5 million in 1997. The increase was primarily a result of
the additional reporting requirements imposed on us as a public company
and increased infrastructure to support our expanded activities. We
expect 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 $449,000 in 1998
compared to $128,000 in 1997. The increase was primarily the result of
higher average cash balances subsequent to our initial public offering
in August 1998.
Series F Convertible Preferred Stock Dividend. We recorded a dividend
of $23.9 million in 1998. The dividend represented the fair value of a
warrant to purchase 3,000,000 shares of our common stock (the "Shaw
Warrant"), and was recorded under the provision of EITF No. 96-13,
"Accounting for Derivative Financial Instruments Indexed to, and
Potentially Settled in, a Company's Own Stock." The Shaw Warrant was
issued in connection with the sale of $5.0 million of convertible
preferred stock to Shaw (the "Shaw Financing"). Our accounting
conclusion was 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 we issued the $5.0 million of
convertible preferred stock and the Shaw Warrant on April 6, 1998, our
singular objective was to obtain sufficient liquidity to continue as a
going concern. At the time of the Shaw Financing, our ability to
continue as a going concern was in serious doubt. At March 31, 1998, we
had only $109,000 in cash, but were using cash of approximately $1.0
million, net, per month in operations. In addition, we had a deficit in
working capital of $8.8 million. On March 11, 1999, Shaw purchased
1,500,000 shares of our common stock under the terms of the above
warrant resulting in net proceeds to us of $9.75 million.
Income Taxes. We have not generated any net income to date and
therefore we have not accrued any income taxes since our inception. We
account 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, 1998 and 1997 have been established to
reflect these uncertainties.
At December 31, 1998, we 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 our net operating loss and
tax credit carryforwards before full utilization.
Stock-Based Compensation. As of December 31, 1998, we have recorded
deferred compensation of $2.6 million related to certain stock options
granted in 1998 and 1997. We amortized approximately $421,000 of the
deferred compensation in 1998 and $12,000 in 1997. The remainder will be
amortized over the related vesting period of the stock options. See Note
10 of Notes to Consolidated Financial Statements.
Years Ended December 31, 1997 and 1996
Revenues. We recognized product revenues of $1.6 million in 1997,
primarily due to sales of headend controllers and cable modems. We did
not recognize any revenues from product sales in 1996, since we did not
commence selling our products until June 1997. A majority of the
products shipped during 1997 were for customer trial purposes. During
1997, we also recognized $480,000 of technology development revenues
pursuant to a technology development to provide telephony modules to a
telecommunications systems manufacturer. We do not expect significant
revenues to be recognized pursuant to technology development agreements
in the future.
Cost of Goods Sold. We 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. We did not incur any
cost of goods sold in 1996.
Gross Loss. We 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 our products. We did not realize any gross profit
or loss in 1996.
Research and Development. Research and development expenses increased
to $11.3 million in 1997 from $8.0 million in 1996 due to increased
staffing and associated engineering costs related to new and existing
product development.
Sales and Marketing. Sales and marketing expenses increased to $4.5
million in 1997 from $1.1 million in 1996, primarily due to increased
payroll costs related to additional sales and support personnel for
commercial and market trials and the commercial launch of our products.
General and Administrative. General and administrative expenses
increased to $2.5 million in 1997 from $1.8 million in 1996, due to an
increased number of personnel and related payroll costs and higher legal
and executive travel expenses.
Net Interest Income. Net interest income decreased to $128,000 in
1997 from $253,000 in 1996, primarily as a result of higher interest
expense due to larger loan balances in 1997.
Liquidity and Capital Resources
We have met our liquidity needs since inception through December 31,
1998 primarily through private sales of preferred stock and an initial
public offering completed in August 1998. The private sales of preferred
stock resulted in aggregate proceeds to us, before deduction of issuance
costs, of $52.7 million. The initial public offering of 3,000,000 shares
of common stock at a price of $13.00 per share resulted in net proceeds
of $35.1 million.
We have used cash in operating activities of $50.6 million since our
inception through December 31, 1998. Cash used in operating activities
was $18.1 million in 1998, $20.8 million in 1997 and $9.4 million in
1996. Cash used in investing activities was $16.1 million in 1998 and
$6.5 million in 1996. Investment activities in 1998 and 1996 consisted
primarily of the purchase of short-term investments. Cash provided by
investing activities, primarily from the sales and maturities of short-
term investments, was $1.5 million in 1997. Cash provided by financing
activities was $47.0 million in 1998, $12.6 million in 1997 and $15.6
million in 1996. Cash provided by financing activities consisted
primarily of proceeds from private sales of preferred stock in 1998,
1997 and 1996 and proceeds from our initial public offering of common
stock in 1998.
At December 31, 1998, we 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.
On January 21, 1999, we completed a public offering of 3,250,000
shares of common stock at a offering price of $38.00 per share. Of the
3,250,000 shares, we sold 1,750,000 shares and certain selling
stockholders sold 1,500,000 shares. We received net proceeds of $62.5
million, after the underwriting discount of approximately $3.3 million
and offering expenses of approximately $700,000. The proceeds from this
offering have been designated for general corporate purposes. On
February 9, 1999, the underwriters exercised their option to purchase
487,500 additional shares of common stock to cover over-allotments, of
which 351,946 shares were purchased from us and 135,554 shares were
purchased from certain selling stockholders. Our net proceeds from the
exercise of the over-allotment option were $12.7 million.
On March 11, 1999, Shaw purchased 1,500,000 shares of our common
stock at $6.50 per share, resulting in net proceeds to us of $9.75
million. The shares were purchased pursuant to the exercise of a
warrant to purchase 3,000,000 shares of our common stock issued to Shaw
in 1998.
Our cash equivalents and short-term investments are subject to market
risk, primarily interest rate and credit risk. Our investments are
managed by outside professional managers within guidelines we establish.
The guidelines, which include security type, credit quality and
maturity, are intended to limit market risk by restricting our
investments to high quality debt instruments with short-term maturities.
Due to the relatively short-term duration of our 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 our
investments. Our investments in debt securities are classified as
available-for-sale, therefore, we do not recognize gains or losses due
to changes in interest rates unless such securities are sold prior to
maturity. We generally hold securities until maturity and carry the
securities at amortized cost, which approximates market value.
As of December 31, 1998, we had approximately $10.3 million of
unconditional purchase obligations. We anticipate that we will pay these
obligations by May 1999. We intend to make these payments out of
available working capital.
We believe that our current cash balances will be sufficient to
satisfy our cash requirements for at least the next 24 months. We may
require additional financing prior to that time to fund our operations
and we 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 our stockholders. Additional financing may not be available
to us on acceptable terms, or at all, when we require it.
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 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 harm us in ways that are not currently
known, discernible, quantifiable or otherwise anticipated.
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
is responsible for developing a plan for timely Year 2000 compliance
(the "Plan"). The 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 to remedy their own Year 2000 issues. In addition, the Plan will
address the development of contingency plans for 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 significant 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 our key suppliers and customers. The operations of our key
suppliers and customers could be harmed in the event they do not
successfully and timely achieve Year 2000 compliance. Our business and
results of operations could suffer 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 suffer 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 not be able 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 such plan. In addition, any upgrades we do 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. Furthermore, there can be no
guarantee that the systems of other companies on which our systems rely
will be timely converted. In addition, a failure to convert by another
company, or a conversion that is incompatible with our systems, would
harm 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.
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 we believe that the
adoption of FAS 133 will not have a significant impact on our operating
results or cash flows.
Certain Business Risks
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 harm our business. 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:
o variations in the timing of orders and shipments of our products;
o variations in the size of the orders by our customers;
o new product introductions by competitors;
o delays in introducing new products;
o delays of orders forecasted by our customers;
o delays by our customers in the completion of upgrades of cable
infrastructure;
o variations in capital spending budgets of cable operators; and
o 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 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:
o the sales mix of our products;
o the volume of products manufactured;
o the type of distribution channel through which we sell our
products;
o the average selling prices or "ASPs" of our products; and
o 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 70% of our revenues in
1998 and three customers accounted for approximately 73% of our revenues
in 1997. 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%. 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%. 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 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 suffer.
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 some or all 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 harm 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 harm 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
33% of our revenues in 1998 and 78% of our revenues in 1997. 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 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 harm 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 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:
o Digital Subscriber Line technologies known as "xDSL";
o Integrated Service Digital Network or "ISDN";
o data transmission over fiber optic cable;
o direct broadcast satellite;
o Local Multipoint Distribution Service; and
o 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 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 @ 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
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:
o the availability of financing;
o cable operators' annual budget cycles, as well as the typical
reduction in upgrade projects during the winter months;
o the status of federal, local and foreign government regulation
and deregulation of the telecommunications industry;
o overall demand for cable services;
o competitive pressures (including the availability of alternative
data transmission and access technologies);
o discretionary consumer spending patterns; and
o 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 source 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 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 harm 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 74% of our revenues in 1998 and approximately 88% of our
revenues in 1997. 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:
o changes in foreign government regulations and communications
standards;
o export license requirements, tariffs and taxes;
o other trade barriers;
o difficulty in collecting accounts receivable;
o difficulty in managing foreign operations; and
o 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 significantly reduced. 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 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 harm 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:
o product performance, features and reliability;
o price;
o size and stability of operations;
o breadth of product line;
o sales and distribution capability;
o technical support and service;
o relationships with cable operators; and
o compliance with industry standards.
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, Vice President, Manufacturing Operations and Vice
President of Engineering, all of whom joined the Company less than one
year ago. 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
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 are co-authoring, 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 with 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 a termination like this were to occur, we
would continue to have access to some 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. Because
of these terms, we may find it difficult to enforce our intellectual
property rights against certain companies. Under the terms of proposed
license agreement, 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. 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 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 a country without these regulations or
enter into the market in a country these regulations do not exist, new
regulations could be proposed at any time. The imposition of regulations
like this could place limitations on a 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 required licenses could harm 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 be unable 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 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:
o Actual or anticipated variations in quarterly operating results;
o Announcements of technological innovations;
o New products or services offered by us or our competitors;
o Changes in financial estimates by securities analysts;
o Conditions or trends in the broadband access services industry;
o Changes in the economic performance and/or market valuations of
Internet, online service or broadband access service industries;
o Changes in the economic performance and/or market valuations of
other Internet, online service or broadband access service
companies;
o Our announcement of significant acquisitions, strategic
partnerships, joint ventures or capital commitments;
o Additions or departures of key personnel;
o Sales of common stock; and
o 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.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
TERAYON COMMUNICATION SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Report of Ernst & Young LLP, Independent Auditors
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders' Equity (Net Capital
Deficiency)
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
<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, 1998 and 1997,
and the related consolidated statements of operations, stockholders'
equity (net capital deficiency), and cash flows for each of the three
years in the period ended December 31, 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, 1998 and 1997, and the consolidated results of its operations and
its cash flows for each of the three years in the period ended December
31, 1998, in conformity with generally accepted accounting principles.
/s/ Ernst & Young LLP
San Jose, California
January 15, 1999
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
<TABLE>
<CAPTION>
December 31,
----------------------
1998 1997
---------- ----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents............................. $14,342 $1,569
Short-term investments................................ 14,538 418
Accounts receivable, less allowance for doubtful
accounts of $594 in 1998 and $20 in 1997............. 2,090 574
Accounts receivable from related parties.............. 1,549 362
Inventory............................................. 3,950 1,322
Other current assets.................................. 1,856 690
---------- ----------
Total current assets.................................... 38,325 4,935
Property and equipment, net............................. 3,593 3,615
Officer note receivable................................. 100 100
Other assets............................................ 128 128
---------- ----------
Total assets............................................ $42,146 $8,778
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICIENCY)
Current liabilities:
Accounts payable...................................... $8,600 $2,232
Accrued payroll and related expenses.................. 2,475 1,052
Other accrued liabilities............................. 2,799 1,526
Advance from related party............................ -- 2,000
Deferred revenue...................................... -- 95
Current portion of long-term debt..................... -- 2,812
Current portion of capital lease obligations.......... 29 65
---------- ----------
Total current liabilities........................... 13,903 9,782
Long-term portion of capital lease obligations.......... 10 44
Deferred rent........................................... 130 126
Commitments and contingencies
Redeemable common stock, $.001 par value:
Authorized shares--included in common stock authorized
Issued and outstanding shares--none in 1998 and
10,000 in 1997....................................... -- 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--none in 1998 and 10,000,000 in 1997
Issued and outstanding shares--none in 1998 and
7,131,161 in 1997.................................... -- 35,807
Common stock, $.001 par value:
Authorized shares--30,000,000
Issued and outstanding shares--16,458,121 in 1998 and
4,620,447 in 1997.................................... 16 458
Additional paid in capital............................ 114,594 --
Accumulated deficit................................... (84,301) (37,163)
Deferred compensation................................. (2,184) (216)
Stockholders' notes receivable........................ (22) (60)
---------- ----------
Total stockholders' equity (net capital deficiency). 28,103 (1,174)
---------- ----------
Total liabilities and stockholders' equity (net
capital deficiency)................................ $42,146 $8,778
========== ==========
</TABLE>
See accompanying notes.
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
<TABLE>
<CAPTION>
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Revenues:
Product revenues....................... $19,150 $1,021 $ --
Related party product revenues......... 12,546 617 --
Contract consulting and technology
development revenues.................. -- 480 --
---------- ---------- ----------
Total revenues....................... 31,696 2,118 --
Cost of goods sold:
Cost of product revenues............... 22,296 3,904 --
Cost of related party product revenues. 12,222 2,558 --
---------- ---------- ----------
Total cost of goods sold............. 34,518 6,462 --
---------- ---------- ----------
Gross loss ................................. (2,822) (4,344) --
Operating expenses:
Research and development............... 10,685 11,319 8,020
Sales and marketing.................... 6,947 4,468 1,141
General and administrative............. 3,223 2,546 1,789
---------- ---------- ----------
Total operating expenses............. 20,855 18,333 10,950
---------- ---------- ----------
Loss from operations..................... (23,677) (22,677) (10,950)
Interest income.......................... 808 396 393
Interest expense......................... (359) (268) (140)
---------- ---------- ----------
Net loss................................. (23,228) (22,549) (10,697)
Series F convertible preferred
stock dividend.......................... (23,910) -- --
---------- ---------- ----------
Net loss applicable to common
stockholders............................ ($47,138) ($22,549) ($10,697)
========== ========== ==========
Historical basic and diluted net loss
per share applicable to common
stockholders............................ ($5.25) ($5.26) ($2.64)
========== ========== ==========
Shares used in computing historical
basic and diluted net loss per share
applicable to common stockholders....... 8,986 4,289 4,054
========== ========== ==========
Pro forma basic and diluted net loss
per share applicable to common
stockholders............................ ($3.41) ($2.07)
========== ==========
Shares used in computing pro forma
basic and diluted net loss per share
applicable to common stockholders....... 13,804 10,873
========== ==========
</TABLE>
See accompanying notes.
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY)
(in thousands, except share amounts)
<TABLE>
<CAPTION>
Total
Convertible Addi- Stock- Stockholders'
Preferred Stock Common Stock tional Deferred holders' Equity
--------------------- --------------------- Paid-In Accumulated 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
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 -- -- -- -- -- -- 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.
<PAGE>
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Years Ended December 31,
-----------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Operating activities:
Net loss applicable to common stockholders...... ($47,138) ($22,549) ($10,697)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization................. 1,992 1,563 830
Amortization of unearned compensation related
to stock options............................. 421 12 --
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.......................... (1,516) (574) --
Accounts receivable from related parties..... (1,187) (362) --
Inventory.................................... (2,628) (1,322) --
Other current assets......................... (1,166) (391) (177)
Other assets................................. -- 15 (118)
Accounts payable............................. 6,368 1,550 8
Accrued payroll and related expenses......... 1,423 482 346
Other accrued liabilities.................... 1,442 1,076 263
Deferred revenue............................. (95) (330) --
Deferred rent................................ 4 24 102
Other noncurrent liabilities................. -- (24) 24
--------- --------- ---------
Net cash used in operating activities........... (18,116) (20,830) (9,382)
--------- --------- ---------
Investing activities:
Purchases of short-term investments............. (32,959) (10,995) (6,863)
Proceeds from sales and maturities of
short-term investments......................... 18,839 15,085 2,355
Purchases of property and equipment............. (1,970) (2,606) (1,892)
Proceeds from sale of assets.................... -- -- 42
Officer note receivable......................... -- -- (100)
--------- --------- ---------
Net cash provided by (used in) investing
activities..................................... (16,090) 1,484 (6,458)
--------- --------- ---------
Financing activities:
Principal payments on capital leases............ (70) (144) (124)
Principal payments on long-term debt............ (2,812) (909) (273)
Proceeds from long-term debt.................... -- 1,654 1,843
Exercise of options and warrant to purchase
common stock................................... 778 140 11
Advance from related party...................... -- 2,000 --
Proceeds from issuance of preferred stock....... 6,387 9,818 14,085
Proceeds from issuance of redeemable preferred
stock.......................................... 7,500 -- --
Principal payments on redeemable common
stockholder and common stockholder notes
receivable..................................... 60 -- 34
Proceeds from issuance of common stock.......... 35,136 -- --
--------- --------- ---------
Net cash provided by financing activities.... 46,979 12,559 15,576
--------- --------- ---------
Net increase (decrease) in cash and cash
equivalents.................................... 12,773 (6,787) (264)
Cash and cash equivalents at beginning of year.. 1,569 8,356 8,620
--------- --------- ---------
Cash and cash equivalents at end of year........ $14,342 $1,569 $8,356
========= ========= =========
Supplemental disclosures of cash flow
information:
Cash paid for interest.......................... $359 $268 $140
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.
<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, 1998, 1997 and 1996 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 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,
---------------------
1998 1997
---------- ----------
<S> <C> <C>
Finished goods.................... $3,355 $163
Work-in-process................... 170 366
Raw materials..................... 425 793
---------- ----------
$3,950 $1,322
========== ==========
</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 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,
---------------------
1998 1997
---------- ----------
<S> <C> <C>
Software and computers............ $4,411 $3,695
Furniture and equipment........... 3,567 2,421
Leasehold improvements............ 197 89
---------- ----------
8,175 6,205
Accumulated depreciation and
amortization..................... (4,582) (2,590)
---------- ----------
Property and equipment, net....... $3,593 $3,615
========== ==========
</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.
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, 1998, 1997 and 1996.
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).
A reconciliation of shares used in the calculation of historical and
pro forma basic and diluted net loss per share applicable to common
stockholders follows (in thousands, except per share data):
<TABLE>
<CAPTION>
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Net loss.................................. ($23,228) ($22,549) ($10,697)
Series F convertible preferred stock
dividend (Note 10)....................... (23,910) -- --
---------- ---------- ----------
Net loss applicable to common
stockholders............................. ($47,138) ($22,549) ($10,697)
========== ========== ==========
Shares used in computing historical
basic and diluted net loss per share
applicable to common stockholders........ 8,986 4,289 4,054
Historical basic and diluted net loss
per share applicable to common
stockholders............................. ($5.25) ($5.26) ($2.64)
========== ========== ==========
Shares used in computing historical
basic and diluted net loss per share
applicable to common stockholders........ 8,986 4,289
========== ==========
Adjustment to reflect the effect of the
assumed conversion of convertibel
preferred stock outstanding to
common stock............................. 4,818 6,584
----------------------
Shares used in computing pro forma
basic and diluted net loss per share
applicable to common stockholders........ 13,804 10,873
========== ==========
Pro forma basic and diluted net loss
per share applicable to common
stockholders............................ ($3.41) ($2.07)
========== ==========
</TABLE>
Options to purchase 2,691,234 and 2,337,184 shares of common stock
were outstanding at December 31, 1998 and 1997, respectively, and
warrants to purchase 3,019,191 shares of common stock were outstanding
at December 31, 1998, but were not included in the computation of
diluted net loss per share, since the effect would be antidilutive.
Impact of Recently Issued Accounting Standard
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.
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)
<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 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 $853,000, $850,000, and $542,000 for
the years ended December 31, 1998, 1997, and 1996, respectively. In
March 1996, the Company subleased its former facilities to a third party
through December 1997. Sublease rental income was approximately $122,000
and $106,000 for the years ended December 31, 1997 and 1996,
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, 1998 and 1997. Related
accumulated amortization was approximately $375,000 and $337,000 at
December 31, 1998 and 1997, 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.
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 $256,000, $205,000, and $88,000 for the years ended
December 31, 1998, 1997, and 1996, 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.
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 or (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 $88,000 and $29,000 for the years ended December 31, 1998
and 1997, 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.
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
Issued
Shares 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
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, 1998 and 1997, the Company
recorded aggregate deferred compensation of approximately $2,389,000 and
$228,000, respectively, representing the difference 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, 1998 and 1997, the amortized expense was
approximately $421,000 and $12,000, 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 Average Contractual
of Exercise 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 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, 1998, 1997 and 1996
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 5.39%, 5.75% and 6.22% for 1998, 1997, and
1996, 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.
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,
--------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Pro forma net loss applicable to common
stockholders............................. ($48,597) ($22,627) ($10,718)
========== ========== ==========
Pro forma basic and diluted net loss per
share applicable to common stockholders.. ($5.41) ($5.28) ($2.64)
========== ========== ==========
</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, 1998, 1997, and 1996 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 $3.20, $0.41, $0.11and
for options granted during 1998, 1997, and 1996, 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 approximately $81,000 for the purpose of
purchasing the Company's Series A preferred stock. The underlying full
recourse notes were paid in June 1998and August 1996.
In January 1998, the Company issued common stock to an employee in
exchange for a full recourse note receivable for $9,000. The note bears
interest at 5.7% and is payable in three equal annual payments
commencing in January 1999.
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, 1998, 1997, and 1996.
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, 1998 and 1997 are as follows (in thousands):
<TABLE>
<CAPTION>
Year Ended December 31,
---------------------
1998 1997
---------- ----------
<S> <C> <C>
Deferred Tax Assets:
Net operating loss carryforwards............ $18,448 $11,323
Tax credit carryforwards.................... 1,956 2,531
Capitalized research and development........ 1,776 1,373
Other, net.................................. 2,364 1,158
---------- ----------
Total deferred tax assets................. 24,544 16,385
Valuation allowance.......................... (24,544) (16,385)
---------- ----------
Net deferred tax assets $ -- $ --
========== ==========
</TABLE>
Realization of deferred tax assets is dependent on future earnings,
if any, the timing and the amount of which are uncertain. Accordingly, a
valuation allowance, in an amount equal to the net deferred tax asset as
of December 31, 1998 and 1997, has been established to reflect these
uncertainties. The change in the valuation allowance was a net increase
of approximately $8,159,000, $10,329,000, $4,444,000 and for the years
ended December 31, 1998, 1997, and 1996, 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,
1998, 1997, and 1996 is as follows (in thousands):
<TABLE>
<CAPTION>
Years Ended December 31,
--------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Tax provision (benefit) at U.S.
statutory rate.................... ($16,027) ($7,667) ($3,638)
Loss for which no tax benefit is
currently recognizable............ 7,898 7,667 3,638
Nondeductible preferred stock 8,129 -- --
1
---------- ---------- ----------
$ -- $ -- $ --
========== ========== ==========
</TABLE>
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, Shaw Communications, Inc.,
Cablevision Systems Corporation and Sumitomo Corporation, accounted for
40%, 16% and 14% of revenues, respectively, for the year ended December
31, 1998. 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. 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 $23,383,000 and $1,855,000 for the years ended
December 31, 1998 and 1997, respectively. Revenues by geographic region
were as follows (in thousands):
<TABLE>
<CAPTION>
Years Ended December 31,
---------------------
1998 1997
---------- ----------
<S> <C> <C>
Revenues:
United States................................. $8,313 $263
Canada........................................ 13,032 198
Asia.......................................... 4,614 617
South America................................. 1,350 326
Europe and Israel............................. 4,387 714
---------- ----------
Total....................................... $31,696 $2,118
========== ==========
</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, 1998, 1997, and 1996.
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 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 (see Note 10) with 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 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.
15. Subsequent Events (Unaudited)
In January 1999, the Company completed a public offering of
3,250,000 shares of common stock, of which 1,750,000 shares were offered
by the Company and 1,500,000 shares were offered by existing
stockholders. The public offering resulted in proceeds to the Company
of approximately $62,500,000, net of underwriting discounts,
commissions, and other offering costs. In February 1999, the
underwriters purchased an additional 487,500 shares of common stock as a
result of the exercise of the over-allotment option, of which 351,946
and 135,554 shares of common stock were purchased from the Company and
certain existing stockholders, respectively. This additional sale of
common stock resulted in additional proceeds of approximately
$12,700,000 to the Company.
On March 11, 1999, Shaw Communications, Inc. purchased 1,500,000
shares of the Company's common stock at $6.50 per share, resulting in
net proceeds to the Company of approximately $9,750,000. The shares
were purchased pursuant to the exercise of a warrant to purchase
3,000,000 shares of the Company's common stock issued to Shaw in 1998.
On March 18, 1999, the Company entered into a one-year Product
Development Assistance Agreement ("Development Agreement") with Rogers
Communications Inc. Under the terms of the Development Agreement, Rogers
will provide the Company assistance with the characterization and
testing of the Company's subscriber-end and head-end voice over cable
equipment. In addition, Rogers will provide the Company technology to
assist the Company in connection with its efforts to develop high
quality, field proven technology solutions that are DOCSIS (1.0, 1.1 and
1.2)-compliant and packet cable-compliant. In consideration of Rogers
entering into the Development Agreement, the Company issued Rogers two
fully vested and non-forfeitable warrants, each to purchase 1,000,000
shares of common stock. One warrant has an exercise price of $1.00 per
share and one warrant has an exercise price of $37.00 per share. The
warrants may be exercised in full or in part through March 31, 2000.
The fair value of the two warrants is estimated to be approximately
$45,000,000 and will be a noncash charge included in operations over the
term of the Product Development Assistance Agreement.
In addition, on March 18, 1999, the Company entered into a Supply
Agreement with Rogers Cablevision Limited, a subsidiary of Rogers
Communications Inc. Under the Supply Agreement, the Company agreed to
make available to Rogers its current TeraLink Gateway and TeraLink 1000
Master Controller, and TeraPro Cable Modems and specified software. The
Company also committed to certain product pricing and specifications.
The Supply Agreement and the Development Agreement do not constitute
a commitment by Rogers to purchase or deploy any particular volume or
quantity of the Company's product. No such commitment will be made
unless Rogers issues the Company a purchase order.
ITEM 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosures
Not applicable.
PART III
ITEM 10. Directors and Officers of the Registrant
The information required by this item for the Company's directors is
incorporated by reference to the 1999 Proxy Statement, under the caption
"Election of Directors", and for the executive officers of the Company,
the information is included in Part I hereof under the caption
"Executive Officers of the Registrant."
ITEM 11. Executive Compensation
Incorporated by reference to the 1999 Proxy Statement, the section
title "Executive Compensation."
ITEM 12. Security Ownership of Certain Beneficial Owners and Management
Incorporated by reference to the 1999 Proxy Statement, the section
titled "Record Date and Voting Securities" and the section titled
"Security Ownership."
ITEM 13. Certain Relationship and Related Transactions
Incorporated by reference to the 1999 Proxy Statement, under the
section titled "Certain Transactions."
PART IV
ITEM 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) Exhibits.
<TABLE>
<CAPTION>
Exhibit
Number Description of Document
- ---------- --------------------------------------------------------------
<C> <S>
3.1 Amended and Restated Certificate of Incorporation of the
Registrant.
3.2 Bylaws of the Registrant. (2)
4.1 Reference is made to Exhibits 3.1 through 3.2.
4.2 Specimen Common Stock Certificate. (2)
4.3 Amended and Restated Information and Registration Rights Agreement
dated April 6, 1998. (2)
10.1 Form of Indemnity Agreement between the Registrant and each of its
directors and officers. (2)
10.2 1995 Stock Option Plan, as amended on March 26, 1996. (2)
10.3 1997 Equity Incentive Plan, as amended on June 9, 1998. (2)
10.4 1998 Employee Stock Purchase Plan. (2)
10.5 1998 Non-Employee Directors Stock Option Plan. (2)
10.6* Supply Agreement between the Registrant and ECI Telecom Ltd. dated
March 3, 1998. (2)
10.7* Strategic Partnership and Distributorship Agreement between the
Registrant and Sumitomo Corporation dated December 4, 1996. (2)
10.8* Master Agreement between the Registrant and NET Brasil S.A. dated
June 30, 1997. (2)
10.9 Resale and License Agreement between the Registrant and Digital
Equipment Corporation dated December 9, 1996. (2)
10.10 Lease Agreement dated January 23, 1996 between the Registrant and
Arrillaga Family Trust and Richard T. Peery Separate Property
Trust. (2)
10.11 Employment Agreement between the Registrant and Zaki Rakib dated
February 1993. (2)
10.12 Employment Agreement between the Registrant and Selim Rakib dated
February 1993. (2)
10.13 Loan and Security Agreement dated August 10, 1998 between the
Company and Silicon Valley Bank and Schedule to Loan and Security
Agreement dated August 10, 1998 between the Company and Silicon
Valley Bank (3)
10.14 Streamline Facility Agreement dated October 30, 1998 between the
Company and Silicon Valley Bank. (1)
10.15 Product Development Agreement between the Registrant and Cisco
Systems, Inc. dated July 22, 1996. (2)
10.16 Promissory Note and Stock Pledge Agreement between the Registrant
and Shlomo Rakib dated March 6, 1996. (2)
10.17 Stock Repurchase Agreement between the Registrant and Zaki Rakib
dated March 16, 1995. (2)
10.18 Stock Repurchase Agreement between the Registrant and Shlomo Rakib
dated March 16, 1995. (2)
10.19 Series A Preferred Stock Purchase Agreement between the Registrant
and Lewis Solomon dated June 16, 1995. (2)
10.20 Promissory Note between the Registrant and Lewis Solomon dated June
16, 1997. (2)
10.21 Stock Pledge Agreement between the Registrant and Lewis Solomon
dated June 16, 1997. (2)
10.22 Anti-Dilution Warrant to Purchase Shares of Common Stock dated
April 6, 1998 issued ("Anti-Dilution Warrant") to Shaw
Communications Inc. (2)
10.23 Waiver to Anti-Dilution Warrant dated January 19, 1999. (1)
21.1 List of Subsidiaries. (2)
23.2 Consent of Ernst & Young LLP, Independent Auditors.
24.1 Power of Attorney (reference is made to page 53).
</TABLE>
- ---------
(1) Incorporated by reference to exhibits to the Company's Registration
Statement on Form S-1 filed on December 24, 1998 (File No. 333-69699)
(2) Incorporated by reference to exhibits to the Company's Registration
Statement on Form S-1 filed on June 16, 1998 (File No. 333-56911)
(3) Incorporated by reference to exhibits to the Company's Report on Form 10-Q
filed on November 12, 1998 (File No. 000-24647)
* Confidential treatment has been granted for portions of this document. The
information omitted pursuant to such confidential treatment order has been
filed separately with the Securities and Exchange Commission.
(b) Reports on Form 8-K.
No such reports were filed in the fourth quarter of 1998.
(c) Financial Statement Schedules.
Schedule II--Valuation and Qualifying Accounts
Schedules not listed above are omitted because they are not required, they
are not applicable or the information is already included in the consolidated
financial statements or notes thereto.
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, in County of
Santa Clara, State of California, on the 23rd day of March, 1999.
TERAYON COMMUNICATION SYSTEMS, INC.
/s/ Ray M. Fritz
By___________________________________
Ray M. Fritz
Chief Financial Officer
Each person whose signature appears below constitutes and appoints
Dr. Zaki Rakib, Shlomo Rakib and Ray M. Fritz his true and lawful
attorney-in-fact and agent, each acting alone, with full power of
substitution and resubstitution, for him and in his name, place and
stead, in any and all capacities, to sign any or all amendments to this
Annual Report on Form 10-K, and to file the same, with all exhibits
thereto, and all documents in connection therewith, with the Securities
and Exchange Commission, granting unto said attorney-in-fact and agent,
full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully
to all intents and purposes as he might or could do in person, hereby
ratifying and confirming all that said attorney-in-fact and agent, each
acting alone, or his or her substitute or substitutes, may lawfully do
or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Act of 1934, this report has
been signed below by the following persons in the capacities and on the dates
indicated.
<TABLE>
<CAPTION>
Signature Title Date
- --------------------------- ---------------------------------- --------------
<S> <C> <C>
/s/ Zaki Rakib Chief Executive Officer and March 23, 1999
- --------------------------- Director (Principal Executive
Dr. Zaki Rakib Officer)
/s/ Ray M. Fritz Chief Financial Officer (Principal March 23, 1999
- --------------------------- Financial and Accounting Officer)
Ray M. Fritz
/s/ Shlomo Rakib Chairman of the March 23, 1999
- --------------------------- Board of Directors
Shlomo Rakib
/s/ Michael D'Avella Director March 23, 1999
- ---------------------------
Michael D'Avella
/s/ Christopher J. Schaepe Director March 23, 1999
- ---------------------------
Christopher J. Schaepe
/s/ Lewis Solomon Director March 23, 1999
- ---------------------------
Lewis Solomon
/s/ Mark Stevens Director March 23, 1999
- ---------------------------
Mark Stevens
</TABLE>
<PAGE>
SCHEDULE II
VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
Balance Additions Balance
at Charged to at
Beginning Costs and Write- End of
of Period Expenses offs Period
----------- ----------- ---------- ----------
(in thousands)
<S> <C> <C> <C> <C>
Allowance for doubtful
accounts:
Year ended December 31, 1998.... $20 $574 $ -- $594
Year ended December 31, 1997.... $ -- $20 $ -- $20
Year ended December 31, 1996.... $ -- $ -- $ -- $ --
</TABLE>
<PAGE>
EXHIBIT 23.2
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration
Statement (Form S-8 No. 333-66139) pertaining to the 1995 Stock Option
Plan, the 1997 Equity Incentive Plan, the 1998 Non-Employee Directors'
Stock Option Plan, the 1998 Employee Stock Purchase Plan and Non-Plan
Option Grants of Terayon Communication Systems, Inc. of our report dated
January 15, 1999, with respect to the consolidated financial statements
of Terayon Communication Systems, Inc. included in the Annual Report
(Form 10-K) for the year ended December 31, 1998.
Our audits also included the financial statement schedule of Terayon
Communication Systems, Inc. listed in Item 14(c). The schedule is the
responsibility of the Company's management. Our responsibility is to
express an opinion based on our audits. In our opinion, the financial
statement schedule referred to above, when considered in relation to the
basic financial statements taken as a whole, presents fairly in all
material respects the information set forth therein.
/s/ Ernst & Young LLP
San Jose, California
March 23, 1999
