<PAGE> 1
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2000
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Transition Period from __________ to ____________ .
Commission File Number: 000-27687
----------------
BSQUARE CORPORATION
(Exact name of registrant as specified in its charter)
WASHINGTON 91-1650880
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
3150 139TH AVENUE SE, SUITE 500, BELLEVUE WA 98005
(Address of principal executive offices) (Zip Code)
(425) 519-5900
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ___.
As of August 1, 2000, there were 33,539,758 shares of the registrant's
common stock outstanding.
Page 1 of 31 pages.
Exhibit Index at Page 25.
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<PAGE> 2
BSQUARE CORPORATION
FORM 10-Q
For the Quarterly Period Ended June 30, 2000
TABLE OF CONTENTS
--------------------------------------------------------------------------------
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements 3
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 8
Item 3. Quantitative and Qualitative Disclosures About Market Risk 21
PART II. OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds 22
Item 4. Submission of Matters to a Vote of Security Holders 23
Item 6. Exhibits and Reports on Form 8-K 23
</TABLE>
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
BSQUARE CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
<TABLE>
<CAPTION>
June 30, December 31,
2000 1999
--------- ------------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 56,608 $ 55,604
Short-term investments 23,165 27,368
Accounts receivable, net 6,270 4,302
Deferred income tax asset 197 1,035
Prepaid expenses and other current assets 1,072 883
--------- --------
Total current assets 87,312 89,192
Furniture, equipment and leasehold improvements, net 5,638 7,238
Intangible assets, net 19,376 --
Deposits and other assets 1,416 212
--------- --------
Total assets $ 113,742 $ 96,642
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 380 $ 654
Accrued expenses 7,838 5,733
Deferred revenue 6,046 1,130
--------- --------
Total current liabilities 14,264 7,517
--------- --------
Shareholders' equity:
Blue Water Systems, Inc. Series A Preferred
stock, no par value: authorized 500,000
shares, no shares issued outstanding as of
June 30, 2000 and 46,246 shares issued and
outstanding as of December 31, 1999 -- 250
Common stock, no par value: authorized
50,000,000 shares, 33,481,045 shares issued
and outstanding as of June 30, 2000 and
32,509,978 issued and outstanding as of
December 31, 1999 102,638 90,845
Deferred stock option compensation (550) (868)
Cumulative foreign currency translation adjustment (43) (15)
Accumulated deficit (2,567) (1,087)
--------- --------
Total shareholders' equity 99,478 89,125
--------- --------
Total liabilities and shareholders' equity $ 113,742 $ 96,642
========= ========
</TABLE>
See notes to condensed consolidated financial statements.
<PAGE> 4
BSQUARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Three Months Six Months
Ended June 30, Ended June 30,
------------------- -------------------
2000 1999 2000 1999
-------- ------- -------- -------
(unaudited)
<S> <C> <C> <C> <C>
Revenue:
Service $ 14,195 $ 9,525 $ 26,479 $18,087
Product 1,505 569 2,513 1,174
-------- ------- -------- -------
Total revenue 15,700 10,094 28,992 19,261
-------- ------- -------- -------
Cost of revenue:
Service 6,907 4,632 13,104 8,740
Product 514 62 666 139
-------- ------- -------- -------
Total cost of revenue 7,421 4,694 13,770 8,879
-------- ------- -------- -------
Gross profit 8,279 5,400 15,222 10,382
-------- ------- -------- -------
Operating expenses:
Research and development 2,201 1,659 4,245 3,301
Selling, general and administrative 4,354 2,835 7,874 5,337
Acquired in-process research and development 4,100 -- 4,100 --
Amortization of intangible assets 350 -- 350 --
Amortization of deferred stock option compensation 147 176 318 294
-------- ------- -------- -------
Total operating expenses 11,152 4,670 16,887 8,932
-------- ------- -------- -------
Income (loss) from operations (2,873) 730 (1,665) 1,450
Other income (expense), net:
Interest income, net 1,008 80 1,834 133
Acquisition related expenses -- -- (620) --
-------- ------- -------- -------
Income (loss) before income taxes (1,865) 810 (451) 1,583
Provision for income taxes 610 368 1,029 712
-------- ------- -------- -------
Net income (loss) $ (2,475) $ 442 $ (1,480) $ 871
======== ======= ======== =======
Basic earnings (loss) per share $ (0.07) $ 0.02 $ (0.05) $ 0.04
======== ======= ======== =======
Weighted average shares outstanding used to compute
basic earnings (loss) per share 33,076 18,476 32,821 18,467
======== ======= ======== =======
Diluted earnings (loss) per share $ (0.07) $ 0.02 $ (0.05) $ 0.03
======== ======= ======== =======
Weighted average shares outstanding used to compute
diluted earnings (loss) per share 33,076 29,145 32,821 28,945
======== ======= ======== =======
</TABLE>
See notes to condensed consolidated financial statements.
<PAGE> 5
BSQUARE CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Six Months Ended
June 30,
----------------------
2000 1999
-------- -------
(unaudited)
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $ (1,480) $ 871
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization 1,488 1,094
Acquired in-process research and development 4,100 --
Deferred income taxes 839 (581)
Amortization of deferred stock option compensation 318 294
Changes in operating assets and liabilities, net
of effects from acquisition:
Accounts receivable (1,682) 922
Prepaid expenses and other current assets 108 (54)
Deposits and other assets 40 (315)
Accounts payable and accrued expenses 2,491 853
Deferred revenue 4,855 482
-------- -------
Net cash provided by operating activities 11,077 3,566
-------- -------
Cash flows from investing activities:
Purchases of furniture, equipment and leasehold (597) (1,070)
improvements
Maturity of short-term investments, net 4,203 1,582
Purchase of Mainbrace Corporation, net of cash acquired (14,294) --
Purchase of an investment (1,250) --
-------- -------
Net cash (used in) provided by investing activities (11,938) 512
-------- -------
Cash flows from financing activities:
Payments on long-term obligations (6) (82)
Net proceeds from issuance of BlueWater Systems
Series A Preferred Stock 527 250
Proceeds from exercise of stock options, warrants
and employee stock purchase plan 1,366 6
Deferred financing costs -- (25)
-------- -------
Net cash provided by financing activities 1,887 149
Effect of exchange rate changes on cash -------- -------
(22) (46)
-------- -------
Net increase in cash and cash equivalents 1,004 4,181
Cash and cash equivalents, beginning of period 55,604 5,474
-------- -------
Cash and cash equivalents, end of period $ 56,608 $ 9,655
======== =======
</TABLE>
See notes to condensed consolidated financial statements.
<PAGE> 6
BSQUARE CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The condensed consolidated financial statements have been prepared by
BSQUARE Corporation (the "Company" or "BSQUARE") pursuant to the rules and
regulations of the Securities and Exchange Commission and include the accounts
of the Company. Certain information and footnote disclosures, normally included
in financial statements prepared in accordance with generally accepted
accounting principles, have been condensed or omitted pursuant to such rules and
regulations. In the opinion of the Company, the unaudited financial statements
reflect all adjustments, consisting only of normal recurring adjustments,
necessary for a fair presentation of the Company's financial position at June
30, 2000, its operating results and cash flows for the three and six-months
ended June 30, 2000 and 1999. These financial statements and the notes should be
read in conjunction with the Company's financial statements and notes thereto
contained in the Company's annual report on Form 10-K for the year ended
December 31, 1999 (File No. 000-27687) filed with the Securities and Exchange
Commission. Interim results are not necessarily indicative of results for a full
year.
2. ACQUISITIONS
BLUEWATER SYSTEMS, INC.
On January 5, 2000, the Company acquired BlueWater Systems, Inc. in a
transaction accounted for as a pooling of interests. BlueWater Systems, formerly
located in Edmonds, Washington is dedicated to the design of software
development tool kits and system integration services for the creation of
Windows-based intelligent computing devices. The transaction was effected
through the exchange of 261,391 shares of BSQUARE common stock for all of the
issued and outstanding common shares of BlueWater Systems. The consolidated
financial statements of BSQUARE have been restated for all periods prior to the
merger to include the accounts and operations of BlueWater Systems, Inc. In
connection with the acquisition, the Company incurred $620,000 ($515,000 after
taxes, or $0.02 per diluted share) of acquisition-related costs which were
charged to operations in the first quarter of 2000.
The following table presents a reconciliation of revenue and net income
previously reported by BSQUARE to those presented in the accompanying condensed
consolidated financial statements:
<TABLE>
<CAPTION>
Three Months Six Months
Ended June 30, Ended June 30,
1999 1999
-------------- --------------
(in thousands)
<S> <C> <C>
Revenue:
BSQUARE Corporation $ 9,734 $18,543
BlueWater Systems, Inc. 360 718
------- -------
Combined $10,094 $19,261
======= =======
Net income:
BSQUARE Corporation $ 434 $ 866
BlueWater Systems, Inc. 8 5
------- -------
Combined $ 442 $ 871
======= =======
</TABLE>
<PAGE> 7
MAINBRACE CORPORATION
On May 24, 2000, the Company acquired Mainbrace Corporation in a
transaction accounted for as a purchase. Mainbrace Corporation, located in
Sunnyvale, California, an intellectual property-licensing and enabling software
firm delivering products and services to high-volume market segments including
set-top boxes, Web-enabled phones, wireless thin clients and electronic book
readers. Total consideration included the issuance of 627,334 shares of BSQUARE
common stock, and approximately $10.8 million in cash. Additionally, the Company
assumed Mainbrace's outstanding vested and unvested employee stock options,
which were converted into the right to acquire approximately 173,000 shares of
the Company's common stock. The Mainbrace options assumed by the Company had a
fair market value of approximately $552,000.
A summary of the purchase price paid in connection with the acquisition
is as follows:
<TABLE>
<CAPTION>
(in thousands)
<S> <C>
Cash $10,800
Stock and stock options 9,650
Direct acquisition costs 347
Other acquisition costs 2,840
Net deferred tax liability 319
Assumed debt 900
-------
Total $24,856
=======
</TABLE>
The purchase price was allocated as follows:
<TABLE>
<CAPTION>
(in thousands)
<S> <C>
Working capital acquired $ 871
Equipment 160
Goodwill 16,885
Intangible assets 2,840
In-process research and development 4,100
-------
Total $24,856
=======
</TABLE>
The excess of consideration paid over the fair value of the net assets
acquired will be recorded as goodwill and other intangible assets, and will be
amortized over periods ranging from two to seven years.
In accordance with generally accepted accounting principles, the amount
allocated to in-process research and development, which was determined by an
independent valuation, has been recorded as a charge to expense in the second
quarter of 2000 because its technological feasibility had not been established
and it had no alternative future use at the date of acquisition.
The following table presents unaudited pro forma results of operations
as if the acquisition of Mainbrace had occurred at the beginning of each of the
periods presented. The unaudited pro forma information is not necessarily
indicative of the combined results that would have occurred had the acquisition
taken place at the beginning of the periods presented, nor is it necessarily
indicative of future results.
<TABLE>
<CAPTION>
Three Months Six Months
Ended June 30, Ended June 30,
2000 1999 2000 1999
-------- -------- -------- --------
(in thousands)
<S> <C> <C> <C> <C>
Revenue $ 16,134 $ 10,692 $ 30,779 $ 20,454
======== ======== ======== ========
Net loss (2,191) (1,620) (1,840) (914)
======== ======== ======== ========
Net loss per share (basic and diluted) $ (0.07) $ (0.09) $ (0.06) $ (0.05)
======== ======== ======== ========
</TABLE>
<PAGE> 8
3. COMPREHENSIVE INCOME (LOSS)
Components of comprehensive income (loss) consist of the following:
<TABLE>
<CAPTION>
Three Months Six Months
Ended June 30, Ended June 30,
2000 1999 2000 1999
------- ----- ------- -----
(in thousands)
<S> <C> <C> <C> <C>
Net income (loss) $(2,475) $ 442 $(1,480) $ 871
Foreign currency translation adjustment (7) (86) (28) (56)
------- ----- ------- -----
Comprehensive income (loss) $(2,482) $ 356 $(1,508) $ 815
======= ===== ======= =====
</TABLE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
From time to time, information provided by us, statements made by our
employees or information included in our filings with the Securities and
Exchange Commission may contain statements that are "forward-looking statements"
involving risks and uncertainties. In particular, statements in "Management's
Discussion and Analysis of Financial Condition and Results of Operations"
relating to our revenue, profitability, sufficiency of capital to meet working
capital and capital expenditure requirements may be forward-looking statements.
The words "expect," "anticipate," "plan," "believe," "seek," "estimate" and
similar expressions are intended to identify such forward-looking statements.
Such statements are not guarantees of future performance and involve certain
risks, uncertainties and assumptions that could cause our future results to
differ materially from those expressed in any forward-looking statements made by
or on behalf of us. Many such factors are beyond our ability to control or
predict. Readers are accordingly cautioned not to place undue reliance on
forward-looking statements. We disclaim any intent or obligation to update
publicly any forward-looking statements, whether in response to new information
or future events or otherwise. Important factors that may cause our actual
results to differ from such forward-looking statements include, but are not
limited to, the factors discussed elsewhere in this report in the section
entitled "Certain Factors That May Affect Future Results."
OVERVIEW
We are a leading provider of software solutions that enable the
development and proliferation of a wide variety of intelligent computing devices
based on the Microsoft Windows-based operating systems. Intelligent computing
devices, or ICDs, are classes of non-personal computer devices that offer
electronic connectivity. We work with semiconductor vendors and original
equipment manufacturers to provide software products and engineering services
for the development of intelligent computing devices.
We enable the rapid and low-cost deployment of intelligent computing
devices by providing a variety of software products and services for the
development, integration and deployment of Windows-powered operating systems
with industry-specific applications. We also develop software applications that
are licensed to end users to provide intelligent computing devices with
additional functionality. Our products and services are marketed and supported
on a worldwide basis through a direct sales force augmented by distributors.
To date, we have derived the majority of our revenue from the provision
of services to Microsoft, semiconductor vendors and original equipment
manufacturers. We also generate product revenue from software sales and royalty
licenses. We perform our services under both time-and-materials contracts and
fixed-fee contracts. We also receive a small portion of service revenue from the
provision of contract support services upon the purchase of our software
products. We sell our packaged software products through standard retail
channels, our direct sales force and through indirect channels, such as
resellers. In addition, we receive royalty payments from original equipment
manufacturers related to the bundling of our software on their intelligent
computing devices and,
<PAGE> 9
more recently, from the license to them of software products contained in our
intelligent computing device integration tool kits.
In January 2000, we acquired BlueWater Systems, Inc., a privately held
designer of software development tools for the creation of Windows-based
intelligent computing devices. The transaction was accounted for using the
pooling-of-interests method of accounting. All of our financial data presented
in the condensed consolidated financial statements and results of operations
have been restated to include the historical financial information of BlueWater
as if it had always been a part of BSQUARE.
On May 24, 2000, the Company acquired Mainbrace Corporation in a
transaction accounted for as a purchase. Mainbrace Corporation, located in
Sunnyvale, California, an intellectual property-licensing and enabling software
firm delivering products and services to high-volume market segments including
set-top boxes, Web-enabled phones, wireless thin clients and electronic book
readers. The financial data presented in the condensed consolidated financial
statements include the results of operations of Mainbrace Corporation beginning
on May 25, 2000.
MICROSOFT MASTER DEVELOPMENT AND LICENSE AGREEMENT
For the six months ended June 30, 2000 and 1999, approximately 70% and
85% of our revenue, respectively, was generated under our master development and
license agreement with Microsoft. We anticipate that we will continue to receive
a substantial portion of our revenue from the provision of services to
Microsoft. The master agreement, the current term of which concludes in July
2001, includes a number of project-specific work plans. We bill Microsoft on a
time-and-materials basis, although each project has a maximum dollar cap, and
recognize revenue generated under the master agreement as the services are
rendered. The master agreement and each of the individual work plans may be
modified or terminated by Microsoft at any time. While we anticipate that our
relationship with Microsoft will remain strong, we are unable to predict the
magnitude and number of future projects for Microsoft.
<PAGE> 10
RESULTS OF OPERATIONS
The following table presents certain financial data as a percentage of
total revenue for the three and six- month periods ended June 30, 2000 and 1999.
Our historical operating results are not necessarily indicative of the results
for any future period.
<TABLE>
<CAPTION>
Three Months Six Months
Ended June 30, Ended June 30,
---------------- ----------------
2000 1999 2000 1999
---- ---- ---- ----
<S> <C> <C> <C> <C>
Revenue:
Service 90% 94% 91% 94%
Product 10 6 9 6
---- --- ---- ---
Total revenue 100 100 100 100
---- --- ---- ---
Cost of revenue:
Service 44 46 45 45
Product 3 1 2 1
---- --- ---- ---
Total cost of revenue 47 47 47 46
---- --- ---- ---
Gross margin 53 53 53 54
---- --- ---- ---
Operating expenses:
Research and development 14 16 15 17
Selling, general and administrative 28 28 28 27
Acquired in process research and development 26 -- 14 --
Amortization of intangible assets 2 -- 1 --
Amortization of deferred stock option compensation 1 2 1 2
---- --- ---- ---
Total operating expenses 71 46 59 46
---- --- ---- ---
Income (loss) from operations (18) 7 (6) 8
---- --- ---- ---
Interest income (expense), net:
Interest income, net 6 1 6 --
Merger related expenses -- -- (2) --
---- --- ---- ---
Income (loss) before income taxes (12) 8 (2) 8
Provision for income taxes 4 4 3 3
---- --- ---- ---
Net income (loss) (16)% 4% (5)% 5%
==== === ==== ===
</TABLE>
REVENUE
Revenue consists of service and product revenue, which includes software
license fees and royalties. Total revenue for the quarter ended June 30, 2000
increased 56% to $15.7 million, from $10.1 million for the same period in 1999.
Total revenue for the six-month period ended June 30, 2000 increased 51% to
$29.0 million, from $19.3 million for the same period in 1999. The increase in
total revenue for 2000 over 1999 resulted from an increase in number and scope
of professional service projects as well as an increase in product revenue.
Microsoft accounted for 60% and 95% of revenue for the second quarter ended June
30, 2000 and 1999, respectively. For the six-month periods, Microsoft accounted
for 68% and 85%, of revenue for 2000 and 1999, respectively. The decrease in the
percentage of revenue derived from Microsoft decreased in 2000 over 1999 due to
the signing of silicon vendors under the Porting Partner Agreement and the
growth in services provided to non-tools customers.
Revenue outside of the U.S. totaled $2.3 million and $131,000 for the
three months ended June 30, 2000 and 1999, respectively, and totaled $3.5
million and $271,000 for the six months ended June 30, 2000 and 1999,
respectively. The increase in international revenue in 2000 over 1999 was due to
an increase in both services and products sold to international OEM customers.
<PAGE> 11
SERVICE REVENUE. For the three months ended June 30, 2000, service
revenue increased 49% to $14.2 million, from $9.5 million for the same period in
1999. Service revenue was $26.5 million for the six months ended June 30, 2000
compared to $18.1 million for the same period in 1999, a 46% increase. The
increase in 2000 over 1999 was due to a continued increase in the number and
size of consulting service projects.
PRODUCT REVENUE. Product revenue increased 164% to $1.5 million for the
three months ended June 30, 2000, from $569,000 for the same period in 1999. For
the six month period ended June 30, 2000, product revenue was $2.5 million
compared to $1.2 million for the same period in 1999, a 114% increase. The
increase in product sales was due to increases in sales of the CE Validator
quality assurance test suite, strategic alliance third-party products and
royalty income. As a percentage of total revenue, product revenue increased to
10% of revenue for the quarter ended June 30, 2000 versus 6% for the same period
last year.
COST OF REVENUE
COST OF SERVICE REVENUE. Cost of service revenue consists primarily of
salaries and benefits for software developers and quality assurance personnel,
plus an allocation of facilities and depreciation costs. Cost of service revenue
increased 49% to $6.9 million for the three months ended June 30, 2000, from
$4.6 million for the same period in 1999. For the six month period ended June
30, 2000, cost of service revenue was $13.1 million compared to $8.7 million for
the same period in 1999, a 50% increase. Cost of service revenue increased in
absolute dollars due to hiring and training of additional employees to support
an increased number of consulting projects. At June 30, 2000 and 1999, we had
approximately 284 and 209 employees, respectively, engaged in engineering
consulting. Cost of service revenue as a percentage of related service revenue
was 49% for both three-month periods ended June 30, 2000 and 1999, respectively.
For the six-month periods ended June 30, 2000 and 1999, cost of service revenue
as a percentage of related service revenue was 49% and 48%, respectively. The
increase in cost of service revenue as a percentage of the related service
revenue in 2000 was primarily the result of an increase in software engineering
compensation due to competitive employee recruiting and retention pressures in
the greater-Seattle area.
COST OF PRODUCT REVENUE. Cost of product revenue consists of license
fees and royalties for third-party software, product media, product duplication
and manuals. Cost of product revenue increased 729% to $514,000 for the three
months ended June 30, 2000, from $62,000 for the three months ended June 30,
1999. As a percent of product revenue, cost of product sales was 34% for the
three months ended June 30, 2000 and 11% for the same period in 1999. For the
six month period ended June 30, 2000, cost of product revenue was $666,000,
compared to $139,000 for the same period in 1999, a 379% increase. As a percent
of product revenue, cost of product sales was 27% for the six months ended June
30, 2000 and 12% for the same period in 1999. The increase in cost of product
sales as a percent of related product revenue relates to an increase in sales of
third-party products in 2000 over 1999.
OPERATING EXPENSES
RESEARCH AND DEVELOPMENT. Research and development expenses consist
primarily of salaries and benefits for software developers, quality assurance
personnel, and program managers, plus an allocation of our facilities and
depreciation costs. Research and development expenses increased 33% to $2.2
million for the three months ended June 30, 2000, from $1.7 million for the
three months ended June 30, 1999. For the six month period ended June 30, 2000,
research and development costs were $4.2 million, compared to $3.3 million for
the same period in 1999, a 29% increase. These increases were due to an increase
in the number of software developers and quality assurance personnel hired to
expand our product offerings and to support development and testing activities.
Research and development expenses represented 14% and 16% of our total revenue
for the three months ended June 30, 2000 and 1999, respectively. For the
six-month periods ended June 30, 2000 and 1999, research and development
represented 15% and 17%, of total revenue, respectively. The decrease in
research and development expenses as a percentage of total revenue for each of
the periods presented for 2000 over the respective periods in 1999, reflects the
more rapid increase of our revenue compared to the growth in research and
development. We anticipate that research and development expenses will continue
to increase in absolute dollars in future periods as we continue to expand our
market position.
<PAGE> 12
SELLING, GENERAL AND ADMINISTRATIVE. Selling, general and administrative
expenses increased 54% to $4.4 million for the three months ended June 30, 2000,
from $2.8 million for the same period in 1999. For the six month period ended
June 30, 2000, selling, general and administrative expenses were $7.9 million
compared to $5.3 million for the same period in 1999, a 48% increase. This
increase resulted primarily from our investment in sales and marketing
infrastructure, both domestically and internationally, which included
significant personnel-related expenses, travel expenses and related facility and
equipment costs, corporate advertising, as well as annual reporting and other
costs associated with having become a public company. Selling, general and
administrative expenses were 28% of our total revenue for each of the
three-month periods ended June 30, 2000 and 1999. For the six-month periods
ended June 30, 2000 and 1999, these expenses represented 28% and 27% of total
revenue, respectively. We anticipate that selling, general and administrative
expenses will continue to increase in absolute dollars in future periods as we
expand our sales and marketing staff both internationally and domestically.
ACQUISITION OF IN-PROCESS RESEARCH AND DEVELOPMENT AND AMORTIZATION OF
INTANGIBLE ASSETS. On May 24, 2000, we acquired Mainbrace Corporation, a leading
IP-licensing and enabling software firm delivering product solutions to high
volume market segments including set-top boxes, Web-enabled phones, wireless
thin clients, and electronic book readers. The acquisition was accounted for
using the purchase method of accounting and, accordingly, the results of
Mainbrace's operations are included in our consolidated financial statements
since the date of acquisition.
The purchase price was allocated to the fair value of the acquired
assets and assumed liabilities based on their fair market values at the date of
the acquisition. Of the total purchase price, we allocated $4.1 million to
acquired in-process research and development, $16.9 million was allocated to
goodwill and other intangible assets and $1.0 million was allocated to working
capital and tangible assets. The amount allocated to in-process research and
development was determined by an independent valuation and has been recorded as
a charge to expense because its technological feasibility had not been
established and it had no alternative future use at the date of acquisition.
Goodwill and other intangible assets will be amortized over their estimated
future lives, two to seven years. We anticipate that future amortization of
intangible assets will approximate $1.1 million per quarter.
AMORTIZATION OF DEFERRED STOCK OPTION COMPENSATION. We recorded
amortization of deferred stock option compensation of $147,000 for the three
months ended June 30, 2000 and $176,000 for the same period in 1999. For the
six-month periods ended June 30, 2000 and 1999, we recorded $318,000 and
$294,000, respectively. These charges resulted from stock option grants at
prices below the deemed fair market value of our common stock when we were a
private company. Deferred stock option compensation is amortized over the
vesting periods of the options.
OTHER INCOME (EXPENSE), NET
Interest income, net consists primarily of earnings on our cash, cash
equivalents and short-term investment balances offset by interest expense
associated with debt obligations. Interest income, net was $1.1 million for the
three months ended June 30, 2000 and $79,000 for the three months ended June 30,
1999. For the six-month periods ended June 30, 2000 and 1999, interest income,
net was $1.8 million and $133,000, respectively. The increase resulted from
higher average cash, cash equivalent and short-term investment balances in 2000
over 1999.
In January 2000, the Company acquired BlueWater Systems, Inc. in a
transaction accounted for as a pooling of interests. In connection with the
acquisition, the Company incurred $620,000 ($515,000 after taxes, or $0.01 per
diluted share) of acquisition-related costs which were charged to operations
during the three months ended June 30, 2000.
PROVISION FOR INCOME TAXES.
Our provision for federal, state and international income taxes was
$610,000 for the three months ended June 30, 2000, compared to $368,000 for the
three months ended June 30, 1999, yielding effective rates of (33)% during that
period in 2000 and 45% during that period in 1999. The provision for income
taxes was $1.0 million for the six months ended June 30, 2000 and $712,000 for
the six months ended June 30, 1999, yielding an effective rate of (229)% and
45%, respectively. The effective rate in 2000 was positively impacted by the tax
benefit of interest income earned on tax-exempt and tax-advantaged municipal
securities held in our short-term investment portfolio,
<PAGE> 13
and was negatively impacted by the non-deductibility of in-process research and
development and amortization of intangible assets. The effective tax rate in
1999 was negatively impacted by the non-deductibility of the losses generated by
international operations.
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 2000, we had $79.8 million of cash, cash equivalents and
short-term investments. This represents a decrease of $3.2 million over December
31, 1999. In October 1999, we completed an initial public offering of 4,000,000
shares of common stock and raised $54.4 million, net of offering costs. Our
working capital at June 30, 2000 was $73.0 million compared to $81.7 million at
December 31, 1999.
Our operating activities resulted in net cash inflows of $11.1 million
for the six months ended June 30, 2000 and $3.6 million for the same period in
1999. Cash provided by operating activities resulted primarily from income from
operations (excluding acquired in-process research and development and
amortization of intangible assets) and increases in deferred revenue, accounts
payable and accrued liabilities, partially offset by increases in accounts
receivable.
Investing activities used $11.9 million for the six months ended June
30, 2000, compared to providing $512,000 of cash for the six months ended June
30, 1999. Investing activities in 2000 included $14.3 million in net cash used
in connection with the acquisition of Mainbrace Corporation, $1.3 million use of
cash for the purchase of an investment and $597,000 of capital equipment
purchases. Investing activities in 1999 included $1.6 million maturity of
short-term investments and an $1.1 million in capital equipment purchases.
Financing activities generated $1.9 million for the six months ended
June 30, 2000, due to $1.4 million in proceeds from issuance of shares under the
Employee Stock Purchase Plan and stock options and the exercise of warrants by
former BlueWater Systems, Inc. Series A Preferred shareholders. Financing
activities generated $149,000 for the same period in 1999, due primarily to the
net proceeds from issuance of the BlueWater Systems Inc. Series A Preferred
stock, offset by payments on long-term obligations.
We have a working capital revolving line of credit with Imperial Bank
that is secured by our accounts receivable. This facility allows us to borrow up
to the lesser of 80% of our eligible accounts receivable or $3.0 million and
bears interest at the bank's prime rate, which was 9.5% at July 12, 2000. The
facility expires in July 2001. The agreement, under which the line of credit was
established contains certain covenants, including a provision requiring us to
maintain specified financial ratios. We were in compliance with these covenants
at June 30, 2000, and at that time there were no borrowings outstanding under
this credit facility.
As of June 30, 2000, our principal commitments consisted of obligations
outstanding under operating leases. In October 1999, we began leasing
approximately 126,000 square feet in a single facility located in Bellevue,
Washington pursuant to a lease, which expires in 2009. The annual cost of this
lease is approximately $3.0 million, subject to annual adjustments. Although we
have no other material commitments, we anticipate an increase in our capital
expenditures and lease commitments consistent with our anticipated growth in our
operations, infrastructure and personnel.
We currently anticipate that we will continue to experience significant
increases in our operating expenses for the foreseeable future as we enter new
markets for our products and services, increase research and development
activities and sales and marketing activities, develop new distribution channels
and broaden our professional service capabilities. We believe that our existing
cash and cash equivalents and available bank borrowings will be sufficient to
meet our anticipated cash needs for working capital and capital expenditures for
at least the next 12 months. We believe that we will be able to meet our
anticipated cash needs after that time from cash generated from operations and
do not currently anticipate the need to raise additional capital. If we do seek
to raise additional capital, there can be no assurance that additional financing
will be available on acceptable terms, if at all. We may use a portion of our
available cash to acquire additional businesses, products and technologies or to
establish joint ventures that we believe will complement our current or future
business. Pending such uses, we will invest our surplus cash in government
securities and other short-term, investment grade, interest-bearing instruments.
<PAGE> 14
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities." This statement requires that all derivative
instruments be recorded on the balance sheet at their fair value. Changes in the
fair value of derivatives are recorded each period in current earnings or other
comprehensive income, depending on whether a derivative is designated as a part
of a hedge transaction and, if it is, the type of hedge transaction. This
statement is effective for all fiscal quarters of all fiscal years beginning
after June 15, 2000. We do not use derivative instruments, therefore the
adoption of this statement will not have any effect on our results of operations
or financial position.
In December 1999, SEC Staff Accounting Bulletin No. 101 ("SAB 101"),
"Revenue Recognition in Financial Statements," was issued. This pronouncement
summarizes certain of the SEC staff's views in applying generally accepted
accounting principles to revenue recognition. We are required to adopt SAB 101
for the year ended December 31, 2000. We are currently reviewing the
requirements of SAB 101 and assessing its impact on our financial statements.
In March 2000, the Emerging Issues Task Force (EITF) of the FASB reached
a consensus on Issue No. 00-2, "Accounting for Web Site Development Costs" which
provides guidance on when to capitalize versus expense costs incurred to develop
a Web site. The consensus is effective for Web site development cost in quarters
beginning after June 30, 2000. We have not yet determined the impact, if any,
this issue will have on our operations.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS
In addition to the factors discussed in the "Liquidity and Capital
Resources" section of this Management's Discussion and Analysis of Financial
Condition and Results of Operations, the following additional factors may affect
our future results.
UNANTICIPATED FLUCTUATIONS IN OUR QUARTERLY OPERATING RESULTS DUE TO FACTORS
SUCH AS ADVERSE CHANGES IN OUR RELATIONSHIP WITH MICROSOFT OR A DECLINE IN THE
MARKET FOR WINDOWS-BASED INTELLIGENT COMPUTING DEVICES COULD CAUSE OUR STOCK
PRICE TO DECLINE SIGNIFICANTLY.
Our operating results have fluctuated in the past, and we expect that
they will continue to do so. We believe that period-to-period comparisons of our
operating results are not meaningful, and you should not rely on such
comparisons to predict our future performance. If our operating results fall
below the expectations of stock analysts and investors, the price of our common
stock may fall. Factors that may cause our quarterly operating results to
fluctuate include:
- the failure or perceived failure of Windows CE, the operating system
upon which demand for the majority of our products and services is
dependent, to achieve widespread market acceptance;
- the failure of the intelligent computing device market to develop;
- adverse changes in our relationship with Microsoft, from whom a
substantial portion of our revenue is generated and on whom we rely
to continue to develop and promote Windows CE;
- our inability to develop and market new and enhanced products and
services on a timely basis;
- unanticipated delays, or announcement of delays, by Microsoft of
Windows product releases, which could cause us to delay our product
introductions and adversely affect our customer relationships;
- changes in demand for our products and services;
- increased competition and changes in our pricing as a result of
increased competitive pressure;
- our ability to control our expenses, a large portion of which are
relatively fixed and which are budgeted based on anticipated revenue
trends, in the event that customer projects, particularly Microsoft
projects, are delayed, curtailed or discontinued;
- changes in the mix of our services and product revenue, which have
different gross margins;
- underestimates by us of the costs to be incurred in significant
fixed-fee service projects; and
- varying customer-buying patterns which are often influenced by
year-end budgetary pressures.
<PAGE> 15
In addition, our stock price may fluctuate due to conditions unrelated
to our operating performance, including general economic conditions in the
software industry and the market for technology stocks.
THE MAJORITY OF OUR REVENUE, INCLUDING 68% OF OUR TOTAL REVENUE FOR THE SIX
MONTHS ENDED JUNE 30, 2000, IS GENERATED FROM OUR RELATIONSHIP WITH MICROSOFT,
WHICH CAN BE MODIFIED OR TERMINATED BY MICROSOFT AT ANY TIME.
For the year ended December 31, 1999 and for the six months ended June
30, 2000, approximately 84% and 68% of our revenue, respectively, was generated
under our master development and license agreement with Microsoft. The master
agreement, the current renewable term of which concludes in July 2000, includes
a number of project-specific work plans. We bill Microsoft on a
time-and-materials basis, although each project has a maximum dollar cap. We
expect the revenue generated from work plans with Microsoft will continue to
comprise the majority of our revenue for the next several years. We presently
have dedicated approximately 160 of our 370 engineers to these projects.
However, the master agreement and each of the individual work plans may be
terminated or modified by Microsoft at any time. In addition, there is no
guarantee that Microsoft will continue to enter into additional work plans with
us. In the past, Microsoft has modified the timing and scope of certain
projects, requesting that our engineers be moved from one project to another.
For example, in late 1997 Microsoft decided to contract with us to provide
Windows CE support services to semiconductor vendors with whom we had previously
contracted directly. As a result, from late 1997 through late 1998 our revenue
shifted from being generated by a variety of semiconductor vendors to being
generated primarily by Microsoft. We do not believe that we could replace the
Microsoft revenue in the short- or medium-term if existing work plans were
canceled or curtailed, and such cancellations or curtailments would
substantially reduce our revenue. Microsoft is a publicly traded company that
files financial reports and information with the Securities and Exchange
Commission. These reports are publicly available under Microsoft's Exchange Act
filing number, 000-14278.
IF THE MARKET FOR THE WINDOWS CE OPERATING SYSTEM FAILS TO DEVELOP FULLY OR
DEVELOPS MORE SLOWLY THAN WE EXPECT, OUR BUSINESS AND OPERATING RESULTS WILL BE
MATERIALLY HARMED.
Windows CE is one of many operating systems developed for the
intelligent computing device market and the extent of its future acceptance is
uncertain. Because all of our revenue through 1999 has been generated by
software products and services dependent on the Windows CE operating system, if
the market for Windows CE fails to develop fully or develops more slowly than we
expect, our business and operating results will be significantly harmed. Market
acceptance of Windows CE will depend on many factors, including:
- Microsoft's development and support of the Windows CE market. As the
developer and primary promoter of Windows CE, if Microsoft were to
decide to discontinue or lessen its support of the Windows CE
operating system, potential customers could select competing
operating systems, which would reduce the demand for our Windows
CE-based software products and services. In addition, Microsoft has
developed a version of its Windows NT operating system for
intelligent computing devices and could decide to shift its support
to this operating system to the detriment of Windows CE;
- the ability of the Windows CE operating system to compete against
existing and emerging operating systems for the intelligent computing
device market including: VxWorks from WindRiver Systems Inc., pSOS
from Integrated Systems, Inc., VRTX from Mentor Graphics Corporation,
JavaOS from Sun Microsystems, Inc. and LINUX. In particular, in the
market for palm-size devices, Windows CE faces intense competition
from PalmOS used on 3Com Corporation's Palm devices and to date has
had limited success in this market. In the market for cellular
phones, Windows CE faces intense competition from the EPOC operating
system from Symbian, a joint venture between several of the largest
manufacturers of cellular phones, which recently announced it has
agreed to discuss cross-licensing its technology with the Palm
Computing unit of 3Com. Windows CE may be unsuccessful in capturing a
significant share of these two segments of the intelligent computing
device market, or in maintaining its market share in those other
segments of the intelligent computing device market on which our
business currently focuses, including the markets for
Internet-enabled television set-top boxes, handheld industrial
devices, consumer Internet appliances such as kiosk terminals and
vehicle navigational devices, and Windows-based terminals;
- the acceptance by original equipment manufacturers and consumers of
the mix of features and functions offered by Windows CE; and
<PAGE> 16
- the willingness of software developers to continue to develop and
expand the applications that run on Windows CE. To the extent that
software developers write applications for competing operating
systems that are more attractive to intelligent computing device end
users than those available on Windows CE, potential purchasers could
select competing operating systems over Windows CE.
IF THE MARKET FOR INTELLIGENT COMPUTING DEVICES FAILS TO DEVELOP FULLY OR
DEVELOPS MORE SLOWLY THAN WE EXPECT, OUR REVENUE WILL NOT GROW AS FAST AS
ANTICIPATED, IF AT ALL.
The market for intelligent computing devices is emerging and the
potential size of this market and the timing of its development are not known.
As a result, our profit potential is uncertain and our revenue may not grow as
fast as we anticipate, if at all. We are dependent upon the broad acceptance by
businesses and consumers of a wide variety of Windows CE-based intelligent
computing devices, which will depend on many factors, including:
- the development of content and applications for intelligent computing
devices;
- the willingness of large numbers of businesses and consumers to use
devices such as handheld and palm-size PCs and handheld industrial
data collectors to perform functions currently carried out manually
or by traditional PCs, including inputting and sharing data,
communicating among users and connecting to the Internet; and
- the evolution of industry standards that facilitate the distribution
of content over the Internet to these devices via wired and wireless
telecommunications systems, satellite or cable.
IF MICROSOFT ADDS FEATURES TO ITS WINDOWS OPERATING SYSTEM THAT DIRECTLY COMPETE
WITH SOFTWARE PRODUCTS AND SERVICES WE PROVIDE, OUR REVENUE COULD BE REDUCED AND
OUR PROFIT MARGINS COULD SUFFER.
As the developer of Windows, Microsoft could add features to its
operating system that directly compete with the software products and services
we provide to our customers. Such features could include, for example, faxing,
hardware-support packages and quality-assurance tools. The ability of our
customers or potential customers to obtain software products and services
directly from Microsoft that compete with our software products and services
could harm our business. Even if the standard features of future Microsoft
operating system software were more limited than our offerings, a significant
number of our customers and potential customers might elect to accept more
limited functionality in lieu of purchasing additional software. Moreover, the
resulting competitive pressures could lead to price reductions for our products
and reduce our profit margins.
IF WE DO NOT MAINTAIN OUR FAVORABLE RELATIONSHIP WITH MICROSOFT, WE WILL HAVE
DIFFICULTY MARKETING OUR SOFTWARE PRODUCTS AND SERVICES AND MAY NOT RECEIVE
DEVELOPER RELEASES OF WINDOWS CE, AND OUR REVENUE AND OPERATING MARGINS WILL
SUFFER.
In the event that our relationship with Microsoft were to deteriorate,
then our efforts to market and sell our software products and services to
original equipment manufacturers could be adversely affected and our business
would be harmed. Microsoft has great influence over the development plans and
buying decisions of original equipment manufacturers utilizing Windows CE for
intelligent computing devices. Microsoft refers many of our original equipment
manufacturer customers to us. Moreover, Microsoft controls the marketing
campaigns related to its operating systems, including Windows CE. Microsoft's
marketing activities, including trade shows, direct mail campaigns and print
advertising, are important to the continued promotion and market acceptance of
Windows CE and, consequently, of our Windows CE-based software products and
services. We must maintain mutually successful relationships with Microsoft so
that we may continue to participate in joint marketing activities with
Microsoft, including participating in "partner pavilions" at trade shows and
listing our services on Microsoft's website, and to receive referrals from
Microsoft. In the event that we are unable to continue our joint marketing
efforts with Microsoft or fail to receive referrals from Microsoft, we would be
required to devote significant additional resources and incur additional
expenses to market our software products and services directly to potential
customers. In addition, we depend on receiving from Microsoft developer releases
of new versions of and upgrades to Windows CE and related Microsoft software in
order to timely develop and ship our products and provide services. If we are
unable to receive these developer releases, our revenue and operating margins
would suffer.
<PAGE> 17
UNANTICIPATED DELAYS, OR ANNOUNCEMENT OF DELAYS, BY MICROSOFT OF WINDOWS CE
PRODUCT RELEASES COULD ADVERSELY AFFECT OUR SALES.
Unanticipated delays, or announcement of delays, in Microsoft's delivery
schedule for new versions of its Windows CE operating system could cause us to
delay our product introductions and impede our ability to complete customer
projects on a timely basis. These delays or announcements by Microsoft could
also cause our customers to delay or cancel their project development activities
or product introductions. Any resulting delays in, or cancellations of, our
planned product introductions or in our ability to commence or complete customer
projects may adversely affect our revenue and could cause our quarterly
operating results to fluctuate. For example, in 1998 Microsoft delayed the
release of a version of its Windows CE Platform Builder, which delayed our
introduction of a complementary product for an original equipment manufacturer
customer.
OUR MARKET IS BECOMING INCREASINGLY COMPETITIVE, WHICH MAY RESULT IN PRICE
REDUCTIONS, LOWER GROSS MARGINS AND LOSS OF MARKET SHARE.
The market for Windows CE-based software products and services is
becoming increasingly competitive. In addition, competition is intense for the
business of the limited number of original equipment manufacturer customers that
are capable of building and shipping large quantities of intelligent computing
devices. Increased competition may result in price reductions, lower gross
margins and loss of market share, which would harm our business. We face
competition from:
- our current and potential customers' internal research and
development departments that may seek to develop their own
proprietary solutions;
- large professional engineering services firms;
- established intelligent computing device software and tools;
- small- and medium-size engineering services; and
- software and component distributors.
As we develop new products, particularly products focused on specific
industries, we may begin competing with companies with whom we have not
previously competed. It is also possible that new competitors will enter the
market or that our competitors will form alliances, including alliances with
Microsoft, that may enable them to rapidly increase their market share.
Microsoft has not agreed to any exclusive arrangement with us nor has it agreed
not to compete with us. The barrier to entering the market as a provider of
Windows-based intelligent computing device software and services is low. In
addition, Microsoft has created a marketing program to encourage systems
integrators to work on Windows. These systems integrators are given the same
access by Microsoft to the Windows technology as we are, with respect to system
integration. New competitors may have lower overhead than us and may therefore
be able to offer advantageous pricing. We expect that competition will increase
as other established and emerging companies enter the Windows based intelligent
computing device market and as new products and technologies are introduced.
IF WE FAIL TO ADEQUATELY PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, COMPETITORS
MAY BE ABLE TO USE OUR TECHNOLOGY OR TRADEMARKS, WHICH COULD WEAKEN OUR
COMPETITIVE POSITION, REDUCE OUR REVENUE AND INCREASE OUR COSTS.
If we fail to adequately protect our intellectual property, our
competitive position could be weakened and our revenue adversely affected. We
rely primarily on a combination of patent, copyright, trade secret and trademark
laws, confidentiality procedures and contractual provisions to protect our
intellectual property. These laws and procedures provide only limited
protection. We have applied for three patents relating to our engineering work.
These patents, if issued, may not provide sufficiently broad protection or they
may not prove to be enforceable against alleged infringers. There can be no
assurance that any of our pending patents will be granted. Even if granted,
patents may be circumvented or challenged and, if challenged, may be
invalidated. Any patents obtained may provide limited or no competitive
advantage to us. It is also possible that another party could obtain patents
that block our use of some, or all, of our products and services. If that
occurred, we would need to obtain a license from the patent holder or design
around their patent. The patent holder may or may not choose to make a license
available to us at all or on acceptable terms. Similarly, it may not be possible
to design around such a blocking patent.
<PAGE> 18
In general, there can be no assurance that our efforts to protect our
intellectual property rights through patent, copyright, trade secret and
trademark laws will be effective to prevent misappropriation of our technology,
or to prevent the development and design by others of products or technologies
similar to or competitive with those developed by us. We frequently license the
source code of our products and the source code results of our services to
customers. There can be no assurance that customers with access to our source
code will comply with the license terms or that we will discover any violations
of the license terms or, in the event of discovery of violations, that we will
be able to successfully enforce the license terms and/or recover the economic
value lost from such violations. To license many of our software products, we
rely in part on "shrinkwrap" and "clickwrap" licenses that are not signed by the
end user and, therefore, may be unenforceable under the laws of certain
jurisdictions. As with other software products, our products are susceptible to
unauthorized copying and uses that may go undetected, and policing such
unauthorized use is difficult.
A significant portion of our marks include the word "BSQUARE" or the
preface "b." Other companies use forms of "BSQUARE" or the preface "b" in their
marks alone or in combination with other words, and we cannot prevent all such
third-party uses. We license certain trademark rights to third parties. Such
licensees may not abide by compliance and quality control guidelines with
respect to such trademark rights and may take actions that would harm our
business.
The computer software market is characterized by frequent and
substantial intellectual property litigation, which is often complex and
expensive, and involves a significant diversion of resources and uncertainty of
outcome. Litigation may be necessary in the future to enforce our intellectual
property or to defend against a claim of infringement or invalidity. Litigation
could result in substantial costs and the diversion of resources and could harm
our business and operating results.
THIRD PARTIES COULD ASSERT THAT OUR SOFTWARE PRODUCTS AND SERVICES INFRINGE
THEIR INTELLECTUAL PROPERTY RIGHTS, WHICH COULD EXPOSE US TO ADDITIONAL COSTS
AND LITIGATION.
Third parties may claim that our current or future software products and
services infringe their proprietary rights, and these claims, regardless of
their merit, could increase our costs and harm our business. We have not
conducted patent searches to determine whether the technology used in our
products infringes patents held by third parties. In addition, it is difficult
to determine whether our software products and services infringe third-party
intellectual property rights, particularly in a rapidly evolving technological
environment in which there may be numerous patent applications pending, many of
which are confidential when filed, with regard to similar technologies. If we
were to discover that one of our software products violated a third party's
proprietary rights, we may not be able to obtain a license on commercially
reasonable terms, or at all, to continue offering that software product.
Moreover, any indemnification we obtain against claims that the technology we
license from third parties infringes the proprietary rights of others may not
always be available or may be limited in scope or amount. Even if we receive
broad third-party indemnification, these indemnitors may not have the financial
capability to indemnify us in the event of infringement. In addition, in some
circumstances we could be required to indemnify our customers for claims made
against them that are based on our solutions.
There can be no assurance that infringement or invalidity claims related
to the software products and services we provide or arising from the
incorporation by us of third-party technology, and claims for indemnification
from our customers resulting from such claims, will not be asserted or
prosecuted against us. We expect that software product developers will be
increasingly subject to infringement claims, as the number of products and
competitors in the software industry grows and the functionality of products in
different industry segments overlaps. Such claims, even if not meritorious,
could result in the expenditure of significant financial and managerial
resources in addition to potential product redevelopment costs and delays.
IF WE DO NOT RESPOND ON A TIMELY BASIS TO TECHNOLOGICAL ADVANCES AND EVOLVING
INDUSTRY STANDARDS, OUR FUTURE PRODUCT SALES COULD BE NEGATIVELY IMPACTED.
The market for Windows-based software products and services is new and
evolving. As a result, the life cycles of our products are difficult to
estimate. To be successful, we must continue to enhance our current product line
and develop new products. We have experienced delays in enhancements and new
product release dates in the past and may be unable to introduce enhancements or
new products successfully or in a timely manner in the future.
<PAGE> 19
Our business may be harmed if we must delay releases of our products and product
enhancements or if these products and product enhancements fail to achieve
market acceptance when released. In addition, our customers may defer or forego
purchases of our products if we, Microsoft, our competitors or major hardware,
systems or software vendors introduce or announce new products or product
enhancements. Such deferrals or failures to purchase would decrease our revenue.
OUR SIX-YEAR OPERATING HISTORY MAKES IT DIFFICULT TO EVALUATE OUR FUTURE
PROSPECTS, AND WE CANNOT ASSURE YOU THAT OUR REVENUE GROWTH RATE WILL NOT
DECLINE OR THAT WE WILL BE ABLE TO SUSTAIN OR INCREASE OUR PROFITABILITY.
We were founded in July 1994, generated our first revenue in October
1994 and shipped our first product in November 1996. Accordingly, we have a
limited operating history and you should not rely on our past results to predict
our future performance. The rate of growth of our revenue over the prior year
was 245% from 1996 to 1997, 71% from 1997 to 1998, and 62% from 1998 to 1999.
The rate of growth of our revenue over prior periods may continue to decline. We
anticipate that our expenses will increase substantially in the foreseeable
future as we continue to develop our technology and expand our product and
service offerings. These efforts may prove more expensive than we currently
anticipate, and we may not succeed in increasing our revenue sufficiently to
offset these higher expenses. If we fail to increase our revenue to keep pace
with our expenses, we may experience losses.
IF WE ARE UNABLE TO MANAGE OUR GROWTH OUR BUSINESS WILL SUFFER.
Our rapid growth has placed, and is expected to continue to place, a
significant strain on our managerial, technical, operational and financial
resources. From August 1996 to June 2000, we grew from 21 employees to 459
employees, and we expect rapid growth to continue for the foreseeable future. To
manage our growth, we must implement additional management information systems,
further develop our operational, administrative and financial systems and
expand, train and manage our work force. We will also need to manage an
increasing number of complex relationships with customers, marketing partners
and other third parties. We cannot guarantee that our systems, procedures or
controls will be adequate to support our current or future operations or that
our management will be able to effectively manage our expansion. Our failure to
do so could seriously harm our ability to deliver products and services in a
timely fashion, fulfill existing customer commitments and attract and retain new
customers.
OUR INTERNATIONAL OPERATIONS EXPOSE US TO GREATER INTELLECTUAL PROPERTY,
MANAGEMENT, COLLECTIONS, REGULATORY AND OTHER RISKS.
In late 1998 we opened offices in Munich, Germany and Tokyo, Japan. For
the year ended December 31, 1999 and for the six months ended June 30, 2000,
less than 1% of our total revenue was generated by our international offices.
Our international operations expose us to a number of risks, including the
following:
- greater difficulty in protecting intellectual property due to less
stringent foreign intellectual property laws and enforcement
policies;
- greater difficulty in managing foreign operations due to the lack of
proximity between our home office and our foreign operations;
- longer collection cycles in Japan than we typically experience in the
U.S.;
- unfavorable changes in regulatory practices and tariffs;
- adverse changes in tax laws;
- seasonal European sales declines in the summer months;
- the impact of fluctuating exchange rates between the U.S. dollar and
foreign currencies; and
- general economic and political conditions in Asian and European
markets.
These risks could have a material adverse effect on the financial and
managerial resources required to operate our foreign offices, as well as on our
future international revenue, which could harm our business.
IF WE CONDUCT FUTURE ACQUISITIONS, THEY COULD PROVE DIFFICULT TO INTEGRATE,
DISRUPT OUR BUSINESS, DILUTE SHAREHOLDER VALUE AND ADVERSELY AFFECT OUR
OPERATING RESULTS.
<PAGE> 20
We may make investments in complementary companies, services and
technologies in the future. If we fail to properly evaluate and execute
acquisitions and investments, they may seriously harm our business and
prospects. To successfully complete an acquisition, we must properly evaluate
the technology, accurately forecast the financial impact of the transaction,
including accounting charges and transaction expenses, integrate and retain
personnel, combine potentially different corporate cultures and effectively
integrate products and research and development, sales, marketing and support
operations. If we fail to do any of these, we may suffer losses or our
management may be distracted from our day-to-day operations. In addition, if we
conduct acquisitions using debt or equity securities, existing shareholders may
be diluted, which could affect the market price of our stock.
IF WE ARE UNABLE TO LICENSE KEY SOFTWARE FROM THIRD PARTIES OUR BUSINESS COULD
BE HARMED.
We often integrate third-party software with our internally developed
software to provide software products and services for our original equipment
manufacturer customers. If our relationships with our third-party vendors were
to deteriorate, we might be unable to obtain licenses on commercially reasonable
terms, if at all, for newer versions of their software required to maintain
compatibility. In the event that we are unable to obtain additional licenses, we
would be required to develop this technology internally, which could delay or
limit our ability to introduce enhancements or new products or to continue to
sell existing products.
OUR SOFTWARE PRODUCTS OR THE THIRD-PARTY HARDWARE OR SOFTWARE INTEGRATED WITH
OUR SOFTWARE PRODUCTS AND SERVICES MAY SUFFER FROM DEFECTS OR ERRORS THAT COULD
IMPAIR OUR ABILITY TO SELL OUR SOFTWARE PRODUCTS AND SERVICES.
Software and hardware components as complex as those needed for
intelligent computing devices frequently contain errors or defects, especially
when first introduced or when new versions are released. We have had to delay
commercial release of certain versions of our software products until software
problems were corrected, and in some cases have provided product enhancements to
correct errors in released products. Some of our contracts require us to repair
or replace products that fail to work. To the extent that we repair or replace
products our expenses may increase, resulting in a decline in our gross margins.
In addition, it is possible that by the time defects are fixed the market
opportunity may have been missed which may result in lost revenue. Moreover,
errors that are discovered after commercial release could result in loss of
revenue or delay in market acceptance, diversion of development resources,
damage to our reputation or increased service and warranty costs, all of which
could harm our business.
WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS THAT COULD RESULT IN SIGNIFICANT
COSTS.
Our license agreements with our customers typically contain provisions
designed to limit our exposure to potential product liability claims. It is
possible, however, that these provisions may be ineffective under the laws of
certain jurisdictions. Although we have not experienced any product liability
claims to date, the sale and support of our software products and services
entail the risk of such claims and we may be subject to such claims in the
future. A product liability claim brought against us, whether successful or not,
could harm our business and operating results.
THE LENGTHY SALES CYCLE OF OUR PRODUCTS AND SERVICES MAKES OUR REVENUE
SUSCEPTIBLE TO FLUCTUATIONS.
Our sales cycle is typically three to six months because the expense and
complexity of our products and services generally require a lengthy customer
approval process, and may be subject to a number of significant risks over which
we have little or no control, including:
- customers' budgetary constraints and internal acceptance review
procedures;
- the timing of budget cycles; and
- the timing of customers' competitive evaluation processes.
In addition, to successfully sell our products and services, we
frequently must educate our potential customers about the full benefits of our
products and services, which can require significant time. If our sales cycle
lengthens unexpectedly, it could adversely affect the timing of our revenue
which could cause our quarterly results to fluctuate.
<PAGE> 21
A SMALL NUMBER OF OUR EXISTING SHAREHOLDERS CAN EXERT CONTROL OVER US.
Our executive officers, directors and principal shareholders holding
more than 5% of our common stock together control a majority of our outstanding
common stock. As a result, these shareholders, if they act together, could
control our management and affairs of the company and all matters requiring
shareholder approval, including the election of directors and approval of
significant corporate transactions. This concentration of ownership may have the
effect of delaying or preventing a change in control of us and might affect the
market price of our common stock.
IT MIGHT BE DIFFICULT FOR A THIRD PARTY TO ACQUIRE US EVEN IF DOING SO WOULD BE
BENEFICIAL TO OUR SHAREHOLDERS.
Certain provisions of our amended and restated articles of
incorporation, bylaws and Washington law may discourage, delay or prevent a
change in the control of us or a change in our management even if doing so would
be beneficial to our shareholders. Our board of directors has the authority
under our amended and restated articles of incorporation to issue preferred
stock with rights superior to the rights of the holders of common stock. As a
result, preferred stock could be issued quickly and easily with terms calculated
to delay or prevent a change in control of our company or make removal of our
management more difficult. In addition, as of this year's annual meeting of
shareholders, our board of directors was divided into three classes. The
directors in each class will serve for three-year terms, one class being elected
each year by our shareholders. This system of electing and removing directors
may tend to discourage a third party from making a tender offer or otherwise
attempting to obtain control of our company because it generally makes it more
difficult for shareholders to replace a majority of our directors.
In addition, Chapter 19 of the Washington Business Corporation Act
generally prohibits a "target corporation" from engaging in certain significant
business transactions with a defined "acquiring person" for a period of five
years after the acquisition, unless the transaction or acquisition of shares is
approved by a majority of the members of the target corporation's board of
directors prior to the time of acquisition. This provision may have the effect
of delaying, deterring or preventing a change in control of our company. The
existence of these antitakeover provisions could limit the price that investors
might be willing to pay in the future for shares of our common stock.
IMPACT OF THE YEAR 2000
We have not experienced any adverse impacts from the transition to the
year 2000. We are also not aware of any material year 2000 problems with our
vendors, service providers, customers or distribution partners. Accordingly, we
do not anticipate incurring material expenses or experiencing any material
operational disruptions as a result of any year 2000 issues that may arise.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Interest Rate Risk. We do not hold derivative financial instruments or
equity securities in our investment portfolio. Our cash equivalents consist of
high-quality securities, as specified in our investment policy guidelines. The
policy limits the amount of credit exposure to any one issue or issuer to a
maximum of 20% of the total portfolio with the exception of treasury securities,
commercial paper and money market funds, which are exempt from size limitation.
The policy limits all short-term investments to mature in two years or less,
with the average maturity being one year or less. These securities are subject
to interest rate risk and will decrease in value if interest rates increase.
Foreign Currency Risk. Currently, the majority of our sales and expenses
are denominated in U.S. dollars, and, as a result, we have not experienced
significant foreign exchange gains and losses to date. While we have conducted
some transactions in foreign currencies during the three months ended June 30,
2000 and expect to continue to do so, we do not anticipate that foreign exchange
gains or losses will be significant. We have not engaged in foreign currency
hedging to date, although we may do so in the future.
Investment Risk. The Company has an investment in voting capital stock
of a privately-held, technology company for business and strategic purposes.
This investment is included in other assets and is accounted for under the cost
method since ownership is less than 20% and the Company does not have
significant influence. The
<PAGE> 22
securities do not have a quoted market price. The Company's policy is to
regularly review the operating performance in assessing the carrying value of
the investment.
The Company reviews its long-lived assets, including goodwill, for
impairment whenever events or changes in circumstances indicate that the
carrying amount of an asset may not be recoverable.
PART II. OTHER INFORMATION
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
(c) Since April 1, 2000, the Company has issued unregistered securities as
follows:
On May 25, 2000, the Company issued 627,334 shares of its common stock
in connection with the acquisition of Mainbrace Corporation. The issuance was
exempt from registration pursuant to Section 4(2) of the Securities Act.
(d) Our registration statement (No. 333-85351) under the Securities Act of 1933,
as amended, for our initial public offering of common stock became effective on
October 19, 1999. Offering proceeds to the Company, net of aggregate expenses of
approximately $5.6 million, were approximately $54.4 million. From the time of
receipt through June 30, 2000, the proceeds were applied as follows:
- $315,000 was applied to repay long term debt obligations.
- $5 million was allocated towards leasehold improvements associated
with our principal administrative, sales, marketing, support and
research and development facilities.
- $14.3 million was used in the acquisition of Mainbrace Corporation.
The remaining proceeds are being held as cash, cash equivalents and
short-term investments.
The terms of our current credit facility prohibit us from paying
dividends without our lender's consent.
<PAGE> 23
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
On May 2, 2000, the following items were voted on at the Annual Meeting
of Shareholders:
PROPOSAL 1: Election of Directors. Two Class I directors are to be elected at
the Annual Meeting for a one-year term ending in 2001. Two Class II directors
are to be elected at the Annual Meeting for a two-year term ending in 2002. Two
Class III directors are to be elected for a three-year term ending in 2003. The
Board of Directors has nominated Scot E. Land and William L. Larson for election
as Class I directors. The Board has nominated Albert T. Dosser and Jeffrey T.
Chambers for election as Class II directors. The Board of Directors has
nominated William T. Baxter and David M. Moore for election as Class III
directors. The following nominees were elected as directors, each to hold office
until his successor is elected and qualified, by the vote set forth below:
<TABLE>
<CAPTION>
NOMINEE FOR WITHHELD
------- ---------- --------
<S> <C> <C>
William T. Baxter 26,650,980 31,838
Albert T. Dosser 25,650,880 31,938
Scot. E. Land 25,650,665 32,153
David M. Moore 25,649,880 32,938
Jeffrey T. Chambers 25,650,365 32,453
William L. Larson 25,650,080 32,738
</TABLE>
PROPOSAL 2: Ratify and approve an amendment to the stock option plan to annual
increase the number of shares reserved for issuance during each of the Company's
fiscal years beginning on January 1, 2000 by an amount equal to the lesser of
(A) four percent (4%) of the Company's outstanding shares at the end of such
fiscal year or (B) an amount determined by the Board of Directors. This proposal
was approved by the vote set forth below:
FOR AGAINST ABSTAIN
--- ------- -------
24,005,650 1,660,572 16,596
PROPOSAL 3: Approve an amendment to the Company's Amended and Restated Articles
of Incorporation to increase the number of authorized shares of Common Stock
from 50,000,000 shares to 150,000,000 shares. This proposal was approved by the
vote set forth below:
FOR AGAINST ABSTAIN
--- ------- -------
24,006,998 1,666,107 9,713
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits
3.1 Amended and Restated Articles of Incorporation
11.1 Statement re: computation of net income per share
27.1 Financial Data Schedule
(b) Reports on Form 8-K
On May 23, 2000, the Company filed a Form 8-K under Item 5 announcing
that the Company entered into a definitive agreement to acquire Mainbrace
Corporation, a California corporation, pursuant to an Agreement and Plan of
Merger dated as of May 10, 2000.
On June 7, 2000, the Company filed a Form 8-K/A under Item 2, amending
the form 8-K filed on May 23, 2000, to announce that on May 24, 2000 the Company
completed its acquisition of Mainbrace Corporation
On July 19, 2000, the Company filed a report on Form 8-K/A pursuant to
Item 7, amending the Form 8-K filed on May 23, 2000 to include financial
statements and pro forma financial information in connection with its
acquisition of Mainbrace Corporation.
<PAGE> 24
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
BSQUARE CORPORATION
(Registrant)
Brian V. Turner
--------------------------------------------
Date: August 7, 2000 Brian V. Turner
Senior Vice President of Operations,
Chief Financial Officer and Secretary
(Principal Financial and Accounting Officer)
<PAGE> 25
BSQUARE CORPORATION
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER
(REFERENCED TO
ITEM 601 OF EXHIBIT
REGULATION S-K) DESCRIPTION
--------------- -----------
<S> <C>
3.1 Amended and Restated Articles of Incorporation.
11.1 Statement re: computation of net income per share.
27.1 Financial Data Schedule.
</TABLE>
