<PAGE> 1
Filed Pursuant to Rule 424(b)(1)
Registration No. 333-44529
3,000,000 SHARES
(INTERNET SECURITY SYSTEMS LOGO)
ISS GROUP, INC.
COMMON STOCK
(PAR VALUE $0.001 PER SHARE)
----------------------
Of the 3,000,000 shares of Common Stock offered hereby, 2,685,000 shares
are being sold by the Company and 315,000 shares are being sold by the Selling
Stockholders. See "Principal and Selling Stockholders". The Company will not
receive any of the proceeds from the sale of the shares being sold by the
Selling Stockholders. Prior to this Offering, there has been no public market
for the Common Stock of the Company. For factors to be considered in determining
the initial public offering price, see "Underwriting".
Shares of Common Stock may be reserved for sale at the initial public
offering price to the Company's employees, directors and other persons with
direct business relationships with the Company. Such employees, directors and
other persons may purchase, in the aggregate, not more than 7% of the Common
Stock offered hereby. See "Underwriting".
SEE "RISK FACTORS" BEGINNING ON PAGE 6 FOR CERTAIN CONSIDERATIONS RELEVANT
TO AN INVESTMENT IN THE COMMON STOCK.
The Common Stock has been approved for quotation on the Nasdaq National
Market under the symbol "ISSX".
----------------------
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES
AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS
THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES
COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS.
ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
----------------------
<TABLE>
<CAPTION>
INITIAL PUBLIC UNDERWRITING PROCEEDS TO PROCEEDS TO SELLING
OFFERING PRICE DISCOUNT(1) COMPANY(2) STOCKHOLDERS
-------------- ------------ ----------- -------------------
<S> <C> <C> <C> <C>
Per Share............................ $22.00 $1.54 $20.46 $20.46
Total(3)............................. $66,000,000 $4,620,000 $54,935,100 $6,444,900
</TABLE>
- ---------------
(1) The Company and the Selling Stockholders have agreed to indemnify the
Underwriters against certain liabilities, including liabilities under the
Securities Act of 1933.
(2) Before deducting estimated expenses of $850,000 payable by the Company.
(3) The Company and the Selling Stockholders have granted the Underwriters an
option for 30 days to purchase up to an additional 450,000 shares at the
initial public offering price per share, less the underwriting discount,
solely to cover over-allotments, if any, of which an option to purchase
385,000 shares has been granted by the Company and an option to purchase
65,000 shares has been granted by the Selling Stockholders. The Company will
not receive any proceeds from the sale of shares by the Selling
Stockholders. If such option is exercised in full, the total initial public
offering price, underwriting discount, proceeds to Company and proceeds to
Selling Stockholders will be $75,900,000, $5,313,000, $62,812,200, and
$7,774,800, respectively. See "Principal and Selling Stockholders" and
"Underwriting".
----------------------
The shares offered hereby are offered severally by the Underwriters, as
specified herein, subject to receipt and acceptance by them and subject to their
right to reject any order in whole or in part. It is expected that certificates
for the shares will be ready for delivery in New York, New York, on or about
March 27, 1998, against payment therefor in immediately available funds.
GOLDMAN, SACHS & CO.
BANCAMERICA ROBERTSON STEPHENS
UBS SECURITIES
WESSELS, ARNOLD & HENDERSON
----------------------
The date of this Prospectus is March 23, 1998.
<PAGE> 2
[PHOTOS]
[GRAPHIC WITH COMPANY LOGO AND PRODUCT LOGOS]
Firecell, Fireblanket, Firewall Scanner, Internet Scanner, Internet
Security Systems, Intranet Scanner, ISS, SAFEsuite, System Security Scanner, S3,
Web Security Scanner and the ISS logo are trademarks of the Company. All other
trademarks or trade names referred to in this Prospectus are the property of
their respective owners.
The Company intends to furnish to its stockholders annual reports
containing audited financial statements examined by its independent auditors.
---------------------
CERTAIN PERSONS PARTICIPATING IN THIS OFFERING MAY ENGAGE IN TRANSACTIONS
THAT STABILIZE, MAINTAIN OR OTHERWISE AFFECT THE PRICE OF THE COMMON STOCK,
INCLUDING OVER-ALLOTMENT, STABILIZING AND SHORT-COVERING TRANSACTIONS IN SUCH
SECURITIES, AND THE IMPOSITION OF A PENALTY BID, IN CONNECTION WITH THE
OFFERING. FOR A DESCRIPTION OF THESE ACTIVITIES, SEE "UNDERWRITING".
2
<PAGE> 3
INDUSTRY-LEADING PROTECTION WITH SAFESUITE
INTERNET SECURITY SYSTEMS (ISS) applies its comprehensive security risk
knowledge base to the security management process, and is a leader in security
detection and response technologies. ISS offers enterprise-wide network
protection through the Adaptive Security Management model - utilizing
SAFEsuite to monitor suspicious activity, detect security weaknesses and
threats, and respond to security risk in information networks.
ISS SAFESUITE is a policy management driven enterprise software solution
consisting of three integrated applications: REALSECURE, a real-time intrusion
detection and response system designed to monitor networks for suspicious
activity; INTERNET SCANNER, a security vulnerability detection and analysis
system designed to recognize and respond to security weaknesses in
applications, operating systems and network services; and SYSTEM SECURITY
SCANNER(S3), a host-based security system designed to detect and react to
internal vulnerabilities in operating systems.
[Product Flow Chart Graphic Depicting Deployment of RealSecure]
Real-time intrusion detection and response
High speed Digital FingerPrint attack recognition
Automatically respond to threats
<PAGE> 4
[Product Flow Chart Graphic Depicting Internet Scanner Deployment]
Comprehensive vulnerability detection and analysis
Corrective action for security weaknesses
Intuitive graphical reporting
[Product Flow Chart Graphic Depicting System Security Scanner Deployment]
Complete host-based security assesment
System integrity and configuration analysis
Automated vulnerability corrections
<PAGE> 5
PROSPECTUS SUMMARY
The following summary should be read in conjunction with, and is qualified
in its entirety by, the more detailed information and the Consolidated Financial
Statements and Notes thereto appearing elsewhere in this Prospectus. Except as
otherwise noted, all information in this Prospectus, including share and per
share information, assumes (i) the mandatory conversion into Common Stock of all
outstanding shares of Series A and Series B Redeemable, Convertible Preferred
Stock (the "Convertible Preferred Stock") upon the consummation of the Offering,
(ii) no exercise of stock options after December 31, 1997 and (iii) no exercise
of the Underwriters' over-allotment option. Unless the context otherwise
requires, the terms "Internet Security Systems", "ISS" and the "Company" refer
to ISS Group, Inc. and its consolidated subsidiaries. See "Description of
Capital Stock" and "Underwriting".
THE COMPANY
Internet Security Systems is the leading provider, based on market share,
of network security monitoring, detection and response software that protects
the security and integrity of enterprise information systems according to
reports by The Aberdeen Group and The Gartner Group. The Company's SAFEsuite
family of products enforces "best practice" information protection automatically
across distributed computing environments by monitoring and responding to
continuously changing network security risks. By dynamically detecting and
responding to the security vulnerabilities and real-time threats inherent in
open systems, SAFEsuite products protect distributed computing environments,
including internal corporate networks, extranets and the Internet, from attacks,
misuse and security policy violations. The Company's products rely on an
innovative Adaptive Security Management ("ASM") approach to network security,
which entails continuous security risk monitoring and response to develop and
enforce an active network security policy. ISS pioneered the technology for
vulnerability and threat detection through a dedicated security research and
development team and believes, based on a report by The Aberdeen Group and the
Company's own research, that it has the most comprehensive vulnerability and
threat database in existence. The Company has delivered its network security
monitoring, detection and response solutions to over 1,500 organizations
worldwide, including firms in the Global 2000, U.S. and international government
agencies and major universities. Nine of the ten largest commercial banks in the
United States as ranked by Fortune have licensed the Company's products.
The proliferation of client/server architectures, the growth of the
Internet as a business tool and the emergence of intranets have dramatically
increased the openness of distributed computing environments. Although open
computing environments have many business advantages, their accessibility and
the relative anonymity of users makes these systems, and the integrity of the
information that is stored on them, vulnerable to security threats. According to
the 1997 Annual Information Week/Ernst & Young LLP Information Security Survey
of information technology ("IT") managers and professionals, 42% of all United
States respondents reported malicious acts from external sources, up from 16% in
the previous year, and 43% reported malicious acts by employees, compared with
29% in the previous year. The conflict between the benefits of open systems that
provide easy access to corporate information and the need to protect
mission-critical information and applications from unauthorized use and
disruption requires solutions that allow organizations to implement, enforce and
evaluate an informed security policy.
ISS has developed ASM, a dynamic, process-driven approach to
enterprise-wide network protection. The ASM process relies on the principles of
monitoring, detection and response to the ever-changing vulnerabilities in and
threats to the network protocols, operating systems and applications that
comprise every network system. The Company's monitoring, detection and response
products provide easy-to-use software solutions designed to enable network
managers to centrally define and manage an enterprise-wide security policy for
their existing network system infrastructure, including all Internet protocol-
enabled devices. The Company's SAFEsuite family of products provides the ability
to visualize, measure and analyze real-time security vulnerabilities and control
threats across the entire enterprise network
3
<PAGE> 6
infrastructure, keeping the organization's IT personnel informed of changing
network conditions and automatically making adjustments as necessary. Through
custom policies or by using the Company's "best-practice" templates, network
managers can minimize security risks without closing off the organization's
network to the benefits of open computing environments and the Internet. The
Company's products extend across a broad range of platforms and work with the
products of leading security and network management vendors to provide a single
point of management and control for an enterprise-wide security policy across
multiple hosts, operating systems and applications. Through the Company's senior
research and development team of security experts known as the "X-Force", ISS
maintains a proprietary and comprehensive knowledge base of computer exploits
and attack methods, including what the Company believes is the most extensive
collection of Windows NT vulnerabilities and threats, based on reports in
InfoWorld and the Company's own research.
The Company's objective is to be the leading provider of ASM systems that
proactively protect the integrity and security of enterprise-wide information
systems from vulnerabilities, misuse, attacks and other policy violations. ISS
focuses on developing innovative and automated software solutions to provide
customers with a comprehensive framework for protecting their networks by
monitoring for vulnerabilities and real-time threats in order to enforce "best
practice" network and system security policies. The Company is seeking to meet
its objective by continuing its leadership position in security technology,
expanding its domestic sales channels, promoting its professional services
capabilities, expanding its international operations and creating ASM category
awareness.
The Company has only a limited operating history upon which an evaluation
of its business and prospects can be based. From its inception through December
31, 1997, the Company's aggregate revenues were less than $19.0 million.
Furthermore, the Company has experienced net losses in each of its three prior
fiscal years and does not expect to achieve profitability in the foreseeable
future. To date, the Company has derived a majority of its revenues from
software licenses and related maintenance fees and services for its Internet
Scanner product; and in 1997, over 80% of the Company's revenues were derived
from that product. The market for the Company's products is in its early stage
and there can be no assurance that the market will grow, or even if it does
grow, that businesses and other organizations will adopt the Company's products.
See "Risk Factors" for further discussion of these and other considerations
relevant to an investment in the shares of Common Stock offered hereby.
The Company was incorporated under the laws of Delaware on December 8, 1997
as a holding company for Internet Security Systems, Inc., a Georgia corporation
incorporated on April 19, 1994. Prior to incorporation in Georgia, the Company
operated as an unincorporated association and distributed its first product as
shareware in 1992. The Company's principal executive offices are located at 41
Perimeter Center East, Suite 660, Atlanta, Georgia 30346. Its telephone number
at that location is (770) 395-0150.
THE OFFERING
<TABLE>
<S> <C>
Common Stock offered by the Company..................... 2,685,000 shares
Common Stock offered by the Selling Stockholders........ 315,000 shares
Common Stock to be outstanding after the Offering....... 16,368,928 shares(1)
Nasdaq National Market symbol........................... ISSX
Use of proceeds......................................... For general corporate purposes,
including working capital and
possible acquisitions. See "Use of
Proceeds".
</TABLE>
- ---------------
(1) Excludes 1,863,850 shares of Common Stock issuable upon exercise of options
outstanding at December 31, 1997. See "Management -- Board of Directors" and
"-- Restated 1995 Stock Incentive Plan", "Certain Transactions" and Note 6
of Notes to Consolidated Financial Statements.
4
<PAGE> 7
SUMMARY CONSOLIDATED FINANCIAL DATA
The following table sets forth certain consolidated financial data for the
Company. This information should be read in conjunction with the Consolidated
Financial Statements and Notes thereto appearing elsewhere in this Prospectus.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations".
<TABLE>
<CAPTION>
APRIL 19, 1994
(INCEPTION) YEAR ENDED DECEMBER 31,
THROUGH -------------------------
DECEMBER 31, 1994 1995 1996 1997
----------------- ----- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues......................................... $ 38 $ 257 $ 4,462 $13,467
Operating income (loss).......................... 20 (140) (1,205) (4,147)
Net income (loss)................................ 20 (140) (1,131) (3,919)
Basic and diluted net income (loss) per
share(1)....................................... -- (.03) (.14) (.50)
Weighted average shares used in basic and diluted
net income (loss) per share calculation(1)..... 4,586 5,001 7,916 7,907
Unaudited pro forma net loss per share(1)........ $ (.29)
Unaudited weighted average shares used in
unaudited pro forma net loss per share
calculation(1)................................. 13,644
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31, 1997
---------------------------------------
PRO FORMA AS
HISTORICAL PRO FORMA(2) ADJUSTED(3)
---------- ------------ ------------
(IN THOUSANDS)
<S> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents............................. $ 3,929 $ 3,929 $58,014
Working capital....................................... 2,272 2,272 56,357
Total assets.......................................... 9,866 9,866 63,951
Long-term debt, net of current portion................ 70 70 70
Convertible Preferred Stock........................... 8,878 -- --
Stockholders' equity (deficit)........................ (5,058) 3,820 57,905
</TABLE>
- ---------------
(1) See Note 1 of Notes to Consolidated Financial Statements for the
determination of shares used in computing basic and diluted net income
(loss) per share and unaudited pro forma net loss per share. Pro forma net
loss per share is not included for periods prior to 1997 because such
comparisons are not meaningful due to the conversion of all outstanding
shares of Convertible Preferred Stock into Common Stock upon consummation of
the Offering.
(2) Reflects the conversion of all Convertible Preferred Stock into an aggregate
of 5,736,957 shares of Common Stock upon consummation of the Offering. See
Note 4 of Notes to Consolidated Financial Statements.
(3) Pro forma as adjusted gives effect to the sale by the Company of 2,685,000
shares of Common Stock offered hereby after deducting estimated underwriting
discounts and commissions and estimated offering expenses payable by the
Company. See "Use of Proceeds".
5
<PAGE> 8
RISK FACTORS
In addition to the other information in this Prospectus, prospective
purchasers of the Common Stock offered hereby should carefully consider the
following factors in evaluating the Company and its business.
LIMITED OPERATING HISTORY; HISTORY OF LOSSES
The Company was incorporated in April 1994 and has never achieved
profitability, nor does the Company expect to achieve profitability in the
foreseeable future. Accordingly, the Company has only a limited operating
history upon which an evaluation of the Company and its prospects can be based
and is subject to all of the risks inherent in the establishment of a new
business enterprise. The Company's prospects must be considered in light of the
risks, expenses and difficulties frequently encountered by companies in their
early state of development, particularly companies in new and rapidly evolving
markets. To address these risks, the Company must, among other things, respond
to competitive developments, continue to upgrade and expand its product
offerings and continue to attract, retain and motivate qualified personnel.
There can be no assurance that the Company will be successful in addressing such
risks, that the Company's revenue growth will continue in the future or that the
Company will achieve profitability in the future or, if achieved, that the
Company could maintain such profitability on a quarterly or annual basis. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations".
SIGNIFICANT POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS
The Company's future revenues and operating results are uncertain and are
expected to fluctuate from quarter to quarter and from year to year due to a
combination of factors, including the level of demand for the Company's
products, the volume and timing of orders, the level of product and price
competition, the Company's ability to expand its domestic and international
sales and marketing organizations, the Company's ability to develop new and
enhanced products and control costs, the Company's ability to attract and retain
key technical, sales and managerial personnel, the mix of distribution channels
through which the Company's products are sold, the growth in the acceptance of,
and activity on, the Internet and World Wide Web ("Web"), particularly by
corporate, institutional and government users, the growth of private Internet
protocol ("IP") networks (or "intranets"), the extent to which unauthorized
access and use of online information is perceived as a threat to network
security, customer budgets, seasonal trends in customer purchasing, foreign
currency exchange rates and general economic factors. As the Company
increasingly focuses on sales of the Company's product suite rather than
individual products, the Company expects that the sales cycle associated with
the purchase of the Company's products will lengthen. In addition, the amount of
revenues associated with particular licenses can vary significantly based upon
the number of products that are licensed and the number of devices involved in
the installation. The Company has experienced, and may continue to experience
from time to time, large individual license sales which can cause significant
variations in quarterly license revenues. Moreover, small delays in customer
orders can cause significant variability in the Company's license revenues and
results of operations for any particular period. As a result, the timing of
significant orders is unpredictable and, like many software companies, the
Company typically realizes a significant portion of its software license
revenues in the last month of a quarter. The Company establishes its expenditure
levels for product development, sales and marketing and other operating expenses
based, in large part, on its expected future revenues. As a result, if revenues
fall below expectations, operating results and net income are likely to be
adversely and disproportionately affected because only a small portion of the
Company's expenses vary with its revenues.
Based upon all of the foregoing, the Company believes that the Company's
quarterly and annual revenues, expenses and operating results are likely to vary
significantly in the future and that period-to-period comparisons of its results
of operations are not necessarily meaningful and, in any event, such comparisons
should not be relied upon as indications of future performance. Moreover,
although the Company's revenues have increased in recent periods, there can be
no assurance that the Company's
6
<PAGE> 9
revenues will grow in future periods, that they will grow at past rates or that
the Company will achieve profitability on a quarterly or annual basis. Due to
the foregoing or other factors, it is likely that the Company's operating
results may be below market analysts' expectations in some future quarters,
which could materially and adversely affect the market price of the Common
Stock. See "Selected Consolidated Financial Data" and "Management's Discussion
and Analysis of Financial Condition and Results of Operations -- Selected
Quarterly Financial Results".
COMPETITION
The market for security monitoring, detection and response products and
services is intensely competitive and the Company expects competition to
increase further in the future. There can be no assurance that the Company can
maintain its competitive position against current and potential competitors,
especially those with significantly greater financial, marketing, service,
support, technical and other competitive resources.
The Company's principal competitors generally fall within one of three
categories: internal IT departments or consulting firms that assist such
departments, relatively smaller software companies that offer applications with
limited scope and larger software companies that are either in the process of
entering the Company's market or have the potential to develop products to
compete with the Company's products. Due to a lack of awareness of the Company's
products and services or a lack of appreciation of the complexity involved in
the development of automated systems to establish and, more importantly,
maintain comprehensive and effective levels of security within a distributed
computing environment, potential customers often rely on their IT departments to
internally formulate security systems or to retain consultants to undertake such
a project. Second, there are a number of companies that currently market or have
under development software applications to provide network and Internet
security. The Company expects additional competition from these established
competitors and from other emerging companies. Mergers or consolidations among
these competitors or acquisitions of these competitors by larger companies would
make them more formidable competitors to the Company. Recently both Cisco
Systems and Network Associates have announced acquisitions of companies with
products that compete with some of the Company's current product offerings. Many
of these larger companies have longer operating histories, greater name
recognition, access to larger customer bases and significantly greater
financial, technical and marketing resources than the Company. As a result, they
may be able to adapt more quickly to new or emerging technologies and changes in
customer requirements or to devote greater resources to the promotion and sale
of their products than the Company. If these companies were to introduce
products that effectively competed with the Company's products, they could be in
a position to substantially lower the price of their security monitoring,
detection and response products or to bundle such products with their other
products, which would make it more difficult for the Company to compete with
them. There can be no assurance that the Company's current and potential
competitors will not develop security monitoring, detection and response
products that may be more effective than the Company's current or future
products or that the Company's technologies and products will not be rendered
obsolete by such developments. Finally, there are a number of companies,
including Axent Technologies, that currently market and sell various software
products, such as encryption, firewalls, operating system security and virus
detection software, that have been broadly adopted by the Company's customers
and potential customers to provide various levels of security within their
computing environments. Some of these companies have released products which
provide similar functionality as certain of the Company's products. In addition,
vendors of operating system software or networking hardware may in the future
enhance their products to include functionality that is currently provided by
the Company's products. The widespread inclusion of the functionality of the
Company's software as standard features of operating system software or
networking hardware could render the Company's products obsolete and
unmarketable, particularly if the quality of such functionality were comparable
to that of the Company's products. Even if the security monitoring, detection
and response functionality provided as standard features by operating system
software or networking hardware is more limited than that of the Company's
software, there can be no assurance that a significant number of customers would
not elect to accept more limited functionality in lieu of purchasing additional
software.
7
<PAGE> 10
For the foregoing reasons, there can be no assurance that the Company will
be able to compete successfully against its current and future competitors.
Increased competition may result in price reductions, reduced gross margins and
loss of market share, any of which would materially and adversely affect the
Company's business, operating results and financial condition. See "Business --
Competition".
RAPID TECHNOLOGICAL CHANGE AND NEW PRODUCTS
The market for the Company's products is characterized by rapid
technological advances, including by those seeking to establish more secure
systems and those seeking to compromise such systems, evolving industry
standards in computer hardware and software technology, changes in customer
requirements and frequent new product introductions and enhancements. As a
result, the Company must continually change and improve its products in response
to changes in operating systems, application and networking software, computer
and communications hardware, programming tools and computer language technology.
In particular, the market for Internet and intranet software applications has
only recently begun to develop and is rapidly evolving. Therefore, the Company's
future success will depend upon its ability to continue to enhance its current
product line and to develop and introduce new products that adequately address
and respond to innovations in computer hacking methodologies, keep pace with
technological developments, satisfy increasingly sophisticated customer
requirements and achieve market acceptance. There can be no assurance that the
Company will be successful in developing and marketing, on a timely and
cost-effective basis, fully functional product enhancements or new products that
respond to technological advances by computer hackers and other unauthorized
users of online information, or that its new products will achieve market
acceptance. If the Company does not respond adequately to the need to develop
and introduce new products or enhancements of existing products in a timely
manner, the Company's business, operating results and financial condition would
be materially and adversely affected. See "Business -- Product Development".
As a result of the complexities inherent in the security of distributed
computing environments and the broad functionality and performance demanded by
customers for such products, major new product enhancements and new products can
require long development and testing periods to achieve market acceptance. The
Company has on occasion experienced delays in the scheduled introduction of new
and enhanced products. In addition, software programs as complex as those
offered by the Company may contain undetected errors or "bugs" when first
introduced or as new versions are released that, despite testing by the Company,
are discovered only after a product has been installed and used by customers.
The deployment and use of the Company's products by one or more customers, if
not properly completed, has resulted in the past and may result in the future in
temporary disruptions to the operation of the customer's networking system,
which may adversely affect the Company's relationship with such customers. There
can be no assurance that errors will not be found in future releases of the
Company's software, or that any such errors will not impair the market
acceptance of these products and materially and adversely affect the Company's
business, operating results and financial condition.
The processes and methodologies used by computer hackers to access or
sabotage networks and intranets are ever changing and generally not recognized
until launched against one or more targets. Therefore, the Company, in most
cases, is unable to anticipate these processes and methodologies. To the extent
that customers' computing environments are compromised, such customers may
perceive the Company's products as ineffective in protecting their systems,
which may result in a reduction in orders from such customers and the loss of
customer goodwill, which could adversely affect the Company's business,
operating results and financial condition.
MANAGEMENT OF GROWTH
The Company's business has grown rapidly in the last three years, with
total revenues increasing from $257,000 in 1995 to over $13 million in 1997 and
the total number of employees increasing from seven in 1995 to 141 in 1997. This
expansion has resulted in substantial growth in the scope of the Company's
infrastructure, including operating and financial applications and the
geographic area of its
8
<PAGE> 11
operations and customers. Recent rapid growth has placed and, if such growth
continues, is expected to continue to place, a significant strain on the
Company's management and operations. In particular, the Company is in the
process of upgrading its internal financial and reporting systems to enhance
management's ability to obtain and more timely analyze information derived from
its domestic and international operations. There can be no assurance, however,
that the Company's existing or future controls, systems or procedures will be
adequate to support the Company's operations. The Company's ability to manage
its future growth, if any, will require the Company to continually improve its
financial and management controls, reporting systems and procedures on a timely
basis, implement new systems as necessary and expand, train and manage its
employee workforce. There can be no assurance that the Company will be able to
manage any future expansion successfully, and any inability to do so would have
a material adverse effect on the Company's business, operating results and
financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations -- Overview".
RISKS ASSOCIATED WITH THE EMERGING MARKET FOR SECURITY MONITORING, DETECTION AND
RESPONSE PRODUCTS
The market for the Company's products is rapidly evolving. There can be no
assurance that Internet protocols will continue to be used to facilitate
communications or that the market for security monitoring, detection and
response systems in general will continue to expand. Continued growth of this
market will depend, in large part, upon the continued expansion of Internet
usage and in the number of organizations adopting or expanding intranets, the
ability of their respective infrastructures to support an increasing number of
users and services, the public recognition of the potential threat posed by
computer hackers and other unauthorized users and the continued development of
new and improved services for implementation across the Internet and between the
Internet and intranets. If the necessary infrastructure or complementary
products and services are not developed in a timely manner and, consequently,
the market for products to monitor Internet and intranet security fails to grow
or grows more slowly than the Company currently anticipates, the Company's
business, operating results and financial condition would be materially and
adversely affected. See "Business -- Industry Background".
Although the demand for Internet security systems and firewalls has grown
in recent years, the market for security monitoring, detection and response
software is still nascent and there can be no assurance that this market will
grow or that, even if the market does grow, businesses will adopt the Company's
products. Historically, network and Internet security monitoring, detection and
response has been addressed by applications and solutions that have largely been
developed by the internal IT departments of organizations having large computing
systems with a particular need for such products, including the U.S. Government,
banking and financial institutions, technology firms and universities. In
addition, many organizations do not separately budget for information security
products. The Company has spent, and intends to continue to spend, considerable
resources educating potential customers about the vulnerabilities associated
with their Internet, intranet and networking systems and about the features and
functions of the Company's SAFEsuite products. However, there can be no
assurance that such expenditures will enable SAFEsuite products to achieve any
additional degree of market acceptance, and if the market for SAFEsuite products
fails to grow or grows more slowly than the Company currently anticipates, the
Company's business, operating results and financial condition would be
materially and adversely affected. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and "Business -- Sales and
Marketing" and " -- Competition".
PRODUCT CONCENTRATION
The Company currently derives a majority of its revenues from software
licenses and related maintenance fees and services for its Internet Scanner
product. In 1997, the Company derived over 80% of its revenues from Internet
Scanner and the Company expects that Internet Scanner-related revenues,
including maintenance contracts, will continue to account for a majority of the
Company's revenues for the foreseeable future. As a result, the Company's future
operating results are dependent upon continued market acceptance of Internet
Scanner and enhancements thereto. There can be no assurance
9
<PAGE> 12
that Internet Scanner will achieve continued market acceptance or that the
Company will be successful in marketing its SAFEsuite products or product
enhancements. A decline in demand for, or market acceptance of, Internet Scanner
as a result of competition, technological change or other factors would have a
material adverse effect on the Company's business, operating results and
financial condition.
INTERNATIONAL OPERATIONS
The Company derived approximately 4% and 21% of its total revenues from
sales to customers outside North America in 1996 and 1997, respectively. The
Company opened sales offices in Belgium in February 1996, Japan in February
1997, England in April 1997, France in April 1997 and Canada in December 1997,
and believes that its future growth will require continued expansion of its
operations in international markets. In order to expand internationally, the
Company must establish additional foreign operations and hire additional
personnel. To the extent that the Company is unable to do so in a timely and
effective manner, the Company's growth, if any, in international sales will be
limited, and the Company's business, operating results and financial condition
could be materially and adversely affected. To date, the Company's revenues from
international operations have primarily been denominated in United States
dollars, although some sales have been denominated in foreign currencies. An
increase in the value of the United States dollar relative to foreign currencies
would make the Company's products more expensive and, therefore, potentially
less competitive in those markets. In addition, even if international operations
are successfully expanded, there can be no assurance that the Company will be
able to maintain or increase international market demand for its products.
The Company's international operations are subject to risks inherent in
international business activities, including, in particular, management of an
organization spread over various countries, longer accounts receivable payment
cycles in certain countries, compliance with a variety of foreign laws and
regulations, unexpected changes in regulatory requirements, overlap of different
tax structures, foreign currency exchange rate fluctuations, import and export
licensing requirements, trade restrictions, changes in tariff and freight rates
and regional economic conditions. There can be no assurance that such factors
will not have a material adverse effect on the Company's future international
sales and, consequently, the Company's business, operating results and financial
condition. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Business -- Sales and Marketing".
INCREASING RELIANCE ON INDIRECT DISTRIBUTION CHANNELS
Although direct sales to date have accounted for a majority of the
Company's revenues, ISS expects that it will increasingly distribute its
products to end users through various indirect distribution channels, including
channel partners, value added resellers ("VARs"), original equipment
manufacturers ("OEMs"), Internet service providers ("ISPs") and systems
integrators. The Company's relationships with many of its channel partners have
been established within the last 18 months, and the Company is unable to predict
the extent to which these channel partners will be successful in marketing and
selling licenses for the Company's products. The Company is dependent on the
marketing and sales efforts of these channel partners, many of whom also market
and sell competitive products or are able, under the terms of their agreements,
to market and sell competitive products. While no one channel partner accounted
for more than 10% of the Company's consolidated revenues in 1997, the loss of
several of the Company's major channel partners without replacement, either to
competitive products offered by other companies or products developed internally
by these channel partners, could have a material adverse effect on the Company's
business, operating results and financial condition. In addition, there can be
no assurance that the Company will be able to effectively manage potential
conflicts among channel partners, that economic conditions or industry demand
will not adversely affect these or other indirect channel partners or that these
channel partners will not devote greater resources to marketing and supporting
the products of other companies. The Company's future performance will also
depend, in part, on its ability to attract additional channel partners that will
be able to market and support the Company's products effectively, especially in
markets in which the Company has not previously
10
<PAGE> 13
distributed its products. In addition, the Company depends in large part upon
its channel partners for product installation and support for such channel
partners' customers. There can be no assurance that revenue from channel
partners that accounted for significant revenues in past periods will continue,
or if continued will reach or exceed historical levels. In addition, there can
be no assurance that the Company's channel partners will continue to provide
adequate installation and support to end users or will provide installation and
support for new products. If the Company's channel partners fail to provide
adequate installation and support, end users of the Company's products could
cease using, or improperly implement and operate, such products, which could
result in a substantial increase in customer support costs to the Company and
thereby materially and adversely affect the Company's business, operating
results and financial condition. See "Business -- Sales and Marketing".
DEPENDENCE UPON KEY PERSONNEL
The Company's future operating results depend in significant part upon the
continued service of a relatively small number of key technical and senior
management personnel, especially Thomas E. Noonan, the Company's Chairman of the
Board, President and Chief Executive Officer, and Christopher Klaus, the
Company's founder and Chief Technology Officer, neither of whom is bound by an
employment agreement. The Company currently has key-man life insurance coverage
for each of Messrs. Noonan and Klaus, which the Company intends not to renew
following completion of the Offering. The Company's future success also depends
on its continuing ability to attract and retain other highly qualified technical
and managerial personnel. Competition for such personnel is intense, and the
Company has at times in the past experienced difficulty in recruiting qualified
personnel, especially engineers experienced in network security issues. There
can be no assurance that the Company will retain its key managerial and
technical employees or that it will be successful in attracting, assimilating or
retaining other highly qualified technical and managerial personnel in the
future. The loss of any member of the Company's key technical and senior
management personnel or the inability to attract and retain additional qualified
personnel could have a material adverse effect on the Company's business,
operating results and financial condition. See "Management".
INTELLECTUAL PROPERTY RIGHTS; USE OF LICENSED TECHNOLOGY; TRADEMARK ISSUES
The Company relies primarily on a combination of copyright and trademark
laws, trade secrets, confidentiality procedures and contractual provisions to
protect its proprietary rights. The Company also believes that factors such as
the technological and creative skills of its personnel, new product
developments, frequent product enhancements, name recognition and reliable
product maintenance are essential to establishing and maintaining a technology
leadership position. The Company seeks to protect its software, documentation
and other written materials under the trade secret and copyright laws, which
afford only limited protection. The Company has also submitted one United States
patent application. There can be no assurance that a patent will issue from this
application or, if issued, that such patent would provide meaningful competitive
advantages to the Company. The Company generally licenses SAFEsuite products to
end users in object code (machine-readable) format. Certain customers have
required the Company to maintain a source-code escrow account with a third-party
software escrow agent, and a failure by the Company to perform its obligations
under any of the related license and maintenance agreements, or the insolvency
of the Company, could conceivably cause the release of the Company's source code
to such customers. Despite the Company's efforts to protect its proprietary
rights, unauthorized parties may attempt to copy aspects of the Company's
products or to obtain and use information that the Company regards as
proprietary. Policing unauthorized use of the Company's products is difficult,
and while the Company is unable to determine the extent to which piracy of its
software products exists, software piracy can be expected to be a persistent
problem. In addition, the laws of some foreign countries do not protect the
Company's proprietary rights to as great an extent as do the laws of the United
States. There can be no assurance that the Company's competitors will not
independently develop similar technology.
11
<PAGE> 14
Although the Company is not aware that any of its products infringes the
proprietary rights of third parties, there can be no assurance that third
parties will not claim infringement by the Company with respect to current or
future products. The Company expects that software product developers will
increasingly be subject to infringement claims as the number of products and
competitors in the Company's industry segment grows and the functionality of
products in different industry segments overlaps. Any such claims, with or
without merit, could be time consuming, result in costly litigation, cause
product shipment delays or require the Company to enter into royalty or
licensing agreements. Such royalty or licensing agreements, if required, may not
be available on terms acceptable to the Company or at all, which could have a
material adverse effect upon the Company's business, operating results and
financial condition.
The name "Internet Security Systems" is currently not subject to trademark
registration in the United States, and may not be a name for which trademark
protection is available due to its general use in a variety of security-related
applications. Although the Company has in the past asserted and intends to
continue to assert its rights with respect to the name "Internet Security
Systems" and has in the past taken and will take action against any use of such
name in a manner that may create confusion for its products in relevant markets,
there can be no assurance that the Company will be successful in such efforts,
which could have a material adverse effect upon the Company's business,
operating results and financial condition. See "Business -- Proprietary Rights
and Trademark Issues".
PRODUCT LIABILITY; RISK OF PRODUCT DEFECTS
The Company's products are used to monitor and enhance network security,
which is typically a critical function for organizations. As a result, the
licensing and support of products by the Company may entail the risk of product
liability and related claims. Although the Company's license agreements
typically contain provisions that are designed to limit the Company's exposure
to potential product liability or related claims, including provisions that
limit the Company's liability for special, consequential or incidental damages,
there can be no assurance that such provisions will be enforceable under the
laws of applicable domestic or foreign jurisdictions. In addition, the Company
currently has products liability insurance coverage in the amount of $2.0
million that, subject to customary exclusions, covers claims resulting from
failure of the Company's products or services to perform the function or to
serve the purpose intended. To the extent that any claims are not covered by
such insurance, the Company's business, operating results and financial
condition may be materially and adversely affected by a successful product
liability claim, particularly since the Company's products are used in critical
processes within its customers' computing systems.
In addition, software products as complex as those offered by the Company
may contain undetected errors or result in failures when first introduced or
when new versions are released. In particular, the personal computer hardware
environment is characterized by a wide variety of non-standard configurations
that make pre-release testing for programming or compatibility errors very
difficult and time-consuming. Despite testing by the Company and by current and
potential customers, there can be no assurance that errors will not be found in
new products or enhancements after commencement of commercial shipments. The
occurrence of these errors could result in adverse publicity, loss of or delay
in market acceptance or claims by customers against the Company, any of which
could have a material adverse effect upon the Company's business, operating
results and financial condition. See "Business -- Products" and "-- Product
Development".
RISK OF TARGETED ATTACKS AGAINST THE COMPANY
Due to the Company's notoriety in monitoring, detecting and thwarting the
activities of computer hackers, the Company in the past has been, and expects in
the future that it will continue to be, a target of attacks by computer hackers
who seek to infiltrate the Company's internal network system to obtain sensitive
data and information or create bugs or viruses in an attempt to sabotage the
functionality of the Company's products. There can be no assurance that the
Company will be able to respond to such
12
<PAGE> 15
attacks in a timely or effective manner and any failure to do so could have a
material adverse effect upon the Company's business, operating results and
financial condition.
GOVERNMENT REGULATION OF TECHNOLOGY EXPORTS
A number of governments have imposed controls, export license requirements
and restrictions on the export of certain technology, specifically with respect
to encryption technology. Although the Company has incorporated encryption
technology into its products, the Company has been able to receive prior
approvals or authorizations to sell its products in foreign markets. There can
be no assurance, however, that current export controls will not be extended to
cover the Company's products which may have a material adverse effect on the
Company's business, operating results and financial condition.
YEAR 2000 COMPLIANCE
Many currently installed computer systems and software products are coded
to accept only two-digit entries in the date code field. Beginning in the year
2000, these date code fields will need to accept four-digit entries to
distinguish 21st century dates from 20th century dates. As a result, computer
systems and software used by many companies may need to be upgraded to comply
with such "Year 2000" requirements. Significant uncertainty exists in the
software industry concerning the potential effects associated with such
compliance. Although all of the products currently offered by the Company are
designed to be Year 2000 compliant, there can be no assurance that the Company's
products contain all necessary date code changes, or that, in the year 2000, the
Company's products will be compatible with third-party software that may be
integrated or used in conjunction with the Company's products.
NO PRIOR MARKET FOR THE COMMON STOCK; POSSIBLE VOLATILITY OF SHARE PRICE
Prior to the Offering, there has been no public market for the Common
Stock, and there can be no assurance that an active trading market will develop
upon completion of the Offering or, if it does develop, that such market will be
sustained. The initial public offering price of the Common Stock was determined
by negotiation between the Company and the representatives of the Underwriters,
and may not be representative of the price that will prevail in the open market.
See "Underwriting" for a discussion of the factors to be considered in
determining the initial public offering price.
The market price of the Common Stock after the Offering may be
significantly affected by factors such as the announcement of new products or
product enhancements by the Company or its competitors, technological innovation
by the Company or its competitors, quarterly variations in the Company's results
of operations, and general market conditions or market conditions specific to
particular industries. In particular, the stock prices for many companies in the
technology and emerging growth sector have experienced wide fluctuations which
have often been unrelated to the operating performance of such companies. Such
fluctuations may adversely affect the market price of the Common Stock.
Furthermore, in the past, following periods of volatility in the market price of
a company's securities, securities class action claims have been brought against
the issuing company. There can be no assurance that such litigation will not
occur in the future with respect to the Company. Such litigation could result in
substantial costs and a diversion of management's attention and resources, and
any adverse determination in such litigation could also subject the Company to
significant liabilities, any or all of which could have a material adverse
effect on the Company's business, operating results and financial condition.
ANTI-TAKEOVER PROVISIONS
The Company's Certificate of Incorporation (the "Charter") and the
Company's Bylaws (the "Bylaws") contain certain provisions that may have the
effect of discouraging, delaying or preventing a change in control of the
Company or unsolicited acquisition proposals that a stockholder might consider
favorable. The Charter provides the Company's Board of Directors with the
authority to issue up to
13
<PAGE> 16
50,000,000 shares of Common Stock, and up to 20,000,000 shares of Preferred
Stock in one or more series and to determine the price, rights (including voting
rights), preferences, privileges and restrictions of each such series of
Preferred Stock, without any vote or action by the Company's stockholders. The
rights and preferences of any series of such Preferred Stock could include a
preference over the Common Stock on the distribution of the Company's assets
upon a liquidation or sale of the Company, preferential dividends, redemption
rights, the right to elect one or more directors and other voting rights. The
rights of the holders of the Common Stock will be subject to, and may be
adversely affected by, the rights of the holders of any series of Preferred
Stock that may be issued in the future. The Company has no current plans to
issue Preferred Stock. The existence of large amounts of authorized but unissued
Common Stock could be used to prevent or delay a change in control of the
Company. In addition, the Charter and Bylaws include provisions establishing a
Board of Directors with staggered, three-year terms, requiring supermajority
voting to effect certain amendments to the Charter and Bylaws, limiting the
persons who may call special meetings of stockholders, prohibiting stockholder
action by written consent and establishing advance notice requirements for
nominations for election to the Board of Directors or for proposing matters that
can be acted upon at stockholders' meetings. Certain provisions of Delaware law
and the Company's Restated 1995 Stock Incentive Plan (the "1995 Plan") may also
have the effect of discouraging, delaying or preventing a change in control of
the Company or unsolicited acquisition proposals. See "Management -- Restated
1995 Stock Incentive Plan" and "Description of Capital Stock -- Certain
Anti-Takeover, Limited Liability and Indemnification Provisions".
SHARES ELIGIBLE FOR FUTURE SALE; REGISTRATION RIGHTS
Sales of substantial amounts of Common Stock in the public market, or the
perception that such sales may occur, could adversely affect the prevailing
market price of the Common Stock or the ability of the Company to raise capital
through a public offering of its equity securities. Upon completion of the
Offering, the Company will have outstanding 16,368,928 shares of Common Stock
(not including shares issuable upon exercise of outstanding stock options).
Under agreements entered into between the representatives of the Underwriters
and each of the Company's officers, directors, principal stockholders and their
respective affiliates (the "Lock-Up Agreements") who beneficially hold, in the
aggregate, 13,683,928 shares of Common Stock (which includes 24,500 shares
acquired in 1998 upon the exercise of stock options) prior to the Offering, no
shares held by such holders will be eligible for sale in the public market for a
period of 180 days following the date of this Prospectus. The Company intends to
file a registration statement under the Securities Act of 1933, as amended (the
"Securities Act"), covering the sale of Common Stock reserved for issuance under
the 1995 Plan. As of December 31, 1997, there were options outstanding under the
1995 Plan to purchase an aggregate of 1,808,350 shares and options issued
outside of the 1995 Plan to purchase 80,000 shares; all shares acquired upon
exercise of options within 180 days of the Offering are or will be subject to
Lock-Up Agreements as required under the 1995 Plan. Following the expiration of
the 180-day term of the Lock-Up Agreements, 16,084,741 shares, including the
3,000,000 shares offered hereby and approximately 466,513 shares subject to
options that will be exercisable on or before the end of such term, will be
eligible for sale in the public market subject, in some cases, to the
requirements of Rule 144 or Rule 701 under the Securities Act. Goldman, Sachs &
Co. in its sole discretion and at any time without notice, may release all or
any portion of the securities subject to the Lock-Up Agreements. Any such
decision to release securities would likely be based upon individual stockholder
circumstances, prevailing market conditions and other relevant factors. Any such
release could have a material adverse effect upon the price of the Common Stock.
See "Underwriting".
After the Offering, holders of 6,493,457 shares of Common Stock are
currently entitled to certain demand and piggy-back registration rights with
respect to such shares and holders of an additional 7,145,471 shares of Common
Stock are currently entitled to piggy-back registration rights. If the Company
were required to register the shares held by such holders pursuant to the
exercise of their demand or piggy-back registration rights, such sales could
have an adverse effect upon the Company's ability to raise needed capital. See
"Shares Eligible for Future Sale".
14
<PAGE> 17
CONCENTRATION OF SHARE OWNERSHIP
Upon completion of the Offering, the directors, executive officers and
principal stockholders of the Company and their respective affiliates will
beneficially own approximately 72.4% of the outstanding Common Stock
(approximately 72.0% if the Underwriters' over-allotment option is exercised in
full). As a result, these stockholders will be able to exercise significant
influence over all matters requiring stockholder approval, including the
election of directors and approval of significant corporate transactions. Such
concentration of ownership may have the effect of delaying or preventing a
change in control of the Company. See "Principal and Selling Stockholders".
DISCRETION AS TO USE OF PROCEEDS
The Company has not yet identified specific uses of a significant portion
of the net proceeds from the Offering. Therefore, the Company's management will
retain broad discretion to allocate the net proceeds from the Offering to uses
that the stockholders may not deem desirable, and there can be no assurance that
the proceeds can or will yield a significant return. See "Use of Proceeds".
IMMEDIATE AND SUBSTANTIAL DILUTION
The initial public offering price is substantially higher than the book
value per share of the outstanding Common Stock. As a result, investors
purchasing Common Stock in the Offering will incur immediate and substantial
dilution of the net tangible book value per share of the Common Stock of $18.46
from the initial public offering price. In addition, the Company has issued
options to acquire Common Stock at prices significantly below the initial public
offering price. To the extent such outstanding options are exercised, there will
be further dilution to investors in the Offering. See "Dilution".
15
<PAGE> 18
USE OF PROCEEDS
Based on the initial public offering price of $22.00 per share, the net
proceeds from the sale of shares of Common Stock to be sold by the Company will
be approximately $54,085,000 (approximately $61,962,000 if the Underwriters
exercise their over-allotment option in full) after deduction of underwriting
discounts and commissions and estimated offering expenses payable by the
Company.
The principal purposes of the Offering are to increase the Company's equity
capital, to create a public market for the Common Stock, to facilitate future
access by the Company to public equity markets, to provide liquidity to certain
of the Company's existing stockholders and to provide increased visibility and
credibility to the Company in a marketplace where many of its competitors are
publicly-held companies.
The Company currently intends to use the net proceeds of the Offering for
working capital and general corporate purposes, including financing accounts
receivable and capital expenditures made in the ordinary course of its business,
as well as for possible acquisitions of businesses, products and technologies
that are complementary to those of the Company. Although the Company has not
identified any specific businesses, products or technologies that it may
acquire, nor are there any current agreements or negotiations with respect to
any such transactions, the Company from time to time evaluates such
opportunities. Pending such uses, the net proceeds will be invested in
government securities and other short-term, investment-grade, interest-bearing
instruments. The Company will not receive any proceeds from the sale of Common
Stock by the Selling Stockholders.
DIVIDEND POLICY
The Company has never declared or paid any cash dividends on its capital
stock other than a $10,000 dividend paid in each of 1994 and 1995, and does not
intend to pay any cash dividends on its Common Stock in the foreseeable future.
The Company's bank credit facility currently permits the payment of cash
dividends only to the extent that the Company maintains certain financial ratios
and a specified minimum net worth. For a description of the Company's credit
facility, see Note 3 of Notes to Consolidated Financial Statements.
16
<PAGE> 19
DILUTION
At December 31, 1997, the pro forma net tangible book value of the Company
was approximately $3,820,000, or $0.28 per share of Common Stock. Pro forma net
tangible book value per share represents the amount of total tangible assets of
the Company reduced by the amount of its total liabilities, divided by the
number of shares of Common Stock outstanding after giving effect to the
mandatory conversion of all shares of Convertible Preferred Stock upon the
consummation of the Offering. After giving effect to the issuance by the Company
of the 2,685,000 shares offered hereby at the initial public offering price of
$22.00 per share and the receipt of the estimated net proceeds therefrom, the
pro forma as adjusted net tangible book value of the Company as of December 31,
1997 would have been approximately $57,905,000, or $3.54 per share of Common
Stock. This represents an immediate increase in pro forma net tangible book
value of $3.26 per share to existing stockholders and an immediate dilution of
$18.46 per share to new investors purchasing shares of Common Stock in the
Offering. The following table illustrates the per share dilution:
<TABLE>
<S> <C> <C>
Initial public offering price per share..................... $22.00
Pro forma net tangible book value per share as of December
31, 1997............................................... $0.28
Increase per share attributable to new investors.......... 3.26
-----
Pro forma as adjusted net tangible book value per share
after the Offering........................................ 3.54
------
Dilution per share to new investors in the Offering......... $18.46
======
</TABLE>
The following table sets forth, on a pro forma basis as of December 31,
1997, with respect to existing stockholders and new investors in the Offering, a
comparison of the number of shares of Common Stock acquired from the Company,
the percentage of ownership of such shares, the total cash consideration paid,
the percentage of total cash consideration paid and the average price per share.
<TABLE>
<CAPTION>
SHARES PURCHASED TOTAL CONSIDERATION
--------------------- --------------------- AVERAGE PRICE
NUMBER PERCENT AMOUNT PERCENT PER SHARE
----------- ------- ----------- ------- -------------
<S> <C> <C> <C> <C> <C>
Existing stockholders(1)........... 13,658,428 83.6% $ 9,080,000 13.3% $ 0.66
New investors(1)................... 2,685,000 16.4 59,070,000 86.7 22.00
----------- ----- ----------- -----
Total.................... 16,343,428 100.0% $68,150,000 100.0%
=========== ===== =========== =====
</TABLE>
- ---------------
(1) The net effect of sales by the Selling Stockholders in the Offering will be
to reduce the number of shares held by existing stockholders to 13,368,928
shares, or 81.7% of the total number of shares of Common Stock outstanding
after the Offering, and to increase the number of shares held by new
investors to 3,000,000 shares, or 18.3% of the total number of shares of
Common Stock outstanding after the Offering.
The preceding table assumes no exercise of any stock options outstanding as
of December 31, 1997, except for 20,000 shares that were acquired by a Selling
Stockholder in January 1998 upon the exercise of a stock option with an exercise
price of $0.15 per share, which shares will be sold in the Offering. As of
December 31, 1997, there were stock options outstanding to purchase a total of
1,888,350 shares of Common Stock with a weighted average exercise price of $2.71
per share, all of which are exercisable, and 1,184,650 additional shares
reserved for issuance under the 1995 Plan.
17
<PAGE> 20
CAPITALIZATION
The following table sets forth, as of December 31, 1997, the cash position
and capitalization of the Company (i) on a historical basis; (ii) on a pro forma
basis, giving effect to the conversion of each share of Convertible Preferred
Stock into one share of Common Stock, which will occur upon the consummation of
the Offering; and (iii) on a pro forma basis, as adjusted to give effect to the
sale of the Common Stock offered hereby and the receipt of the estimated net
proceeds therefrom as described under "Use of Proceeds".
<TABLE>
<CAPTION>
DECEMBER 31, 1997
------------------------------------
PRO FORMA
HISTORICAL PRO FORMA AS ADJUSTED
---------- --------- -----------
(IN THOUSANDS)
<S> <C> <C> <C>
Cash and cash equivalents................................... $ 3,929 $ 3,929 $58,014
======= ======= =======
Long-term debt, less current portion(1)..................... $ 70 $ 70 $ 70
Redeemable, Convertible Preferred Stock, $0.001 par value,
5,736,957 shares authorized............................
Series A Redeemable, Convertible Preferred Stock,
3,650,000 shares authorized, 3,650,000 shares issued
and outstanding (historical) and none issued or
outstanding (pro forma and pro forma as adjusted).... 3,621 -- --
Series B Redeemable, Convertible Preferred Stock,
2,086,957 shares authorized, 2,086,957 shares issued
and outstanding (historical), and none issued or
outstanding (pro forma and pro forma as adjusted).... 5,257 -- --
Stockholders' equity (deficit):
Preferred Stock, $0.001 per value, 20,000,000 shares
authorized, none issued or outstanding(2).............. -- -- --
Common Stock, $0.001 par value, 50,000,000 shares
authorized, 7,921,471 shares (historical), 13,658,428
shares (pro forma) 16,343,428 shares (pro forma as
adjusted) issued and outstanding, respectively(3)...... 8 14 16
Additional paid-in capital................................ 695 9,567 63,650
Deferred compensation..................................... (571) (571) (571)
Accumulated deficit....................................... (5,190) (5,190) (5,190)
------- ------- -------
Total stockholders' equity (deficit)................... (5,058) 3,820 57,905
------- ------- -------
Total capitalization........................................ $(4,988) $ 3,890 $57,975
======= ======= =======
</TABLE>
- ---------------
(1) See Note 3 of Notes to Consolidated Financial Statements.
(2) The 20,000,000 shares of authorized Preferred Stock includes 3,650,000
shares designated as Series A Convertible Preferred Stock and 2,086,957
shares designated as Series B Convertible Preferred Stock.
(3) Pro forma and pro forma as adjusted Common Stock excludes 1,888,350 shares
issuable upon the exercise of outstanding options as of December 31, 1997,
and an additional 1,184,650 shares reserved for future issuance as of
December 31, 1997 pursuant to the 1995 Plan. See "Management -- Restated
1995 Stock Incentive Plan," "Certain Transactions" and Note 6 of Notes to
Consolidated Financial Statements.
18
<PAGE> 21
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data of the Company is
qualified by reference to, and should be read in conjunction with, the
Consolidated Financial Statements and Notes thereto and the other financial
information appearing elsewhere in this Prospectus. The financial data set forth
below for each of the three years in the period ending December 31, 1997, and as
of December 31, 1996 and 1997, has been derived from the audited Consolidated
Financial Statements of the Company appearing elsewhere in this Prospectus. The
financial data for the period from inception (April 19, 1994) through December
31, 1994, and as of December 31, 1994 and 1995, has been derived from audited
financial statements of the Company not included in this Prospectus. Historical
results are not necessarily indicative of the results that may be expected in
the future. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations".
<TABLE>
<CAPTION>
APRIL 19, 1994
(INCEPTION) YEAR ENDED DECEMBER 31,
THROUGH ---------------------------
DECEMBER 31, 1994 1995 1996 1997
----------------- ------- ------- -------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues:
Licenses..................................... $ 38 $ 246 $ 4,233 $10,936
Support services............................. -- 11 229 2,531
------ ------- ------- -------
38 257 4,462 13,467
Costs and expenses:
Cost of revenues............................. -- 4 18 676
Research and development..................... 5 97 1,225 3,434
Sales and marketing.......................... 11 252 3,768 11,731
General and administrative................... 2 44 656 1,773
------ ------- ------- -------
18 397 5,667 17,614
------ ------- ------- -------
Operating income (loss)........................ 20 (140) (1,205) (4,147)
Interest income, net........................... -- -- 74 228
------ ------- ------- -------
Net income (loss).............................. $ 20 $ (140) $(1,131) $(3,919)
====== ======= ======= =======
Basic and diluted net income (loss) per
share(1)..................................... $ -- $ (.03) $ (.14) $ (.50)
Weighted average shares used in basic and
diluted net income (loss) per share
calculation (2).............................. 4,586 5,001 7,916 7,907
Unaudited pro forma net loss per share(1)...... $ (.29)
=======
Unaudited weighted average shares used in
unaudited pro forma net loss per share
calculation(2)............................... 13,644
=======
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
-------------------------------------
1994 1995 1996 1997
------- ------- ------- -------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
BALANCE SHEET DATA:
Cash and cash equivalents.............................. $ 9 $ 6 $ 2,007 $ 3,929
Working capital (working capital deficit).............. 10 (26) 2,298 2,272
Total assets........................................... 10 176 4,380 9,866
Long-term debt, net of current portion................. -- -- 140 70
Convertible Preferred Stock............................ -- -- 3,614 8,878
Stockholders' equity (deficit)......................... 10 (7) (1,160) (5,058)
</TABLE>
- ---------------
(1) Computed on the basis described in Note 1 of Notes to Consolidated Financial
Statements.
(2) See Note 1 of Notes to Consolidated Financial Statements for the
determination of shares used in computing basic and diluted net income
(loss) per share and unaudited pro forma net loss per share. Pro forma net
loss per share is not included for periods prior to 1997 because such
comparisons are not meaningful due to the conversion of all outstanding
shares of Convertible Preferred Stock to Common Stock upon consummation of
the Offering.
19
<PAGE> 22
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements and related Notes thereto included elsewhere
in this Prospectus. This discussion contains forward-looking statements that
involve risks and uncertainties. The Company's actual results may differ
materially from those anticipated in these forward-looking statements as a
result of certain factors, including, but not limited to, those set forth under
"Risk Factors" and elsewhere in this Prospectus.
OVERVIEW
Internet Security Systems is the leading provider, based on its market
share, of network security monitoring, detection and response software that
protects the security and integrity of enterprise information systems according
to reports by The Aberdeen Group and The Gartner Group. The Company's products
rely on an innovative Adaptive Security Management ("ASM") approach to network
security which entails continuous security risk monitoring and response to
develop an active and informed network security policy. From inception through
December 31, 1995, the Company was considered to be in the development stage
with activities primarily related to raising capital, recruiting personnel,
conducting research and development activities, purchasing operating assets,
building the Internet Security Systems identity and establishing the market for
ASM products. During 1996 and 1997, the Company continued to invest in research
and development, expand its marketing activities, build domestic and
international sales channels and develop its general and administrative
infrastructure.
Historically, the Company has generated substantially all its revenues from
the license and related maintenance of its SAFEsuite products. In particular,
most of the Company's revenues to date have been generated from the Company's
Internet Scanner product, which was first introduced in 1992 and is currently
offered in version 5.0. RealSecure, introduced in the fourth quarter of 1996,
and System Security Scanner ("S3"), introduced in the first quarter of 1997,
have generated lesser amounts of revenue for the Company. The Company has also
derived a small portion of its revenue from responses to customer requests for
training and implementation services, on a time and materials basis, to assist
in the successful deployment of its products within customer networks,
development of customers' security policies and assessing the effectiveness of
security policy decisions. The Company believes that each of its current
products and products in development, together with professional services, will
represent important revenue sources in the future.
The Company recognizes its license revenue upon (i) delivery of software
or, if the customer has evaluation software, delivery of the software key, and
(ii) issuance of the related license, assuming that no significant vendor
obligations or customer acceptance rights exist. In October 1997, the American
Institute of Certified Public Accountants issued Statement of Position ("SOP")
No. 97-2, Software Revenue Recognition, which the Company adopted, effective
January 1, 1997. Such adoption had no effect on the Company's methods of
recognizing revenue from its license and maintenance activities. Prior to 1997,
the Company's revenue policy was in accordance with the preceding authoritative
guidance provided by SOP No. 91-1, Software Revenue Recognition. Revenues from
perpetual licenses are recorded as license revenues in the statements of
operations. Support service revenues include maintenance, term license revenues
and professional services. Maintenance is a separate component of each contract
and is recognized ratably over the contract term. Term licenses, which allow
customer use of the product and maintenance for a specified period, generally
twelve months, are also recognized ratably over the contact term. Professional
services revenues are recognized as such services are performed. Research and
development expenditures have been charged to operations as incurred. The
Company has not capitalized any such development costs under Statement of
Financial Accounting Standards ("SFAS") No. 86.
Pricing is based on the number of devices or engines being managed by the
customer, scaled to provide discounts when the managed system is larger or
several SAFEsuite products are licensed concurrently. Annual maintenance, which
is virtually always purchased in conjunction with the licensing of
20
<PAGE> 23
a product, is a separate component that is offered for a fee generally equal to
20% of the perpetual license fee and recognized ratably over the contract term.
Maintenance packages typically include telephone support, product updates,
access to the Company's security advisory notices and error corrections. ISS
recommends that its customers renew their maintenance contracts and, to date,
most customers have done so. Because of the dynamic nature of vulnerabilities
and threats to distributed computing environments, the Company's ongoing program
of security updates and increased awareness created by the Company's products,
the Company believes that a substantial majority of its customers will continue
to renew their maintenance contracts.
Licenses originate principally from the Company's direct sales force and
telephone sales operations. Indirect sales channels, including resellers,
security consultants, ISPs and OEMs that incorporate the Company's products into
their own product offerings, are also important sources of revenues. Indirect
channels provide less revenue per license to ISS since the channel partners
usually receive discounts ranging from 35% to 50% of list price.
The Company's business has grown rapidly in the last three years, with
total revenues increasing from $257,000 in 1995 to $13.5 million in 1997.
However, ISS has experienced net losses in each of these years and, as of
December 31, 1997, had an accumulated deficit of $5.2 million. These losses
resulted from significant costs incurred in the development and sale of the
Company's products and services. During this period, the number of ISS employees
increased from seven at December 31, 1995 to 141 at December 31, 1997. The
Company currently expects to expand its sales and marketing operations, to
continue an aggressive international expansion, to increase its investment level
in product development and its proprietary database, and to improve its internal
operating and financial infrastructure in support of the Company's business
plan, all of which will increase operating expenses. As a result, ISS expects to
continue to incur losses for the foreseeable future.
The Company recorded deferred compensation of $571,000 as of December 31,
1997, which represents the difference between the exercise price and the fair
value of shares of the Company's Common Stock issuable upon the exercise of
stock options that were granted to employees and directors in December 1997.
Furthermore, the Company has recorded an additional $829,000 of deferred
compensation in 1998 as a result of stock option grants that were made in
January 1998 and February 1998 with exercise prices less than the fair value of
the shares of Common Stock issuable upon the exercise of such options as
determined on the applicable dates of grant. The deferred compensation will be
amortized over the four-year vesting period of the stock options. Amortization
of deferred compensation for the year ended December 31, 1997 was not material.
Because the market for the Company's products has only recently emerged,
period-to-period comparisons of its operating results are not meaningful.
Although ISS has experienced significant revenue growth recently, there can be
no assurance that such growth rates are sustainable and they should not be
relied upon as predictive of future performance. The Company's prospects must be
considered in light of the risks, expenses and difficulties frequently
encountered by companies in the early stage of development, particularly
companies in new and rapidly evolving markets. There can be no assurance that
the Company will be successful in addressing such risks and difficulties or that
ISS will achieve profitability in the future. See "Risk Factors -- Limited
Operating History; History of Losses","-- Significant Potential Fluctuations in
Operating Results" and " -- Management of Growth".
21
<PAGE> 24
RESULTS OF OPERATIONS
The following table sets forth certain consolidated historical operating
information for the Company, as a percentage of total revenues, for the periods
indicated.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------
1995 1996 1997
------ ------ -----
<S> <C> <C> <C>
PERCENTAGE OF TOTAL REVENUES:
Revenues:
Licenses.................................................. 95.7% 94.9% 81.2%
Support services.......................................... 4.3 5.1 18.8
------ ------ -----
100.0 100.0 100.0
Costs and expenses:
Cost of revenues.......................................... 1.6 0.4 5.0
Research and development.................................. 37.7 27.5 25.5
Sales and marketing....................................... 98.1 84.4 87.1
General and administrative................................ 17.1 14.7 13.2
------ ------ -----
154.5 127.0 130.8
------ ------ -----
Operating loss.............................................. (54.5) (27.0) (30.8)
Interest income, net........................................ -- 1.7 1.7
------ ------ -----
Net loss.................................................... (54.5)% (25.3)% (29.1)%
====== ====== =====
</TABLE>
REVENUES
The Company's revenues increased from $257,000 in 1995, to $4.5 million in
1996 and to $13.5 million in 1997. During these periods, Internet Scanner was
the Company's primary revenue-generating product with license revenues
accounting for approximately 96%, 93% and 66% of the Company's total revenues in
1995, 1996 and 1997, respectively. Maintenance revenue related to all licenses
and annual contracts for product usage and support accounted for approximately
4%, 5% and 18% of total revenues in 1995, 1996 and 1997, respectively. The
balance of revenues originated from the Company's more recent product offerings,
S3 and RealSecure, and professional services provided on a time and materials
basis. The Company had no customer that accounted for more than 10% of its
revenues in 1997. The Company recognized over 95% of its revenues in 1995 and
1996 from sales to customers within North America; however, international
operations were significantly expanded in 1997 and represent an increasing
source of the Company's revenues. In 1997, revenues from customers outside North
America were $2.8 million, representing approximately 21% of total revenues.
COST OF REVENUES
Cost of revenues includes packaging and distribution costs for the
Company's software products which, since the Company uses the Internet to
provide product updates and keys necessary to activate a customer's software, is
a minor cost. This category also includes the costs related to the Company's
professional services offerings, which were provided by a dedicated employee
group beginning in 1997 and is expected to be an area of future personnel growth
in 1998. Gross margins were 98.4% in 1995, 99.6% in 1996 and 95.0% in 1997. The
Company's gross margins will decline in future years if, as anticipated,
professional services become a more significant portion of the Company's
business.
RESEARCH AND DEVELOPMENT
Research and development expenses consist of salary and related costs of
the Company's research and development personnel, including costs for employee
benefits, computer equipment and support services used in product and technology
development. This includes the "X-Force", a team composed of security experts
dedicated to understanding, documenting and coding new vulnerability checks,
real-time threats and attack signatures and solutions to global security issues.
The Company believes that this primary research, which aids in the design of new
products and product enhancements to respond to an ever-changing risk profile,
is an essential ingredient for retaining its leadership position in its market-
22
<PAGE> 25
place. Accordingly, the Company has increased its research and development
expenses from $97,000 in 1995, to $1.2 million in 1996 and to $3.4 million in
1997, representing approximately 38%, 27% and 25% of revenues, respectively. ISS
expects that research and development expenses will continue to increase in
absolute dollars, and approximate the 1997 level as a percentage of revenues, as
the Company recruits and hires additional experienced security experts and makes
other investments in research and development. The Company does not expect to
incur significant costs to make its products Year 2000 compliant because it
believes its products are currently designed to properly function through and
beyond the year 2000.
SALES AND MARKETING
Sales and marketing expenses consist primarily of salaries and travel,
commissions, advertising, maintenance of the ISS Web site, trade show expenses,
personnel recruiting costs and costs of marketing materials. Sales and marketing
expenses were $252,000 in 1995, $3.8 million in 1996 and $11.7 million in 1997,
representing approximately 98%, 84% and 87% of total revenues, respectively.
This increase in absolute dollars is primarily the result of a significant
increase in the number of regional United States sales locations, increased
commissions commensurate with increased direct sales revenues and expanded
international operations in the Europe and Asia/Pacific regions. The Company
anticipates that sales and marketing expenses will continue to increase in
absolute dollars, but decrease as a percentage of revenues, as it continues to
expand its direct sales force and telephone sales operations and hires
additional marketing and business development personnel to promote its indirect
sales distribution channels.
GENERAL AND ADMINISTRATIVE
General and administrative expenses were $44,000 in 1995, $656,000 in 1996
and $1.8 million in 1997, representing approximately 17%, 15% and 13% of
revenues, respectively. Such expenses consisted primarily of salaries and
personnel and related costs for the Company's executive, administrative, finance
and human resources personnel, support services and professional services fees.
The Company anticipates that these expenses will approximate 1997 levels as a
percentage of revenues, but will increase in absolute dollars in 1998 as it
upgrades internal and financial reporting systems to enhance management's
ability to obtain and analyze information about its domestic and international
operations. The Company believes that the upgrade of these reporting systems
will result in all of its internal systems being operational through and beyond
the year 2000 without significant additional expense to the Company. Also, the
Company anticipates additional costs related to being a public company,
including annual and other public reporting costs, directors' and officers'
liability insurance, investor relations programs and professional services fees.
INCOME TAXES
No provision for federal, state or foreign income taxes has been recorded
because the Company has experienced cumulative net losses since inception. As of
December 31, 1997, ISS had net operating loss carryforwards of approximately
$3.9 million for federal tax purposes which will expire, if not utilized, in
2011 and 2012. The Company also has approximately $295,000 of net operating loss
carryforwards related to its foreign operations which will expire, if not
utilized, in 2011. The Company has not recognized any benefit from the future
use of such loss carryforwards because management's evaluation of all the
available evidence in assessing the realizability of the tax benefits of such
loss carryforwards indicates that the underlying assumptions of future
profitable operations contain risks that do not provide sufficient assurance to
recognize such tax benefits currently.
23
<PAGE> 26
SELECTED QUARTERLY FINANCIAL RESULTS
The following tables set forth unaudited consolidated statements of
operations data for the eight quarters ended December 31, 1997, as well as such
data expressed as a percentage of the Company's total revenues for the periods
indicated. This data has been derived from unaudited interim consolidated
financial statements that, in the opinion of management, include all adjustments
(consisting only of normal recurring adjustments) necessary for a fair
presentation of such information when read in conjunction with the Company's
Consolidated Financial Statements and Notes thereto appearing elsewhere in this
Prospectus. The operating results for any quarter are not necessarily indicative
of results for any future period.
<TABLE>
<CAPTION>
QUARTER ENDED
---------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
-------- -------- --------- -------- -------- -------- --------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
CONSOLIDATED STATEMENT OF
OPERATIONS DATA:
Revenues:
Licenses.................... $ 360 $ 885 $ 940 $2,048 $1,872 $2,150 $ 2,767 $ 4,147
Support services............ 8 19 88 114 353 521 706 951
------ ------ ------ ------ ------ ------ ------- -------
368 904 1,028 2,162 2,225 2,671 3,473 5,098
Costs and expenses:
Cost of revenues............ 1 4 2 11 87 137 176 276
Research and development.... 176 275 332 442 493 569 895 1,477
Sales and marketing......... 242 871 965 1,690 1,754 2,342 3,051 4,584
General and
administrative............ 95 153 155 253 320 301 443 709
------ ------ ------ ------ ------ ------ ------- -------
514 1,303 1,454 2,396 2,654 3,349 4,565 7,046
------ ------ ------ ------ ------ ------ ------- -------
Operating loss................ (146) (399) (426) (234) (429) (678) (1,092) (1,948)
Interest income, net.......... 18 29 15 12 35 68 66 59
------ ------ ------ ------ ------ ------ ------- -------
Net loss...................... $ (128) $ (370) $ (411) $ (222) $ (394) $ (610) $(1,026) $(1,889)
====== ====== ====== ====== ====== ====== ======= =======
</TABLE>
<TABLE>
<CAPTION>
QUARTER ENDED
---------------------------------------------------------------------------------------
MAR. 31, JUNE 30, SEPT. 30, DEC. 31, MAR. 31, JUNE 30, SEPT. 30, DEC. 31,
1996 1996 1996 1996 1997 1997 1997 1997
-------- -------- --------- -------- -------- -------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
AS A PERCENTAGE OF TOTAL
REVENUES:
Revenues:
Licenses.................... 97.8% 97.9% 91.4% 94.7% 84.1% 80.5% 79.7% 81.3%
Support services............ 2.2 2.1 8.6 5.3 15.9 19.5 20.3 18.7
------ ------ ------ ------ ------ ------ ------- -------
100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Costs and expenses:
Cost of revenues............ 0.3 0.4 0.2 0.5 3.9 5.1 5.1 5.4
Research and development.... 47.8 30.4 32.3 20.4 22.2 21.3 25.8 29.0
Sales and marketing......... 65.8 96.4 93.9 78.2 78.8 87.7 87.8 89.9
General and
administrative............ 25.8 16.9 15.1 11.7 14.4 11.3 12.7 13.9
------ ------ ------ ------ ------ ------ ------- -------
139.7 144.1 141.5 110.8 119.3 125.4 131.4 138.2
------ ------ ------ ------ ------ ------ ------- -------
Operating loss................ (39.7) (44.1) (41.5) (10.8) (19.3) (25.4) (31.4) (38.2)
Interest income, net.......... 4.9 3.2 1.5 0.5 1.6 2.6 1.9 1.1
------ ------ ------ ------ ------ ------ ------- -------
Net loss...................... (34.8)% (40.9)% (40.0)% (10.3)% (17.7)% (22.8)% (29.5)% (37.1)%
====== ====== ====== ====== ====== ====== ======= =======
</TABLE>
24
<PAGE> 27
During the Company's short history, its operating results have varied on a
quarterly basis and may fluctuate significantly in the future on a quarterly and
annual basis as a result of a combination of factors. These factors include the
level of demand for the Company's products, the volume and timing of orders, the
level of product and price competition, the Company's ability to expand its
domestic and international sales and marketing organizations, the Company's
ability to develop new and enhanced products, the Company's ability to attract
and retain key technical, sales and managerial personnel, the mix of
distribution channels through which the Company's products are sold, the growth
in the acceptance of, and activity on, the Internet and the Web, particularly by
corporate, institutional and government users, the level of growth of intranets,
the extent to which unauthorized access and use of online information is
perceived as a threat to network security, customer budgets, seasonal trends in
customer purchasing, foreign currency exchange rates and general economic
factors. In addition, the amount of revenues associated with particular licenses
can vary significantly based upon the number of products licensed and the number
of devices involved in the installation. The Company has experienced, and may
continue to experience from time to time, large individual license sales which
can cause significant variability in license revenues and results of operations
for any particular period. As a result, the timing of significant orders is
unpredictable and, like many software companies, the Company typically realizes
a significant portion of software license revenues in the last month of the
quarter. The Company establishes its expenditure levels for product development,
sales and marketing and other operating expenses based, in large part, on its
expected future revenues. As a result, if revenues fall below expectations,
operating results and net income are likely to be adversely and
disproportionately affected because only a small portion of the Company's
expenses vary with its revenues.
LIQUIDITY AND CAPITAL RESOURCES
Since its inception, the Company has financed its operations primarily
through sales of its equity securities in private placements. In February 1996
and February 1997, the Company received aggregate net proceeds of $8.9 million
from the sale of Convertible Preferred Stock, which shares will automatically
convert into Common Stock upon consummation of the Offering.
Net cash used in operating activities of approximately $1.6 million for the
year ended December 31, 1997 resulted from $3.9 million in net operating losses
partially offset by a decrease in working capital. Although revenue growth
increased accounts receivable by $2.1 million in 1997, working capital decreased
as accounts payable and accrued expenses grew $2.7 million and deferred revenues
increased $1.5 million. The increase in deferred revenues was attributable to
the growth of maintenance contracts and term licenses, which are recognized
ratably as revenue over the contract term.
Cash provided by financing activities of $5.2 million in 1997 consisted
primarily of the proceeds from the issuance of Convertible Preferred Stock which
has been invested in short-term investments. Purchase of computer equipment used
in conducting the Company's business represented the primary component of cash
used in investing activities.
As of December 31, 1997, the Company had $3.9 million of cash and cash
equivalents. The Company believes that the net proceeds of this Offering,
together with existing cash, cash equivalents and short-term investments, will
be sufficient to fund its anticipated operating losses and to meet its working
capital and anticipated capital expenditures for at least the next 12 months.
The Company currently intends to use the net proceeds of the Offering for
working capital and general corporate purposes, including financing accounts
receivable and capital expenditures made in the ordinary course of its business,
as well as for possible acquisitions of businesses, products and technologies
that are complementary to those of the Company. Although the Company has not
identified any specific businesses, products or technologies that it may
acquire, nor are there any current agreements or negotiations with respect to
any such transactions, the Company from time to time evaluates such
opportunities. Pending such uses, the net proceeds will be invested in
government securities and other short-term, investment-grade, interest-bearing
instruments.
25
<PAGE> 28
BUSINESS
OVERVIEW
Internet Security Systems is the leading provider, based on market share,
of network security monitoring, detection and response software that protects
the security and integrity of enterprise information systems according to
reports by The Aberdeen Group and The Gartner Group. The Company's SAFEsuite
family of products enforces "best practice" information protection automatically
across distributed computing environments by monitoring and responding to
continuously changing network security risks. By dynamically detecting and
responding to the security vulnerabilities and real-time threats inherent in
open systems, SAFEsuite products protect distributed computing environments,
including internal corporate networks, extranets and the Internet, from attacks,
misuse and security policy violations. The Company's products rely on an
innovative Adaptive Security Management ("ASM") approach to network security,
which entails continuous security risk monitoring and response to develop and
enforce an active network security policy. ISS pioneered the technology for
vulnerability and threat detection through a dedicated security research and
development team and believes, based on a report by The Aberdeen Group and the
Company's own research, that it has the most comprehensive vulnerability and
threat database in existence. The Company has delivered its network security
monitoring, detection and response solutions to over 1,500 organizations
worldwide, including firms in the Global 2000, U.S. and international government
agencies and major universities. Nine of the ten largest commercial banks in the
United States as ranked by Fortune have licensed the Company's products.
INDUSTRY BACKGROUND
The rise of client/server computing in recent years has driven the need for
connectivity beyond local area networks ("LANs") to enterprise-wide networks
spanning multiple LANs and wide area networks ("WANs"). Concurrently with the
shift to distributed computing architectures, the use of the Internet by
organizations has grown dramatically, driven largely by the development of the
Web and graphically intuitive browsers, the proliferation of multimedia personal
computers and the emergence of compelling Web-based content and commerce
applications. International Data Corporation ("IDC") estimated in a July 1997
report that at the end of 1997 there would be over 29 million Web users in the
United States and over 50 million users worldwide, with the number expected to
increase to 94 million in the United States and 175 million worldwide by the end
of 2001. Additionally, IDC estimates that the number of devices accessing the
Web will increase from 64 million at the end of 1997 to 331 million by the end
of 2001.
Growth of the Internet has to date been fueled primarily by the increased
use of e-mail, general information browsing and the exchange of non-sensitive
data. However, organizations are increasingly connecting their enterprise
networks to the Internet to extend beyond these limited uses, thus facilitating
and supporting a number of more valuable and sensitive activities, including
business-to-business transactions, electronic data interchange (EDI), Web-based
access to account and benefits information, secure messaging and online retail
purchases and payments. The proliferation of client/server architectures and the
growth of the Internet as a business tool has led to the emergence of
"intranets" -- private enterprise information systems that use Internet
protocols ("IP") and applications to share information and services both within
and outside the enterprise network. As a result, businesses are able to share
internal information and to run enterprise applications across geographically
dispersed facilities, and customers, remote employees, suppliers and other
business partners are able to inexpensively link into each other's enterprise
information systems. In its July 1997 report, IDC projected that 9 million users
in the U.S. and 13 million users worldwide had bought or would buy goods or
services in Web-based transactions during 1997, with that number expected to
grow to 42 million and 68 million users, respectively, by 2001. In addition, IDC
estimates that commerce over the Internet will grow from less than $11 billion
in 1997 to more than $223 billion in 2001.
26
<PAGE> 29
THE NEED FOR NETWORK SECURITY
Although open computing environments have many business advantages, their
accessibility and the relative anonymity of users makes these systems, and the
integrity of the information that is stored on them, vulnerable to security
threats. Distributed computing systems contain an organization's mission-
critical applications, such as payroll, financial reports, customer and supplier
records and manufacturing and engineering designs. The advent and widespread
adoption of open systems, together with their inherent vulnerabilities, present
inviting opportunities for computer hackers, curious or disgruntled employees,
contractors and competitors to compromise or destroy sensitive information
within the system or to otherwise disrupt the normal operation of the system. In
addition, client/server computing environments are inherently complex, typically
involving a variety of hardware, operating systems, networking protocols and
applications supplied by a multitude of vendors, making these networks difficult
to manage, monitor and protect from unauthorized access. Each application,
operating system and device introduced to a network contains additional
vulnerabilities that may be exploited by an unauthorized network user. Newly
introduced versions of products like Windows NT and Sun Solaris, which are
designed to maximize connectivity both within and among networks, create many
more new vulnerabilities. To adequately secure a network, IT managers must have
the resources to not only correctly configure the security measures in each
system, but also to understand the risks created by any change to existing
systems on the network. Exacerbating this situation is the limited supply of
personnel knowledgeable in information security issues.
These factors create an urgent need for enterprises to protect their
information systems from unauthorized access and misuse. The security risks are
real. According to the 1997 Annual Information Week/Ernst & Young LLP
Information Security Survey of IT managers and professionals, 42% of all United
States respondents reported malicious acts from external sources, up from 16% in
the previous year, 43% reported malicious acts from employees as compared to 29%
in the previous year, and 55% reported insufficient IT professionals to monitor
network security. Despite the convenience and the compelling economic incentives
for the use of IP networks, they cannot reach their full potential as a platform
for global communication and commerce until the current lack of security
associated with these networks is adequately resolved.
Organizations have generally responded to perceived security threats by
implementing passive point tools designed to protect individual components of
their internal networks from unauthorized use or outside attacks. Some security
concerns are being addressed through encryption, firewalls and other
technologies, but these technologies can be circumvented. Encryption protects
information during transmission, but it does not typically protect information
at either the source or the destination. A "firewall" controls the flow of data
between an internal network and outside networks or the Internet. While
firewalls are necessary for access control, they must be initially configured,
and regularly reconfigured, to accommodate new applications, users and business
partners on the network, each of which creates additional risks. Furthermore,
firewalls are vulnerable to hackers and others seeking to compromise network
integrity and fail to protect against an improper use of the systems by internal
authorized users within the network. In addition to encryption and firewalls,
many organizations deploy operating system security mechanisms, such as user
authentication, passwords and multi-level access rights, to prevent unauthorized
access to information by external as well as internal users. Implementation
issues such as easily-guessed passwords or default accounts left on newly
installed devices diminish the effectiveness of these measures. Passive point
tools do not address the fundamental issue that "open" systems are, by
definition, open and that their inherent utility is itself the source of their
vulnerability. This conflict between the benefits of open systems and the risks
of their unauthorized use or disruption has not been widely recognized or
addressed by IT managers.
To be effective, passive point tools that secure specific elements of an
enterprise network need to be coordinated through an enterprise-wide computer
security policy with systems to automatically enforce and evaluate the
effectiveness of that policy. Many organizations have developed security
policies that address the appropriate use of network resources, the proper
configuration of network services, operating systems and applications and
actions to be taken if there is a violation of such policy or an
27
<PAGE> 30
attack on the network; however, such organizations have not had the systems to
automatically enforce and implement such policies across their entire IT
infrastructure. Without such systems, the dynamic nature of enterprise networks
causes the organization's actual security practice to diverge from the stated
security policy, potentially exposing the organization to additional
unanticipated risks. Direct observation of vulnerabilities and threats can allow
an organization to define and automatically enforce an integrated,
enterprise-wide security policy that can be managed centrally and implemented on
a distributed basis. Because of the shortage of personnel trained in network
security issues, any security solution must be easy to use by both management
and the organization's existing IT personnel. An effective network security
solution also needs to work with existing security technologies as well as be
flexible enough to incorporate new technologies.
THE ISS SOLUTION
ISS has developed Adaptive Security Management, a dynamic, process-driven
approach to enterprise-wide network protection. The ASM process relies on the
principles of monitoring, detection and response to the ever-changing
vulnerabilities in and threats to the network protocols, operating systems and
applications that comprise every network system. The Company's monitoring,
detection and response products provide easy-to-use software solutions designed
to enable network managers to centrally define and manage an enterprise-wide
security policy for their existing network system infrastructure, including all
IP-enabled devices. The Company's SAFEsuite family of products provides the
ability to visualize, measure and analyze real-time security vulnerabilities and
control threats across the entire enterprise network infrastructure, keeping the
organization's IT personnel informed of changing network conditions and
automatically making adjustments as necessary. Through custom policies or by
using the Company's "best practice" templates, network managers can minimize
security risks without closing off the organization's network to the benefits of
open computing environments and the Internet. The Company's solution reaches
beyond the traditional approaches to network security in the following respects:
ADAPTIVE SECURITY MANAGEMENT
ASM is a proactive, risk management-based approach to network security
management that links security practice and security policy through a continuous
improvement process. ASM incorporates four critical processes: (i) continuously
monitoring network traffic and the configuration of devices on the network; (ii)
detecting security risks in network traffic and network devices; (iii)
responding to network security risks to minimize such risks; and (iv) reporting
response actions and updating security policies. The Company's products
incorporate the ASM approach to enable continuous improvement to the security of
the customer's existing systems by identifying and minimizing the security risks
on the network. The Company's SAFEsuite family of products continuously monitors
the network for security risks that violate the customer's security policy and
provides actions to eliminate or minimize the security weaknesses. SAFEsuite is
a critical enhancement to traditional passive security technologies such as
encryption, firewalls and authentication. The Company's products provide a
unique, active component to an organization's overall security infrastructure
that enables end-to-end network protection. The software automatically
identifies systems and activities that are not in compliance with a customer's
policies, and provides a critical feedback mechanism for adjusting the security
levels of networked systems based upon its findings. Without these capabilities,
an organization is limited in its ability to effectively measure and control
security across its enterprise network.
COMPREHENSIVE ENTERPRISE SECURITY SOLUTION
ISS combines ASM principles with its extensive knowledge of network
vulnerabilities and threats to provide scalable security solutions. The Company
sells its products individually as solutions to problems for a particular
network function or as a suite of products that provide a comprehensive network
security framework. The Company's products extend across a broad range of
platforms and work with the products of leading security and network management
vendors to provide a single point of management and control for an
enterprise-wide security policy across multiple hosts, operating systems and
28
<PAGE> 31
applications. Products are designed to be easily installed, configured, managed
and updated by a system administrator through an intuitive graphical user
interface ("GUI") without interrupting or affecting network operation. The
Company's products generate easy-to-understand reports ranging from
executive-level trend analysis to detailed step-by-step instructions for
eliminating security risks that include automatic links to vendor Web sites for
software patches.
THE "X-FORCE"
Because there are few IT professionals specifically trained in network
security issues, the Company created a senior research and development team
composed of security experts who are dedicated to understanding, documenting and
coding new vulnerability tests, real-time threats and attack signatures. The
team is known in the industry as the "X-Force". The X-Force conducts primary
research in the field of vulnerability and threat science, which is the basis of
the core competency of the Company. Because of the knowledge and experience of
the people comprising the X-Force, the Company believes that the X-Force is one
of the largest and most sophisticated groups of IT security experts researching
vulnerability and threat science and therefore represents one of the Company's
competitive advantages. Organizations such as CERT (Computer Emergency Response
Team), the FBI and leading technology companies routinely consult the X-Force on
network security issues. Through the X-Force, ISS maintains a proprietary and
comprehensive knowledge base of computer exploits and attack methods, including,
what the Company believes is the most extensive collection of Windows NT
vulnerabilities and threats based on reports in InfoWorld and the Company's own
research. To respond to an ever-changing risk profile, the X-Force continually
updates this knowledge base with the latest network vulnerability information,
which aids in the design of new products and product enhancements.
STRATEGY
The Company's objective is to be the leading provider of ASM systems that
proactively protect the integrity and security of enterprise-wide information
systems from vulnerabilities, misuse, attacks and other policy violations. ISS
focuses on developing innovative and automated software solutions to provide
customers with a comprehensive framework for protecting their networks by
monitoring for vulnerabilities and real-time threats in order to enforce "best
practice" network and system security policies. Key elements of the Company's
strategy are to:
- CONTINUE LEADERSHIP POSITION IN SECURITY TECHNOLOGY. The Company intends
to maintain and enhance its technological leadership in the enterprise
security market by hiring additional network and Internet security
experts, broadening the Company's proprietary knowledge base and
continuing to invest in product development and product enhancements. By
solidifying its position as the leader in the emerging market for
monitoring, detection and response software, the Company believes that
customers and potential customers will view ISS as the firm of choice for
establishing and maintaining effective security practices and policies.
- EXPAND DOMESTIC SALES CHANNELS. To increase the distribution and
visibility of its products, ISS plans to execute its enterprise-wide
systems sales strategy by expanding its regional direct sales program and
to increase market coverage by establishing additional indirect channels
with key ISPs, systems integrators, VARs, OEMs and other channel partners
to address enterprise-wide system opportunities. As the potential
customer base for network security products encompasses a wide variety of
industries, the Company believes that a multi-channel sales efforts will
build customer awareness of the need for the Company's products and
enable the Company to more rapidly penetrate these industry markets.
- PROMOTE PROFESSIONAL SERVICES CAPABILITIES. ISS intends to establish
long-term relationships with its customers by serving as a "trusted
advisor" in addressing network security issues. To fulfill this
responsibility to its customers, the Company will expand its professional
services capabilities to provide additional security system design,
planning, installation, testing and consulting services to assist
customers in the effective adaptation of their security policies as new
29
<PAGE> 32
computing products and systems are deployed or new users or
infrastructure to existing systems are added. By providing professional
services, the Company can heighten customer awareness about network
security issues, which creates opportunities for ISS to sell new products
or product enhancements to its existing customers.
- EXPAND INTERNATIONAL OPERATIONS. ISS plans to aggressively expand its
international operations to address the rapid global adoption of
distributed computing environments. Many foreign countries do not have
laws recognizing network intrusion or misuse as a crime or the resources
to enforce such laws if they do exist, and therefore, the Company
believes that organizations in such countries will have greater need for
effective security solutions. The Company currently maintains
international offices in Belgium, Canada, England, France, Germany and
Japan. ISS plans to expand in those regions where businesses, governments
and other institutional users are using distributed networks and the
Internet for their mission-critical needs.
- CREATE ASM CATEGORY AWARENESS. The Company intends to increase and
broaden awareness of the need for ASM and the Company's enterprise
monitoring, detection and response systems by increasing its level of
public relations, educational events, seminars, advertising, direct
marketing and trade show participation. ISS believes that the risks and
dangers associated with the adoption of open computing systems have not
received the same level of general recognition or publicity as have the
benefits of using such systems. By increasing awareness of the
vulnerabilities and threats that are endemic to open computing
environments and the ability to manage such vulnerabilities and threats
through ASM, the Company can demonstrate to its customers how better
network protection can be achieved.
PRODUCT ARCHITECTURE
The ISS SAFEsuite family of products delivers the Company's ASM approach
through a flexible architecture designed to be integrated with existing security
and network system infrastructures. Passive point tools such as firewalls
provide specific security functionality for components within the network
infrastructure. SAFEsuite enhances the effectiveness of these tools by
monitoring them for threats and vulnerabilities and responding with actions that
align the customer's security practice with its security policy. SAFEsuite
complements network and security management frameworks by providing information
required for informed decisions to minimize security risks while maintaining the
desired level of network functionality. Thus, the Company's products provide a
risk management-based approach to security with scalable deployment of
best-of-breed products and integrated enterprise-wide implementations.
The following depicts the SAFEsuite product architecture:
(Safesuite Architecture Chart)
30
<PAGE> 33
The Adaptive Security Application Programming Interface ("ASAPI") is the
focal point for automated interaction with static security technologies such as
encryption, firewalls and authentication servers. ASAPI is a two-way
communication protocol that allows SAFEsuite products to leverage information
and capabilities available across the network and to proactively adapt
configurations of security subsystems on the network. For example, SAFEsuite
products identify valid Java and ActiveX applets in Web traffic by using the
authentication information available in digital certificates such as those from
VeriSign. When a security risk is identified, ASAPI is used to send a message
directly to the appropriate passive protection tool to eliminate the risk (e.g.,
when an attacker is identified, the firewall is automatically reconfigured to
block the attacker's IP address). ASAPI leverages existing infrastructure
control standards such as Check Point Software Technologies' OPSEC (Open
Platform for Secure Enterprise Connectivity), allowing deployment of the
Company's products without requiring upgrades or changes to the customer's
existing hardware or software.
The SAFEsuite policy management interface lets the customer choose from
"best practice" templates or provides the ability to define a specific policy
that establishes the level of risk appropriate for the network. The individual
products automatically verify compliance with the policy in terms of actual
system configuration and activity present on the network. Graphical reports
express the deviations from the established policy, including the measures
required to reduce the risk. The policy can include automatic intervention by a
SAFEsuite product through ASAPI.
This product architecture allows all the SAFEsuite technologies to connect
directly into common standards, providing comprehensive security reports for the
entire enterprise. To ensure communication confidentiality between individual
SAFEsuite components and to prevent misuse, SAFEsuite uses RSA encryption
algorithms, which have become de facto encryption standards. The SAFEsuite
Security Repository, a database containing information about the devices and
security risks on a customer's network, utilizes an Open Database Connectivity
("ODBC") interface and allows customers to select their preferred database such
as Oracle, Microsoft SQL Server, Sybase, Informix or any ODBC-compliant database
for data storage. All ISS products use a common taxonomy for identifying
specific security issues. The various SAFEsuite products consolidate security
data, enabling the user to quickly determine its risk posture and take
appropriate actions. In addition, SAFEsuite products provide automated decision
support by assessing priorities and providing a graphical representation of
important security risk data sets. This allows key decision-makers to prioritize
their program strategies for effective deployment of resources to minimize
security risks.
The SAFEsuite architecture also delivers scalability in deployment options,
usage models and ongoing operations. Each SAFEsuite product can be deployed as a
stand-alone, best-of-breed solution to meet the needs of the local administrator
or departmental user. Through support for remote, multi-level management
consoles and the SAFEsuite Security Repository, enterprise-level users can
analyze security risk conditions for the entire network. The SAFEsuite Security
Repository allows the customer to address both vulnerabilities and threats,
thereby minimizing network security risk and associated costs. SAFEsuite's
frequent updates integrate the latest identified security vulnerabilities and
threats into the operations of an existing ISS product installation.
31
<PAGE> 34
PRODUCTS
The following table lists the SAFEsuite products currently offered by the
Company, and includes a brief description of each product's functionality and
current list pricing:
<TABLE>
<CAPTION>
INTRODUCTION
DESCRIPTION SCOPE U.S. LIST PRICE DATE
<S> <C> <C> <C> <C>
- ------------------------------------------------------------------------------------------------------------
NETWORK SECURITY VULNERABILITY DETECTION, ANALYSIS AND REPORTING
- ------------------------------------------------------------------------------------------------------------
Internet Scanner Comprehensive security 50 devices $ 3,495 October 1992
assessment for all 100 devices $ 5,395
devices on an enterprise 500 devices $14,650
network
- ------------------------------------------------------------------------------------------------------------
Intranet Scanner Security assessment for 10 devices $ 795 August 1996
internal devices on an 20 devices $ 1,495
enterprise network 50 devices $ 2,995
- ------------------------------------------------------------------------------------------------------------
Firewall Scanner Security assessment for 1 firewall $ 995 August 1996
firewalls and gateways 5 firewalls $ 4,495
10 firewalls $ 7,995
- ------------------------------------------------------------------------------------------------------------
Web Security Scanner....... Security assessment for 1 Web server $ 495 August 1996
Web servers 5 Web servers $ 1,995
10 Web servers $ 3,495
- ------------------------------------------------------------------------------------------------------------
INTERNAL SYSTEM SECURITY VULNERABILITY DETECTION, ANALYSIS AND REPORTING
- ------------------------------------------------------------------------------------------------------------
System Security Internal security 5 computers $ 1,995 January 1997
Scanner -- S3 assessment for 10 computers $ 3,495
operating systems 20 computers $ 5,995
- ------------------------------------------------------------------------------------------------------------
NETWORK SECURITY THREAT AND MISUSE DETECTION, ANALYSIS AND RESPONSE
- ------------------------------------------------------------------------------------------------------------
RealSecure Real time attack 1 engine $ 4,995 December 1996
recognition, misuse 5 engines $19,900
detection and response 10 engines $34,900
for networks
- ------------------------------------------------------------------------------------------------------------
</TABLE>
INTERNET SCANNER
Internet Scanner provides automated security vulnerability detection and
analysis for devices on a network and supports the security risk management
process from policy development through implementation. In addition, Internet
Scanner performs scheduled or event-driven probes of network communication
services, operating systems, routers, e-mail and Web servers, firewalls and
applications to identify weaknesses that could be exploited by intruders to gain
access to the network. After selecting from a list of pre-defined "best
practice" templates or customizing a template appropriate for the organization,
Internet Scanner quickly produces a technical security policy document with
detailed implementation instructions. Internet Scanner can then assess the
entire network for compliance with the security policy, identifying the specific
instances where security practice does not match the prescribed policy. Internet
Scanner identifies and prioritizes security risks and generates a wide range of
reports ranging from executive-level trend analysis to detailed step-by-step
instructions for eliminating security risks including automatic links to vendor
Web sites for software patches.
32
<PAGE> 35
Internet Scanner is also packaged as separate modules -- Intranet Scanner,
Web Security Scanner and Firewall Scanner -- each targeted for specific market
segments. The Internet Scanner embodies all three network-scanning modules.
INTRANET SCANNER. Intranet Scanner assesses the vulnerability of a network
to attack from intruders who have penetrated a firewall by systematically
probing each network device to identify security vulnerabilities. Network
platforms and devices, including Windows NT and Windows 95, Unix hosts, routers,
e-mail servers, Web servers and firewalls, are among those automatically checked
by Intranet Scanner. Many system operators typically focus security measures on
only those devices within the system that contain the most sensitive
information. Other devices often are left vulnerable, thus enabling unauthorized
users to compromise a less sensitive device (like a Unix printer server) to gain
access that can springboard them into more sensitive systems. Intranet Scanner
scans for such weak-link vulnerabilities in the chain of devices in the network,
including vulnerabilities arising from the use of default and easily-guessable
passwords for devices within the system, misconfigured file system servers and
unprotected Windows NT registry settings. Intranet Scanner not only determines
if an intruder could gain access, but also ascertains if a device is susceptible
to denial of service attacks by vandals who may seek to deny access to or use of
systems by authorized users.
WEB SECURITY SCANNER. Web Security Scanner tests the configuration of a
Web server, evaluates the security of the underlying operating system and
determines whether the Web server application has been updated with the latest
security patches. This module searches the Web server's common gateway
interface, active server page scripts and HTML (hypertext mark-up language)
directories to detect whether known vulnerabilities exist within the customer's
Web server system. For private HTML pages that are password protected, Web
Security Scanner assesses vulnerability to a "brute-force attack" (i.e., a
flooding of log-on attempts in an effort to overwhelm password screening and
thereby gain unauthorized access) through checks of easily-guessable or default
passwords. Finally, Web Security Scanner identifies any Java and ActiveX applets
on the Web server that may conflict with the customer's security policy.
FIREWALL SCANNER. Firewall Scanner identifies vulnerabilities by
monitoring the configuration of firewalls through a series of security checks.
The improper configuration of a firewall can seriously compromise the
effectiveness of the firewall as a security measure. Firewall Scanner's checks
include attempting to bypass the firewall by trying to connect through packet
filter-based firewalls, stateful inspection-based firewalls and application
proxy servers. Blocked or permitted connections validate the firewall's
configured filter rules. A firewall permitting an outside connection through to
an inside vulnerable server can provide an intruder with the opportunity to
compromise the entire network. The Firewall Scanner determines whether a SNMP
(simple network management protocol) is enabled on the firewall allowing
sensitive network information to be obtained by intruders and determines whether
a vandal can bring down a firewall through numerous denial of service attacks.
In addition, the Company offers Advanced Packet Exchange ("APX") as a
recent enhancement for Firewall Scanner. APX provides a GUI that facilitates the
creation of low-level custom network packets. It then attempts to transmit them
through the firewalls or routers conducting packet validation. This determines
whether these packets were allowed or blocked at the gateway. By doing so, this
technology enables more precise testing and assessment of the security rules
associated with network access controls.
SYSTEM SECURITY SCANNER
System Security Scanner provides a host-based security assessment analyzing
internal security weaknesses. While the Internet Scanner determines
vulnerabilities by scanning devices at the network level, S3 detects
vulnerabilities internally at the system level by having an S3 agent resident on
the devices. These S3 agents allow a continuous security policy to be managed
and controlled across an enterprise from a central point. S3 compares an
organization's stated security policy with the actual configuration of the host
computer for potential security risks, including easily-guessed passwords, user
33
<PAGE> 36
privileges, file system access rights, service configurations, data integrity,
and the existence of Trojan backdoors and suspicious activity that indicate an
intrusion. S3 verifies that the components of the operating system have been
updated with the latest patches from the operating system vendor. Each security
risk is prioritized by S3, which also generates scripts that implement the
appropriate corrective action.
REALSECURE
RealSecure is an automated, real-time intrusion detection, misuse and
response system for computer networks. The RealSecure Attack Recognition Engine,
which unobtrusively analyzes packets of information as they travel across the
network, recognizes hostile activity on a network by interpreting network
traffic patterns that indicate attacks. RealSecure's Suspicious Reassembly
algorithm analyzes packets for unusual formations that can indicate an attack
while simultaneously protecting RealSecure itself from these attacks. When an
attack is recognized, the administrator is alerted via e-mail and an alarm is
displayed on the central management console. In addition, the attack can be
terminated automatically, logged to a database, or recorded for later forensic
analysis. With RealSecure's distributed architecture, customers can install
Attack Recognition Engines throughout their enterprise network to detect and
stop internal misuse as well as attacks from outside the network perimeter.
Increasing network speeds and numbers of attacks geometrically increase the
potential workload for attack recognition solutions. RealSecure utilizes the
Company's Digital FingerPrinting to recognize a large number of attack-patterns
on high-speed networks. Additionally, the Company's Adaptive Filtering Algorithm
tunes the packet filter rules in response to network load, allowing the engine
to effectively function during bursts in network traffic.
PRODUCT PRICING
ISS uses a range of fee structures to license its products, depending on
the type of product and the intended use. The vulnerability detection
products -- the Internet Scanner family of products and System Security
Scanner -- are licensed based on the number of devices being scanned. The
pricing scheme is scalable, providing low entry points for departmental users
without capping the Company's revenue for large networks. Pricing for the threat
detection product, RealSecure, is based on the number of engines deployed on the
network. Thus, licensing fees for the Company's products are ultimately
determined by the size of the customer's network, as the size will dictate the
number of devices to be scanned or the number of engines to be deployed for a
given performance level. In addition to license fees, customers virtually always
purchase maintenance agreements in conjunction with their purchase of a software
license for annual maintenance fees equal to 20% of the product's list price;
maintenance agreements include annually renewable telephone support, product
updates, access to the Company's X-Force Security Alerts and error corrections.
The Company's continuing research into new security risks and resultant product
updates provides significant ongoing value, and as a result, a substantial
majority of the Company's customers purchase maintenance agreements. Customers
who use the Company's products to provide IT consulting services have license
agreements that are based on a revenue sharing model. ISS has historically sold
fully-paid perpetual licenses with a renewable annual maintenance fee, but it is
currently in the process of increasing the licensing of its products on a
subscription basis (which includes maintenance) for one or two year periods.
SERVICES
ISS offers specialized consulting and training services that are designed
to complement the general knowledge and experience derived by IT professionals
with specific information and assistance to promote customer success in the use
of the Company's products.
The Company's Professional Services Group assists customers in the
successful implementation of the Company's products. The Professional Services
Group's senior operational and technical consultants work with the Company's
customers to identify potential security risks within the customer's operations,
business processes and constraints in order to develop an implementation
strategy that will configure
34
<PAGE> 37
products in a manner that balances the customer's need for system security with
ease-of-use and flexibility requirements. In this manner, ISS consultants assist
customers in mapping the deployment of the Company's products to the customer's
network and security policy and the metrics for assessing the effectiveness of
and enforcing the security policy. The Company charges its customers for
professional services on a time and materials basis.
In addition to performing consulting services for customers, ISS provides
focused education and training in the use of its products and with respect to
security issues through the ISS University program. Students who complete the
curriculum and pass both a hands-on product test and a written test become ISS
Certified Engineers. See "-- Customer Service and Support".
PRODUCT DEVELOPMENT
The Company has developed its SAFEsuite products to operate in
heterogeneous computing environments. Products are compatible with other
vendors' products across a broad range of platforms, including Windows NT,
Windows 95, Sun Solaris, SunOS, SGI IRIX, Linux, HP-UX and IBM AIX. The Company
incorporates a modular design to permit plug-and-play capabilities for its
products, although customers often use professional services provided by the
Company or its strategic partners to install and configure products for use in
larger or complex network systems.
The Company employs a two-pronged product development strategy to achieve
its goal of providing the most comprehensive security coverage within the
monitoring, detection and response market. First, the Company will continue to
develop best-of-breed security products to address particular network
configurations. Such new products, and the Company's existing products like
Internet Scanner, System Security Scanner and RealSecure, are updated
approximately every four to six months to add new features, improve
functionality and incorporate responses to vulnerabilities and threats that have
been added to the Company's vulnerability and threat database. These updates are
usually provided as part of separate maintenance agreements sold with the
product license.
Second, to complement its existing products and provide more comprehensive
security coverage to networks, the Company is expanding its existing SAFEsuite
products by developing additional enterprise-level products that incorporate ASM
principles. These products will add functionality to the Company's existing
product line by allowing customers to protect their network by continuously
measuring and analyzing the status of their network's security, and by
monitoring and controlling the security risks in real time across the enterprise
network. These new products will be interoperable with existing Company
products, allowing modular implementation.
Expenses for product development were $97,000, $1.2 million and $3.4
million in 1995, 1996 and 1997, respectively. All product development activities
are conducted at the Company's principal offices in Atlanta, where, as of
December 31, 1997, 48 personnel were employed in product development teams. In
addition, Company personnel are members of the Computer Security Institute,
Forum for Incident Response and Security Technicians (FIRST), Georgia Tech
Industrial Partners Association and the International Computer Security
Association (ICSA), enabling the Company to actively participate in the
development of industry standards in the emerging market for network and
Internet security systems and products.
CUSTOMERS
As of December 31, 1997, the Company had licensed versions of its SAFEsuite
family of products to over 1,500 customers. No customer accounted for 10% of the
Company's consolidated revenues in 1996 or 1997. The Company's target customers
include both public and private sector organizations that utilize IP-enabled
information systems to facilitate mission-critical processes in their
operations. The Company's customers represent a broad spectrum of organizations
within diverse sectors, including financial services, technology,
telecommunications, government and services.
35
<PAGE> 38
The following is a list of certain of the Company's customers that have
purchased licenses and services from the Company with an aggregate price of at
least $15,000 and which the Company believes are representative of its overall
customer base.
FINANCIAL SERVICES
Charles Schwab
First Union
KeyCorp
Merrill Lynch
PNC Bank
TECHNOLOGY
Hewlett-Packard
IBM
Intel
Lucent Technologies
Microsoft
NCR
Siemens
VeriSign
Xerox
OTHER
Lockheed Martin
Merck
TELECOMMUNICATIONS
America Online
Bell Atlantic
BellSouth
GTE Internetworking
NETCOM On-Line Communications
Nippon Telephone & Telegraph
GOVERNMENT
NASA
Salt River Project
U.S. Department of the Air Force
U.S. Department of the Army
U.S. Department of Defense
U.S. State Department
SERVICES
EDS
KPMG Peat Marwick
Price Waterhouse
SAIC
SITA
SALES AND MARKETING
SALES ORGANIZATION
The Company's sales organization is divided regionally among the Americas,
Europe and the Asia/Pacific regions. In the Americas region, ISS markets its
software primarily through its direct sales organizations augmented by its
indirect channels, including security consultants, VARs and systems consulting
and integration firms. The direct sales organization for the Americas consists
of regionally-based sales representatives and sales engineers and a tele-sales
organization located in Atlanta. At December 31, 1997, the Company's sales
offices were located in the Atlanta, Austin, Boston, Chicago, Cincinnati,
Dallas, Los Angeles, New York, Palo Alto, Philadelphia, San Francisco, Toronto
and Washington, D.C. metropolitan areas. A dedicated group of professionals in
the Atlanta headquarters covers Latin America. As of December 31, 1997, the
Company employed 35 people in the Americas region direct sales organization. The
regionally-based direct sales representatives focus on opportunities where the
Company believes it can realize more than $200,000 in revenues.
In the Europe and Asia/Pacific regions, substantially all of the Company's
sales occur through authorized resellers. Internationally, the Company has
established regional sales offices in Brussels, London, Paris, Stuttgart and
Tokyo. Personnel in these offices are responsible for market development,
including managing the Company's relationships with its resellers, assisting
them in winning and supporting key customer accounts and acting as a liaison
between the end user and the Company's marketing and product development
organizations. As of December 31, 1997, 15 employees were located in the
Company's Europe and Asia/Pacific regional offices. The Company expects to
continue to expand its field organization into additional countries in these
regions.
36
<PAGE> 39
SECURITY PARTNERS PROGRAM
The Company has established its Security Partners Program to train and
organize security consulting practices, ISPs, systems integrators and VARs to
match the Company's products with their own complementary products and services.
By reselling SAFEsuite products, Security Partners provide additional value for
specific market and industry segments, while maintaining the Company's ongoing
commitment to quality software and guaranteed customer satisfaction. To support
the varying needs of different partners, ISS has established four different
levels of partnership opportunities: Consulting Partners, Premier Partners,
Authorized Partners and Registered Partners. Consulting Partners consist of
general systems integrators and others who use the Company's products to provide
information security services for their clients. Consulting Partners may
purchase travelling licenses that can be used for one concurrent user for one
year. Premier Partners combine sales and integration of encryption, firewall and
authentication technologies with the Company's products. Authorized and
Registered Partners must purchase products from Premier Partners. In addition,
all Security Partners are required to employ a designated number of ISS
Certified Engineers. ISS provides its partners with technical support, sales and
marketing tools, quarterly rebates and other sales incentives and cooperative
marketing funds at varying levels depending on the level of partnership.
MARKETING PROGRAMS
The Company conducts a number of marketing programs to support the sale and
distribution of its products. These programs are designed to inform existing and
potential OEMs, resellers and end-user customers about the capabilities and
benefits of the Company's products. Marketing activities include: press
relations and education; publication of technical and educational articles in
industry journals and in the Company's on-line magazine, ISS Alert;
participation in industry tradeshows; product/technology conferences and
seminars; competitive analysis; sales training; advertising; development and
distribution of Company literature; and maintenance of the Company's Web site. A
key element of the Company's marketing strategy is to establish the Company's
products and its ASM model as the leading approach for enterprise-wide security
management. The Company has implemented a multi-faceted program to leverage the
use of the SAFEsuite product family and increase its acceptance through
relationships with various channel partners:
STRATEGIC RESELLERS. Although the Company has numerous resellers,
certain of these relationships have generated significant leverage for the
Company in targeted markets. The Company's strategic resellers, which
include EDS, SAIC, Siemens, Softbank and Tivoli Systems, provide ISS broad
brand awareness through enhanced marketing activity, access to large sales
forces, competitive control points and access to larger strategic customer
opportunities.
CONSULTANTS. The use of the Company's products by security
consultants not only generates revenue for the Company from the license to
the consultant, but also provides the Company with leads to potential end
users with a concern for network security. Consultants who have generated
substantial leads for the Company's sales organization include Andersen
Consulting, Deloitte Touche Tohmatsu International, IBM, KPMG Peat Marwick
and Price Waterhouse.
ISPS. The Company licenses its products to certain ISPs to be used as
part of their value-added services for their customers. With the Company's
products, ISPs can offer their users perimeter vulnerability scanning and
assessment, intrusion detection for Web services and applications that
typically reside outside the firewalled perimeter. ISS licenses its
products to BellSouth, GTE, PSINet and other ISPs for these purposes and
receives a percentage of the value-added revenue stream.
OEMS. A number of vendors of security products, including NCR and ODS
Networks, have signed OEM agreements with the Company. These agreements
enable OEMs to incorporate the Company's products into their own security
offerings to provide a complete security package. The Company receives
royalties from OEM vendors and increased acceptance of the Company's
37
<PAGE> 40
products under these arrangements, which in turn promotes sales of the
Company's other products to the OEM's customers.
The Company typically enters into written agreements with its strategic
resellers, consultants, ISPs and OEMs. These agreements generally do not provide
for firm dollar commitments from the strategic parties, but are intended to
establish the basis upon which the parties will work together to achieve
mutually beneficial objectives.
ADVISORY BOARD
The Company established an Advisory Board in February 1998, and its members
currently consist of the following individuals of recognized stature in certain
key industries, to further the Company's sales and recruiting efforts:
SAM NUNN. Mr. Nunn has been a partner in the Atlanta law firm of King
& Spalding since January 1997 and is the current co-chair of the
President's Critical Infrastructure Protection Program sanctioned by
Executive Order 13010. Previously, he served in the United States Senate
for four terms starting in 1972. Mr. Nunn is a director of The Coca-Cola
Company, General Electric Company, Scientific-Atlanta, Inc., Texaco, Inc.
and Total System Services, Inc.
JOHN P. IMLAY, JR. Mr. Imlay is Chairman of Imlay Investments, Inc.,
and serves on the board of directors of the Atlanta Falcons, Gartner Group,
Inc., Metromedia International Group, Inc. and several other organizations.
He was Chairman of Dun & Bradstreet Software Services, Inc., a software
company, from March 1990 until November 1996. Prior to that he was Chairman
and Chief Executive Officer of Management Science America, Inc., a company
that was acquired by Dun & Bradstreet Software Services, Inc.
The Advisory Board members advise the Company on long-term strategic
growth, including strategies for selling to key industries, recruitment of board
members and other key personnel, and trends in national and international policy
influencing the Company's products and services. The Company also anticipates
that Advisory Board members will provide high visibility for ISS at industry
events and will play key roles in leading Customer User Groups to support the
growth and prominence of the Company. Members of the Advisory Board meet
individually or as a group with the management of the Company from time to time
and are compensated through issuances of Common Stock or options to acquire
Common Stock.
CUSTOMER SERVICE AND SUPPORT
The Company provides ongoing product support services under its license
agreements. Maintenance contracts are typically sold to customers for a one-year
term at the time of the initial product license and may be renewed for
additional periods. Under its maintenance agreements with its customers, the
Company provides, without additional charge, telephone support, documentation
and software updates and error corrections. Customers that do not renew their
maintenance agreements but wish to obtain product updates and new version
releases are generally required to purchase such items from the Company at
market prices. In general, major new product releases come out annually, minor
updates come out every four to six months and new checks come out every two to
four weeks. All product updates are available to customers with current
maintenance agreements for downloading from the Company's Web site.
The Company believes that providing a high level of customer service and
technical support is necessary to achieve rapid product implementation which, in
turn, is essential to customer satisfaction and continued license sales and
revenue growth. Accordingly, the Company is committed to continued recruiting
and maintenance of a high-quality technical support team. The Company provides
telephone support to customers who purchase maintenance agreements along with
their product license. A team of dedicated engineers trained to answer questions
on the installation and usage of the SAFEsuite products provides telephone
support from 8:00 a.m. to 6:00 p.m., Eastern time, Monday through Friday, from
the
38
<PAGE> 41
Company's corporate office in Atlanta. The Company provides telephone support 24
hours a day, seven days a week through a call-back procedure to certain
customers who pay an additional fee for the service. In the United States and
internationally, the Company's VARs provide telephone support to their customers
with technical assistance from the Company.
Because security-knowledgeable IT personnel are in extremely short supply
throughout the industry, ISS provides focused education and training in the use
of its products and security issues through the ISS University program.
Education on security effectiveness and minimizing security risks in IT
infrastructure are natural extensions of the Company's position as a provider of
network security monitoring, detection and response systems. ISS University
offers certification on ISS products through the ICE (ISS Certified Engineer)
program. ISS University also offers a CNSE (Certified Network Security Engineer)
degree for network security management. The Company's reputation as a security
expert provides the basis for the value of such security degrees. Leveraging the
efforts of current security training organizations accelerates the acceptance of
the Company's certification program by the industry. Participation hours, or
credits, received from other complementary security training programs, such as
those offered by Computer Security Institute, MIS Training and similar
organizations, can be applied towards the hours required to be completed in the
ISS University program.
COMPETITION
The market for monitoring, detection and response products and services is
intensely competitive and the Company expects competition to increase further in
the future. The Company believes that the principal competitive factors
affecting the market for network security products include security
effectiveness, manageability, technical features, performance, ease of use,
price, scope of product offerings, distribution relationships and customer
service and support. Although the Company believes that its SAFEsuite family of
products generally competes favorably with respect to such factors, there can be
no assurance that the Company can maintain its competitive position against
current and potential competitors, especially those with significantly greater
financial, marketing, service, support, technical and other competitive
resources.
The Company's principal competitors generally fall within one of three
categories: internal IT departments or consulting firms that assist such
departments, relatively smaller software companies that offer applications with
limited scope and larger software companies that are either in the process of
entering the Company's market or have the potential to develop products to
compete with the Company's products. Due to a lack of awareness of the Company's
products and services or a lack of appreciation of the complexity involved in
the development of automated systems to establish, and more importantly,
maintain comprehensive and effective levels of security within a distributed
computing environment, potential customers often rely on their IT departments to
internally formulate security systems or to retain consultants to undertake such
a project. However, because experts in security issues are in extremely short
supply, such in-house solutions typically fail to provide a comprehensive and
sophisticated approach to security, are not designed to adapt to changing
security policies and are extremely expensive to develop. The Company expects
that as IT consulting firms learn of the Company's products and their relative
cost, they will be less inclined to undertake projects that require them to
independently develop systems with functionalities similar to the Company's
products.
In addition, a number of companies currently market or have under
development software applications to provide network and Internet security. The
Company believes that, to date, none of these relatively smaller companies offer
products that are as robust in features or as comprehensive in scope as the
SAFEsuite family of products. Although it is likely that the product development
efforts of these companies will eventually enable them to offer a line of
products to compete with the Company's current product line, the Company intends
to continue to dedicate significant resources for product development and
recruiting in order to expand the Company's product capabilities ahead of these
competitors. Notwithstanding, the Company expects additional competition from
these established competitors and from other emerging companies. Mergers or
consolidations among these competitors or acquisitions of these companies by
larger competitors would make them more formidable competitors to the Company.
39
<PAGE> 42
Recently, both Cisco Systems and Network Associates have announced acquisitions
of companies with products that compete with some of the Company's current
product offerings. Because the Company believes that Cisco Systems and Network
Associates will integrate these security products with their other product
offerings, the Company believes that its own products will compete favorably
based on the Company's product and platform functionality and Adaptive Security
Management approach. Notwithstanding, many of these larger companies have longer
operating histories, greater name recognition, access to larger customer bases
and significantly greater financial, technical and marketing resources than the
Company. As a result, they may be able to adapt more quickly to new or emerging
technologies and changes in customer requirements or to devote greater resources
to the promotion and sale of their products than the Company. The Company
believes that the entry of these larger companies into its market will require
them to undertake operations that are currently not within their core areas of
expertise, and thus expose them to significant uncertainties in the product
development process or in providing a range of products to comprehensively
address the security risks and vulnerabilities which the SAFEsuite product
family addresses. However, if these companies were to introduce products that
effectively competed with the Company's products, they could be in a position to
substantially lower the price of their security monitoring, detection and
response products or to bundle such products with their other products, which
would make it more difficult for the Company to compete with them. There can be
no assurance that the Company's current and potential competitors will not
develop security monitoring, detection and response products that may be more
effective than the Company's current or future products or that the Company's
technologies and products will not be rendered obsolete by such developments.
Finally, there are a number of companies that currently market and sell
various software products, such as encryption, firewall, operating system
security and virus detection software, that have been broadly adopted by the
Company's customers and potential customers to provide various levels of
security within their computing environments. Some of these companies have
released products which provide similar functionality as certain of the
Company's products. Axent Technologies markets products that compete with some
of the Company's products. In addition, vendors of operating system software or
networking hardware may in the future enhance their products to include
functionality that is currently provided by the Company's products. The
widespread inclusion of the functionality of the Company's software as standard
features of operating system software or networking hardware could render the
Company's products obsolete and unmarketable, particularly if the quality of
such functionality were comparable to that of the Company's products.
Furthermore, even if the security monitoring, detection and response
functionality provided as standard features by operating systems software or
networking hardware is more limited than that of the Company's software, there
can be no assurance that a significant number of customers would not elect to
accept more limited functionality in lieu of purchasing additional software.
For the foregoing reasons, there can be no assurance that the Company will
be able to compete successfully against its current and future competitors.
Increased competition may result in price reductions, reduced gross margins and
loss of market share, any of which would materially and adversely affect the
Company's business, operating results and financial condition. See "Risk
Factors -- Competition".
PROPRIETARY RIGHTS AND TRADEMARK ISSUES
The Company relies primarily on a combination of copyright and trademark
laws, trade secrets, confidentiality procedures and contractual provisions to
protect its proprietary rights. The Company also believes that factors such as
the technological and creative skills of its personnel, new product
developments, frequent product enhancements, name recognition and reliable
product maintenance are essential to establishing and maintaining a technology
leadership position. The Company seeks to protect its software, documentation
and other written materials under the trade secret and copyright laws, which
afford only limited protection. The Company also has submitted one United States
patent application. There can be no assurance that a patent will issue from this
application or, if issued, that
40
<PAGE> 43
such patent would provide meaningful competitive advantages to the Company. The
Company generally licenses SAFEsuite products to end users in object code
(machine-readable) format. Certain customers have required the Company to
maintain a source-code escrow account with a third-party software escrow agent,
and a failure by the Company to perform its obligations under any of the related
license and maintenance agreements, or the insolvency of the Company, could
conceivably cause the release of the Company's source code to such customers.
The standard form agreement allows the end user to use the SAFEsuite products
solely on the end user's computer equipment for the end user's internal
purposes, and the end user is generally prohibited from sublicensing or
transferring the products.
Despite the Company's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy aspects of the Company's products or to
obtain and use information that the Company regards as proprietary. Policing
unauthorized use of the Company's products is difficult, and while the Company
is unable to determine the extent to which piracy of its software products
exists, software piracy can be expected to be a persistent problem. In addition,
the laws of some foreign countries do not protect the Company's proprietary
rights to as great an extent as do the laws of the United States. There can be
no assurance that the Company's competitors will not independently develop
similar technologies.
Although the Company is not aware that any of its products infringes the
proprietary rights of third parties, there can be no assurance that third
parties will not claim infringement by the Company with respect to current or
future products. The Company expects that software product developers will
increasingly be subject to infringement claims as the number of products and
competitors in the Company's industry segment grows and the functionality of
products in different industry segments overlaps. Any such claims, with or
without merit, could be time consuming, result in costly litigation, cause
product shipment delays or require the Company to enter into royalty or
licensing agreements. Such royalty or licensing agreements, if required, may not
be available on terms acceptable to the Company or at all, which could have a
material adverse effect upon the Company's business, operating results and
financial condition.
The name "Internet Security Systems" is not currently subject to trademark
registration in the United States, and may not be a name for which a trademark
is registrable due to its general use in a variety of security-related
applications. Although the Company has in the past asserted and intends to
continue to assert its rights with respect to the name "Internet Security
Systems" and has taken and will take action against any use of such name in a
manner that may create confusion with the Company's products in relevant
markets, there can be no assurance that the Company will be successful in such
efforts, which could have a material adverse effect upon the Company's business,
operating results and financial condition.
EMPLOYEES
As of December 31, 1997, the Company had 141 employees, of whom 48 were
engaged in product research and development, 50 were engaged in sales, six were
engaged in customer service and support, six were engaged in professional
services, 19 were engaged in marketing and business development and 12 were
engaged in administrative functions. The Company believes that its relations
with its employees are good.
FACILITIES
The Company is in the process of relocating its Atlanta headquarters and
research and development facilities into approximately 47,000 square feet of
office space to be occupied pursuant to a sublease expiring in June 2002 which
has minimum annual lease obligations of approximately $842,000. Until such
relocation, these operations will continue to be conducted in Atlanta in
facilities totalling approximately 26,000 square feet under leases that
primarily expire in 1998. Under such leases, the Company paid approximately
$407,000 in 1997. The Company also leases office space for its sales and
marketing personnel in Austin, Boston, Chicago, Cincinnati, Dallas, Nashua, New
York, Palo Alto, Philadelphia, San Mateo and Washington, D.C., as well as
Brussels, London, Paris, Stuttgart, Tokyo and Toronto. The Company believes that
its existing facilities are adequate for its current needs and that additional
space will be available as needed.
41
<PAGE> 44
MANAGEMENT
DIRECTORS AND EXECUTIVE OFFICERS
Set forth below is certain information concerning the directors and
executive officers of the Company.
<TABLE>
<CAPTION>
NAME AGE POSITION(S)
- ---- --- -----------
<S> <C> <C>
Thomas E. Noonan.................. 37 President, Chief Executive Officer and Chairman of the
Board of Directors
Christopher W. Klaus.............. 24 Chief Technical Officer, Secretary and Director
Richard Macchia................... 46 Vice President and Chief Financial Officer
H. Keith Cooley................... 44 Vice President (Engineering)
M. Thomas McNeight................ 53 Vice President (Americas Sales)
Alex Bogaerts..................... 48 Vice President (Europe)
Lin Ja Hong....................... 39 Vice President (Asia/Pacific)
Richard S. Bodman................. 59 Director
Robert E. Davoli.................. 49 Director
Kevin J. O'Connor................. 36 Director
David N. Strohm................... 49 Director
</TABLE>
Mr. Noonan has served as the President and as a Director of ISS since
August 1995, and as its Chief Executive Officer and Chairman of the Board of
Directors since November 1996. Prior to joining ISS, Mr. Noonan served as Vice
President, Sales and Business Development with TSI International, an electronic
commerce company then owned by Warburg Pincus and Dun & Bradstreet, from October
1994 until August 1995. From November 1989 until October 1994, Mr. Noonan held
high-level sales and marketing positions at Dun & Bradstreet Software, a
developer of enterprise business software. Prior to 1989, Mr. Noonan co-founded
Actuation Electronics, a motion control company for precision applications, and
founded Leapfrog Technologies, an object-oriented software development tools
company for networked applications. Mr. Noonan holds a B.S. in mechanical
engineering from the Georgia Institute of Technology and a C.S.S. in business
administration and management from Harvard University.
Mr. Klaus founded ISS in April 1994 and served as its President until
August 1995 and as its Chief Executive Officer until November 1996. Mr. Klaus
continues to serve the Company as its Chief Technical Officer and as a Director.
Prior to founding ISS, Mr. Klaus developed a shareware version of the Internet
Scanner while attending the Georgia Institute of Technology.
Mr. Macchia joined ISS as its Vice President and Chief Financial Officer in
December 1997. From December 1989 until December 1997, Mr. Macchia was employed
by First Financial Management Corporation ("FFMC") as its Executive Vice
President (Finance), and by First Data Corporation as its Senior Vice President
(Finance) following its merger with FFMC. Mr. Macchia received a B.B.A. in
accounting from the University of Notre Dame.
Mr. Cooley has served as Vice President (Engineering) of ISS since January
1996. Mr. Cooley has over twenty years of executive-level experience in software
development and customer support, most recently as a founding partner for Value
Sourcing Group, an Atlanta-based management consultancy specializing in
information technology, from 1995 to 1996. Prior to that, Mr. Cooley was
employed by Dun & Bradstreet Software for over 16 years where he held various
management and executive-level positions in marketing, development and support,
and ended his tenure as Chief Information Officer. Mr. Cooley holds a B.S. in
industrial engineering from the Georgia Institute of Technology.
Mr. McNeight has served as Vice President (Americas Sales) of ISS since
August 1996. Prior to joining ISS, Mr. McNeight was employed for more than
twenty years in various sales, sales management
42
<PAGE> 45
and executive management positions with technology and service companies, having
most recently been a principle in The Complex Sale, a strategic sales consulting
and training firm, from December 1995 to August 1996. In 1995, Mr. McNeight was
Senior Vice President, Americas Operations, for TSW International, Inc., a
supplier of plant performance and maintenance management software. Additionally,
Mr. McNeight was Chief Executive Officer of Aurum Software Inc., a provider of
sales, marketing and customer service software that was subsequently acquired by
Baan Company, from 1993 to 1994 and, prior to that, spent thirteen years at Dun
& Bradstreet, ending his tenure there as Executive Vice President for the
Americas. Mr. McNeight has a B.S. in chemistry from Oklahoma State University
and an M.S. in management information sciences from Texas Christian University.
Mr. Bogaerts joined ISS as its Vice President (Europe) in February 1996.
Before joining ISS, Mr. Bogaerts was an independent technology consultant from
September 1995 to February 1996, and prior to that held sales, marketing and
strategic marketing, and general management positions with Dun & Bradstreet
Software from 1992 to September 1995, and with Ethica N.V., an enterprise IT
management and consulting firm, from 1989 to 1992. Mr. Bogaerts received a
degree in applied economics and management sciences from the University of
Leuven, Belgium, and an M.B.A. through a joint program of the University of
Leuven, the University of Chicago and Cornell University Business Schools.
Mr. Lin has served ISS as Vice President (Asia/Pacific) since January 1997
and manages the Company's Asia/Pacific operations from the Company's office in
Tokyo. Mr. Lin has over twenty years of sales and marketing experience in the
Asia/Pacific software market. From 1984 to December 1996, he held a number of
sales, marketing and development positions with Dun & Bradstreet Technology Asia
(formerly known as Ashisuto KK), most recently as its Vice President and General
Manager of Sales and Operations. Mr. Lin holds a B.A. in business administration
from Aoyama Gakuin University in Tokyo.
Mr. Bodman joined the Company's Board of Directors in July 1997. Since May
1996, Mr. Bodman has served as the Managing General Partner of AT&T Ventures,
LLC, which manages numerous venture capital investments. Before joining AT&T
Ventures, LLC, Mr. Bodman served AT&T Corporation in various senior management
positions. Mr. Bodman serves on the board of directors of several public
companies, including Tyco International, Inc., LIN Television, Inc. and Reed
Elsevier plc., and several private companies. Mr. Bodman holds a B.S. in
engineering from Princeton University and an M.S. in industrial management from
the Massachusetts Institute of Technology.
Mr. Davoli has been a Director of the Company since February 1996. Mr.
Davoli has been a General Partner of or an advisor to Sigma Partners, a venture
capital firm, since January 1995. Mr. Davoli was President and Chief Executive
Officer of Epoch Systems, Inc., a client/server storage management provider,
from February 1993 to September 1994. From May 1986 through June 1992, Mr.
Davoli was the President and Chief Executive Officer of SQL Solutions, a
relational database management systems consulting and tools company that he
founded and sold to Sybase, Inc. in January 1990. Mr. Davoli serves as a
director of several privately held companies. Mr. Davoli received a B.A. in
history from Ricker College.
Mr. O'Connor has served as a Director of the Company since October 1995.
Mr. O'Connor has been the Chief Executive Officer and Chairman of DoubleClick
Inc. ("DoubleClick"), a provider of Internet advertising services, since January
1996. From September 1994 to December 1995, Mr. O'Connor served as Director of
Research for Digital Communications Associates, a data communications company
(now Attachmate Corporation), and from April 1992 to September 1994, as its
Chief Technical Officer and Vice President, Research. From its inception in May
1983 until its sale in April 1992, Mr. O'Connor served as Vice President,
Research of Intercomputer Communications Corp., a software development company.
Mr. O'Connor received his B.S. in electrical engineering from the University of
Michigan.
Mr. Strohm has served as a Director of the Company since January 1996.
Since 1980, Mr. Strohm has been an employee of Greylock Management Corporation,
a venture capital group ("Greylock"), and has been a general partner of several
venture capital funds affiliated with Greylock. Mr. Strohm currently serves as a
director of DoubleClick, Banyan Systems, Inc., an enterprise networking software
company,
43
<PAGE> 46
and Legato Systems, Inc., a data storage management software company. Mr. Strohm
received his B.A. from Dartmouth College and his M.B.A. from Harvard Business
School.
BOARD OF DIRECTORS
The Charter and Bylaws provide that the size of the Board of Directors of
the Company (the "Board") shall be determined by resolution of the Board. The
Board is currently composed of six members. Each director holds office until the
next annual meeting of stockholders or until his or her successor is duly
elected and qualified. The Company's Charter and Bylaws provide that, beginning
with the first annual meeting of stockholders following this Offering, the Board
will be divided into three classes serving for staggered, three-year terms.
Following the completion of the Offering, the Class I directors, who will stand
for election at the Company's 1999 Annual Meeting of Stockholders, will be
Messrs. Bodman and O'Connor; the Class II directors will be Messrs. Noonan and
Strohm; and the Class III directors will be Messrs. Klaus and Davoli.
The Board has established a Compensation Committee and an Audit Committee.
The members of the Compensation Committee are Robert E. Davoli, Kevin J.
O'Connor and David N. Strohm, and the members of the Audit Committee are Richard
S. Bodman, Robert E. Davoli and Thomas E. Noonan.
The Audit Committee of the Board was established in January 1998 and
reviews, acts on and reports to the Board with respect to various auditing and
accounting matters, including the selection of the Company's auditors, the scope
of the annual audits, fees to be paid to the auditors, the performance of the
Company's independent auditors and the accounting practices of the Company.
The Compensation Committee of the Board was established in February 1996
and re-authorized in January 1998. The Compensation Committee determines the
salaries and incentive compensation of the officers of the Company and provides
recommendations for the salaries and incentive compensation of the other
employees of the Company. The Compensation Committee also administers the
Company's various incentive compensation, stock and benefit plans.
Except for grants of stock options, directors of the Company generally do
not receive compensation for services rendered as a director. The Company also
does not pay compensation for committee participation or special assignments of
the Board. Following this Offering, each director will be reimbursed for all
out-of-pocket expenses incurred in attending meetings of the Board and
committees thereof. Non-employee Board members will receive option grants at
periodic intervals under the Automatic Option Grant Program of the 1995 Plan and
will also be eligible to receive discretionary option grants under the
Discretionary Option Grant Program of such plan. See "-- Restated 1995 Stock
Incentive Plan".
On December 8, 1997, the Company granted to each of Messrs. Bodman, Davoli,
O'Connor and Strohm an option to purchase 20,000 shares of Common Stock at an
exercise price of $7.00 per share. The options are immediately exercisable for
all of the option shares. However, the shares purchasable upon exercise of the
options are unvested, and subject to repurchase at the option exercise price
paid per share, upon an early termination of the optionee's Board service. The
shares subject to each option grant will vest as to 25% of the option shares
upon the optionee's completion of each of the four years of Board service after
the grant date. The options have a maximum term of 10 years measured from the
grant date, subject to earlier termination following the cessation of the
optionee's Board service. The options will immediately vest in the event of (i)
certain changes in the ownership or control of the Company, unless such options
are assumed by the successor corporation or (ii) the death or disability of the
optionee while serving as a Board member.
The Bylaws provide for indemnification of directors and officers to the
fullest extent permitted by Delaware law, except if limited by contract. The
Company has entered into indemnification agreements with all of its directors
and has purchased directors' and officers' liability insurance. In addition, the
Charter limits the personal liability of Board members to the Company or its
stockholders for breaches of the directors' fiduciary duties to the fullest
extent permitted by Delaware law. See "Description of Capital Stock -- Certain
Anti-Takeover, Limited Liability and Indemnification Provisions".
44
<PAGE> 47
EMPLOYMENT CONTRACTS
The officers serve at the discretion of the Board. The Company does not
presently have an employment contract in effect with any of its executive
officers. The Compensation Committee, as Plan Administrator of the 1995 Plan,
has the authority to provide for the accelerated vesting of the shares of Common
Stock subject to outstanding options held by the Chief Executive Officer and the
Company's other executive officers or any unvested shares actually held by those
individuals under the 1995 Plan, in the event the Company is acquired by merger,
consolidation or asset sale or there is a change in control effected by a
successful tender or exchange offer for more than 50% of the Company's
outstanding voting securities or a change in the majority of the Board as a
result of one or more contested elections for Board membership. Alternatively,
the Compensation Committee may condition such accelerated vesting upon the
individual's position with the Company being replaced with a lesser position or
the termination of the individual's service within a designated period following
the acquisition or take over. In addition, the Company has agreements with
certain management members regarding acceleration of option vesting in the event
of the consummation of a transaction that results in a change of control of the
Company.
EXECUTIVE COMPENSATION
Summary Compensation Table. The following table provides certain summary
information concerning the compensation earned by the Company's Chief Executive
Officer and certain other executive officers of the Company (collectively, the
"Named Officers") whose salary and bonus exceeded $100,000 for services rendered
in all capacities to the Company and its subsidiaries during 1997.
<TABLE>
<CAPTION>
LONG-TERM
COMPENSATION
------------
ANNUAL COMPENSATION OPTIONS
--------------------- (# OF
NAME AND PRINCIPAL POSITION(S) SALARY BONUS SHARES)
- ------------------------------ -------- -------- ------------
<S> <C> <C> <C>
Thomas E. Noonan.................................... $130,000 $ 60,000 --
President, Chief Executive Officer and Chairman of
the Board
Alex Bogaerts....................................... 89,000(1) 76,000(1) 25,000
Vice President (Europe)
H. Keith Cooley..................................... 109,000 26,000 --
Vice President (Engineering)
Lin Ja Hong......................................... 110,000 43,890 27,500
Vice President (Asia/Pacific)
M. Thomas McNeight.................................. 125,000 91,300 --
Vice President (Americas Sales)
</TABLE>
- ---------------
(1) Mr. Bogaerts' compensation, other than options, was paid to a consulting
company owned by Mr. Bogaerts.
45
<PAGE> 48
Option Grants in Last Fiscal Year. The following table provides certain
information concerning stock options granted to each of the Named Officers
during 1997. No stock appreciation rights were granted to these individuals
during such year.
OPTION GRANTS IN 1997
<TABLE>
<CAPTION>
POTENTIAL REALIZABLE VALUE
AT ASSUMED ANNUAL RATES
NUMBER OF % OF TOTAL OF STOCK PRICE
SECURITIES OPTIONS EXERCISE APPRECIATION FOR OPTION
UNDERLYING GRANTED TO PRICE TERM(2)
OPTIONS EMPLOYEES PER EXPIRATION --------------------------
NAME GRANTED(1) IN 1997 SHARE DATE 5% 10%
- ---- ---------- ---------- -------- ---------- ---------- ----------
<S> <C> <C> <C> <C> <C> <C>
Thomas E. Noonan............. -- --% $ -- -- $ -- $ --
Alex Bogaerts................ 25,000 2.3 0.60 4/20/07 9,433 23,906
H. Keith Cooley.............. -- -- -- -- -- --
Lin Ja Hong.................. 20,000 1.8 0.60 3/9/07 7,547 19,125
7,500 * 7.00 12/30/07 33,016 83,671
M. Thomas McNeight........... -- -- -- -- -- --
</TABLE>
- ---------------
* Indicates less than 1%.
(1) The options are immediately exercisable in full upon grant; however, the
shares underlying all options vest over a four-year period at the rate of
25% per year and are subject to repurchase by the Company at the exercise
price should the optionee cease employment prior to full vesting. In the
event that the Company is acquired by merger, consolidation or asset sale,
the option shares will accelerate in full unless the option is assumed by
the successor corporation and the Company's repurchase rights with respect
to the unvested option shares are assigned to such corporation. In the event
that the option is so assumed by, and the Company's repurchase rights with
respect to unvested shares are assigned to, the successor corporation and,
within 12 months following the acquisition, the optionee's position is
reduced to a lesser position or the optionee's employment is involuntarily
terminated, the option shares will accelerate in part so that the next
annual installment of option shares scheduled to vest will immediately vest
in full and, to the extent the optionee continues in the Company's service,
each installment of option shares scheduled to vest thereafter will vest on
each subsequent anniversary of the acceleration date. Each option expires on
the earlier of (i) ten years from the date of grant, or (ii) termination of
the optionee's employment with the Company. All options were granted at fair
market value as determined by the Board of Directors of the Company on the
date of grant.
(2) Future value assumes appreciation in the market value of the Common Stock of
5% and 10% per year over the ten-year option period as mandated by the rules
and regulations of the Commission and does not represent the Company's
estimate or projection of the future value of the Common Stock. The actual
value realized may be greater than or less than the potential realizable
values set forth in the table.
46
<PAGE> 49
Aggregate Option Exercises in Last Fiscal Year and Fiscal Year-End Option
Values. No options were exercised by the Named Officers during 1997. The
following table provides certain information concerning option exercises and
option holdings for the fiscal year ended December 31, 1997 with respect to each
of the Named Officers.
YEAR-END OPTION VALUES
<TABLE>
<CAPTION>
NUMBER OF SECURITIES VALUE OF UNEXERCISED
UNDERLYING UNEXERCISED IN-THE-MONEY OPTIONS
OPTIONS AT DECEMBER 31, 1997 AT DECEMBER 31, 1997(2)
------------------------------- ---------------------------
NAME EXERCISABLE(1) UNEXERCISABLE EXERCISABLE UNEXERCISABLE
- ---- -------------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Thomas E. Noonan...................... -- -- $ -- $ --
Alex Bogaerts......................... 45,000(3) -- 297,000 --
H. Keith Cooley....................... 200,000 -- 1,370,000 --
Lin Ja Hong........................... 27,500(4) -- 128,000 --
M. Thomas McNeight.................... 235,000 -- 1,609,750 --
</TABLE>
- ---------------
(1) The shares purchasable upon exercise of the options are subject to
repurchase by the Company at the exercise price upon the optionee's
termination of employment prior to vesting in the shares. The Company's
repurchase right lapses with respect to, and the optionee vests in, 25% of
the option shares upon the optionee's completion of each year of service. As
of December 31, 1997, the number of vested shares for which each Named
Officer's option was exercisable was as follows: Mr. Bogaerts -- 5,000
shares; Mr. Cooley -- 50,000; Mr. Lin -- no shares; Mr. McNeight -- 58,750
shares.
(2) Value determined by subtracting the exercise price from the fair market
value of the Common Stock at December 31, 1997 ($7.00 per share), as
determined by the Company's Board of Directors, multiplied by the number of
shares underlying the options.
(3) Represents options for 20,000 shares at an exercise price of $0.15 per share
and options for 25,000 shares at an exercise price of $0.60 per share.
(4) Represents options for 20,000 shares at an exercise price of $0.60 per share
and options for 7,500 shares at an exercise price of $7.00 per share.
RESTATED 1995 STOCK INCENTIVE PLAN
The Restated 1995 Stock Incentive Plan was first adopted by the Board of
Directors of Internet Security Systems, Inc. on September 6, 1995 and approved
by the stockholders of Internet Security Systems, Inc. on January 31, 1996. On
December 8, 1997, the Company assumed the 1995 Plan and all outstanding options
thereunder and converted such options on a share-for-share basis into options to
purchase shares of the Company's Common Stock. Three million shares of Common
Stock have been authorized for issuance under the 1995 Plan. In addition, the
share reserve will automatically be increased on the first trading day of each
calendar year, beginning with the 1999 calendar year, by an amount equal to 3%
of the number of shares of Common Stock outstanding on the last trading day of
the immediately preceding calendar year. In no event may any one participant in
the 1995 Plan receive option grants or direct stock issuances for more than
300,000 shares per calendar year.
The 1995 Plan is divided into three separate components: (i) the
Discretionary Option Grant Program under which eligible individuals may, at the
discretion of the Plan Administrator, be granted options to purchase shares of
Common Stock at an exercise price equal to, greater than or less than their fair
market value on the grant date, (ii) the Stock Issuance Program under which such
individuals may, in the Plan Administrator's discretion, be issued shares of
Common Stock directly, through the purchase of such shares at a price equal to,
greater than or less than their fair market value at the time of issuance or as
a bonus for services rendered, and (iii) the Automatic Option Grant Program
under which option grants will automatically be made at periodic intervals to
eligible non-employee Board members to
47
<PAGE> 50
purchase shares of Common Stock at an exercise price equal to 100% of the fair
market value of such shares on the grant date.
The Discretionary Option Grant Program and the Stock Issuance Program are
administered by the Compensation Committee of the Board. The Compensation
Committee as Plan Administrator has complete discretion to determine which
eligible individuals are to receive option grants or stock issuances, the time
or times when such option grants or stock issuances are to be made, the number
of shares subject to each such grant or issuance, the status of any granted
option as either an incentive stock option or a non-statutory stock option under
the Federal tax laws, the vesting schedule to be in effect for the option grant
or stock issuance and the maximum term for which any granted option is to remain
outstanding. The administration of the Automatic Option Grant Program is
self-executing in accordance with the express provisions of such program.
The exercise price for the shares of Common Stock subject to option grants
made under the 1995 Plan may be paid in cash or in shares of Common Stock (held
for the requisite period necessary to avoid a charge to the Company's earnings
for financial reporting purposes) valued at fair market value on the exercise
date. The option may also be exercised through a same-day sale program without
any cash outlay by the optionee. In addition, the Plan Administrator may provide
financial assistance to one or more optionees in the exercise of their
outstanding options by allowing such individuals to deliver a full-recourse,
interest-bearing promissory note in payment of the exercise price and any
associated withholding taxes incurred in connection with such exercise. During
the 180-day period following the date of this Prospectus, optionees exercising
options under the 1995 Plan will be required to enter into Lock-Up Agreements
with the representatives of the Underwriters.
In the event that the Company is acquired by merger, consolidation or asset
sale, each outstanding option under the Discretionary Option Grant Program which
is not to be assumed by the successor corporation will automatically become
fully exercisable, and all unvested shares under the Stock Issuance Program will
immediately vest, except to the extent the Company's repurchase rights with
respect to those shares are to be assigned to the successor corporation. In the
event an outstanding option is assumed, and the Company's repurchase rights are
assigned to the successor corporation, and, within 12 months following the
merger, consolidation or asset sale either (i) the optionee is offered a lesser
position compared to the position held by the optionee prior to the acquisition
or (ii) the optionee's service is terminated, either involuntarily or through
resignation as a result of being offered a lesser position, then the option will
accelerate in part so that it will become immediately exercisable with respect
to the next annual installment of option shares scheduled to vest. The Plan
Administrator also has the authority under the Discretionary Option Grant and
Stock Issuance Programs to grant options and to structure repurchase rights so
that the shares subject to those options or repurchase rights will automatically
vest in the event the individual is offered a lesser position or the
individual's service is terminated, whether involuntarily or through a
resignation as a result of being offered a lesser position, within a specified
period (not to exceed 12 months) following a change in control of the Company
effected by a successful tender offer for more than 50% of the outstanding
voting stock or by proxy contest for the election of Board members. The Plan
Administrator also has the discretion to provide for the automatic acceleration
of outstanding options and the lapse of any outstanding repurchase rights upon
certain changes in the ownership or control of the Company.
In February 1998, the Company entered into an Amended and Restated
Agreement Regarding Acceleration of Vesting of Future Optionees with Greylock
Equity Limited Partnership ("Greylock"), Sigma Associates III, L.P., Sigma
Investors III, L.P. and Sigma Partners III, L.P. (collectively, the "Sigma
Entities"), AT&T Venture Fund II, L.P. and Venture Fund I, L.P. (collectively,
the "AT&T Entities") and Kleiner, Perkins, Caufield & Byers VIII, KPCB
Information Sciences Zaibatsu Fund II and KPCB Java Fund (collectively, the
"KPCB Entities") which provides that in all option grants made after the date of
the agreement, the Company will provide that no more than the greater of (i) 50%
of the unvested shares issued pursuant to such grant or (ii) the options which
would be vested in such optionee's next vesting installment may become
immediately vested in the event that (x) the Company sells, conveys or otherwise
disposes of all or substantially all of its property or business, or merges into
or effects a
48
<PAGE> 51
reorganization with any corporation (other than a wholly-owned subsidiary
corporation) in which the stockholders of the Company immediately prior to the
transaction possess less than 50% of the voting power of the surviving entity
(or its parent), and (y) the optionee is not offered a position with the
surviving entity which (I) offers compensation equivalent to or greater than
that provided to the optionee by the Company immediately prior to the change in
control, and (II) offers duties and responsibilities comparable to those
associated with the position held by the optionee with the Company immediately
prior to the change in control such that the duties and responsibilities of the
optionee with the surviving entity are not materially diminished from those of
the optionee at the Company.
Stock appreciation rights are authorized for issuance under the
Discretionary Option Grant Program which provide the holders with the election,
subject to the Plan Administrator's approval, to surrender their outstanding
options for an appreciation distribution from the Company equal to the excess of
(i) the fair market value of the vested shares of Common Stock subject to the
surrendered option over (ii) the aggregate exercise price payable for such
shares. In addition, the Plan Administrator has the authority to grant to
certain officers and directors of the Company limited stock appreciation rights
which, upon a hostile take-over of the Company (as defined in the 1995 Plan),
generally provide the holders with the automatic right to surrender his or her
outstanding options for an appreciation distribution from the Company equal to
the excess of (i) the tender price paid in the hostile take-over for the vested
shares subject to the surrendered options over (ii) the aggregate exercise price
payable for such shares. Such appreciation distribution may be made in cash or
in shares of Common Stock.
The Plan Administrator has the authority to effect the cancellation of
outstanding options under the Discretionary Option Grant Program with the
consent of the affected option holders in return for the grant of new options
for the same or different number of option shares with an exercise price per
share based upon the fair market value of the Common Stock on the new grant
date.
Under the Automatic Option Grant Program, each individual who first joins
the Board as a non-employee Board member after the effective date of this
Offering will receive an option to purchase 50,000 shares of Common Stock on the
date he or she is first elected or appointed to the Board, provided such
individual has not otherwise been in the prior employ of the Company. In
addition, at each Annual Stockholders Meeting, beginning with the 1999 Annual
Meeting, each individual who is to continue to serve as a non-employee Board
member after the meeting will receive an additional option to purchase 5,000
shares of Common Stock.
Each automatic grant will have a term of 10 years, subject to earlier
termination following the optionee's cessation of Board service. Each automatic
option will be immediately exercisable; however, any shares purchased upon
exercise of the option will be subject to repurchase should the optionee's
service as a non-employee Board member cease prior to vesting in the shares. The
initial 50,000-share grant will vest in four equal and successive annual
installments over the optionee's period of Board service. Each additional
5,000-share grant will vest in two equal and successive annual installments over
the optionee's period of Board service measured from the grant date. However,
the shares subject to each outstanding automatic grant will immediately vest
upon (i) certain changes in the ownership or control of the Company or (ii) the
death or disability of the optionee while serving as a Board member.
The Board may amend or modify the 1995 Plan at any time. The 1995 Plan will
terminate on the earlier of (i) September 6, 2005, (ii) the date on which all
available shares have been issued as vested shares or (iii) the termination of
all outstanding options in connection with certain changes in the ownership or
control of the Company.
49
<PAGE> 52
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The Board established a Compensation Committee in February 1996. During
1997, Robert E. Davoli, Kevin J. O'Connor and David N. Strohm served as members
of the Compensation Committee. None of these individuals has served at any time
as an officer or employee of the Company. Prior to the establishment of the
Compensation Committee, all decisions relating to executive compensation were
made by the Board. For a description of the transactions between the Company and
members of the Compensation Committee and entities affiliated with such members,
see "Certain Transactions". No executive officer of the Company serves as a
member of the board of directors or compensation committee of any entity which
has one or more executive officers serving as a member of the Board of Directors
or Compensation Committee.
50
<PAGE> 53
CERTAIN TRANSACTIONS
SALE OF SERIES A PREFERRED STOCK
In February 1996, the Company sold an aggregate of 3,650,000 shares of its
Series A Redeemable, Convertible Preferred Stock (the "Series A Preferred
Stock") for $1.00 per share in a private placement exempt from registration
under Section 4(2) of the Securities Act. The purchasers of the Series A
Preferred Stock included, among others, Greylock and the Sigma Entities. The
Series A Preferred Stock will automatically convert into Common Stock on a
one-for-one basis upon the completion of the Offering. Concurrently with the
closing of the financing, David N. Strohm, an employee of Greylock and the
general partner of several venture capital funds associated with Greylock, and
Robert E. Davoli, a general partner of the Sigma Entities, became directors of
the Company.
In connection with the sale of the Series A Preferred Stock, the Company
entered into an agreement with Greylock and Sigma Partners concerning certain of
the shares of the Common Stock sold by the underwriters of an initial public
offering of the Common Stock to persons designated by the Company ("Directed
Shares"). Under this agreement, in the event that the Company designates any
person to receive Directed Shares, the Company must use its best efforts to
cause (i) Greylock and (ii) the Sigma Entities to receive up to 100,000 Directed
Shares at the initial public offering price. Also in connection with the Series
A Preferred Stock financing, the Company (i) entered into an Agreement Regarding
Acceleration of Vesting of Future Optionees with Greylock and the Sigma
Entities, which was later amended and restated to make certain technical
clarifications, (ii) entered into a Rights Agreement, which was amended and
restated in connection with the sale of the Company's Series B Redeemable,
Convertible Preferred Stock (the "Series B Preferred Stock"), and (iii)
repurchased 100,000 shares of Common Stock from Christopher W. Klaus, a founder,
officer and director of the Company, for $15,000.
SALE OF SERIES B PREFERRED STOCK
In February 1997, the Company sold an aggregate of 2,086,957 shares of its
Series B Preferred Stock for $2.53 per share in a private placement exempt from
registration under Section 4(2) of the Securities Act. The purchasers of the
Series B Preferred Stock included, among others, (i) Greylock, (ii) the Sigma
Entities, (iii) the AT&T Entities, and (iv) the Kleiner Entities. The Series B
Preferred Stock will automatically convert into Common Stock on a one-for-one
basis upon the completion of the Offering. Richard S. Bodman, the managing
general partner of the AT&T Entities, became a director of the Company in July
1997.
In connection with the sale of the Series B Preferred Stock, the Company
entered into an agreement with the AT&T Entities and Kleiner, Perkins, Caufield
& Byers ("KPCB") concerning Directed Shares. Under the agreement, in the event
that the Company designates any person to receive Directed Shares, the Company
must use its best efforts to cause each of (i) the AT&T Entities and (ii) KPCB
to receive up to 100,000 Directed Shares at the initial public offering price.
In connection with the sale of the Series B Preferred Stock, the Company also
entered into (i) an Agreement Regarding Acceleration of Vesting of Future
Optionees with the AT&T Entities and the Kleiner Entities, which was later
amended and restated to make certain technical clarifications, and (ii) an
Amended and Restated Rights Agreement. Pursuant to the Amended and Restated
Rights Agreement, purchasers of the Series A Preferred Stock and Series B
Preferred Stock have the right, beginning six months after this Offering and
subject to certain conditions and limitations, to require the Company to file a
registration statement, including, if requested, a shelf registration statement,
under the Securities Act in order to register all or part of their shares of
Common Stock. The Company in certain circumstances, may defer such registrations
and the underwriters have the right, subject to certain limitations, to limit
the number of shares included in such registrations. In the event that the
Company proposes to register any of its securities under the Securities Act,
either for its own account or for the account of other security holders, the
purchasers of the Series A Preferred Stock and Series B Preferred Stock and
certain holders of the Common Stock, including Christopher W. Klaus and Thomas
E. Noonan, the Company's Chairman, President and Chief Executive Officer, are
entitled to include their shares of Common Stock in such registration, subject
to marketing
51
<PAGE> 54
and other limitations. Generally, the Company is required to bear all expenses
associated with such registrations.
AMENDED AND RESTATED AGREEMENT REGARDING ACCELERATION OF FUTURE OPTIONEES
In February 1998, the Company entered into an Amended and Restated
Agreement Regarding Acceleration of Vesting of Future Optionees with Greylock,
the Sigma Entities, the AT&T Entities and the Kleiner Entities which provides
that in all option grants made after the date of the agreement, the Company will
provide that no more than the greater of (i) 50% of the unvested shares issued
pursuant to such grant or (ii) the options which would be vested in such
optionee's next vesting installment may become immediately vested in the event
that (x) the Company sells, conveys or otherwise disposes of all or
substantially all of its property or business, or merges into or effects a
reorganization with any corporation (other than a wholly-owned subsidiary
corporation) in which the stockholders of the Company immediately prior to the
transaction possess less than 50% of the voting power of the surviving entity
(or its parent), and (y) the optionee is not offered a position with the
surviving entity which (I) offers compensation equivalent to or greater than
that provided to the optionee by the Company immediately prior to the change in
control, and (II) offers duties and responsibilities comparable to those
associated with the position held by the optionee with the Company immediately
prior to the change in control such that the duties and responsibilities of the
optionee with the surviving entity are not materially diminished from those of
the optionee at the Company.
DOUBLECLICK PURCHASES
During 1997, the Company purchased approximately $125,000 of Internet
advertising services from DoubleClick. Kevin J. O'Connor, who has served as a
director of the Company since September 1995, is the Chairman and Chief
Executive Officer of DoubleClick. David N. Strohm, who has served as a director
of the Company since February 1996, is a director of DoubleClick. Such purchases
were made pursuant to purchase orders involving only the sale of routine
services having a determinable market price, at such market price.
FUTURE TRANSACTIONS
All future transactions, including loans, between the Company and its
officers, directors, principal stockholders and their affiliates will be
approved by a majority of the Board, including a majority of the independent and
disinterested outside directors on the Board, and will continue to be on terms
no less favorable to the Company than could be obtained from unaffiliated third
parties.
52
<PAGE> 55
PRINCIPAL AND SELLING STOCKHOLDERS
The following table sets forth certain information regarding beneficial
ownership of the Common Stock as of February 28, 1998 adjusted on a pro forma
basis to reflect the automatic conversion of each share of Convertible Preferred
Stock into one share of Common Stock, and as adjusted to reflect the sale of
shares offered hereby, by (i) each person who is known by the Company to own
beneficially more than five percent of the Common Stock, (ii) each of the
Company's Named Officers and directors, (iii) each of the Selling Stockholders,
and (iv) all current officers and directors as a group. Unless otherwise
indicated, the address for the following stockholders is 41 Perimeter Center
East, Suite 660, Atlanta, Georgia 30346.
<TABLE>
<CAPTION>
SHARES BENEFICIALLY SHARES BENEFICIALLY
OWNED BEFORE OWNED AFTER
OFFERING (1)(2) NUMBER OF OFFERING(1)(2)
------------------------ SHARES OFFERED -------------------------
BENEFICIAL OWNER NUMBER PERCENTAGE FOR SALE NUMBER PERCENTAGE
- ---------------- ----------- ---------- -------------- ------------ ----------
<S> <C> <C> <C> <C> <C>
Christopher W. Klaus(3)....... 4,373,836 32.0% 100,000 4,273,836 26.1%
Greylock Equity Limited
Partnership(4).............. 2,657,614 19.4 -- 2,657,614 16.2
755 Page Mill Road, Bldg. A
Palo Alto, California 94304
Sigma Entities(5)............. 1,950,218 14.2 -- 1,950,218 11.9
20 Custom House Street
Boston, Massachusetts 02110
Thomas E. Noonan(6)........... 1,922,070 14.1 125,000 1,797,070 11.0
Kleiner Perkins Caufield &
Byers Entities(7)........... 1,429,858 10.5 -- 1,429,858 8.7
2750 Sand Hill Road
Menlo Park, California 94025
Kevin J. O'Connor(8).......... 713,475 5.2 55,000 658,475 4.0
DoubleClick
41 Madison Avenue
New York, New York 10010
Alex Bogaerts(9).............. 45,000 * -- 45,000 *
H. Keith Cooley(10)........... 200,000 1.4 20,000 180,000 1.1
Lin Ja Hong(11)............... 27,500 * -- 27,500 *
M. Thomas McNeight(12)........ 235,000 1.7 -- 235,000 1.4
Richard S. Bodman(13)......... 395,494 2.9 -- 395,494 2.4
c/o AT&T Ventures, L.L.C.
Two Wisconsin Circle
Chevy Chase, Maryland 20815
Robert E. Davoli(5)........... 1,950,218 14.2 -- 1,950,218 11.9
David N. Strohm(4)............ 2,657,614 19.4 -- 2,657,614 16.2
Glenn M. McGonnigle(14)....... 241,590 1.8 15,000 226,590 1.4
All directors and officers as
a group(11 persons)(15)..... 12,645,207 88.0 12,345,207 72.4
</TABLE>
53
<PAGE> 56
- ---------------
* Indicates less than 1%.
(1) Assumes no exercise of the Underwriters' over-allotment option.
(2) Beneficial ownership is calculated in accordance with the rules of the
Commission. In computing the number of shares beneficially owned by a
person and the percentage ownership of that person, shares of Common Stock
subject to options held by that person that are currently exercisable or
become exercisable within 60 days following February 28, 1998, are deemed
outstanding. However, such shares are not deemed outstanding for the
purpose of computing the percentage ownership of any other person. Unless
otherwise indicated in the footnotes to this table, the persons and
entities named in the table have sole voting and sole investment power with
respect to all shares beneficially owned, subject to community property
laws where applicable.
(3) Includes 3,560 shares held by Mr. Klaus' family. Mr. Klaus disclaims
beneficial ownership of such shares. In addition to the number of shares
shown as offered for sale in the table, Mr. Klaus has granted the
Underwriters the right to purchase up to an additional 25,000 shares
pursuant to the Underwriters' over-allotment option.
(4) Includes 20,000 shares of Common Stock held by Mr. Strohm and 2,637,614
shares held by Greylock Equity Limited Partnership. The general partner of
Greylock Equity Limited Partnership is Greylock Equity GP Limited
Partnership. Mr. Strohm, a director of the Company, is a general partner of
Greylock Equity GP Limited Partnership. Mr. Strohm disclaims beneficial
ownership of the shares held by Greylock Equity Limited Partnership except
to the extent of his pecuniary interest therein arising from his general
partnership interest in Greylock Equity GP Limited Partnership.
(5) Includes options immediately exercisable for 20,000 shares of Common Stock
held by Mr. Davoli, 311,506 shares held by Sigma Associates III, L.P.,
28,792 shares held by Sigma Investors III, L.P. and 1,589,920 shares held
by Sigma Partners III, L.P. Mr. Davoli, a director of the Company, is also
a general partner of Sigma Management III, L.P., which is the general
partner of Sigma Associates III, L.P., Sigma Investors III, L.P. and Sigma
Partners III, L.P. Mr. Davoli disclaims beneficial ownership of the shares
held by Sigma Associates III, L.P., Sigma Investors III, L.P. and Sigma
Partners III, L.P. except to the extent of his pecuniary interest therein
from his general partnership interest in Sigma Management III, L.P.
(6) Includes 172,778 shares held in family trusts. In addition to the number of
shares shown as offered for sale in the table, Mr. Noonan has granted the
Underwriters the right to purchase up to an additional 25,000 shares
pursuant to the Underwriters' over-allotment option.
(7) Includes 371,700 shares held by Kleiner Perkins Caufield & Byers VIII,
21,511 shares held by Kleiner Perkins Caufield & Byers VIII Founders Fund,
35,746 shares held by KPCB Information Sciences Zaibatsu Fund II and
1,000,901 shares held by KPCB Java Fund. The general partner of Kleiner
Perkins Caufield & Byers VIII, Kleiner Perkins Caufield & Byers VIII
Founders Fund and KPCB Java Fund is KPCB VIII Associates. The general
partner of KPCB Information Sciences Zaibatsu Fund II is KPCB VII
Associates.
(8) Includes options immediately exercisable for 20,000 shares of Common Stock.
In addition to the number of shares shown as offered for sale in the table,
Mr. O'Connor has granted the Underwriters the right to purchase up to an
additional 15,000 shares pursuant to the Underwriters' over-allotment
option.
(9) Includes options immediately exercisable for 45,000 shares of Common Stock.
(10) Includes options immediately exercisable for 180,000 shares of Common
Stock.
(11) Includes options immediately exercisable for 27,500 shares of Common Stock.
(12) Includes options immediately exercisable for 235,000 shares of Common
Stock.
(13) Includes options immediately exercisable for 20,000 shares of Common Stock
held by Mr. Bodman and 337,945 shares held by AT&T Venture Fund II, L.P.
and 37,549 shares held by Venture Fund I, L.P. The general partner of AT&T
Venture Fund II, L.P. is Venture Management LLC. The general partner of
Venture Fund I, L.P. is Venture Management I, GP. Mr. Bodman is a managing
member of Venture Management LLC and a general partner of Venture
Management I, GP. Mr. Bodman disclaims beneficial ownership of the shares
held by AT&T Venture Fund II, L.P. and Venture Fund I, L.P. except to the
extent of his pecuniary interest therein from his management interest in
Venture Management LLC and his general partnership interest in Venture
Management I, GP.
(14) Includes options immediately exercisable for 85,500 shares of Common Stock.
(15) Includes options immediately exercisable for 692,500 shares of Common
Stock.
54
<PAGE> 57
DESCRIPTION OF CAPITAL STOCK
AUTHORIZED AND OUTSTANDING CAPITAL STOCK
The authorized capital stock of the Company consists of 50,000,000 shares
of Common Stock, par value $0.001 per share, and 20,000,000 shares of Preferred
Stock, par value $0.001 per share ("Preferred Stock"). Upon consummation of this
Offering, no shares of Preferred Stock and 16,368,928 shares of Common Stock
(16,753,928 shares if the Underwriters' overallotment option is exercised in
full) will be outstanding. The following summary is qualified in its entirety by
reference to the Company's Charter and Bylaws, copies of which are filed as
exhibits to the Registration Statement of which this Prospectus is a part.
COMMON STOCK
As of December 31, 1997, there were 7,921,471 shares of Common Stock
outstanding that were held by eight stockholders. The holders of Common Stock
are entitled to one vote per share on all matters to be voted upon by the
stockholders. Subject to preferences that may be applicable to any outstanding
Preferred Stock, the holders of Common Stock are entitled to receive ratably
such dividends, if any, as may be declared from time to time by the Board of
Directors out of funds legally available therefor. In addition, the Company's
bank credit facility permits the payment of cash dividends only to the extent
the Company maintains certain financial ratios and a specified minimum net
worth. See "Dividend Policy". In the event of liquidation, dissolution or
winding up of the Company, the holders of Common Stock are entitled to share
ratably in all assets remaining after payment of liabilities, subject to prior
distribution rights of Preferred Stock, if any, then outstanding. The Common
Stock has no preemptive or conversion rights or other subscription rights. There
are no redemption or sinking fund provisions applicable to the Common Stock. All
outstanding shares of Common Stock are fully paid and nonassessable, and the
shares of Common Stock to be issued upon completion of this Offering will be
fully paid and nonassessable.
PREFERRED STOCK
The Board of Directors has the authority to issue the Preferred Stock in
one or more series and to fix the rights, preferences, privileges and
restrictions thereof, including dividend rights, dividend rates, conversion
rights, voting rights, terms of redemption, redemption prices, liquidation
preferences and the number of shares constituting any series or the designation
of such series, without further vote or action by the stockholders. The issuance
of Preferred Stock may have the effect of delaying, deferring or preventing a
change in control of the Company without further action by the stockholders and
may adversely affect the voting and other rights of the holders of Common Stock.
The issuance of Preferred Stock with voting and conversion rights may adversely
affect the voting power of the holders of Common Stock, including the loss of
voting control to others. At present, the Company has no plans to issue any
shares of Preferred Stock.
CERTAIN ANTI-TAKEOVER, LIMITED LIABILITY AND INDEMNIFICATION PROVISIONS
SECTION 203 OF THE DELAWARE GENERAL CORPORATION LAW
The Company is subject to Section 203 of the Delaware General Corporation
Law, as amended ("Section 203"), which, subject to certain exceptions, prohibits
a Delaware corporation from engaging in any business combination with any
interested stockholder for a period of three years following the date that such
stockholder became an interested stockholder, unless (i) prior to such date, the
board of directors of the corporation approved either the business combination
or the transaction that resulted in the stockholder becoming an interested
stockholder, (ii) upon consummation of the transaction that resulted in the
stockholder becoming an interested stockholder, the interested stockholder owned
at least 85% of the voting stock of the corporation outstanding at the time the
transaction commenced, excluding for purposes of determining the number of
shares outstanding those shares owned (x) by
55
<PAGE> 58
persons who are directors and also officers and (y) by employee stock plans in
which employee participants do not have the right to determine confidentially
whether shares held subject to the plan will be tendered in a tender or exchange
offer, or (iii) on or subsequent to such date, the business combination is
approved by the board of directors and authorized at an annual or special
meeting of stockholders, and not by written consent, by the affirmative vote of
at least 66 2/3% of the outstanding voting stock that is not owned by the
interested stockholder.
Section 203 defines business combinations to include (i) any merger or
consolidation involving the corporation or any majority-owned subsidiary of the
corporation and any other person or entity, (ii) subject to certain exceptions,
any sale, transfer, pledge or other disposition of 10% or more of the assets of
the corporation or any majority-owned subsidiary of the corporation involving
the interested stockholder, (iii) subject to certain exceptions, any transaction
that results in the issuance or transfer by the corporation or any
majority-owned subsidiary of the corporation of any stock of the corporation to
the interested stockholder, (iv) any transaction involving the corporation or
any majority-owned subsidiary of the corporation that has the effect of
increasing the proportionate share of the stock of any class or series of the
corporation or any majority-owned subsidiary of the corporation beneficially
owned by the interested stockholder, or (v) the receipt by the interested
stockholder of the benefit of any loans, advances, guarantees, pledges or other
financial benefits provided by or through the corporation or any majority-owned
subsidiary of the corporation. In general, Section 203 defines an interested
stockholder as any entity or person beneficially owning 15% or more or the
outstanding voting stock of the corporation and any entity or person affiliated
with or controlling or controlled by such entity or person.
CHARTER AND BYLAW PROVISIONS
The Company's Charter and Bylaws include provisions that may have the
effect of discouraging, delaying or preventing a change in control of the
Company or an unsolicited acquisition proposal that a stockholder might consider
favorable, including a proposal that might result in the payment of a premium
over the market price for the shares held by stockholders. These provisions are
summarized in the following paragraphs.
CLASSIFIED BOARD OF DIRECTORS
The Charter and Bylaws provide, beginning with the first annual meeting of
stockholders following this Offering, for the Board to be divided into three
classes of directors serving staggered, three-year terms. The classification of
the Board has the effect of requiring at least two annual stockholder meetings,
instead of one, to replace a majority of members of the Board.
SUPERMAJORITY VOTING
The Charter requires the approval of the holders of at least 66 2/3% of the
Company's combined voting power to effect certain amendments to the Charter
unless such amendments are approved by a majority of the directors of the
Company not affiliated or associated with any person holding (or which has
announced an intention to acquire) 26% or more of the voting power of the
Company's outstanding capital stock. The Bylaws may be amended by either (a) a
majority of the Board or (b) the holders of a majority of the Company's voting
stock, provided that certain amendments approved by stockholders require the
approval of at least 66 2/3% of the Company's combined voting power unless such
amendments are approved by a majority of the directors of the Company not
affiliated or associated with any person holding (or which has announced an
intention to acquire) 26% or more of the voting power of the Company's
outstanding capital stock.
AUTHORIZED BUT UNISSUED OR UNDESIGNATED CAPITAL STOCK
The Company's authorized capital stock consists of 50,000,000 shares of
Common Stock and 20,000,000 shares of Preferred Stock. No Preferred Stock will
be designated upon consummation of this Offering. After this Offering, the
Company will have outstanding 16,368,928 shares of Common Stock (16,753,928
shares if the Underwriters' over-allotment option is exercised in full). The
authorized but unissued (and in the case of Preferred Stock, undesignated) stock
may be issued by the Board in one or
56
<PAGE> 59
more transactions. In this regard, the Company's Charter grants the Board broad
power to establish the rights and preferences of authorized and unissued
Preferred Stock. The issuance of shares of Preferred Stock pursuant to the
Board's authority described above could decrease the amount of earnings and
assets available for distribution to holders of Common Stock and adversely
affect the rights and powers, including voting rights, of such holders and may
have the effect of delaying, deferring or preventing a change in control of the
Company. The Board does not currently intend to seek stockholder approval prior
to any issuance of Preferred Stock, unless otherwise required by law.
SPECIAL MEETINGS OF STOCKHOLDERS
The Bylaws provide that special meetings of stockholders of the Company may
be called only by the Board, or by the Company's Chairman of the Board or
President.
NO STOCKHOLDER ACTION BY WRITTEN CONSENT
The Charter and the Bylaws provide that an action required or permitted to
be taken at any annual or special meeting of the stockholders of the Company may
only be taken at a duly called annual or special meeting of stockholders. This
provision prevents stockholders from initiating or effecting any action by
written consent, and thereby taking actions opposed by the Board.
NOTICE PROCEDURES
The Bylaws establish advance notice procedures with regard to all
stockholder proposals to be brought before meetings of stockholders of the
Company, including proposals relating to the nomination of candidates for
election as directors, the removal of directors and amendments to the Charter or
Bylaws. These procedures provide that notice of such stockholder proposals must
be timely given in writing to the Secretary of the Company prior to the meeting.
Generally, to be timely, notice must be received by the Secretary of the Company
not less than 120 days prior to the meeting. The notice must contain certain
information specified in the Bylaws.
OTHER ANTI-TAKEOVER PROVISIONS
See "Management -- Restated 1995 Stock Incentive Plan" for a discussion of
certain provisions of the 1995 Plan which may have the effect of discouraging,
delaying or preventing a change in control of the Company or unsolicited
acquisition proposals.
LIMITATION OF DIRECTOR LIABILITY
The Charter limits the liability of directors of the Company (in their
capacity as directors but not in their capacity as officers) to the Company or
its stockholders to the fullest extent permitted by Delaware law. Specifically,
directors of the Company will not be personally liable for monetary damages for
breach of a director's fiduciary duty as a director, except for liability (i)
for any breach of the director's duty of loyalty to the Company or its
stockholders, (ii) for acts or omissions not in good faith or which involve
intentional misconduct or a knowing violation of law, (iii) under Section 174 of
the Delaware General Corporation Law, which relates to unlawful payments of
dividends or unlawful stock repurchases or redemptions, or (iv) for any
transaction from which the director derived an improper personal benefit.
INDEMNIFICATION ARRANGEMENTS
The Bylaws provide that the directors and officers of the Company shall be
indemnified and provide for the advancement to them of expenses in connection
with actual or threatened proceedings and claims arising out of their status as
such to the fullest extent permitted by the Delaware General Corporation Law.
Prior to consummation of this Offering, the Company will enter into
indemnification agreements with each of its directors and executive officers
that will provide them with rights to indemnification and expense advancement to
the fullest extent permitted under the Delaware General Corporation Law.
57
<PAGE> 60
REGISTRATION RIGHTS
Following the closing of the Offering, certain existing stockholders of the
Company holding an aggregate of 13,354,928 shares of Common Stock will be
entitled to certain rights with respect to the registration of such shares of
Common Stock held by them under the Securities Act. Under the terms of the
Rights Agreement between the Company and certain existing stockholders,
beginning six months after this Offering, the existing holders of Convertible
Preferred Stock have the right, subject to certain conditions and limitations,
to require the Company to file a registration statement, including, if
requested, a shelf registration statement, under the Securities Act in order to
register all or part of the existing stockholders' shares of Common Stock. The
Company may in certain circumstances defer such registrations and the
underwriters have the right, subject to certain limitations, to limit the number
of shares included in such registrations. In the event that the Company proposes
to register any of its securities under the Securities Act, either for its own
account or for the account of other security holders, certain of the existing
stockholders of Common Stock and Convertible Preferred Stock are entitled to
include their shares of Common Stock in such registration, subject to marketing
and other limitations. Generally, the Company is required to bear the expense of
all such registrations.
TRANSFER AGENT AND REGISTRAR
The Transfer Agent and Registrar for the Common Stock is SunTrust Bank,
Atlanta, located in Atlanta, Georgia.
58
<PAGE> 61
SHARES ELIGIBLE FOR FUTURE SALE
Upon completion of this Offering, the Company will have 16,368,928 of
Common Stock outstanding (assuming no exercise of the Underwriters'
over-allotment option and no exercise of outstanding options under the Company's
1995 Plan or other options after December 31, 1997). Of such shares, the
3,000,000 shares sold in this Offering will be freely transferable without
restriction or further registration under the Securities Act, except for any
shares held by an existing "affiliate" of the Company, as that term is defined
by the Securities Act (an "Affiliate"), which shares will be subject to the
resale limitations of Rule 144 adopted under the Securities Act. As of the date
of this Prospectus, 13,368,928 "restricted shares" as defined in Rule 144 will
be outstanding. Of such shares, and without consideration of the contractual
restrictions described below, 241,090 shares would be available for immediate
sale in the public market without restriction pursuant to Rule 144(k). Beginning
90 days after the date of this Prospectus, and without consideration of the
contractual restrictions described below, 12,889,228 shares would be eligible
for sale in reliance upon Rule 144 promulgated under the Securities Act and
31,500 shares would be eligible for sale in reliance upon Rule 701 promulgated
under the Securities Act.
In general, under Rule 144 as currently in effect, beginning 90 days after
the Offering, a person (or persons whose shares are aggregated) who owns shares
that were purchased from the Company (or any Affiliate) at least one year
previously, including a person who may be deemed an Affiliate of the Company, is
entitled to sell within any three-month period a number of shares that does not
exceed the greater of (i) 1% of the then outstanding shares of the Common Stock
(approximately 163,689 shares immediately after the Offering) or (ii) the
average weekly trading volume of the Common Stock on the Nasdaq National Market
during the four calendar weeks preceding the date on which notice of the sale is
filed with the Securities and Exchange Commission (the "Commission"). Sales
under Rule 144 are also subject to certain manner of sale provisions, notice
requirements and the availability of current public information about the
Company. Any person (or persons whose shares are aggregated) who is not deemed
to have been an Affiliate of the Company at any time during the 90 days
preceding a sale, and who owns shares within the definition of "restricted
securities" under Rule 144 under the Securities Act that were purchased from the
Company (or any Affiliate) at least two years previously, would be entitled to
sell such shares under Rule 144(k) without regard to the volume limitations,
manner of sale provisions, public information requirements or notice
requirements.
Subject to certain limitations on the aggregate offering price of a
transaction and other conditions, Rule 701 may be relied upon with respect to
the resale of securities originally purchased from the Company by its employees,
directors, officers, consultants or advisers prior to the date the issuer
becomes subject to the reporting requirements of the Securities Exchange Act of
1934, as amended (the "Exchange Act"), pursuant to written compensatory benefit
plans or written contracts relating to the compensation of such persons. In
addition, the Commission has indicated that Rule 701 will apply to typical stock
options granted by an issuer before it becomes subject to the reporting
requirements of the Exchange Act, along with the shares acquired upon exercise
of such options (including exercises after the date of this Prospectus).
Securities issued in reliance on Rule 701 are restricted securities and, subject
to the contractual restrictions described above, beginning 90 days after the
date of this Prospectus, may be sold (i) by persons other than Affiliates,
subject only to the manner of sale provisions of Rule 144, and (ii) by
Affiliates under Rule 144 without compliance with its one-year holding period
requirement.
All stockholders of the Company, including the officers, directors and
Selling Stockholders, have agreed not to sell any of their shares of Common
Stock for 180 days after the date of this Prospectus without the prior written
consent of the representatives of the Underwriters. As a result of these
contractual restrictions and subject to the provisions of Rules 144(k), 144 and
701, as applicable, 12,618,228 shares subject to restriction will be eligible
for sale upon expiration of the Lock-Up Agreements 180 days after the date of
this Prospectus. See "Underwriting".
The Company has agreed not to offer, sell or otherwise dispose of any
shares of Common Stock or any securities convertible into or exercisable or
exchangeable for Common Stock or any rights to acquire
59
<PAGE> 62
Common Stock for a period of 180 days after the date of this Prospectus, without
the prior written consent of the representatives of the Underwriters, subject to
certain limited exceptions. See "Underwriting".
After the Offering, the holders of 13,354,928 shares of Common Stock or
their respective transferees, will be entitled to certain rights with respect to
the registration of such shares under the Securities Act. See "Description of
Capital Stock -- Registration Rights". Registration of such shares under the
Securities Act would result in such shares becoming freely tradeable without
restriction under the Securities Act (except for shares purchased by Affiliates)
immediately upon the effectiveness of such registration.
The Company intends to file a registration statement under the Securities
Act covering approximately 3,000,000 shares of Common Stock reserved for
issuance under the 1995 Plan. See "Management -- Restated 1995 Stock Incentive
Plan". Such registration statement is expected to be filed within 90 days after
the date of this Prospectus and will automatically become effective upon filing.
Following such filing, shares registered under such registration statement will,
subject to the Lock-Up Agreements, Rule 144 volume limitations applicable to
Affiliates and the lapsing of the Company's repurchase rights, be available for
sale in the open market upon the exercise of vested options 90 days after the
effective date of this Prospectus. At December 31, 1997, options to purchase
1,808,350 shares were issued and outstanding under the 1995 Plan and options to
purchase 80,000 shares were issued and outstanding outside of the 1995 Plan.
60
<PAGE> 63
VALIDITY OF COMMON STOCK
The validity of the Common Stock offered hereby will be passed upon for the
Company by Brobeck, Phleger & Harrison LLP, Austin, Texas. Certain legal matters
in connection with the offering will be passed upon for the Underwriters by
Ropes & Gray, Boston, Massachusetts.
EXPERTS
The consolidated financial statements of ISS Group, Inc. at December 31,
1996 and 1997, and for each of the three years in the period ended December 31,
1997, appearing in this Prospectus and the Registration Statement have been
audited by Ernst & Young LLP, independent auditors, as set forth in their report
thereon appearing elsewhere herein and in the Registration Statement, and are
included in reliance upon such report given upon the authority of such firm as
experts in accounting and auditing.
ADDITIONAL INFORMATION
The Company has filed with the Commission, Washington, D.C. 20549, a
Registration Statement on Form S-1 under the Securities Act with respect to the
Common Stock offered hereby. This Prospectus does not contain all of the
information set forth in the Registration Statement and the exhibits and
schedules to the Registration Statement. For further information with respect to
the Company and the Common Stock offered hereby, reference is made to the
Registration Statement and the exhibits and schedules filed as a part of the
Registration Statement. Statements contained in this Prospectus concerning the
contents of any contract or any other document are not necessarily complete;
reference is made in each instance to the copy of such contract or any other
document filed as an exhibit to the Registration Statement. Each such statement
is qualified in all respects by such reference to such exhibit. The Registration
Statement, including exhibits and schedules thereto, may be inspected without
charge at the Commission's principal office in Washington, D.C., and copies of
all or any part thereof may be obtained from the Public Reference Section of the
Commission, 450 Fifth Street, N.W., Washington, D.C. 20549, and at the
Commission's regional offices located at Citicorp Center, 500 West Madison
Street, Suite 1400, Chicago, Illinois 60661 and at 7 World Trade Center, 13th
Floor, New York, New York 10048 after payment of fees prescribed by the
Commission. The Commission also maintains a Web site which provides online
access to reports, proxy and information statements and other information
regarding registrants that file electronically with the Commission at the
address http://www.sec.gov.
61
<PAGE> 64
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Report of Independent Auditors.............................. F-2
Consolidated Balance Sheets as of December 31, 1996 and
1997...................................................... F-3
Consolidated Statements of Operations for the Years Ended
December 31, 1995, 1996 and 1997.......................... F-4
Consolidated Statements of Stockholders' Equity (Deficit)
for the Years Ended
December 31, 1995, 1996 and 1997.......................... F-5
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1995, 1996 and 1997.......................... F-6
Notes to Consolidated Financial Statements.................. F-7
</TABLE>
F-1
<PAGE> 65
REPORT OF INDEPENDENT AUDITORS
Board of Directors
ISS Group, Inc.
We have audited the accompanying consolidated balance sheets of ISS Group,
Inc. (formerly Internet Security Systems, Inc.) as of December 31, 1996 and
1997, and the related consolidated statements of operations, stockholders'
equity (deficit), and cash flows for each of the three years in the period ended
December 31, 1997. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of ISS Group, Inc.
at December 31, 1996 and 1997, and the consolidated results of its operations
and its cash flows for each of the three years in the period ended December 31,
1997, in conformity with generally accepted accounting principles.
/s/ ERNST & YOUNG LLP
Atlanta, Georgia
January 13, 1998
F-2
<PAGE> 66
ISS GROUP, INC.
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------------------
PRO FORMA
1996 1997 1997
----------- ----------- -----------
(UNAUDITED)
<S> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................. $ 2,007,000 $ 3,929,000 $ 3,929,000
Accounts receivable, less allowance for doubtful accounts
of $79,000, $255,000 and $255,000, respectively......... 1,949,000 4,038,000 4,038,000
Prepaid expenses and other current assets................. 128,000 281,000 281,000
----------- ----------- -----------
Total current assets............................... 4,084,000 8,248,000 8,248,000
Property and equipment:
Computer equipment........................................ 267,000 1,688,000 1,688,000
Office furniture and equipment............................ 59,000 268,000 268,000
Leasehold improvements.................................... 15,000 15,000 15,000
----------- ----------- -----------
341,000 1,971,000 1,971,000
Less accumulated depreciation............................. 68,000 402,000 402,000
----------- ----------- -----------
273,000 1,569,000 1,569,000
Other assets................................................ 23,000 49,000 49,000
----------- ----------- -----------
Total assets....................................... $ 4,380,000 $ 9,866,000 $ 9,866,000
=========== =========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable.......................................... $ 341,000 $ 2,002,000 $ 2,002,000
Accrued expenses.......................................... 731,000 1,798,000 1,798,000
Deferred revenues......................................... 644,000 2,106,000 2,106,000
Current portion of long term debt......................... 70,000 70,000 70,000
----------- ----------- -----------
Total current liabilities.......................... 1,786,000 5,976,000 5,976,000
Long term debt.............................................. 140,000 70,000 70,000
Commitments and contingencies............................... -- -- --
Redeemable, Convertible Preferred Stock (5,737,000 shares
authorized):
Series A; $.001 par value; 3,650,000 issued and
outstanding (historical), none issued or outstanding
(pro forma) (liquidation preference $1 per share)..... 3,614,000 3,621,000 --
Series B; $.001 par value; 2,087,000 issued and
outstanding (historical), none issued or outstanding
(pro forma) (liquidation preference $2.53 per
share)................................................ -- 5,257,000 --
Stockholders' equity (deficit):
Preferred Stock; $.001 par value; 20,000,000 shares
authorized (including 5,737,000 designated as
Redeemable, Convertible Preferred Stock), none issued or
outstanding............................................. -- -- --
Common Stock, $.001 par value, 50,000,000 shares
authorized, 7,902,000 and 7,921,000 shares issued and
outstanding (historical), 13,658,000 shares issued and
outstanding (pro forma)................................. 8,000 8,000 14,000
Additional paid-in capital................................ 103,000 695,000 9,567,000
Deferred compensation..................................... -- (571,000) (571,000)
Accumulated deficit....................................... (1,271,000) (5,190,000) (5,190,000)
----------- ----------- -----------
Total stockholders' equity (deficit)............... (1,160,000) (5,058,000) 3,820,000
----------- ----------- -----------
Total liabilities and stockholders' equity
(deficit)........................................ $ 4,380,000 $ 9,866,000 $ 9,866,000
=========== =========== ===========
</TABLE>
See accompanying notes.
F-3
<PAGE> 67
ISS GROUP, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1995 1996 1997
--------- ----------- -----------
<S> <C> <C> <C>
Revenues:
Licenses............................................ $ 246,000 $ 4,233,000 $10,936,000
Support services.................................... 11,000 229,000 2,531,000
--------- ----------- -----------
257,000 4,462,000 13,467,000
Costs and expenses:
Cost of revenues.................................... 4,000 18,000 676,000
Research and development............................ 97,000 1,225,000 3,434,000
Sales and marketing................................. 252,000 3,768,000 11,731,000
General and administrative.......................... 44,000 656,000 1,773,000
--------- ----------- -----------
397,000 5,667,000 17,614,000
--------- ----------- -----------
Operating loss........................................ (140,000) (1,205,000) (4,147,000)
Interest income....................................... -- 77,000 245,000
Interest expense...................................... -- (3,000) (17,000)
--------- ----------- -----------
Net loss.............................................. $(140,000) $(1,131,000) $(3,919,000)
========= =========== ===========
Basic and diluted net loss per share of Common
Stock............................................... (.03) (.14) (.50)
========= =========== ===========
Weighted average number of shares used in calculating
basic and diluted net loss per share of Common
Stock............................................... 5,001,000 7,916,000 7,907,000
========= =========== ===========
Unaudited pro forma net loss per share of Common
Stock............................................... $ (.29)
===========
Unaudited weighted average number of shares used in
calculating pro forma net loss per share of Common
Stock............................................... 13,644,000
===========
</TABLE>
See accompanying notes.
F-4
<PAGE> 68
ISS GROUP, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
<TABLE>
<CAPTION>
RETAINED TOTAL
COMMON STOCK ADDITIONAL EARNINGS STOCKHOLDERS'
------------------ PAID-IN DEFERRED (ACCUMULATED EQUITY
SHARES AMOUNT CAPITAL COMPENSATION DEFICIT) (DEFICIT)
--------- ------ ---------- ------------ ------------ -------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31,
1994................. 4,586,000 $5,000 $ (5,000) $ -- $ 10,000 $ 10,000
Issuance of Common
Stock to investor,
September 8,1995.. 1,293,000 1,000 49,000 -- -- 50,000
Issuance of Common
Stock to
employees,
December 29,1995.. 2,123,000 2,000 81,000 -- -- 83,000
Cash dividends....... -- -- -- -- (10,000) (10,000)
Net loss............. -- -- -- -- (140,000) (140,000)
--------- ------ -------- --------- ----------- -----------
Balance at December
31,1995.............. 8,002,000 8,000 125,000 -- (140,000) (7,000)
Repurchase of Common
Stock from
founder........... (100,000) -- (15,000) -- -- (15,000)
Accretion related to
Redeemable,
Convertible
Preferred Stock... -- -- (7,000) -- -- (7,000)
Net loss............. -- -- -- -- (1,131,000) (1,131,000)
--------- ------ -------- --------- ----------- -----------
Balance at December
31,1996.............. 7,902,000 8,000 103,000 -- (1,271,000) (1,160,000)
Accretion related to
Redeemable,
Convertible
Preferred Stock... -- -- (11,000) -- -- (11,000)
Deferred compensation
related to stock
options........... -- -- 571,000 (571,000) -- --
Issuance of Common
Stock............. 19,000 -- 32,000 -- -- 32,000
Net loss............. -- -- -- -- (3,919,000) (3,919,000)
--------- ------ -------- --------- ----------- -----------
Balance at December
31,1997.............. 7,921,000 $8,000 $695,000 $(571,000) $(5,190,000) $(5,058,000)
========= ====== ======== ========= =========== ===========
</TABLE>
See accompanying notes.
F-5
<PAGE> 69
ISS GROUP, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------
1995 1996 1997
--------- ----------- -----------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss.............................................. $(140,000) $(1,131,000) $(3,919,000)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation........................................ 4,000 66,000 334,000
Non-cash expense.................................... 83,000 -- 31,000
Changes in assets and liabilities:
Accounts receivable.............................. (148,000) (1,802,000) (2,089,000)
Prepaid expenses and other assets................ (3,000) (146,000) (179,000)
Accounts payable and accrued expenses............ 117,000 955,000 2,728,000
Deferred revenues................................ 37,000 607,000 1,462,000
--------- ----------- -----------
Net cash used in operating activities................. (50,000) (1,451,000) (1,632,000)
INVESTING ACTIVITIES
Purchases of property and equipment................... (23,000) (320,000) (1,630,000)
--------- ----------- -----------
Net cash used in investing activities................. (23,000) (320,000) (1,630,000)
FINANCING ACTIVITIES
Proceeds from (payments on) long term debt............ -- 210,000 (70,000)
Net proceeds from Redeemable, Convertible Preferred
Stock issuances..................................... -- 3,607,000 5,253,000
Proceeds from (payments on) notes payable to
shareholder......................................... 30,000 (30,000) --
Common Stock activities............................... 50,000 (15,000) 1,000
Cash dividends........................................ (10,000) -- --
--------- ----------- -----------
Net cash provided by financing activities............. 70,000 3,772,000 5,184,000
--------- ----------- -----------
Net (decrease) increase in cash and cash
equivalents......................................... (3,000) 2,001,000 1,922,000
Cash and cash equivalents at beginning of year........ 9,000 6,000 2,007,000
--------- ----------- -----------
Cash and cash equivalents at end of year.............. $ 6,000 $ 2,007,000 $ 3,929,000
========= =========== ===========
SUPPLEMENTAL CASH FLOW DISCLOSURE
Interest paid......................................... $ -- $ 1,000 $ 17,000
========= =========== ===========
</TABLE>
See accompanying notes.
F-6
<PAGE> 70
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
DECEMBER 31, 1997
1. SIGNIFICANT ACCOUNTING POLICIES
CONSOLIDATION AND DESCRIPTION OF BUSINESS
The consolidated financial statements include the accounts of ISS Group,
Inc. and its subsidiaries ("the Company"). All significant intercompany
investment accounts and transactions have been eliminated in consolidation.
ISS Group, Inc. was incorporated in the State of Delaware on December 8,
1997 to be a holding company for Internet Security Systems, Inc., a Georgia
company incorporated on April 19, 1994 to design, market, and sell computer
network security assessment software. In March 1996, the Company formed Internet
Security Systems Europe N.V. ("ISS Europe"), of which the Company owns 99.96% of
the outstanding stock. In February 1997, the Company formed Internet Security
Systems K.K., a wholly owned subsidiary. These subsidiaries have primary
marketing and sales responsibilities for the Company's products in Europe and
the Asia/Pacific regions.
The financial statements of foreign subsidiaries have been translated into
United States dollars in accordance with Financial Accounting Standards Board
("FASB") Statement of Financial Accounting Standards ("SFAS") No. 52 Foreign
Currency Translation. Revenues with international customers, except in Japan,
were denominated in U.S. dollars. Revenues from Japanese customers and
international expenditures were denominated in the respective local currencies
and translated using the average exchange rates for the year. The effect on the
statements of operations related to transaction gains and losses is
insignificant for all years presented. All balance sheet accounts have been
translated using the exchange rates in effect at the balance sheet date and the
effect of changes in exchange rates from year to year is insignificant.
The Company's business is focused on maintaining the latest security threat
and vulnerability checks within existing products and creating new products and
services that are consistent with the Company's goal of providing an adaptive
security management approach to network security. This approach entails
continuous security risk monitoring and response to develop an active and
informed network security policy.
REVENUE RECOGNITION
The Company recognizes its license revenue upon (i) delivery of software
or, if the customer has evaluation software, delivery of the software key, and
(ii) issuance of the related license, assuming no significant vendor obligations
or customer acceptance rights exist. In October 1997, the AICPA issued Statement
of Position ("SOP") No. 97-2, Software Revenue Recognition, which the Company
adopted, effective January 1, 1997. Such adoption had no effect on the Company's
methods of recognizing revenue from its license and maintenance activities.
Prior to 1997, the Company's revenue recognition policy was in accordance with
the preceding authoritative guidance provided by SOP No. 91-1, Software Revenue
Recognition.
Revenues from perpetual licenses are recorded as license revenues in the
statements of operations. Support service revenues include maintenance, term
license revenues, and professional services. Annual renewable maintenance is a
separate component of each contract, and is recognized ratably over the contract
term. Term licenses, which allow customer use of the product and maintenance for
a specified period, generally twelve months, are also recognized ratably over
the contract term. Professional services revenues are recognized as such
services are performed.
F-7
<PAGE> 71
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with a maturity of
three months or less when purchased to be cash equivalents. Such amounts are
stated at cost which approximates market value.
CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of cash and cash equivalents
and accounts receivable. The Company maintains cash and cash equivalents with
two financial institutions. The Company's sales are primarily to companies
located in the United States, Europe and the Asia/Pacific regions. The Company
performs periodic credit evaluations of its customers' financial condition and
does not require collateral. Accounts receivable are due principally from large
U.S. companies under stated contract terms. The Company provides for estimated
credit losses at the time of sale. Such losses have not been significant to
date.
PROPERTY AND EQUIPMENT
Property and equipment are stated at cost less accumulated depreciation.
Depreciation is computed using the straight-line method for financial reporting
purposes over the estimated useful lives of the assets (primarily three years).
RESEARCH AND DEVELOPMENT COSTS
Research and development costs are charged to expense as incurred. The
Company has not capitalized any such development costs under SFAS No. 86,
Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise
Marketed, because the costs incurred by the Company between the attainment of
technological feasibility for the related software product through the date when
the product is available for general release to customers is insignificant.
ADVERTISING COSTS
The cost of advertising is expensed as incurred. The Company incurred
$34,000, $485,000 and $572,000 of advertising costs for the years ended December
31, 1995, 1996 and 1997, respectively. Such amounts are included in sales and
marketing expense in the statements of operations.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results may differ from those estimates, and such
differences may be material to the consolidated financial statements.
STOCK BASED COMPENSATION
The Company grants stock options generally for a fixed number of shares to
certain employees with an exercise price equal to or below the fair value of the
shares at the date of grant. The Company accounts for stock option grants in
accordance with Accounting Principles Board ("APB") Opinion No. 25, Accounting
for Stock Issued to Employees, and, accordingly, recognizes compensation expense
only if the fair value of the underlying Common Stock exceeds the exercise price
of the stock option on the date of grant. In October 1995, the FASB issued SFAS
No. 123, Accounting for Stock-Based Compensation, which provides an alternative
to APB Opinion No. 25 in accounting for stock-based
F-8
<PAGE> 72
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
STOCK BASED COMPENSATION (CONTINUED)
compensation issued to employees. As permitted by SFAS No. 123, the Company
continues to account for stock-based compensation in accordance with APB Opinion
No. 25 and has elected the pro forma disclosure alternative of SFAS No. 123 (see
Note 6).
PRO FORMA BALANCE SHEET (UNAUDITED)
In conjunction with an initial public offering of the Company's Common
Stock, all outstanding shares of Series A and Series B Redeemable, Convertible
Preferred Stock automatically convert into shares of Common Stock. As such, the
effect of the conversions has been reflected in the unaudited pro forma balance
sheet at December 31, 1997.
LOSS PER SHARE
In 1997, the FASB issued SFAS No. 128, Earnings per Share and in February
1998, the Securities and Exchange Commission issued Staff Accounting Bulletin
No. 98 ("SAB 98") related to SFAS No. 128. SFAS No. 128 replaced the calculation
of primary and fully diluted earnings per share with basic and diluted earnings
per share. Unlike primary earnings per share, basic earnings per share excludes
any dilutive effects of options, warrants, and convertible securities. Diluted
earnings per share is very similar to the previously reported fully diluted
earnings per share. The Company has no Common Stock equivalents due to "cheap
stock" as defined in SAB 98.
Basic and diluted historical net loss per share (see Note 10) was computed
by dividing net loss plus accretion of the Series A and Series B Redeemable,
Convertible Preferred Stock by the weighted average number of shares of Common
Stock. Common Stock equivalents were antidilutive and therefore were not
included in the computation of weighted average shares used in computing diluted
loss per share for the years ended December 31, 1995, 1996 and 1997.
Unaudited pro forma net loss per share was computed by dividing net loss by
the unaudited weighted average number of shares of Common Stock outstanding plus
the conversion of the 3,650,000 shares of Series A and 2,087,000 shares of
Series B Redeemable, Convertible Preferred Stock into 5,737,000 shares of Common
Stock which will occur upon consummation of the Company's initial public
offering.
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1997, the FASB issued SFAS No. 130, Reporting Comprehensive Income,
which establishes standards for reporting and displaying comprehensive income,
as defined, and its components in financial statements. The Company's adoption
of SFAS No. 130 had no impact on the consolidated financial statements.
In June 1997, the FASB issued SFAS No. 131, Disclosures about Segments of
an Enterprise and Related Information. SFAS No. 131 establishes standards for
the way that public business enterprises report information about operating
segments in annual financial statements for periods beginning after December 15,
1997. The Statement requires that business segment financial information be
reported in the financial statements utilizing the management approach. The
management approach is defined as the manner in which management organizes the
segments within the enterprise for making operating decisions and assessing
performance. Management believes the adoption of SFAS No. 131 will not have a
material impact on the financial statements.
F-9
<PAGE> 73
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
1. SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
RECLASSIFICATIONS
Certain reclassifications were made to the prior years' financial
statements to conform with the 1997 presentation.
2. FAIR VALUE OF FINANCIAL INSTRUMENTS
The carrying amounts reported in the balance sheets for cash and cash
equivalents, accounts receivable and accounts payable approximate their fair
values. The carrying amounts reported in the balance sheets for long-term debt
approximate their fair values as the interest rate related to such debt is
variable and commensurate with the Company's credit worthiness.
3. DEBT
At December 31, 1996 and 1997, the Company had outstanding balances of
$210,000 and $140,000, respectively, under an equipment line of credit. Interest
on such line accrues at 1.25% above the prime rate and is payable on a monthly
basis. Borrowings under the equipment line are secured by equipment and are due
in annual installments of $70,000 in 1998 and 1999.
At December 31, 1996, the Company had an unused $500,000 revolving line of
credit which matured on October 31, 1997 and was not renewed by the Company.
4. REDEEMABLE, CONVERTIBLE PREFERRED STOCK
Redeemable, Convertible Preferred Stock consists of the following:
<TABLE>
<CAPTION>
SHARES ISSUED
GROSS NET AND
SERIES DATE OF ISSUANCE PROCEEDS PROCEEDS OUTSTANDING
- ------ ---------------- ---------- ---------- -------------
<S> <C> <C> <C> <C>
A February 2, 1996 $3,650,000 $3,607,000 3,650,000
B February 14, 1997 5,280,000 5,253,000 2,087,000
---------- ---------- ---------
$8,930,000 $8,860,000 5,737,000
========== ========== =========
</TABLE>
Accretion related to the Company's Series A and Series B Redeemable,
Convertible Preferred Stock was recorded over the respective redemption period
by charges against additional paid-in capital with corresponding increases to
the carrying value of the Series A and Series B Redeemable, Convertible
Preferred Stock. Such increases aggregated $7,000 and $11,000 for the years
ended December 31, 1996 and 1997, respectively.
The rights, preferences, qualifications, limitations, and restrictions of
the holders of the Series A and Series B Redeemable, Convertible Preferred Stock
are as follows:
a. Dividend Rights. Dividends as specifically declared by the
Company's Board of Directors are to be in preference to payment of any
dividend (other than dividends payable solely in Common Stock) with respect
to the Common Stock.
b. Liquidation Rights. In the event of any liquidation, dissolution
or winding up of the Corporation, whether voluntary or not, Series A and
Series B holders shall be paid an amount equal to $1.00 per share and $2.53
per share, respectively, (adjusted for stock splits, combinations, or
similar events) plus, in each case, all declared and unpaid dividends, if
any, before any amount shall be paid to holders of Common Stock. Any
remaining assets and surplus funds shall be distributed ratably among the
holders of the Common Stock, the Series A Preferred Stock and the Series B
F-10
<PAGE> 74
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
4. REDEEMABLE, CONVERTIBLE PREFERRED STOCK (CONTINUED)
Preferred Stock on an as-converted basis. In no event shall the holders of
the Series A Preferred Stock and Series B Preferred Stock be entitled to
receive more than $2.00 and $5.06 per share, respectively, unless such
holders have converted their shares of Series A Preferred Stock or Series B
Preferred Stock into Common Stock prior to the occurrence of a liquidation,
dissolution or winding up of the Corporation.
c. Mandatory Redemption. If the Series A or Series B Preferred Stock
has not been redeemed or converted into Common Stock prior to September 30,
2000 each share of Series A and Series B Preferred Stock is redeemable at
the request of the holders of at least 51% of the outstanding shares. If
the redemption provisions are exercised, redemption will occur in stages in
the years 2001, 2002, and 2003. The redemption price is equal to the
original price plus all declared and unpaid dividends.
d. Voting Rights. The Series A and Series B Preferred Stock generally
vote equally with shares of Common Stock on an "as if converted" basis
except that the holders of Series A Preferred Stock, voting as a separate
series, shall elect two members of the Company's Board of Directors. The
holders of Common Stock and Series A and Series B Preferred Stock, voting
together as a class, shall elect all the remaining directors.
e. Protective Provisions. The Series A and Series B Preferred Stock
holders have certain protective provisions which prohibit the Company from
certain activities (e.g. sale of substantially all of the Company's assets,
changes to Series A and Series B instruments, dividend declarations,
creating new classes of Preferred Stock senior to the Series A or Series B
Preferred Stock) without first obtaining the approval of holders of at
least a majority of the then outstanding shares of the Series A and Series
B Preferred Stock holders, as defined.
f. Conversion. Shares of Series A and Series B Preferred Stock are
convertible, at the option of the holder, to Common Stock at any time at
the rate of one share of Common Stock for each share of Preferred Stock.
The Series A and Series B Preferred Stock automatically converts to Common
Stock upon the closing of (i) an underwritten public offering of the
Company's Common Stock in which the aggregate proceeds for such shares is
at least $10,000,000 and the per share price is at least $6.00 per share
(adjusted for any stock split, dividend, combination, recapitalization, or
the like) or (ii) the written election of holders of not less than a
majority of the then outstanding shares of such series.
In connection with the issuance of the Series A Preferred Stock, the
Company effected an 89.92-for-1 share stock split of its Common Stock. The
Company has designated 3,650,000 shares of the authorized Preferred Stock as
Series A Preferred Stock and 2,087,000 shares as Series B Preferred Stock. All
par value and share amounts in the accompanying financial statements have been
retroactively adjusted to reflect the stock split and changes to the articles of
incorporation.
5. STOCKHOLDERS' EQUITY
On April 19, 1994, the Company issued 4,586,000 shares of Common Stock to
the founder in exchange for the assignment of technology previously developed
and distributed by the founder as shareware. In connection with the issuance of
Series A Preferred Stock (see Note 4), the founder entered into a Stock
Repurchase Agreement (the "Founder's Agreement") with the Company. Under the
Founder's Agreement the Company has the right to acquire, at fair market value,
up to 2,293,000 shares of the founder's Common Stock upon the founder's
separation from the Company, as defined. The Company's repurchase rights expire
ratably over a four year period beginning February 1, 1996 or upon the
consummation of an initial public offering of the Company's Common Stock.
F-11
<PAGE> 75
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
5. STOCKHOLDERS' EQUITY (CONTINUED)
On September 8, 1995, the Company issued 1,293,000 shares of Common Stock
to an investor for $50,000.
On December 29, 1995, the Company issued 2,123,000 shares of Common Stock
to two employees and recorded $83,000 of compensation expense. In connection
with the issuance of Series A Preferred Stock (see Note 4), the employees
entered into a Stock Repurchase Agreement (the "Agreement") with the Company.
Under the Agreement, the Company has the right to acquire, at fair market value,
up to 1,633,000 shares of such employees' Common Stock upon the employees'
separation from the Company, as defined. The Company's repurchase rights expire
ratably over a four year period beginning February 1, 1996 or upon the
consummation of an initial public offering of the Company's Common Stock.
On February 2, 1996 the Company acquired 100,000 shares of its Common Stock
from the founder for $15,000.
The Company has reserved 8,810,000 shares of Common Stock for future
issuance upon conversion of outstanding Series A and Series B Preferred Stock
and exercise of options to purchase Common Stock.
In December 1997, the Company commenced plans to offer up to 2,685,000 of
newly issued shares of Common Stock in an initial public offering plus 385,000
shares that the underwriters have the option to purchase to cover
over-allotments, if any.
6. STOCK OPTION PLANS
In 1995, the Company established the 1995 Incentive Stock Plan (the "Plan")
to provide for the granting of qualified or nonqualified options to purchase
shares of the Company's Common Stock. In 1997, the Company amended the Plan to
increase the number of shares reserved for future issuance under such plan to
3,000,000 shares.
Effective with the 1997 Plan amendment, options granted under the Plan
became immediately exercisable, subject to a right of repurchase by the Company
at the original exercise price for all unvested shares. Vesting occurs in equal
annual installments over four years, generally measured from the date of the
grant. Once an optionee vests in the shares underlying the option and until
certain events occur, including an initial public offering of the Company's
common stock, the Company has a right of first refusal to repurchase such shares
after an individual has received a bona fide third party offer with respect to
such vested shares. All options are issued at fair market value on the date of
grant. Fair market value of the Company's Common Stock, in the absence of
trading on a national or regional stock exchange, is determined by the Company's
Board of Directors.
The Plan also includes an Automatic Option Grant Program (the "Program").
Under the Program, each individual who first joins the Company's Board of
Directors as a non-employee Board member after the effective date of an initial
public offering will receive an option to purchase 50,000 shares of Common Stock
on the date he or she is first elected or appointed to the Board of Directors,
provided such individual has not otherwise been in the prior employ of the
Company. In addition, at each annual stockholders' meeting, beginning with the
1999 annual meeting, each individual who is to continue to serve as a
non-employee Board of Directors member after the meeting will receive an
additional option to purchase 5,000 shares of Common Stock. Options under the
Program will be isssued at fair market value at the date of the grant.
On December 8, 1997, the Company's Board of Directors granted to each of
the Company's four non-employee directors a nonstatutory option to purchase up
to 20,000 shares of Common Stock outside
F-12
<PAGE> 76
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
6. STOCK OPTION PLANS (CONTINUED)
the Plan, on the same terms as if those options had been granted under the
Program of the 1995 Plan. The Company reserved 80,000 shares of Common Stock for
issuance under these options.
A summary of the Company's stock option activity is as follows:
<TABLE>
<CAPTION>
1996 1997
-------------------- --------------------
WEIGHTED WEIGHTED
AVERAGE AVERAGE
NUMBER EXERCISE NUMBER EXERCISE
OF SHARES PRICE OF SHARES PRICE
--------- -------- --------- --------
<S> <C> <C> <C> <C>
Outstanding at beginning of year............. -- $ -- 810,000 $ .16
Granted.................................... 810,000 .16 1,103,000 4.54
Exercised.................................. -- -- (7,000) .15
Canceled................................... -- -- (18,000) .50
------- ---------
Outstanding at end of year................... 810,000 .16 1,888,000 2.71
======= =========
Exercisable at end of year................... -- 1,888,000 2.71
======= =========
Weighted average fair value of options
granted during the year.................... $ .04 $ 2.34
======= =========
</TABLE>
The following table summarizes information concerning currently outstanding
options, all of which are exercisable:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
--------------------------------------------------
NUMBER OF
OPTIONS WEIGHTED
OUTSTANDING AT AVERAGE WEIGHTED
DECEMBER 31, REMAINING AVERAGE
RANGE OF EXERCISE PRICES 1997 CONTRACTUAL LIFE EXERCISE PRICE
------------------------ -------------- ---------------- --------------
<S> <C> <C> <C>
$.15-.60................................... 1,067,000 8.6 years $ .28
$1.00-7.00................................. 821,000 9.9 years 5.89
---------
1,888,000
=========
</TABLE>
During the year ended December 31, 1997, deferred compensation of $571,000
was recorded for options granted with an exercise price less than the fair value
of the Common Stock on the date of grant. The deferred compensation will be
amortized over the four year vesting period of the stock options. Amortization
of deferred compensation for the year ended December 31, 1997 was not material.
Pro forma information regarding net income and net income per share is
required by SFAS No. 123, which also requires that the information be determined
as if the Company had accounted for its employee stock options granted
subsequent to December 31, 1994 under the fair value method prescribed by that
Statement. The fair value for options granted was estimated at the date of grant
using the Black-Scholes option pricing model. The following weighted average
assumptions were used for 1996 and 1997, respectively: risk-free interest rates
of 5.97% and 6.28%; no dividend yield; a .60 volatility factor; and an expected
life of the options of 4 years.
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting restrictions
and are fully transferable. In addition, option valuation models require the
input of highly subjective assumptions including the expected stock price
volatility. Because the Company's employee stock options have characteristics
different from those of traded options, and because the changes in the
subjective input assumptions can materially affect the fair value estimate, in
management's opinion, the existing models do not necessarily provide a reliable
single measure of the fair value of its employee stock options.
F-13
<PAGE> 77
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
6. STOCK OPTION PLANS (CONTINUED)
For purposes of pro forma disclosures, the estimated fair value of the
option is amortized to expense over the options' vesting period. The following
pro forma information adjusts the net loss and unaudited pro forma net loss per
share of Common Stock for the impact of SFAS No. 123:
<TABLE>
<CAPTION>
YEAR ENDED
DECEMBER 31,
1997
------------
<S> <C>
Unaudited pro forma net loss................................ $(3,975,000)
===========
Unaudited pro forma net loss per share as adjusted.......... $ (.29)
===========
</TABLE>
7. COMMITMENTS
In 1996, the Company entered into noncancellable operating leases for new
facilities that expire in July 2001. The Company has the option to extend the
terms of the leases for one additional five year term upon expiration of the
initial terms.
Future minimum payments under noncancellable operating leases with initial
terms of one year or more consisted of the following at December 31:
<TABLE>
<CAPTION>
OPERATING
LEASES
----------
<S> <C>
1998........................................................ $ 400,000
1999........................................................ 277,000
2000........................................................ 276,000
2001........................................................ 105,000
----------
Total minimum lease payments...................... $1,058,000
==========
</TABLE>
Rent expense was approximately $4,000, $105,000 and $401,000 for the years
ended December 31, 1995, 1996 and 1997, respectively.
8. INCOME TAXES
On January 1, 1996 the Company adopted the liability method of accounting
for income taxes. Under this method, deferred income tax assets and liabilities
are determined based on the differences between the financial reporting and the
tax bases of assets and liabilities and are measured using the enacted tax rates
and laws that will be in effect when the differences are expected to reverse.
Prior to 1996, the Company qualified as an S-Corporation and any income taxes
were the responsibilities of the shareholders.
A reconciliation of the provision for income taxes to the statutory federal
income tax rate is as follows:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
------------------------
1996 1997
--------- -----------
<S> <C> <C>
Statutory rate at 34%, applied to pre-tax loss........... $(384,000) $(1,332,000)
State income taxes, net of federal tax benefit........... (45,000) (157,000)
Research and development tax credit...................... (28,000) (159,000)
Foreign operations....................................... 100,000 --
Other.................................................... 46,000 (26,000)
Change in valuation allowance............................ 311,000 1,674,000
--------- -----------
$ -- $ --
========= ===========
</TABLE>
F-14
<PAGE> 78
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
8. INCOME TAXES (CONTINUED)
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 net deferred income tax assets are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------
1996 1997
-------- ----------
<S> <C> <C>
Depreciation............................................... $ -- $ 69,000
Accrued liabilities........................................ 20,000 148,000
Allowance for doubtful accounts............................ 30,000 97,000
Net operating loss carryforwards........................... 233,000 1,484,000
Research and development tax credit carryforwards.......... 28,000 187,000
-------- ----------
311,000 1,985,000
Less valuation allowance................................... (311,000) (1,985,000)
-------- ----------
Net deferred income tax assets............................. $ -- $ --
======== ==========
</TABLE>
For financial reporting purposes, a valuation allowance has been recognized
to reduce the net deferred income tax assets to zero. The Company has not
recognized any benefit from the future use of such loss carryforwards because
management's evaluation of all the available evidence in assessing the
realizability of the tax benefits of such loss carryforwards indicates that the
underlying assumptions of future profitable operations contain risks that do not
provide sufficient assurance to recognize such tax benefits currently.
The Company has approximately $3,906,000 of net operating loss
carryforwards for federal income tax purposes that expire in varying amounts
between 2011 and 2012. A small portion of the net operating loss carryforwards
may be subject to certain limitations in the event of a change in ownership. The
Company also has approximately $295,000 of net operating loss carryforwards
related to its foreign operations which have no expiration date. Additionally,
the Company has approximately $187,000 of research and development tax credit
carryforwards which expire between 2011 and 2012.
9. EMPLOYEE BENEFIT PLANS
In January 1996, the Company established a 401(k) plan that covers
substantially all employees over 21 years of age. The Company may make
contributions to the plan at its discretion. The Company made no contributions
to the plan for the years ended December 31, 1996 or 1997.
F-15
<PAGE> 79
ISS GROUP, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS -- (CONTINUED)
10. LOSS PER SHARE
The following table sets forth the computation of basic, diluted and
unaudited pro forma net loss per share:
<TABLE>
<CAPTION>
HISTORICAL PRO FORMA
---------------------------------------- ------------
1995 1996 1997 1997
----------- ----------- ------------ ------------
(UNAUDITED)
<S> <C> <C> <C> <C>
Numerator:
Net loss................... $ (140,000) $(1,131,000) $ (3,919,000) $ (3,919,000)
Accretion of Series A and
Series B Redeemable,
Convertible Preferred
Stock................... -- (7,000) (11,000) (11,000)
----------- ----------- ------------ ------------
$ (140,000) $(1,138,000) $ (3,930,000) $ (3,930,000)
=========== =========== ============ ============
Denominator:
Denominator for basic and
diluted net loss per
share -- weighted
average shares.......... 5,001,000 7,916,000 7,907,000 7,907,000
Redeemable, Convertible
Preferred Stock......... -- -- -- 5,737,000
----------- ----------- ------------ ------------
5,001,000 7,916,000 7,907,000 13,644,000
=========== =========== ============ ============
Basic net loss per share..... $ (.03) $ (.14) $ (.50)
=========== =========== ============
Diluted net loss per share... $ (.03) $ (.14) $ (.50)
=========== =========== ============
Pro forma net loss per
share...................... $ (.29)
============
</TABLE>
11. EXPORT SALES
Export sales from the United States to the Europe and Asia/Pacific regions
represented approximately 10% and 3%, respectively, of total revenues for the
year ended December 31, 1997. Export sales were not significant for the years
ended December 31, 1995 and 1996. Revenues generated from the Company's foreign
operations located in the Asia/Pacific region totalled approximately 8% of total
revenues for the year ended December 31, 1997. The Company had no revenue
generating foreign operations prior to 1997.
F-16
<PAGE> 80
UNDERWRITING
Subject to the terms and conditions of the Underwriting Agreement, the
Company and the Selling Stockholders have agreed to sell to each of the
Underwriters named below, and each of such Underwriters, for whom Goldman, Sachs
& Co., BancAmerica Robertson Stephens, UBS Securities LLC and Wessels, Arnold &
Henderson, L.L.C. are acting as representatives, has severally agreed to
purchase from the Company and the Selling Stockholders, the respective number of
shares of Common Stock set forth opposite its name below:
<TABLE>
<CAPTION>
NUMBER OF
SHARES OF
COMMON
UNDERWRITER STOCK
----------- ---------
<S> <C>
Goldman, Sachs & Co. ....................................... 1,065,750
BancAmerica Robertson Stephens ............................. 369,750
UBS Securities LLC.......................................... 369,750
Wessels, Arnold & Henderson, L.L.C. ........................ 369,750
J.C. Bradford & Co. ........................................ 55,000
Donaldson, Lufkin & Jenrette Securities Corporation......... 110,000
Gerard Klauer Mattison & Co., Inc. ......................... 55,000
Interstate/Johnson Lane Corporation......................... 55,000
NationsBanc Montgomery Securities, Inc. .................... 110,000
Pacific Growth Equities, Inc................................ 55,000
Prudential Securities Incorporated.......................... 110,000
The Robinson-Humphrey Company, LLC.......................... 55,000
Sands Brothers & Co., Ltd. ................................. 55,000
SoundView Financial Group, Inc. ............................ 55,000
Wasserstein Perella Securities, Inc. ....................... 110,000
---------
Total............................................. 3,000,000
=========
</TABLE>
Under the terms and conditions of the Underwriting Agreement, the
Underwriters are committed to take and pay for all of the shares offered hereby,
if any are taken.
The Underwriters propose to offer the shares of Common Stock in part
directly to the public at the initial public offering price set forth on the
cover page of this Prospectus, and in part to certain securities dealers at such
price less a concession of $0.90 per share. The Underwriters may allow, and such
dealers may reallow, a concession not in excess of $0.10 per share to certain
brokers and dealers. After the shares of Common Stock are released for sale to
the public, the offering price and other selling terms may from time to time be
varied by the representatives.
The Company and Selling Stockholders have granted the Underwriters an
option exercisable for 30 days after the date of the Prospectus to purchase up
to an aggregate of 450,000 additional shares of Common Stock solely to cover
over-allotments, if any. If the Underwriters exercise their over-allotment
option, the Underwriters have severally agreed, subject to certain conditions,
to purchase approximately the same percentage thereof that the number of shares
to be purchased by each of them, as shown in the foregoing table, bears to the
3,000,000 shares of Common Stock offered.
The Company and the Selling Stockholders have agreed that, during the
period beginning from the date of this Prospectus and continuing to and
including the date 180 days after the date of this Prospectus, they will not
offer, sell, contract to sell or otherwise dispose of any securities of the
Company (other than pursuant to employee stock option plans existing on the date
of this Prospectus) which are substantially similar to the shares of Common
Stock or which are convertible or exchangeable into shares of Common Stock or
any securities which are substantially similar to the shares of Common Stock,
without the prior written consent of the representatives of the Underwriters.
U-1
<PAGE> 81
In connection with the Offering, the Underwriters may purchase and sell the
Common Stock in the open market. These transactions may include over-allotment
and stabilizing transactions and purchases to cover syndicate short positions
created in connection with the Offering. Stabilizing transactions consist of
certain bids or purchases for the purpose of preventing or retarding a decline
in the market price of the Common Stock; and syndicate short positions involve
the sale by the Underwriters of a greater number of shares of Common Stock than
they are required to purchase from the Company in the Offering. The Underwriters
also may impose a penalty bid, whereby selling concessions allowed to syndicate
members or other broker-dealers in respect of the securities sold in the
Offering for their account may be reclaimed by the syndicate if such shares of
Common Stock are repurchased by the syndicate in stabilizing or covering
transactions. These activities may stabilize, maintain or otherwise affect the
market price of the Common Stock which may be higher than the price that might
otherwise prevail in the open market; and these activities, if commenced, may be
discontinued at any time. These transactions may be effected on the Nasdaq
National Market, in the over-the-counter market or otherwise.
The representatives of the Underwriters have informed the Company that they
do not expect sales to accounts over which the Underwriters exercise
discretionary authority to exceed five percent of the total number of shares of
Common Stock offered by them.
Prior to this Offering, there has been no public market for the shares of
Common Stock. The initial public offering price was negotiated among the Company
and the representatives of the Underwriters. Among the factors considered in
determining the initial public offering price of the Common Stock, in addition
to prevailing market conditions, was the Company's historical performance,
estimates of the business potential and earnings prospects of the Company, an
assessment of the Company's management and the consideration of the above
factors in relation to market valuation of companies in related businesses.
Up to seven percent of the shares of Common Stock offered hereby may be
reserved for sale at the initial public offering price to the Company's
employees, directors and other individuals with direct business relationships
with the Company. The number of shares available for sale to the general public
will be reduced to the extent such persons purchase such reserved shares. Any
reserved shares not so purchased will be offered by the Underwriters to the
general public on the same basis as other shares offered hereby.
The Common Stock has been approved for quotation on the Nasdaq National
Market under the symbol "ISSX". The Company has agreed to indemnify the several
Underwriters against certain liabilities, including liabilities under the
Securities Act.
U-2
<PAGE> 82
[Graphic Depicting SAFEsuite Family & Products]
Security risks are a function of vulnerabilities and threats. The risk
originates from the whole network - including every adjoining system in its
architecture. SAFEsuite monitors, detects and responds to vulnerabilities and
threats throughout the entire enterprise.
The ISS SAFEsuite is drive by the X-Force knowledge base, a comprehensive
security risk database. With this insight, SAFEsuite is able to effectively
manage security risks by monitoring, detecting and responding to vulnerabilities
and threats across whole networks and systems.
<PAGE> 83
============================================================
NO PERSON HAS BEEN AUTHORIZED TO GIVE ANY INFORMATION OR TO MAKE ANY
REPRESENTATIONS OTHER THAN THOSE CONTAINED IN THIS PROSPECTUS, AND, IF GIVEN OR
MADE, SUCH INFORMATION OR REPRESENTATIONS MUST NOT BE RELIED UPON AS HAVING BEEN
AUTHORIZED. THIS PROSPECTUS DOES NOT CONSTITUTE AN OFFER TO SELL OR THE
SOLICITATION OF AN OFFER TO BUY ANY SECURITIES OTHER THAN THE SECURITIES TO
WHICH IT RELATES OR AN OFFER TO SELL OR THE SOLICITATION OF AN OFFER TO BUY ANY
SECURITIES OTHER THAN THE SECURITIES TO WHICH IT RELATES OR AN OFFER TO SELL OR
THE SOLICITATION OF AN OFFER TO BUY SUCH SECURITIES IN ANY CIRCUMSTANCES IN
WHICH SUCH OFFER OR SOLICITATION IS UNLAWFUL. NEITHER THE DELIVERY OF THIS
PROSPECTUS NOR ANY SALE MADE HEREUNDER SHALL, UNDER ANY CIRCUMSTANCES, CREATE
ANY IMPLICATION THAT THERE HAS BEEN NO CHANGE IN THE AFFAIRS OF THE COMPANY
SINCE THE DATE HEREOF OR THAT THE INFORMATION CONTAINED HEREIN IS CORRECT AS OF
ANY TIME SUBSEQUENT TO ITS DATE.
------------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Prospectus Summary......................... 3
Risk Factors............................... 6
Use of Proceeds............................ 16
Dividend Policy............................ 16
Dilution................................... 17
Capitalization............................. 18
Selected Consolidated Financial Data....... 19
Management's Discussion and Analysis of
Financial Condition and Results of
Operations............................... 20
Business................................... 26
Management................................. 42
Certain Transactions....................... 51
Principal and Selling Stockholders......... 53
Description of Capital Stock............... 55
Shares Eligible for Future Sale............ 59
Validity of Common Stock................... 61
Experts.................................... 61
Additional Information..................... 61
Index to Consolidated Financial
Statements............................... F-1
Underwriting............................... U-1
</TABLE>
------------------
THROUGH APRIL 17, 1998 (THE 25TH DAY AFTER THE DATE OF THIS PROSPECTUS), ALL
DEALERS EFFECTING TRANSACTIONS IN THE COMMON STOCK, WHETHER OR NOT PARTICIPATING
IN THIS DISTRIBUTION, MAY BE REQUIRED TO DELIVER A PROSPECTUS. THIS IS IN
ADDITION TO THE OBLIGATION OF DEALERS TO DELIVER A PROSPECTUS WHEN ACTING AS
UNDERWRITERS AND WITH RESPECT TO THEIR UNSOLD ALLOTMENTS OR SUBSCRIPTIONS.
============================================================
============================================================
3,000,000 SHARES
ISS GROUP, INC.
COMMON STOCK
(PAR VALUE $0.001 PER SHARE)
----------------------
[LOGO INTERNET SECURITY SYSTEMS]
----------------------
GOLDMAN, SACHS & CO.
BANCAMERICA ROBERTSON STEPHENS
UBS SECURITIES
WESSELS, ARNOLD & HENDERSON
REPRESENTATIVES OF THE UNDERWRITERS
============================================================
