<PAGE>
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 March 31, 1999
--------------
[_] 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 0-25331
CRITICAL PATH, INC.
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(Exact name of registrant as specified in its charter)
California 91-1788300
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
320 First Street, San Francisco, California 94105
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(Address of principal executive offices) (Zip code)
415-808-8800
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(Registrant's telephone number, including area code)
Not Applicable
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(Former name, former address and former fiscal year,
if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. [_] Yes [X] No
Indicate the number of shares outstanding of each of the issuer's classes of
stock, as of the latest practicable date:
As of March 31, 1999, the Company had outstanding 34,308,817 shares of Common
Stock, $ 0.001 par value per share.
<PAGE>
CRITICAL PATH, INC.
INDEX
<TABLE>
<CAPTION>
Page
----
Part I. Financial Information
Item 1. Financial Statements (Unaudited)
<S> <C>
Consolidated balance sheet: March 31, 1999 and December 31, 1998 2
Consolidated statements of operation: Three months ended
March 31, 1999 and 1998 3
Consolidated statements of cash flow: Three months ended
March 31, 1999 and 1998 4
Notes to consolidated financial statements: March 31, 1999 5-8
Item 2. Management's discussion and analysis of financial condition and results
of operations 9-31
Item 3. Quantitative and Qualitative Disclosures About Market Risk 31
Part II. Other Information
Item 2. Changes in Securities and Use of Proceeds 32
Item 6. Exhibits and Reports on Form 8-K 32
Signature 33
</TABLE>
1
<PAGE>
PART 1 -- FINANCIAL INFORMATION
ITEM 1 -- FINANCIAL STATEMENTS
CRITICAL PATH, INC.
Consolidated Balance Sheet
(unaudited)
(in thousands)
<TABLE>
<CAPTION>
Mar. 31, Dec. 31,
1999 1998
---------------- -----------------
<S> <C> <C>
ASSETS
Current assets
Cash and cash equivalents $ 22,506 $ 14,791
Restricted cash 325 325
Accounts receivable, net 512 121
Prepaid expenses and other current assets 654 138
--------- --------
Total current assets 23,997 15,375
Notes receivable from officers 670 500
Furniture and equipment, net 7,794 4,687
Other assets 220 101
--------- --------
$ 32,681 $ 20,663
========= ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities
Accounts payable and accrued liabilities $ 2,350 $ 423
Accrued compensation and benefits 259 426
Deferred revenue - 500
Capital lease obligations, current 2,537 1,502
--------- --------
Total current liabilities 5,146 2,851
Capital lease obligations, long-term 4,095 2,454
--------- --------
Total liabilities 9,241 5,305
Shareholders' equity:
Series A Convertible Preferred Stock, $0.001 par value, -0- and
13,288 shares authorized, -0- and 12,725 shares
issued and outstanding - 13
Series B Convertible Preferred Stock, $0.001 par value, -0- and
10,000 shares authorized, -0- and 3,637 shares issued and outstanding - 4
Common Stock, $0.001 par value, 150,000 and 38,636 shares
Authorized, 34,309 and 8,294 shares issued and outstanding 34 8
Additional paid-in capital 306,629 46,390
Stock subscriptions receivable (100,440) -
Notes Receivable from Shareholders (1,180) (1,151)
Unearned compensation (151,474) (17,371)
Accumulated deficit (30,129) (12,535)
--------- --------
Total shareholders' equity 23,440 15,358
--------- --------
$ 32,681 $ 20,663
========= ========
</TABLE>
See accompanying notes
2
<PAGE>
CRITICAL PATH, INC.
Consolidated Statement of Operations
(unaudited)
(in thousands, except per share data)
<TABLE>
<CAPTION>
Three Months Ended
----------------------------------
March 31, March 31,
1999 1998
------------ ------------
<S> <C> <C>
Net revenues (1) $ 1,049 $ 70
Cost of net revenues (2) (2,360) (82)
------------ ------------
Gross profit (loss) (1,311) (12)
Operating expenses:
Research and development 1,379 273
Sales and marketing 1,984 135
General and administrative 1,550 307
Stock-based expenses 11,657 443
------------ ------------
Total operating expenses 16,570 1,158
Loss from operations (17,881) (1,170)
Other income (expense):
Interest and other income 351 -
Interest expense (3) (64) (150)
------------ ------------
Net loss $(17,594) $(1,320)
============ ============
Net loss per share (basic and diluted) $ (2.51) $ (0.49)
============ ============
Shares used in per share computations 7,011 2,687
============ ============
</TABLE>
(1) Includes $106 and $0 of stock-based charges in 1999 and 1998, respectively
(2) Includes $446 and $5 of stock-based charges in 1999 and 1998, respectively
(3) Includes $16 and $119 of stock-based charges in 1999 and 1998, respectively
See accompanying notes
3
<PAGE>
CRITICAL PATH, INC.
Consolidated Statement of Cash Flows
(unaudited)
(in thousands)
<TABLE>
<CAPTION>
Three Months Ended
--------------------------------
March 31, March 31,
1999 1998
---------- -----------
<S> <C> <C>
Operating activities:
Net loss $(17,594) $ (1,320)
Adjustments to reconcile net loss to net cash used in
operating activities:
Provision for doubtful accounts 24 -
Depreciation and amortization 626 41
Amortization of warrants and stock purchase rights 106 201
Amortization of unearned compensation 12,104 366
Changes in assets and liabilities:
Accounts receivable (415) (47)
Other assets (741) 2
Accounts payable 1,927 (2)
Accrued expenses (167) 3
Deferred revenue (500) -
---------- -----------
Net cash used in operating activities (4,630) (756)
---------- -----------
Cash flows from investing activities:
Notes receivable from officers (170) -
Purchases of furniture and equipment (659) (189)
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Net cash used in investing activities (829) (189)
---------- -----------
Cash flows from financing activities:
Proceeds from issuance of Convertible Preferred Stock, net 12,496 500
Proceeds from issuance of Common Stock 1,303 -
Proceeds from convertible promissory notes - 500
Principal payments on capital lease obligations (398) (20)
Purchase of treasury stock (227) -
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Net cash provided by financing activities 13,174 980
---------- -----------
Net increase in cash and cash equivalents 7,715 35
Cash and cash equivalents at beginning of period 14,791 1
---------- -----------
Cash and cash equivalents at end of period $ 22,506 $ 36
========== ===========
Supplemental cash flow disclosure:
Cash paid for interest $ 48 $ 31
Non-cash investing and financing activities
Property and equipment leases $ 3,074 $ 20
Common Stock issued for notes receivable $ 29 $ 85
</TABLE>
See accompanying notes
4
<PAGE>
CRITICAL PATH, INC.
Notes to Consolidated Financial Statements
NOTE 1 - BASIS OF PRESENTATION
The accompanying financial information is unaudited but reflects all
adjustments (consisting only of normal recurring adjustments) which are, in
the opinion of management, necessary for a fair presentation of the
consolidated financial position and results of operations for the interim
periods. The consolidated financial statements should be read in conjunction
with the consolidated financial statements and notes thereto, together with
management's discussion and analysis of financial condition and results of
operations, for the fiscal year ended December 31, 1998 as presented in the
Company's Form S-1 Registration Statement filed on March 26, 1999. The results
of operations for the three months ended March 31, 1999 are not necessarily
indicative of the results to be expected for the entire fiscal year.
Reclassifications
In the quarter ended March 31, 1999, the Company elected to disclose stock-based
expenses as a separate component of Operating Expenses. Accordingly, for the
year ended December 31, 1998, approximately $148,000, $582,000, and $1,670,000
have been reclassified from Research and Development, Sales and Marketing, and
General and Administrative expenses, respectively, to Stock-based expenses.
<PAGE>
NOTE 2 - NET LOSS PER SHARE
Net loss per share is calculated in accordance with Statement of Financial
Accounting Standards ("SFAS") No. 128, "Earnings per Share" and Securities and
Exchange Commission ("SEC") Staff Accounting Bulletin No. 98 ("SAB 98"). Under
the provisions of SFAS No. 128 and SAB 98, basic net loss per share is computed
by dividing the net loss available to common stockholders for the period by the
weighted average number of common shares outstanding during the period. Diluted
net loss per share is computed by dividing the net loss for the period by the
weighted average number of common and potential common shares outstanding during
the period if their effect is dilutive. Potential common shares comprise
restricted Common Stock and incremental common and preferred shares issuable
upon the exercise of stock options and warrants. At March 31, 1999, 16,024,637
potential common shares are excluded from the determination of diluted net loss
per share as the effect of such shares on a weighted average basis is anti-
dilutive.
6
<PAGE>
NOTE 3 - LINE OF CREDIT
At March 31, 1999, the Company maintained a line of credit with a bank that
provides for borrowings of up to $1,000,000. The line of credit expires in
November 1999 and accrues interest on outstanding borrowings at a rate equal to
the bank's prime rate plus 2%. The line of credit requires the Company to meet
certain financial tests and to comply with certain other covenants. Borrowings
are secured by substantially all of the assets of the Company. At March 31,
1999, there were no borrowings outstanding and the Company was in compliance
with all covenants.
NOTE 4 - COMMON STOCK WARRANT ISSUED FOR SERVICES
In January 1999, the Company entered into an agreement with ICQ, Inc., a
subsidiary of America Online, Inc., pursuant to which it will provide email
hosting services that will be integrated with ICQ's instant messaging service
provided to ICQ's customers. The ICQ instant messaging service is designed to
allow users to communicate in real time over the Internet. As part of the
agreement, ICQ agreed to provide sub-branded advertising for the Company in
exchange for a warrant to purchase 2,442,766 shares of Common Stock, issuable
upon attainment of each of five milestones. The following table summarizes the
shares underlying each milestone and the related exercise price:
Shares
Underlying Exercise
Warrant Price
---------- --------
Milestone 1......................................... 814,254 $4.26
Milestone 2......................................... 407,128 5.50
Milestone 3......................................... 407,128 6.60
Milestone 4......................................... 407,128 8.80
Milestone 5......................................... 407,128 11.00
----------
Totals.............................................. 2,442,766
==========
The shares underlying the first milestone were immediately vested on the
effective date of the agreement. The shares underlying the remaining milestones
vest on the dates that ICQ completes registration of the specified number of
sub-branded ICQ mailboxes applicable to each milestone. Using the Black-Scholes
option pricing model and assuming a term of seven years and expected volatility
of 90%, the initial fair value of the warrant on the effective date of the
agreement approximated $16.5 million, which is being amortized to advertising
expense using the straight-line method over four years. The shares underlying
the second through fifth milestones will be remeasured at each subsequent
reporting date until each sub-branded ICQ mailbox registration threshold is
achieved. In the event such remeasurement results in increases or decreases
from the initial fair value, which could be substantial, such increases or
decreases will be recognized immediately, in the event the fair value of the
shares underlying the milestone has been previously recognized, or over the
remaining term.
At March 31, 1999, none of the registration milestones specified within the
ICQ warrant agreement had been achieved. Therefore, the shares underlying the
second through fifth milestones of the ICQ warrant were remeasured using the
closing price for our common stock on March 31, 1999 of $77 per share. This
remeasurement resulted in an increase to the fair value of the warrant of
$109.4 million, bringing the total fair value of the warrant to $125.9 million
as of March 31, 1999. This revised fair value will be amortized ratably over
four years, resulting in a quarterly amortization charge to advertising expense
in the amount of $7.9 million beginning in the first quarter of 1999. As noted,
this charge is subject to substantial increase or decrease in future quarters
based upon future changes in the trading price of our common stock.
7
<PAGE>
NOTE 5 - INITIAL PUBLIC OFFERING
On March 29, 1999, the Company completed its initial public offering of
5,175,000 shares of Common Stock (including the exercise of the underwriters
overallotment option) and realized net proceeds of $115.5 million.
8
<PAGE>
ITEM 2 -- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
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1995
- ----
The following discussion should be read in conjunction with the Consolidated
Financial Statements and Notes thereto appearing elsewhere in this report. The
following discussion contains forward-looking statements. Critical Path's
actual results may differ significantly from those projected in the forward-
looking statements. Factors that might cause future results to differ
materially from those projected in the forward-looking statements include, but
are not limited to, future enhancements of our service offering, potential
expansion of our employee base and operating assets, development of new
strategic relationships, opening of new data centers and sales offices,
additional investments in technology, and those discussed in "Factors
Affecting Future Operating Results" and elsewhere in this report.
Overview
Critical Path was founded in February 1997 to deliver email hosting solutions to
Internet service providers, web hosting companies, web portals and corporations.
From its inception to October 1997, Critical Path's operating activities related
primarily to the planning and development of our proprietary technological
solution, recruitment of personnel, raising of capital and purchase of operating
assets. Critical Path initiated its email hosting service in October 1997. We
have since continued to make investments to improve the quality of our service.
In December 1997, we enhanced our initial service offering, a hosting service
based on Post Office Protocol 3, with the addition of a web mail interface. Post
Office Protocol 3 is a standard protocol for receiving email commonly referred
to "POP3". In January 1999, we enhanced service with the addition of an offering
based on the Lightweight Directory Access Protocol, or LDAP, a directory
software protocol. In early 1999, we intend to further enhance our service
offering with the inclusion of IMAP4. IMAP4 is a new hosting service based on
the Internet Message Access Protocol, a standard protocol for accessing and
storing email from a user's server. At March 31, 1999, Critical Path had
approximately 250 customers.
We derive substantially all of our revenues through the sale of email hosting
services. Our service revenues are derived primarily from contractual
relationships which provide for revenues on a per mailbox basis. These contracts
are typically one to three years in length. Agreements with some of our
customers require minimum performance standards regarding the availability and
response time of our email services. If we fail to meet these standards, our
customers could terminate their relationships with us and we could be subject to
contractual monetary penalties. Service revenues are recognized and billed on a
monthly basis as the service is performed.
We expect to expand our operations and employee base, including our sales,
marketing, technical, operational and customer support resources. In particular,
we intend to expand our sales force to deliver our email outsourcing services to
customers in our four target markets: ISPs, web hosting companies, web portals
and corporations. We also intend to further develop new and existing strategic
relationships to expand our distribution channels and to undertake joint product
development and marketing efforts.
9
<PAGE>
We intend to develop worldwide sales offices and data centers. We currently
have sales offices in the United States, Germany and the United Kingdom, and
we expect to open additional data centers in the United States and Europe
during the current fiscal year.
Future investments in technology may involve the development, acquisition or
licensing of technologies that complement or augment our existing services and
technologies.
During 1998, we recorded aggregate unearned compensation totaling
approximately $19.9 million in connection with certain sales of stock and the
grant of certain options to employees, directors and consultants. This amount
is being amortized over the four-year vesting period of the related options.
These options were issued to create incentives for continued performance. Of
the total unearned compensation, approximately $366,000, $217,000, $269,000
and $1.7 million were amortized in the quarters ended March 31, June 30,
September 30, and December 31, 1998, respectively. In January and March 1999,
we granted options resulting in an additional $18.1 million of unearned
compensation. Amortization of unearned compensation for the first quarter of
1999 was approximately $3.7 million. We expect aggregate per quarter
amortization related to unearned compensation of between $4.9 million and $4.0
million during 1999, between $3.2 million and $2.1 million during 2000,
between $1.7 million and $1.0 million during 2001, and between $742,000 and
$331,000 during 2002.
In January 1999, we entered into an agreement with ICQ, a subsidiary of America
Online, Inc., pursuant to which we will provide email hosting services that will
be integrated with ICQ's instant messaging service provided to ICQ's customers.
The ICQ instant messaging service is designed to allow users to communicate in
real time over the Internet. As part of the agreement, ICQ agreed to provide
sub-branded advertising for us in exchange for a warrant to purchase 2,442,766
shares of common stock, issuable upon attainment of each of five
milestones. We believe that this agreement will have a significant current and
potential future impact on our results of operations. The following table
summarizes the shares underlying each milestone and the related exercise price:
<TABLE>
<CAPTION>
Shares
Underlying Exercise
Warrant Price
-------
<S> <C> <C>
Milestone 1...................................... 814,254 $ 4.26
Milestone 2...................................... 407,128 5.50
Milestone 3...................................... 407,128 6.60
Milestone 4...................................... 407,128 8.80
Milestone 5...................................... 407,128 11.00
---------
Totals......................................... 2,442,766
=========
</TABLE>
The shares underlying the first milestone were immediately vested on the
effective date of the agreement. The shares underlying the remaining milestones
vest on the dates that ICQ completes registration of the specified number of
sub-branded ICQ mailboxes applicable to each milestone. Using the Black-Scholes
option pricing model and assuming a term of seven years and expected volatility
of 90%, the initial fair value of the warrant on the effective date of the
agreement
10
<PAGE>
approximated $16.5 million, which is being amortized to advertising expense
using the straight-line method over four years. The shares underlying the second
through fifth milestones will be remeasured at each subsequent reporting date
until each sub-branded ICQ mailbox registration threshold is achieved. In the
event such remeasurement results in increases or decreases from the initial fair
value, which could be substantial, such increases or decreases will be
recognized immediately, in the event the fair value of the shares underlying the
milestone has been previously recognized, or over the remaining term. We expect
to incur substantial non-cash charges associated with the grant of the warrant
to America Online. In addition to amortization of the initial fair value of this
warrant, which totaled $16.5 million, we expect that future changes in the
trading price of our common stock at the end of each quarter and at the date
certain milestones are achieved, will cause additional substantial changes in
the ultimate amount of such amortization.
At March 31, 1999, none of the registration milestones specified within the ICQ
warrant agreement had been achieved. Therefore, the shares underlying the
second through fifth milestones of the ICQ warrant were remeasured using the
closing price for our common stock on March 31, 1999 of $77 per share. This
remeasurement resulted in an increase to the fair value of the warrant of
$109.4 million, bringing the total fair value of the warrant to $125.9
million as of March 31, 1999. This revised fair value will be amortized ratably
over four years, resulting in a quarterly amortization charge to advertising
expense in the amount of $7.9 million beginning in the first quarter of 1999.
As noted, this charge is subject to substantial increase or decrease in future
quarters based upon future changes in the trading price of our common stock.
We have incurred significant losses since our inception, and as of March 31,
1999 had an accumulated deficit of approximately $30.1 million. We intend to
invest heavily in sales and marketing, continued development of our network
infrastructure and continued technology developments. We expect to continue to
incur substantial operating losses for the foreseeable future.
In view of the rapidly evolving nature of our business and our limited operating
history, we believe that period-to-period comparisons of our revenues and
operating results, including our gross profit margin and operating expenses as a
percentage of total net revenues, are not meaningful and should not be relied
upon as indications of future performance. At March 31, 1999, we had 182
employees, in comparison with 27 employees at March 31, 1998. We do not believe
that our historical growth rates for revenue, expenses, or personnel are
indicative of future results.
11
<PAGE>
Results of Operations
The following table sets forth the historical results of our operations,
expressed in absolute dollars and as a percentage of revenues, for the quarters
ended March 31, 1999 and 1998.
(in thousands, except per share data)
<TABLE>
<CAPTION>
Absolute Dollars Percentage of Revenues
--------------------------------- ---------------------------------
Three Months Ended Three Months Ended
--------------------------------- ---------------------------------
March 31, March 31, March 31, March 31,
1999 1998 1999 1998
-------------- -------------- -------------- --------------
<S> <C> <C> <C> <C>
Net revenues (1) $ 1,049 $ 70 100.0 100.0
Cost of net revenues (2) (2,360) (82) 225.0 117.1
-------------- -------------- -------------- --------------
Gross profit (loss) (1,311) (12) 125.0 17.1
Operating expenses:
Research and development 1,379 273 131.5 390.0
Sales and marketing 1,984 135 189.1 192.9
General and administrative 1,550 307 147.8 438.6
Stock-based expenses 11,657 443 1,111.2 632.9
-------------- -------------- -------------- --------------
Total operating expenses 16,570 1,158 1,579.6 1,654.3
-------------- -------------- -------------- --------------
Loss from operations (17,881) (1,170) (1,704.6) (1,671.4)
Other income (expense):
Interest and other income 351 - 33.5 -
Interest expense (3) (64) (150) (6.1) (214.3)
-------------- -------------- -------------- --------------
Net loss $(17,594) $(1,320) (1,677.2) (1,885.7)
============== ============== ============== ==============
Net loss per share (basic and diluted) $(2.51) $(0.49)
============== ==============
Shares used in per share computations 7,011 2,687
============== ==============
</TABLE>
(1) Includes $106 and $ 0 of stock-based charges in 1999 and 1998, respectively
(2) Includes $446 and $ 5 of stock-based charges in 1999 and 1998, respectively
(3) Includes $16 and $119 of stock-based charges in 1999 and 1998, respectively
Net Revenues
Our revenues consist principally of fees we earn from providing email hosting
services. Payments for such services are based either on contractual rates per
active mailbox per month, non-refundable fixed payments, or a percentage of the
email advertising revenues earned by our customers. Revenues from contracts
specifying a contractual rate per active mailbox per
12
<PAGE>
month are recognized monthly for each active mailbox covered by the respective
contract. Revenues from contracts that provide non-refundable fixed payments are
not dependent upon the active number of mailboxes, and are therefore recognized
ratably over the contract term. Revenues based upon a percentage of the email
advertising revenues generated by customers are recognized when such revenues
are earned and reported by the customer.
During the quarter ended March 31, 1999, our revenues were $1,049,000, an
increase of $979,000 over the corresponding quarter of 1998. This increase in
revenues resulted from a substantial increase in the number of mailboxes we
hosted during the quarter ended March 31, 1999, in comparison with the
corresponding quarter of 1998. At March 31, 1999, we hosted approximately 1.4
million active mailboxes. At March 31, 1998, by comparison, we hosted
approximately 25,000 mailboxes. For the quarter ended March 31, 1999, we earned
revenues of $ 0.32 per mailbox for the weighted average of active mailboxes
hosted during the quarter.
In connection with certain customer contracts executed in 1998, we granted
warrants or options to purchase Series B Convertible Preferred Stock to such
customers. The fair value of such warrants or options, determined using the
Black-Scholes option pricing model, has been recognized ratably as a sales
discount over the terms of the respective agreements. Amortization of this
discount amounted to $106,000 during the quarter ended March 31, 1999. As the
customer contracts were executed after March 31, 1998, there was no such
amortization in the first quarter of 1998.
In early 1998, we executed agreements with E*TRADE, an on-line brokerage
services company, and Verio, a web hosting organization, pursuant to which we
derived revenue for providing email services. During the quarter ended, E*TRADE
and Verio accounted for approximately 48% and 32%, respectively, of our net
revenues, excluding the value of stock purchase rights received by customers.
For the entirety of 1998, E*TRADE and Verio accounted for approximately 62% and
30%, respectively, of our net revenues excluding the value of stock purchase
rights received by customers.
Cost of Net Revenues
Cost of net revenues consists principally of costs incurred in the delivery and
support of our email services, including depreciation of capital equipment used
in our network infrastructure and personnel costs in our operations and
customer support functions. During the quarter ended March 31, 1999, these costs
were $2,360,000, or 225% of net revenues, in comparison with costs of $82,000,
or 117% of net revenues, for the corresponding quarter of 1998 . We have made
significant acquisitions of equipment for our data centers over the past nine
months, and as a result our depreciation expense of networking equipment in the
first quarter of 1999 increased substantially in comparison with the first
quarter of 1998. Additionally, we have significantly increased our staffing in
operations and customer support over the past year, and consequently
compensation and other personnel costs were higher in the current fiscal year.
From January 1, 1999 to March 31, 1999, our operations and customer support
staff increased from 25 employees to 50 employees. At March 31, 1998, we had
five employees on staff in operations and customer support functions.
Operating Expenses
Research and Development. Our research and development expenses consist
- ------------------------
principally of compensation for our technical staff, payments to outside
contractors, and, to a lesser extent, related overhead. We expense research and
development expenses as they are incurred. Research and development expenses
amounted to $1.4 million, or 132% of net revenues, during the first
13
<PAGE>
quarter of 1999, and increased substantially from the corresponding quarter of
1998 due to our increases in personnel and use of outside contractors. From
January 1, 1999 to March 31, 1999, our research and development staff increased
from 27 employees to 52 employees. At March 31, 1998, we had 15 employees on
staff in research and development functions.
Sales and Marketing. Our sales and marketing expenses consist principally of
- -------------------
compensation for our sales and marketing personnel, advertising, trade show and
other promotional costs, and, to a lesser extent, related overhead. Sales and
marketing expense during the quarter ended March 31, 1999, amounted to $2.0
million, or 189% of net revenue. Increases in marketing and promotional
expenses, incentive compensation payments to sales personnel, and increases in
compensation associated with additional headcount accounted for the increase to
sales and marketing expense during the first quarter of 1999 in comparison with
the corresponding quarter of 1998. From January 1, 1999 to March 31, 1999, our
sales and marketing staff increased from 30 employees to 61 employees. At March
31, 1998, we had three employees on staff in sales and marketing functions.
General and Administrative. Our general and administrative expenses consist
- ---------------------------
principally of compensation for personnel, fees for outside professional
services, allocated occupancy costs and, to a lesser extent, related overhead.
General and administrative expenses amounted to $1.6 million, or 148% of net
revenues, during the first quarter of 1999, and increased substantially in
comparison with the corresponding quarter in 1998. This increase was due
primarily to increases in compensation associated with additional headcount,
higher fees for outside professional services, and higher occupancy costs. From
January 1, 1999 to March 31, 1999, our general and administrative staff
increased from 11 employees to 19 employees. At March 31, 1998, we had four
employees on staff in general and administrative functions.
Stock-Based Expenses
- --------------------
During 1998, we recorded aggregate unearned compensation in the amount of $19.9
million in connection with the grant of certain stock options during 1998. In
the first quarter of 1999, we recorded an additional $18.1 million of unearned
compensation related to the grant of stock options in the months of January 1999
and March 1999. Amortization of such compensation amounted to approximately $3.7
million during the first quarter of 1999. Approximately $400,000 of this amount
was allocated to Cost of Revenues and approximately $3.3 million was allocated
to Operating Expenses during the quarter.
Additionally, we incurred stock-based expenses for warrants we granted to ICQ, a
subsidiary of AOL, and to one other strategic partner. Amortization of the fair
value of these warrants resulted in stock-based expenses of approximately $8.4
million during the first quarter of 1999. As noted in the Overview section,
quarterly amortization associated with the ICQ warrant is subject to substantial
increase or decrease in future quarters based upon future changes in the trading
price of our common stock.
Interest and Other Income and Interest Expense
- ----------------------------------------------
Interest and other income consist primarily of interest earnings on our cash and
cash equivalents. Interest and other income amounted to $351,000 during the
first quarter of 1999. We concluded private placements of equity securities in
April 1998, September 1998, and January 1999. As a result, interest income
increased significantly during the first quarter of 1999 in comparison with
previous periods due to higher cash balances available for investment. During
the first quarter of 1999, we incurred interest expense on capital lease
obligations in the amount of $64,000. In the corresponding quarter of 1998, we
incurred interest expense of $150,000, of which $119,000 related to the
amortization of stock-based charges and the remainder to interest payments on
notes payable and capital obligations.
Income Taxes
- ------------
No provision for federal and state income taxes has been recorded as we have
incurred net operating losses from inception through March 31, 1999. As of
March 31, 1999, we had approximately $14 million of federal and state net
operating loss carryforwards available to offset future taxable income which
expire in varying amounts beginning in 2005. Under the Tax Reform Act of 1986,
the amounts of and benefits from net operating loss carryforwards may be
impaired or limited in certain circumstances. For example, the amount of net
operating losses that we may utilize in any one year would be limited in the
presence of a cumulative ownership change of more than 50% over a three year
period. Because there is significant doubt as to whether we will realize any
benefit from this deferred tax asset, we have established a full valuation
allowance as of March 31, 1999.
<PAGE>
Fluctuations in Quarterly Results
We have incurred operating losses since inception, and we cannot be certain that
we will achieve profitability on a quarterly or annual basis in the future.
Critical Path believes that future operating results will be subject to
quarterly fluctuations due to a variety of factors, including, but not limited
to:
. continued growth of the Internet and of email usage;
. demand for outsourced email services;
. our ability to attract and retain customers and maintain customer
satisfaction;
. our ability to upgrade, develop and maintain our systems and
infrastructure;
. the amount and timing of operating costs and capital expenditures
relating to expansion of our business and infrastructure;
. technical difficulties or system outages;
. the announcement or introduction of new or enhanced services by our
competitors;
. our ability to attract and retain qualified personnel with Internet
industry expertise, particularly sales and marketing personnel;
. the pricing policies of our competitors;
. movement in the trading price of our common stock, to the extent such
movement causes changes in the remeasurement of the fair value of the
shares underlying the ICQ warrant;
. failure to increase our international sales; and
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. governmental regulation surrounding the Internet and email in particular.
In addition to the factors set forth above, our operating results will be
impacted by the extent to which we incur non-cash charges associated with stock-
based arrangements with the employees and non-employees. In particular, we
expect to incur substantial non-cash charges associated with the grant of a
warrant to America Online. In addition to amortization of the initial fair value
of this warrant, which totaled $16.5 million, we expect that future changes in
the trading price of our common stock at the end of each quarter and at the date
certain milestones are achieved, will cause additional substantial changes in
the ultimate amount of such amortization.
Due to lead times required to purchase, install and test equipment, we typically
need to purchase equipment well in advance of the receipt of any expected
revenues. Delays in obtaining this equipment could result in unexpected revenue
shortfalls.
Liquidity and Capital Resources
Our cash and cash equivalents increased by approximately $7.8 million during the
quarter ended March 31, 1999. This net change occurred as we raised
approximately $13.8 million in proceeds from the sale of equity securities, net
of issuance costs, and used $4.6 million in cash to fund operating activities.
Increased personnel costs and expanded sales and marketing programs were the
primary causes of our increased operating expenses during the first quarter of
1999. Net of depreciation, our investment in property and equipment increased
approximately $3.1 million during the quarter ended March 31, 1999. Installation
of network infrastructure equipment in our data centers, purchases of furniture
and equipment for new employees, and leasehold improvements related to office
expansions accounted for this increase.
We have a credit agreement with a bank which provides a line of credit for
working capital advances of up to $1.0 million. There were no borrowings under
this line of credit as of March 31, 1999. Outstanding borrowings accrue
interest at a rate equal to the bank's prime rate plus 2.0%. Capital lease
obligations, including both short-term and long-term portions, increased
approximately $2.6 million, net of principal repayments, during the quarter
ended March 31, 1999 as we secured financing for a substantial share of our
additions to property and equipment. Deferred revenue decreased $500,000 during
the quarter as we recognized into revenue a payment we had previously received
from one customer as an advance for future service. Our line of credit and
capital lease obligations contain no provisions that would limit our future
borrowing ability.
In January 1999 we completed the second round of the Series B Convertible
Preferred Stock financing through the issuance of approximately 3.2 million
shares, including 454,544 shares issued pursuant to outstanding stock purchase
rights, for gross proceeds of $13.6 million. Also in January 1999, we sold
1,090,909 shares of common stock for gross proceeds of $2.4 million. In April
1999, we received approximately $115.5 million in net proceeds upon the closing
of our initial public offering of common stock.
We believe that our current cash balances, proceeds from the April closing of
our initial public offering of common stock, and cash available under our line
of credit will be sufficient to meet our working capital and capital
expenditure requirements for at least the next 12 months. We anticipate that
further expansion of our operations will cause us to incur negative cash flows
on a short-term basis, and therefore require us to consume our cash and other
liquid resources to support our growth in operations.
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However, our operating and investing activities on a long-term basis may require
us to obtain additional equity or debt financing. In addition, although there
are no present understandings, commitments or agreements with respect to any
acquisition of other businesses, products, or technologies, we may, from time to
time, evaluate potential acquisitions of other businesses, products, and
technologies. In order to consummate potential acquisitions, we may need
additional equity or debt financings in the future.
Net of depreciation, our investment in property and equipment increased
approximately $3.1 million during the first quarter of 1999. Installation of
network infrastructure equipment in our data center, purchases of furniture and
equipment for new employees, and leasehold improvements related to office
expansions accounted for this increase. We expect that our investment in
property and equipment will continue to grow as we seek to increase our capacity
to provide email hosting services.
Year 2000 Issues
The Year 2000 issue is the result of computer programs being written using two
digits rather than four to define the applicable year. Any computer programs or
hardware that have date-sensitive software or embedded chips may recognize a
date using "00" as the year 1900 rather than the year 2000. This could result in
system failures or miscalculations causing disruptions of operations for any
company using such computer programs or hardware, including, among other things,
a temporary inability to process transactions, send invoices or engage in normal
business activities. As a result, many companies' computer systems may need to
be upgraded or replaced in order to avoid "Year 2000" issues.
We are a comparatively new enterprise, and, accordingly, the software and
hardware we use to manage our business has all been purchased or developed by us
within the past 24 months. While this fact pattern does not uniformly protect us
against Year 2000 exposure, we believe we gain some mitigation from the fact
that the information technology ("IT") we use to manage our business is not
based upon "legacy" hardware and software systems. "Legacy system" is a term
often used to describe hardware and software systems which were developed in
previous decades when there was less awareness of Year 2000 issues. Generally,
hardware and software design within the current decade and the past several
years in particular has given greater consideration to Year 2000 issues. All of
the software code we have internally developed to manage our network traffic,
for example, is written with four digits to define the applicable year.
We are in the process of testing our internal IT and non-IT systems. To date, we
have only completed preliminary testing of our internally developed IT and non-
IT systems. All of the testing we have completed has been performed by our own
personnel; to date, we have not retained any outside service or consultants to
test or review our systems for Year 2000 compliance. Based on the testing we
have performed, we believe that this software is Year 2000 compliant. We are
designing our systems to be Year 2000 compliant, and will continue to test these
systems as development of these systems progresses.
In addition to our internally developed software, we utilize software and
hardware developed by third parties both for our network and internal
information systems. To date, we have not done any testing of such third-party
software or hardware to determine Year 2000 compliance. We have, however,
obtained certifications from our key suppliers of hardware and networking
equipment for our data centers that such hardware and networking equipment is
Year 2000
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compliant. Additionally, we have received assurances from the providers of key
software applications for our internal operations that their software is Year
2000 compliant. Based upon an initial evaluation of our broader list of software
and hardware providers, we are aware that all of these providers are in the
process of reviewing and implementing their own Year 2000 compliance programs,
and we will work with these providers to address the Year 2000 issue and
continue to seek assurances from them that their products are Year 2000
compliant.
In addition, we rely on third party network infrastructure providers to gain
access to the Internet. If such providers experience business interruptions as a
result of their failure to achieve Year 2000 compliance, our ability to provide
Internet connectivity could be impaired, which could have a material adverse
effect on our business, results of operations and financial condition.
Our customers' success in maintaining Year 2000 compliance is also significant
to our ability to generate revenues and execute our business plan. We currently
derive revenue either by charging a fixed fee per month for each mailbox we
host, or by sharing advertising revenues with our customers. In either case,
interruptions in our customers' services and on-line activities caused by Year
2000 problems could have a material, adverse effect on our revenues to the
extent that such interruptions limit or delay our customers' ability to expand
their base of email users.
We have not incurred any significant expenses to date, and we do not anticipate
that any future costs associated with our Year 2000 remediation efforts will be
material. However, if we, our customers, our providers of hardware and software,
or our third party network providers fail to remedy any Year 2000 issues, our
service could be interrupted and we could experience a material loss of revenues
that could have a material, adverse effect on our business, results of
operations, and financial condition. We would consider such an interruption to
be the most reasonably likely unfavorable result of any failure by us, or
failure by the third parties upon whom we rely, to achieve Year 2000 compliance.
Presently, we believe we are unable to reasonably estimate the duration and
extent of any such interruption, or quantify the effect it may have on our
future revenues. We have yet to develop a comprehensive contingency plan to
address the issues which could result from such an event. We are prepared to
develop such a plan if our ongoing assessment leads us to conclude we have
significant exposure based upon the likelihood of such an event.
Recent Accounting Pronouncements
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position ("SOP") No. 98-1, "Software for Internal Use," which
provides guidance on accounting for the cost of computer software developed or
obtained for internal use. SOP No. 98-1 is effective for financial statements
for fiscal years beginning after December 15, 1998. Critical Path does not
expect that the adoption of SOP No. 98-1 will have a material impact on its
consolidated financial statements.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities" ("SFAS 133"). Critical Path is required to
adopt SFAS 133 in fiscal 2000. SFAS 133 established methods of accounting for
derivative financial instruments and hedging activities related to those
instruments as well as other hedging activities. Critical Path has not yet
determined what the effect of SFAS 133 will be on its operations and financial
position.
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Factors Affecting Future Operating Results
- ------------------------------------------
Because we have a limited operating history, it is difficult to evaluate our
business and we may face various risks, expenses and difficulties associated
with early stage companies
Because we have only a limited operating history upon which you can evaluate our
business and prospects, you should consider the risks, expenses and difficulties
that we may encounter when making your investment decision. These risks include
our ability to:
. acquire businesses and technologies;
. expand our sales and marketing activities;
. create and maintain strategic relationships;
. expand our customer base and retain key clients;
. introduce new services;
. manage growing operations;
. compete in a highly competitive market;
. upgrade our systems and infrastructure to handle any increases in
messaging traffic;
. reduce service interruptions; and
. recruit and retain key personnel.
We expect that our operating expenses will increase as we spend resources on
building our business, and that this increase may have a negative effect on our
operating results and financial condition
We have spent heavily on technology and infrastructure development. We expect to
continue to spend substantial financial and other resources on developing and
introducing new email service offerings, and expanding our sales and marketing
organizations, strategic relationships and operating infrastructure. We expect
that our cost of revenues, sales and marketing expenses, general and
administrative expenses, operations and customer support expenses, and
depreciation and amortization expenses will continue to increase in absolute
dollars and may increase as a percent of revenues. If our revenues do not
correspondingly increase, our operating results and financial condition could be
negatively affected.
We have a history of losses, expect continuing losses and may never achieve
profitability
We incurred net losses of approximately $1.1 million for the period from
February 19, 1997 (inception) through December 31, 1997, $11.5 million for the
year ended December 31, 1998, and $17.6 million for the period from January 1,
1999 to March 31, 1999. As of March 31, 1999, we had an accumulated deficit of
approximately $30.1 million. We have not achieved profitability in any period,
and we expect to continue to incur net losses for the foreseeable
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future. Should we continue to incur net losses in future periods, we may not be
able to increase our number of employees or our investment in capital equipment,
sales and marketing programs, and research and development in accordance with
our present plans. Continuation of our net losses may also require us to secure
additional financing sooner than anticipated. Such financing may not be
available in sufficient amounts, or on terms acceptable to us, and may dilute
existing shareholders. We may never obtain sufficient revenues to achieve
profitability. If we do achieve profitability, we may not sustain or increase
profitability in the future. This may, in turn, cause our stock price to
decline.
Due to our limited operating history and the emerging nature of the email
services market, our future revenues are unpredictable, and our quarterly
operating results may fluctuate
We cannot accurately forecast our revenues as a result of our limited operating
history and the emerging nature of the Internet-based email services market. Our
revenues could fall short of our expectations if we experience delays or
cancellations of even a small number of orders. We often offer volume-based
pricing, which may affect our operating margins. A number of factors are likely
to cause fluctuations in our operating results, including, but not limited to:
. continued growth of the Internet in general and of email usage in particular;
. demand for outsourced email services;
. our ability to attract and retain customers and maintain customer
satisfaction;
. our ability to upgrade, develop and maintain our systems and infrastructure;
. the amount and timing of operating costs and capital expenditures relating to
expansion of our business and infrastructure;
. technical difficulties or system outages;
. the announcement or introduction of new or enhanced services by our
competitors;
. our ability to attract and retain qualified personnel with Internet industry
expertise, particularly sales and marketing personnel;
. the pricing policies of our competitors;
. failure to increase our international sales; and
. governmental regulation surrounding the Internet and email in particular.
In addition to the factors set forth above, our operating results will be
impacted by the extent to which we incur non-cash charges associated with stock-
based arrangements with employees and non-employees. In particular, we expect to
incur substantial non-cash charges associated with the grant of a warrant to
America Online. In addition to amortization of the initial fair value of this
warrant, which totaled $16.5 million, we expect that future changes in the
trading price of our common stock at the end of each quarter and at the date
certain milestones are achieved, will cause additional substantial changes in
the ultimate amount of such amortization.
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Due to lead times required to purchase, install and test equipment, we typically
need to purchase equipment well in advance of the receipt of any expected
revenues. Delays in obtaining this equipment could result in unexpected revenue
shortfalls. Small variations in the timing of the recognition of specific
revenues could cause significant variations in operating results from quarter to
quarter.
Period-to-period comparisons of our operating results are not a good indication
of our future performance. It is likely that our operating results in some
quarters will be below market expectations. In this event, the price of our
common stock is likely to decline.
Acquisitions could result in dilution, operating difficulties and other harmful
consequences
We expect that we will acquire or invest in businesses, products, services
and technologies that complement or augment our service offerings and customer
base. We are currently engaged in discussions with a number of companies
regarding strategic acquisitions or investments. Although these discussions
are ongoing, we have not signed any definitive agreements and we cannot assure
you that any of these discussions will result in actual acquisitions. To be
successful, we will need to identify suitable acquisition candidates,
integrate disparate technologies and corporate cultures and manage a
geographically dispersed company. We cannot assure you that we will be able to
do this successfully. Acquisitions could divert our attention from other
business concerns and could expose us to unforeseen liabilities. In addition,
we may lose key employees while integrating any new companies.
We expect that we will pay for some of our acquisitions by issuing additional
common stock and this would dilute our shareholders. We may also use cash to
make acquisitions. It may be necessary for us to raise additional funds through
public or private financings. We cannot assure you that we will be able to
raise additional funds at any particular point in the future or on terms that
are favorable to us. In addition, we may be required to amortize significant
amounts of goodwill and other intangible assets in connection with future
acquisitions, which would materially increase our operating expenses.
If we fail to expand our sales and marketing activities, we may be unable to
expand our business
Our ability to increase our revenues will depend on our ability to successfully
recruit, train and retain sales and marketing personnel. As of March 31, 1999,
we had 61 sales and marketing personnel. We plan to continue to invest
significant resources to expand our sales and marketing organizations.
Competition for additional qualified personnel is intense and we may not be able
to hire and retain personnel with relevant experience. We have recently hired
most of our sales and marketing personnel, including our Vice President of
Sales, who joined us in November 1998.
The complexity and implementation of our Internet messaging services require
highly trained sales and marketing personnel to educate prospective customers
regarding the use and benefits of our services. Our current and prospective
customers, in turn, must be able to educate their end-users. With our relatively
brief operating history and our plans for expansion, we have considerable need
to recruit, train, and retain qualified staff. Any delays or difficulties we
encounter in these staffing efforts would impair our ability to attract new
customers and to enhance our relationships with existing customers. This in
turn would adversely impact the timing and extent of our revenues. Because the
majority of our sales and marketing personnel have recently joined Critical Path
and have limited experience working together, our sales and marketing
organizations may not be able to compete successfully against bigger and more
experienced sales and marketing organizations of our competitors. If we do not
successfully expand our sales and marketing activities, our business could
suffer and our stock price could decline.
Unplanned system interruptions and capacity constraints could reduce our ability
to provide email services and could harm our business and our reputation
Our customers have in the past experienced some interruptions in our email
service. We believe that these interruptions will continue to occur from time to
time. These interruptions are due to hardware failures, unsolicited bulk email,
or "spam," attacks and operating system failures. For example, in October 1998,
our customers experienced a four-hour service interruption due to an operating
system failure. Our revenues depend on the number of end-users who use our email
services. Our business will suffer if we experience frequent or long system
interruptions that result in the unavailability or reduced performance of our
systems or networks or reduce our ability to provide email services. We expect
to experience occasional temporary capacity constraints due to sharply increased
traffic, which may cause unanticipated system disruptions, slower response
times, impaired quality and degradation in levels of customer service. If this
were to continue to happen, our business and reputation could suffer
dramatically.
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We have entered into service agreements with some of our customers that require
certain minimum performance standards, including standards regarding the
availability and response time of our email services. If we fail to meet these
standards, our customers could terminate their relationships with us and we
could be subject to contractual monetary penalties. Any unplanned interruption
of services may adversely affect our ability to attract and retain customers.
We depend on strategic relationships and other sales channels and the loss of
any of our strategic relationships could harm our business and have an adverse
impact on our revenue
We depend on our strategic relationships to expand our distribution channels and
to undertake joint product development and marketing efforts. Our ability to
increase revenues depends upon marketing our services through new and existing
strategic relationships. We have entered into written agreements with ICQ, a
subsidiary of America Online, Inc., E*TRADE Group, Inc., Network Solutions,
Inc., Sprint Communications Company L.P. and US West Communications Services,
Inc., among others. We depend on a broad acceptance of outsourced email services
on the part of potential partners and acceptance of us as the supplier for these
outsourced email services. We also depend on joint marketing and product
development through our strategic relationships to achieve market acceptance and
brand recognition. For example, through our relationship with E*TRADE, we can
conduct shared advertising campaigns and include our messaging services in
E*TRADE's international strategic relationships. Our agreements with our
strategic partners typically do not restrict them from introducing competing
services and may be terminated by either party without cause. These agreements
typically are for terms of one to three years, and automatically renew for
additional one-year periods unless either party gives prior notice of its
intention to terminate the agreement. In addition, these agreements are
terminable by our partners without cause, and some agreements are terminable by
us, upon 30-120 days' notice. Most of the agreements also provide for the
partial refund of fees paid or other monetary penalties in the event that our
services fail to meet defined minimum performance standards. Distribution
partners may choose not to renew existing arrangements on commercially
acceptable terms, or at all. If we lose any of our strategic relationships,
fail to renew these agreements or relationships or fail to develop new strategic
relationships, our business will suffer. The loss of any of our key strategic
relationships would have an adverse impact on our current and future revenue.
For example, E*TRADE accounted for approximately 62% of our 1998 net revenues,
excluding the value of stock purchase rights received by E*TRADE, and TABNet, a
wholly owned subsidiary of Verio, accounted for approximately 30% of our 1998
net revenues. In addition to our strategic relationships, we also depend on the
ability of our customers to sell and market our services to their end-users.
We have experienced rapid growth which has placed a strain on our resources and
our failure to manage our growth could cause our business to suffer
We recently began to expand our operations rapidly and intend to continue this
expansion. The number of our employees increased from 17 on December 31, 1997 to
93 on December 31, 1998 and to 182 employees on March 31, 1999. This expansion
has placed, and is expected to continue to place, a significant strain on our
managerial, operational and financial resources. To manage any further growth,
we will need to improve or replace our existing operational, customer service
and financial systems, procedures and controls. Any failure by us to properly
manage these system and procedural transitions could impair our ability to
attract and service customers, and could cause us to incur higher operating
costs and delays in the execution of our business plan. We will also need to
continue the expansion of our operations and employee base. Our management may
not be able to hire, train, retain, motivate and manage required personnel.
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In addition, our management may not be able to successfully identify, manage and
exploit existing and potential market opportunities. If we cannot manage growth
effectively, our business and operating results could suffer.
We may not be able to respond to the rapid technological change of the Internet
messaging industry
The Internet messaging industry is characterized by rapid technological change,
changes in user and customer requirements and preferences and the emergence of
new industry standards and practices that could render our existing services,
proprietary technology and systems obsolete. We must continually improve the
performance, features and reliability of our services, particularly in response
to competitive offerings. Our success depends, in part, on our ability to
enhance our existing email and messaging services and to develop new services,
functionality and technology that address the increasingly sophisticated and
varied needs of our prospective customers. If we don't properly identify the
feature preferences of prospective customers, or if we fail to deliver email
features which meet the standards of these customers, our ability to market our
service successfully and to increase our revenues could be impaired. The
development of proprietary technology and necessary service enhancements entail
significant technical and business risks and require substantial expenditures
and lead-time. We may not be able to keep pace with the latest technological
developments. We may also not be able to use new technologies effectively or
adapt our services to customer requirements or emerging industry standards. If
we cannot, for technical, legal, financial or other reasons, adapt or respond in
a cost-effective and timely manner to changing market conditions or customer
requirements, our business and operating results would suffer.
If our system security is breached, our business and reputation could suffer
A fundamental requirement for online communications is the secure transmission
of confidential information over public networks. Third parties may attempt to
breach our security or that of our customers. If they are successful, they could
obtain our customers' confidential information, including our customers'
profiles, passwords, financial account information, credit card numbers or other
personal information. We may be liable to our customers for any breach in our
security and any breach could harm our reputation. We rely on encryption
technology licensed from third parties. Although we have implemented network
security measures, our servers are vulnerable to computer viruses, physical or
electronic break-ins and similar disruptions, which could lead to interruptions,
delays or loss of data. We may be required to expend significant capital and
other resources to license encryption technology and additional technologies to
protect against security breaches or to alleviate problems caused by any breach.
Our failure to prevent security breaches may have a material adverse effect on
our business and operating results.
We depend on broad market acceptance for outsourced Internet-based email service
The market for outsourced Internet-based email service is new and rapidly
evolving. Concerns over the security of online services and the privacy of users
may inhibit the growth of the Internet and commercial online services. We cannot
estimate the size or growth rate of the potential market for our service
offerings, and we do not know whether our service will achieve broad market
acceptance. To date, substantially all of our revenues have been derived from
sales of our email service offerings and we currently expect that our email
service offerings will account for
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substantially all of our revenues for the foreseeable future. We depend on the
widespread acceptance and use of outsourcing as an effective solution for email.
If the market for outsourced email fails to grow or grows more slowly than we
currently anticipate, our business would suffer dramatically.
We expect the email services market will be very competitive and we will need to
compete successfully in this market
We expect that the market for Internet-based email service will be intensely
competitive. In addition to competing with companies that develop and maintain
in-house solutions, we compete with email service providers, such as USA.NET,
Inc., and iName, and with product-based companies, such as Software.com, Inc.
and Lotus Development Corporation. We believe that competition will increase and
that companies such as Microsoft Corporation and Netscape Communications Corp.,
which currently offer email products primarily to Internet service providers who
provide access to the Internet, web hosting companies, World Wide Web sites
intended to be major starting site for users when they connect to the Internet,
commonly referred to as web portals, and corporations, may leverage their
existing relationships and capabilities to offer email services.
We believe competition will increase as our current competitors increase the
sophistication of their offerings and as new participants enter the market. Many
of our current and potential competitors have longer operating histories, larger
customer bases, greater brand recognition and significantly greater financial,
marketing and other resources than we do and may enter into strategic or
commercial relationships with larger, more established and better-financed
companies. Further, any delays in the general market acceptance of the email
hosting concept would likely harm our competitive position. Any such delay would
allow our competitors additional time to approve their service or product
offerings, and also provide time for new competitors to develop email service
solutions and solicit prospective customers within our target markets.
Increased competition could result in pricing pressures, reduced operating
margins and loss of market share, any of which could cause our business to
suffer.
A limited number of customers account for a high percentage of our revenues, and
the loss of a major customer or failure to attract new customers could harm our
business
In 1998, E*TRADE accounted for approximately 62% and TABNet, a wholly owned
subsidiary of Verio, accounted for approximately 30% of our net revenues,
excluding the value of stock purchase rights received by customers. In the first
quarter of 1999, E*TRADE accounted for approximately 48% and TABNet accounted
for approximately 32% of our net revenues, excluding the value of stock purchase
rights received by customers. We expect that sales of our services to a limited
number of customers will continue to account for a high percentage of our
revenue for the foreseeable future. Our future success depends on our ability to
retain our current customers and attract new customers in our target markets.
The loss of a major customer or our inability to attract new customers could
have a material adverse effect on our business. Our agreements with our
customers have terms of one to three years with automatic one-year renewals and
can be terminated without cause upon 30-120 days' notice.
If we do not successfully address service design risks, our reputation could be
damaged and our business and operating results could suffer
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We must accurately forecast the features and functionality required by target
customers. In addition, we must design and implement service enhancements that
meet customer requirements in a timely and efficient manner. We may not
successfully determine customer requirements and we may be unable to satisfy
customer demands. Furthermore, we may not be able to design and implement a
service incorporating desired features in a timely and efficient manner. In
addition, if any new service we launch is not favorably received by customers
and end-users, our reputation could be damaged. If we fail to accurately
determine customer feature requirements or service enhancements or to market
services containing such features or enhancements in a timely and efficient
manner, our business and operating results could suffer materially.
We need to upgrade our systems and infrastructure to accommodate increases in
email traffic
We must continue to expand and adapt our network infrastructure as the number of
users and the amount of information they wish to transmit increases, and as
their requirements change. The expansion and adaptation of our network
infrastructure will require substantial financial, operational and management
resources. Due to the limited deployment of our services to date, the ability of
our network to connect and manage a substantially larger number of customers at
high transmission speeds is unknown, and we face risks related to the network's
ability to operate with higher customer levels while maintaining expected
performance.
As the frequency and complexity of messaging increases, we will need to make
additional investments in our infrastructure, which may be expensive. In
addition, we may not be able to accurately project the rate or timing of email
traffic increases or upgrade our systems and infrastructure to accommodate
future traffic levels. We may also not be able to achieve or maintain a
sufficiently high capacity of data transmission as customer usage increases.
Customer demand for our services could be greatly reduced if we fail to maintain
high capacity data transmission. In addition, as we upgrade our network
infrastructure to increase capacity available to our customers, we are likely to
encounter equipment or software incompatibility which may cause delays in
implementations. We may not be able to expand or adapt our network
infrastructure to meet additional demand or our customers' changing requirements
in a timely manner or at all. If we fail to do so, our business and operating
results could suffer materially.
If we do not successfully address the risks inherent in the expansion of our
international operations, our business could suffer
We intend to continue to expand into international markets and to spend
significant financial and managerial resources to do so. If our revenues from
international operations do not exceed the expense of establishing and
maintaining these operations, our business, financial condition and operating
results will suffer. At present, we have a subsidiary in Germany, and we have
plans to commence operations in the United Kingdom and in Asia within the next
twelve months. We have limited experience in international operations and may
not be able to compete effectively in international markets. We face certain
risks inherent in conducting business internationally, such as:
. unexpected changes in regulatory requirements;
. difficulties and costs of staffing and managing international operations;
. differing technology standards;
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. difficulties in collecting accounts receivable and longer collection
periods;
. political and economic instability;
. fluctuations in currency exchange rates;
. imposition of currency exchange controls;
. potentially adverse tax consequences; and
. reduced protection for intellectual property rights in certain countries.
Any of these factors could adversely affect our international operations and,
consequently, our business and operating results. Specifically, failure by us to
successfully manage our international growth could result in higher operating
costs than anticipated, or could delay or preclude altogether our ability to
generate revenues in key international markets.
Because we provide our email messaging services over the Internet, our business
could suffer if efficient transmission of data over the Internet is interrupted
The recent growth in the use of the Internet has caused frequent interruptions
and delays in accessing the Internet and transmitting data over the Internet. To
date we have not experienced a significant adverse effect from these
interruptions. However, because we provide email messaging services over the
Internet, interruptions or delays in Internet transmissions will adversely
affect our customers' ability to send or receive their email messages. We rely
on the speed and reliability of the networks operated by third parties.
Therefore, our market depends on improvements being made to the entire Internet
infrastructure to alleviate overloading and congestion.
We depend on telecommunications network suppliers such as MCI WorldCom and
Sprint to transmit email messages across their networks. In addition, to deliver
our services, we rely on a number of public and private peering
interconnections, which are arrangements among access providers to carry traffic
of each other. If these providers were to discontinue these arrangements, and
alternative providers did not emerge or were to increase the cost of providing
access, our ability to transmit our email traffic would be reduced. If we were
to increase our current prices to accommodate any increase in the cost of
providing access, it could negatively impact our sales. If we did not increase
our prices in response to rising access costs, our margins would be negatively
affected. Furthermore, if additional capacity is not added as traffic increases,
our ability to distribute content rapidly and reliably through these networks
will be adversely affected.
If we encounter system failure, we may not be able to provide adequate service
and our business and reputation could be damaged
Our ability to successfully receive and send email messages and provide
acceptable levels of customer service largely depends on the efficient and
uninterrupted operation of our computer and communications hardware and network
systems. Substantially all of our computer and communications systems are
located in Palo Alto and San Francisco, California and Laurel, Maryland. Our
systems and operations are vulnerable to damage or interruption from fire,
flood,
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earthquake, power loss, telecommunications failure and similar events. The
occurrence of any of the foregoing risks could subject us to contractual
monetary penalties if we fail to meet our minimum performance standards, and
could have a material adverse effect on our business and operating results and
damage our reputation.
We must recruit and retain our key employees to expand our business
Our success depends on the skills, experience and performance of our senior
management and other key personnel, many of whom have worked together for only a
short period of time. For example, our Chief Executive Officer, Chief Financial
Officer, Vice President of Sales and Vice President and Chief Information
Officer have joined us within the past six months. The loss of the services of
any of our senior management or other key personnel, including our founder,
David Hayden, and our President and Chief Executive Officer, Douglas Hickey,
could materially and adversely affect our business. We do not have long-term
employment agreements with any of our senior management and other key personnel.
Our success also depends on our ability to recruit, retain and motivate other
highly skilled sales and marketing, technical and managerial personnel.
Competition for these people is intense, and we may not be able to successfully
recruit, train or retain qualified personnel. In particular, we may not be able
to hire a sufficient number of qualified software developers for our email
services. If we fail to retain and recruit necessary sales and marketing,
technical and managerial personnel, our business and our ability to develop new
services and to provide acceptable levels of customer service could suffer.
Unknown software defects could disrupt our services, which could harm our
business and reputation
Our service offerings depend on complex software, both internally developed and
licensed from third parties. Complex software often contains defects,
particularly when first introduced or when new versions are released. Although
we conduct extensive testing, we may not discover software defects that affect
our new or current services or enhancements until after they are deployed.
Although we have not experienced any material software defects to date, it is
possible that, despite testing by us, defects may occur in the software. These
defects could cause service interruptions, which could damage our reputation or
increase our service costs, cause us to lose revenue, delay market acceptance or
divert our development resources, any of which could cause our business to
suffer.
We may need additional capital and raising additional capital may dilute
existing shareholders
We believe that our existing capital resources, including the anticipated
proceeds of our recent public offering of common stock, will enable us to
maintain our current and planned operations for at least the next 12 months.
However, we may be required to raise additional funds due to unforeseen
circumstances. If our capital requirements vary materially from those currently
planned, we may require additional financing sooner than anticipated. Such
financing may not be available in sufficient amounts or on terms acceptable to
us and may be dilutive to existing shareholders.
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<PAGE>
We may not be able to protect our intellectual property and proprietary rights
We regard our copyrights, service marks, trademarks, trade secrets and similar
intellectual property as critical to our success, and rely on trademark and
copyright law, trade secret protection and confidentiality and/or license
agreements with our employees, customers and partners to protect our proprietary
rights. Despite our precautions, unauthorized third parties may copy certain
portions of our services or reverse engineer or obtain and use information that
we regard as proprietary. End-user license provisions protecting against
unauthorized use, copying, transfer and disclosure of the licensed program may
be unenforceable under the laws of certain jurisdictions and foreign countries.
The status of United States patent protection in the software industry is not
well defined and will evolve as the U.S. Patent and Trademark Office grants
additional patents. We have one patent pending in the United States and we may
seek additional patents in the future. We do not know if our patent application
or any future patent application will be issued with the scope of the claims we
seek, if at all, or whether any patents we receive will be challenged or
invalidated. In addition, the laws of some foreign countries do not protect
proprietary rights to the same extent as do the laws of the United States. Our
means of protecting our proprietary rights in the United States or abroad may
not be adequate and competitors may independently develop similar technology.
Third parties may infringe or misappropriate our copyrights, trademarks and
similar proprietary rights. In addition, other parties may assert infringement
claims against us. Although we have not received notice of any alleged
infringement, we cannot be certain that our products do not infringe issued
patents that may relate to our products. In addition, because patent
applications in the United States are not publicly disclosed until the patent is
issued, applications may have been filed which relate to our software products.
We may be subject to legal proceedings and claims from time to time in the
ordinary course of our business, including claims of alleged infringement of the
trademarks and other intellectual property rights of third parties. Intellectual
property litigation is expensive and time-consuming and could divert
management's attention away from running our business.
We may need to license third party technologies and we face risks in doing so
We also intend to continue to license certain technology from third parties,
including our web server and encryption technology. The market is evolving and
we may need to license additional technologies to remain competitive. We may not
be able to license these technologies on commercially reasonable terms or at
all. In addition, we may fail to successfully integrate any
28
<PAGE>
licensed technology into our services. These third-party in-licenses may expose
us to increased risks, including risks with the integration of new technology,
the diversion of resources from the development of our own proprietary
technology, our inability to generate revenues from new technology sufficient to
offset associated acquisition and maintenance costs. Our inability to obtain any
of these licenses could delay product and service development until equivalent
technology can be identified, licensed and integrated. Any such delays in
services could cause our business and operating results to suffer.
Our stock has been volatile and we expect this volatility will continue
Our stock price has been highly volatile since our initial public offering on
March 29, 1999. We expect that this volatility will continue in the future due
to factors such as:
. actual or anticipated fluctuations in our results of operations;
. changes in or failure by us to meet securities analysts' expectations;
. announcements of technological innovations;
. introduction of new services by us or our competitors;
. developments with respect to intellectual property rights;
. conditions and trends in the Internet and other technology industries;
and
. general market conditions.
In addition, the stock market has from time to time experienced significant
price and volume fluctuations that have affected the market prices for the
common stocks of technology companies, particularly Internet companies. These
broad market fluctuations may result in a material decline in the market price
of our common stock. In the past, following periods of volatility in the market
price of a particular company's securities, securities class action litigation
has often been brought against that company. We may become involved in this type
of litigation in the future. Litigation is often expensive and diverts
management's attention and resources, which could have a material adverse effect
upon our business and operating results.
Governmental regulation and legal uncertainties could impair the growth of the
Internet and decrease demand for our services or increase our cost of doing
business
Although there are currently few laws and regulations directly applicable to
the Internet and commercial email services, a number of laws have been proposed
involving the Internet, including laws addressing user privacy, pricing,
content, copyrights, distribution, antitrust and characteristics and quality of
products and services. Further, the growth and development of the market for
online email may prompt calls for more stringent consumer protection laws that
may impose additional burdens on those companies conducting business online.
The adoption of any additional laws or regulations may impair the growth of the
Internet or commercial online services which could decrease the demand for our
services and increase our cost of doing business, or otherwise harm our business
and operating results. Moreover, the applicability to the Internet of existing
laws in various jurisdictions governing issues such as property ownership, sales
and other taxes, libel and personal privacy is uncertain and may take years to
resolve.
If we do not adequately address "Year 2000" issues, we may incur significant
costs and our business could suffer
The Year 2000 issue is the result of computer programs and embedded hardware
systems having been developed using two digits rather than four to define the
applicable year. These computer programs or hardware that have date-sensitive
software or embedded chips may recognize a date using "00" as the year 1900
rather than the year 2000. This could result in system failures or
miscalculations causing disruptions of operations including, among other things,
a temporary inability to process transactions, send invoices or engage in normal
business activities. As a result, many companies' computer systems may need to
be upgraded or replaced in order to comply with the "Year 2000." We are in the
process of testing our internally developed software. Many of our customers
maintain their Internet operations on commercially available operating systems,
which may be impacted by Year 2000 complications. In addition, we rely on third-
party vendors for certain software and hardware included within our services,
which may not be Year 2000 compliant. Failure of our internal computer systems
or third-party equipment or software, or of systems maintained by our suppliers,
to operate properly with regard to the year 2000 and thereafter could require us
to incur significant unanticipated expenses to remedy any problems and could
cause system interruptions and loss of data. Any of these events could harm our
reputation, business and operating results. We have not yet developed a
comprehensive contingency plan to address the issues that could result from Year
2000 complications. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Year 2000 Issues."
We may have liability for Internet content, and we may not have adequate
liability insurance
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<PAGE>
As a provider of email services, we face potential liability for defamation,
negligence, copyright, patent or trademark infringement and other claims based
on the nature and content of the materials transmitted via email. We do not and
cannot screen all of the content generated by our users, and we could be exposed
to liability with respect to this content. Furthermore, some foreign
governments, such as Germany, have enforced laws and regulations related to
content distributed over the Internet that are more strict than those currently
in place in the United States.
Although we carry general liability and umbrella liability insurance, our
insurance may not cover claims of these types or may not be adequate to
indemnify us for all liability that may be imposed. There is a risk that a
single claim or multiple claims, if successfully asserted against us, could
exceed the total of our coverage limits. There is also a risk that single claim
or multiple claims asserted against us may not qualify for coverage under our
insurance policies as a result of coverage exclusions that are contained within
these policies. Should either of these risks occur, capital contributed by our
shareholders may need to be used in order to settle claims. Any imposition of
liability, particularly liability that is not covered by insurance or is in
excess of insurance coverage could have a material adverse effect on our
reputation and our business and operating results, or could result in the
imposition of criminal penalties.
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<PAGE>
Future sales of our common stock may depress our stock price
Upon the closing of our initial public offering of common stock, we had
approximately 34.3 million shares of common stock outstanding. All 4.5 million
shares sold in the initial public offering are freely tradable. The remaining
29.8 million shares of common stock outstanding after the initial public
offering are subject to lock-up agreements that prohibit the sale of the shares
for 180 days after the date public trading of our shares commenced. Immediately
following the 180-day lockup period, approximately 26.6 million shares which
were outstanding at the close of the initial public offering will become
available for sale. The remaining shares of our common stock will become
available at various times thereafter upon the expiration of one-year holding
periods. Sales of a substantial number of shares of common stock in the public
market after this offering or after the expiration of the lockup and the holding
periods could cause the market price of our common stock to decline. In May
1999, we filed a registration statement with the SEC to register an additional
4,000,000 shares of Common Stock, including 3,000,000 to be sold by Critical
Path. All of these 4,000,000 shares will, when sold, be freely tradeable unless
purchased by our affiliates.
ITEM 3 -- QUANTITATIVE AND QUALITATIVE DISCLOSURE
ABOUT MARKET RISK
Not Applicable.
31
<PAGE>
PART 2 -- OTHER INFORMATION
ITEM 2 -- CHANGES IN SECURITIES AND USE OF PROCEEDS
The effective date of the Company's first registration statement, filed on Form
S-1 under the Securities Act of 1933 (No. 333-71499) relating to Company's
initial public offering of its Common Stock, was March 26, 1999. A total of
5,175,000 shares of the Company's Common Stock were sold to an underwriting
syndicate, which was managed by BancBoston Robertson Stephens, Hambrecht &
Quist, Dain Rauscher Wessels, and FAC/Equities. The offering commenced and was
completed on March 29, 1999, at a price of $24.00 per share. The initial public
offering resulted in gross proceeds to the Company of $124.2 million, $8.7
million of which was applied toward the underwriting discount. Other expenses
related to the offering totaled approximately $1.4 million. The Company's net
proceeds from the offering were $115.5 million, all of which were deposited into
the Company's accounts in April 1999 following the close of the offering. As of
March 31, 1999, none of the offering proceeds had been received or applied by
the Company.
ITEM 6 -- EXHIBITS AND REPORTS ON FORM 8-K
a) Exhibits
27.1 Financial Data Schedule
b) Reports on Form 8-K
No reports on Form 8-K were filed in this quarter.
32
<PAGE>
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.
Date: May 11, 1999
CRITICAL PATH, INC.
by: /s/ David A. Thatcher
-----------------------------------
David A. Thatcher
Chief Financial Officer (Duly Authorized
Officer and Principal Financial Officer)
33
<PAGE>
CRITICAL PATH, INC.
EXHIBITS
TABLE OF CONTENTS
Exhibit No. Description
---------- -----------
27.1 Financial Data Schedule
34
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> MAR-31-1999
<CASH> 22,831,000
<SECURITIES> 0
<RECEIVABLES> 586,000
<ALLOWANCES> (74,000)
<INVENTORY> 0
<CURRENT-ASSETS> 23,997,000
<PP&E> 9,465,000
<DEPRECIATION> (1,671,000)
<TOTAL-ASSETS> 32,681,000
<CURRENT-LIABILITIES> 5,146,000
<BONDS> 0
0
0
<COMMON> 34,000
<OTHER-SE> 23,406,000
<TOTAL-LIABILITY-AND-EQUITY> 32,681,000
<SALES> 0
<TOTAL-REVENUES> 1,049,000
<CGS> 0
<TOTAL-COSTS> 2,360,000
<OTHER-EXPENSES> 16,570,000
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 64,000
<INCOME-PRETAX> (17,594,000)
<INCOME-TAX> 0
<INCOME-CONTINUING> (17,594,000)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (17,594,000)
<EPS-PRIMARY> (2.51)
<EPS-DILUTED> (2.51)
</TABLE>
