<PAGE>
As filed with the Securities and Exchange Commission on January 28, 2000
Registration No. 333-95049
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------
AMENDMENT NO. 1
TO
FORM S-1
REGISTRATION STATEMENT
UNDER THE SECURITIES ACT OF 1933
---------------
WATCHGUARD TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)
Delaware 7372 91-1712427
(State or other (Primary Standard (I.R.S. Employer
jurisdiction of Industrial Classification Identification No.)
incorporation or Code Number)
organization)
316 Occidental Avenue South, Suite 200
Seattle, Washington 98104
(206) 521-8340
(Address, including zip code, and telephone number, including area code, of
registrant's principal executive offices)
---------------
CHRISTOPHER G. SLATT
President, Chief Executive Officer and Chairman of the Board
WatchGuard Technologies, Inc.
316 Occidental Avenue South, Suite 200
Seattle, Washington 98104
(206) 521-8340
(Name, address, including zip code, and telephone number, including area code,
of agent for service)
---------------
Copies to:
Stephen M. Graham Thomas Furlong
Alan C. Smith Mark P. Cawley
Ann L. McGuire Warren C. Jones
Perkins Coie LLP Gray Cary Ware & Freidenrich LLP
1201 Third Avenue, 48th Floor 400 Hamilton Avenue
Seattle, Washington 98101 Palo Alto, California 94301
(206) 583-8888 (650) 328-6561
---------------
Approximate date of commencement of proposed sale to the public: As soon as
practicable after this registration statement becomes effective.
---------------
If any of the securities being registered on this Form are to be offered on a
delayed or continuous basis pursuant to Rule 415 under the Securities Act of
1933, check the following box. [_]
If this Form is filed to register additional securities for an offering
pursuant to Rule 462(b) under the Securities Act of 1933, check the following
box and list the Securities Act registration statement number of the earlier
effective registration statement for the same offering. [_]__________
If this Form is a post-effective amendment filed pursuant to Rule 462(c)
under the Securities Act of 1933, check the following box and list the
Securities Act registration statement number of the earlier effective
registration statement for the same offering. [_]__________
If this Form is a post-effective amendment filed pursuant to Rule 462(d)
under the Securities Act of 1933, check the following box and list the
Securities Act registration statement number of the earlier effective
registration statement for the same offering. [_]__________
If delivery of this prospectus is expected to be made pursuant to Rule 434,
please check the following box. [_]
---------------
The registrant hereby amends this registration statement on such dates as may
be necessary to delay its effective date until the registrant files a further
amendment which specifically states that this registration statement will
thereafter become effective in accordance with Section 8(a) of the Securities
Act of 1933 or until this registration statement becomes effective on such date
as the Commission, acting pursuant to Section 8(a), may determine.
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<PAGE>
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
+The information in this prospectus is not complete and may be changed. We may +
+not sell these securities until the registration statement filed with the +
+Securities and Exchange Commission is effective. This prospectus is not an +
+offer to sell these securities and it is not soliciting an offer to buy these +
+securities in any state where the offer or sale is not permitted. +
++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++++
SUBJECT TO COMPLETION, DATED JANUARY 28, 2000
3,000,000 Shares
[LOGO OF WATCHGUARD TECHNOLOGIES, INC.]
Common Stock
--------
We are selling 1,500,000 shares of common stock and the selling stockholders
are selling an additional 1,500,000 shares of common stock. We will not receive
any of the proceeds from the shares of common stock sold by the selling
stockholders.
Our common stock is quoted on The Nasdaq Stock Market's National Market under
the symbol WGRD. The last reported price of our common stock on January 26,
2000 was $30.44 per share.
The selling stockholders have granted the underwriters an option to purchase
a maximum of 450,000 additional shares to cover over-allotments of shares.
Investing in the common stock involves risks. See "Risk Factors" on page 6.
<TABLE>
<CAPTION>
Underwriting Proceeds Proceeds to
Price to Discounts and to Selling
Public Commissions WatchGuard Stockholders
-------- ------------- ---------- ------------
<S> <C> <C> <C> <C>
Per Share................... $ $ $ $
Total....................... $ $ $ $
</TABLE>
Delivery of the shares of common stock will be made on or about ,
2000.
Neither the Securities and Exchange Commission nor any state securities
commission has approved or disapproved of these securities or determined if
this prospectus is truthful or complete. Any representation to the contrary is
a criminal offense.
Credit Suisse First Boston Dain Rauscher Wessels
SoundView Technology Group
Wit Capital Corporation
The date of this prospectus is , 2000.
<PAGE>
------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Prospectus Summary.................. 3
Risk Factors........................ 6
Forward-Looking Statements.......... 14
Use of Proceeds..................... 15
Price Range of Common Stock......... 15
Dividend Policy..................... 15
Capitalization...................... 16
Dilution............................ 17
Selected Financial Data............. 18
Management's Discussion and Analysis
of Financial Condition and Results
of Operations...................... 19
Business............................ 30
Management.......................... 52
Related-Party Transactions.......... 60
Principal and Selling Stockholders.. 62
Description of Capital Stock........ 65
Shares Eligible for Future Sale..... 68
Underwriting........................ 70
Notice to Canadian Residents........ 72
Legal Matters....................... 73
Experts............................. 73
Where You Can Find More
Information........................ 73
Index to Financial Statements....... F-1
</TABLE>
------------
<PAGE>
PROSPECTUS SUMMARY
This summary highlights information that we present more fully in the rest of
this prospectus. This summary does not contain all the information you should
consider before buying shares in this offering. You should read the entire
prospectus carefully.
WatchGuard Technologies, Inc.
WatchGuard is a leading provider of Internet security solutions designed to
protect enterprises or telecommuters using the Internet for electronic commerce
and communications. Our core market is small- to medium-sized enterprises, or
SMEs, those businesses, governmental entities and educational institutions with
fewer than 1,000 employees. We have recently expanded our marketing focus,
however, to include larger enterprises as well as small offices and home
offices, or SOHOs, and telecommuters, particularly those using broadband
Internet connections. Our innovative subscription-based LiveSecurity solution
enables enterprises to keep their security systems current with minimal effort
through our broadcast over the Internet of threat responses, software updates,
information alerts, expert editorials, support flashes and virus alerts.
LiveSecurity is made possible through an updatable security appliance that
executes software sent from a remote management system that receives our
LiveSecurity broadcasts. Our LiveSecurity solution is a fully integrated,
comprehensive, easy-to-install package. Our solution for SMEs and larger
enterprises features a firewall, encryption, virtual private networking, user
authentication, web surfing control and our LiveSecurity broadcast service. In
January 2000, we announced the introduction of our security solutions for SOHOs
and telecommuters, which we expect to begin shipping in the first quarter of
2000. Our solutions for SOHOs and telecommuters will feature a firewall,
virtual private networking, Internet protocol sharing and our LiveSecurity
broadcast service.
We provide enterprises a security management choice through our two product
offerings, the LiveSecurity System and LiveSecurity for MSS, or managed
security service. Our LiveSecurity System enables enterprises to manage their
own Internet security with an easy-to-configure solution that provides point-
and-click security management. The LiveSecurity System allows enterprises to
rapidly distribute security protection from a desktop personal computer to all
security appliances on their corporate network, while retaining centralized
control and administration. Alternatively, SMEs, larger enterprises and, in the
near future, SOHOs and telecommuters, can outsource their security management
to Internet service providers, or ISPs, that have implemented our LiveSecurity
for MSS. Through LiveSecurity for MSS, enterprises can sign up with an ISP to
centrally configure, monitor and update their network security. For the ISP,
our technology greatly improves the economics of managed security services
through a scalable delivery platform that enables the ISP to remotely configure
and manage thousands of customer sites quickly, easily and economically.
We initially incorporated in Washington in 1996 and reincorporated in
Delaware in 1997. References to "we," "our," "us" and "WatchGuard" in this
prospectus refer to WatchGuard Technologies, Inc. and its predecessor. Our
executive offices are located at 316 Occidental Avenue South, Suite 200,
Seattle, Washington 98104, and our telephone number is (206) 521-8340. Our web
site is located at http://www.watchguard.com. Any information that is included
on or linked to our web site is not a part of this prospectus.
We own or have rights to various trademarks and trade names used in our
business. These include WatchGuard(R), Firebox(TM) and LiveSecurity(TM). This
prospectus also includes trademarks, service marks and trade names of other
companies, which remain the property of their owners.
3
<PAGE>
The Offering
<TABLE>
<S> <C>
Common stock offered by WatchGuard......... 1,500,000 shares
Common stock offered by the selling 1,500,000 shares
stockholders..............................
Common stock to be outstanding after this
offering.................................. 21,136,752 shares
Use of proceeds............................ For working capital, corporate facilities
relocation or expansion, possible repayment
of indebtedness and other general corporate
purposes, as well as the possible
acquisition of or investment in
complementary businesses or technologies
Nasdaq National Market symbol.............. WGRD
</TABLE>
The number of shares of outstanding common stock is based on shares
outstanding as of December 31, 1999, and excludes
. 524,999 shares available for grant under our stock option plan as of
December 31, 1999;
. 6,502,680 shares of common stock issuable upon exercise of options
outstanding under our stock option plan as of December 31, 1999, at a
weighted average exercise price of $4.60 per share, of which options to
purchase 2,359,707 shares were exercisable;
. 225,000 shares of common stock issuable upon exercise of warrants
outstanding as of December 31, 1999, at a weighted average exercise
price of $0.92 per share, all of which were exercisable; and
. 600,000 shares of common stock available for issuance under our employee
stock purchase plan as of December 31, 1999.
Except where stated otherwise, the information we present in this prospectus
assumes (1) no exercise by the underwriters of their over-allotment option and
(2) a public offering price of $30.75 per share, which is based on the average
of the high and low trading prices of our common stock on January 26, 2000, as
reported on The Nasdaq National Market.
You should rely only on the information contained in this document or to
which we have referred you. We have not authorized anyone to provide you with
information that is different. This document may be used only where it is legal
to sell these securities. The information in this document may be accurate only
on the date of this document.
4
<PAGE>
Summary Financial Data
<TABLE>
<CAPTION>
Period From
February 14, 1996 Year Ended Nine Months Ended
(Inception) December 31, September 30,
to December 31, ---------------- ------------------
1996 1997 1998 1998 1999
----------------- ------- ------- -------- --------
(unaudited)
(In thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Total revenues ........ $ 331 $ 5,098 $11,379 $ 7,766 $ 14,096
Operating loss ........ (462) (4,396) (9,000) (5,889) (9,218)
Net loss .............. (468) (4,334) (9,119) (5,948) (9,447)
Basic and diluted net
loss per share ....... N/A $(17.17) $(11.34) $ (8.01) $ (1.76)
Shares used in
calculation of basic
and diluted net loss
per share ............ N/A 252 804 743 5,379
Pro forma basic and
diluted net loss per
share (unaudited)..... $ (0.68) $ (0.60)
Shares used in
calculation of pro
forma basic and
diluted net loss per
share (unaudited)..... 13,366 15,755
</TABLE>
See note 6 of Notes to Financial Statements for information concerning the
calculation of pro forma basic and diluted net loss per share.
<TABLE>
<CAPTION>
September 30, 1999
--------------------
Actual As Adjusted
-------- -----------
(unaudited)
(In thousands)
<S> <C> <C>
Balance Sheet Data:
Cash and cash equivalents................................. $ 32,468 $ 75,275
Working capital........................................... 31,543 74,812
Total assets.............................................. 40,306 83,113
Long-term debt, less current portion...................... -- --
Total stockholders' equity................................ 33,344 76,613
</TABLE>
The preceding table summarizes
. actual balance sheet data; and
. balance sheet data as adjusted to give effect to the sale by
WatchGuard of 1,500,000 shares of common stock offered through this
prospectus at an assumed public offering price of $30.75 per share,
after deducting underwriting discounts and commissions and estimated
offering expenses.
5
<PAGE>
RISK FACTORS
In addition to the other information contained in this prospectus, you should
carefully read and consider the following risk factors before purchasing our
common stock. If any of these risks actually occur, our business, financial
condition or operating results could be adversely affected, the trading price
of our common stock could decline and you could lose all or part of your
investment.
We have incurred losses since inception and may never be profitable, which
could result in a decline in the value of our common stock and a loss of your
investment.
We expect our operating losses and negative cash flows to continue. Although
our revenues have increased each year since we began operations, we do not
believe that the historical percentage growth rate of our revenues will be
sustainable as our revenue base increases. Moreover, we currently expect to
increase our operating expenses significantly in connection with
. expanding into new geographic markets;
. expanding into new product markets;
. continuing to develop our technology;
. hiring additional personnel;
. relocating or expanding our corporate facilities in the next six to
eight months;
. upgrading our information and internal control systems; and
. pursuing potential strategic acquisitions.
We may never generate profits, and if we do become profitable, we may be unable
to sustain or increase profitability on a quarterly or annual basis. As a
result, the trading price of our common stock could decline and you could lose
all or part of your investment. We have incurred net losses and experienced
negative cash flows in each quarter since we began doing business. As of
September 30, 1999, we had an accumulated deficit of approximately $23.4
million.
Our operating results fluctuate and could fall below expectations of securities
analysts and investors, resulting in a decrease in our stock price.
Our quarterly and yearly operating results have varied widely in the past and
will probably continue to fluctuate. For this reason, we believe that period-
to-period comparisons of our operating results are not meaningful. In addition,
our limited operating history makes predicting our future performance
difficult. As a result of these factors, our operating results for a particular
quarter or year may fall below the expectations of securities analysts and
investors, which could result in a decrease in our stock price.
We base our spending levels for product development, sales and marketing and
other operating expenses largely on our expected future revenues. Because our
expenses are largely fixed for a particular quarter or year, we may be unable
to adjust our spending in time to compensate for any unexpected quarterly or
annual shortfall in revenues. A failure to so adjust our spending in time also
could cause operating results to fall below the expectations of securities
analysts and investors, resulting in a decrease in our stock price.
Seasonality and concentration of revenues at the end of the quarter could cause
our revenues to fall below the expectations of securities analysts and
investors, resulting in a decrease in our stock price.
Our domestic and international sales tend to be lower in the summer months,
when businesses often defer purchasing decisions. Also, as a result of customer
buying patterns and the efforts of our sales force to meet or exceed quarterly
and year-end quotas, historically we have earned a substantial portion of a
quarter's revenues during its last month. If expected revenues at the end of
any quarter are delayed, our revenues for that quarter could fall below the
expectations of securities analysts and investors, resulting in a decrease in
our stock price.
6
<PAGE>
Because many potential customers are unaware of the need for Internet security
or may perceive it as costly and difficult to implement, our products and
services may not achieve market acceptance.
We believe that many potential customers, particularly SMEs, SOHOs and
telecommuters, are not fully aware of the need for Internet security products
and services. Historically, only enterprises having substantial resources have
developed or purchased Internet security solutions. Also, there is a perception
that Internet security is costly and difficult to implement. We will therefore
not succeed unless we can educate our market about the need for Internet
security and convince our potential customers of our ability to provide this
security in a cost-effective and administratively feasible manner. Although we
have spent, and will continue to spend, considerable resources educating
potential customers about the need for Internet security and the benefits of
our products and services, our efforts may be unsuccessful.
If potential customers do not accept our LiveSecurity products and services,
our business will not succeed.
We currently expect all future revenues to be generated through sales of our
LiveSecurity Internet security products and related services, particularly
subscription and license fees. Our success depends on market acceptance of our
LiveSecurity products and services and our ability and the ability of our ISP
partners to obtain and retain LiveSecurity customers. Our LiveSecurity products
and services, however, are relatively new and unproven. The broadcast portion
of our LiveSecurity products has been available only since February 1999 and
our LiveSecurity for MSS product has been available only since September 1998.
To receive our broadcasts, enterprises will be required to pay an annual
subscription fee, either to us or, if they obtain LiveSecurity through an ISP,
to the ISP. We are not aware of any other Internet security product that allows
enterprises to keep their security solution current by receiving broadcasts of
software updates and related information over the Internet. Enterprises may be
unwilling to pay a subscription fee to keep their Internet security up to date.
Because our broadcast service is relatively new, we cannot predict the rate at
which our customers will renew their annual subscriptions. In addition, most
businesses implementing security services have traditionally managed their own
Internet security rather than seeking the services of third-party service
providers. As a result, our products and services and the outsourcing of
Internet security to third parties may not achieve significant market
acceptance.
If our relationships with ISPs are unsuccessful, our ability to market and sell
our products and services will be limited.
We expect a significant percentage of our revenues to be derived from our
relationships with domestic and international ISPs that implement our
LiveSecurity for MSS solution. If these ISPs are unsuccessful in marketing and
implementing our LiveSecurity for MSS solution, our operating results will be
materially harmed. Because our relationships with ISPs are relatively new, we
cannot predict the degree to which the ISPs will succeed in marketing and
selling services based on our products and services. Many of the ISPs with
which we have established relationships have not had an opportunity to fully
develop and implement service offerings incorporating LiveSecurity. We cannot
predict how long our current or potential ISP partners will take to complete
this development and implementation. Until and unless this development and
implementation is achieved, our revenues from ISPs will be limited. If the ISPs
fail to provide adequate installation, deployment and support of our products
and services, end-users could decide not to subscribe, or cease subscribing,
for managed services that use our solution. The ISPs will offer our products
and services in combination with other products and services, some of which may
be competitive with our products and services.
If our third-party resellers and distributors fail to perform, our ability to
sell our products and services will be limited.
We sell most of our products and services through value-added resellers and
distributors, and we expect our success to continue to depend in large part on
their performance. Our resellers and distributors have the ability to sell
products and services that are competitive with ours, to devote more resources
to those competitive products or to cease selling our products and services
altogether. While no single reseller or
7
<PAGE>
distributor currently accounts for more than 10% of our total revenues, the
loss of or reduction in sales to several value-added resellers or a
distributor, particularly to competitive products offered by other companies,
could adversely affect our revenues.
Product returns or retroactive price adjustments could exceed our allowances,
which could adversely affect our operating results.
We provide some of our distributors and resellers with product return rights
for stock rotation. We also provide some of our distributors and resellers with
price protection rights for inventories of our products held by those
distributors or resellers if we lower our prices for those products. We may
experience significant returns and price adjustments for which we may not have
adequate allowances. The short life cycles of our products and the difficulty
of predicting future sales increase the risk that new product introductions or
price reductions by us or our competitors could result in significant product
returns or price adjustments. In September 1998, when we introduced the Firebox
II security appliance, we experienced an increase in returns of previous
products and product versions. Provisions for returns and allowances for the
years ended December 31, 1997 and 1998 and for the nine months ended September
30, 1999 were $0, $1,655,000 and $915,000, or 0%, 14% and 6% of total revenues
before returns and allowances.
If we are unable to compete successfully in the highly competitive market for
Internet security products and services, our business will fail.
The market for Internet security products is intensely competitive and we
expect competition to intensify in the future. An increase in competitive
pressures in our market or our failure to compete effectively may result in
pricing reductions, reduced gross margins and loss of market share. Currently,
the dominant competitors in our industry are Cisco Systems, Inc., Check Point
Software Technologies Ltd. and Nokia Corporation. We expect the introduction of
our SOHO and telecommuter products to increase competition with SonicWALL Inc.,
a developer of security appliances for SOHOs and home users. Other current and
potential competitors include hardware, software and operating system vendors
such as Axent Technologies, Inc., Lucent Technologies, Inc., Microsoft
Corporation, Network Associates, Inc., Novell, Inc., Sun Microsystems Inc. and
a number of smaller companies. Many of our competitors have longer operating
histories, greater name recognition, larger customer bases and significantly
greater financial, technical, marketing and other resources than we do. In
addition, our current and potential competitors have established or may
establish cooperative relationships among themselves or with third parties that
may further enhance their resources, such as the partnership between Check
Point and Nokia. As a result, they may be able to adapt more quickly to new
technologies and customer needs, devote greater resources to the promotion or
sale of their products and services, initiate or withstand substantial price
competition, take advantage of acquisition or other opportunities more readily
or develop and expand their product and service offerings more quickly. In
addition, our competitors may bundle products competitive with ours with other
products that they may sell to our current or potential customers. These
customers may accept these bundled products rather than separately purchasing
our products.
Rapid changes in technology and industry standards could render our products
and services unmarketable or obsolete, and we may be unable to introduce new
products and services timely and successfully.
To succeed, we must continually change and improve our products in response
to rapid technological developments and changes in operating systems, Internet
access and communications, application and networking software, computer and
communications hardware, programming tools, computer language technology and
hacker techniques. We may be unable to successfully and timely develop these
new products and services or achieve and maintain market acceptance. The
development of new, technologically advanced products and services is a complex
and uncertain process requiring great innovation and the ability to anticipate
technological and market trends. Because Internet security technology is
complex, it can require long development and testing periods. Releasing new
products and services prematurely may result in quality problems, and releasing
them late may result in loss of customer confidence and market share. In the
past, we have on occasion experienced delays in the scheduled introduction of
new and enhanced products and services,
8
<PAGE>
and we may experience delays in the future. When we do introduce new or
enhanced products and services, we may be unable to manage the transition from
the older products and services to minimize disruption in customer ordering
patterns, avoid excessive inventories of older products and deliver enough new
products and services to meet customer demand.
We may be required to defend lawsuits or pay damages in connection with the
alleged or actual failure of our products and services.
Because our products and services provide and monitor Internet security and
may protect valuable information, we may face claims for product liability,
tort or breach of warranty relating to our products and services. Anyone who
circumvents our security measures could misappropriate the confidential
information or other property of end-users using our products and services or
interrupt their operations. If that happens, affected end-users or ISPs may sue
us. In addition, we may face liability for breaches caused by faulty
installation of our products by resellers or end-users. Although we attempt to
reduce the risk of losses from claims through contractual warranty disclaimers
and liability limitations, these provisions may be unenforceable. Some courts,
for example, have found contractual limitations of liability in standard
software licenses to be unenforceable because the licensee does not sign them.
Defending a suit, regardless of its merit, could be costly and could divert
management attention. Although we currently maintain business liability
insurance, this coverage may be inadequate or may be unavailable in the future
on acceptable terms, if at all.
A breach of security could harm public perception of our products and services.
We will not succeed unless the marketplace is confident that we provide
effective Internet security protection. Even networks protected by our software
products may be vulnerable to electronic break-ins and computer viruses. If an
actual or perceived breach of Internet security occurs in an end-user's
systems, regardless of whether the breach is attributable to us, the market
perception of the efficacy of our products and services could be harmed. This
could cause us and our ISP partners to lose current and potential customers or
cause us to lose potential resellers, distributors and ISP partners. Because
the techniques used by computer hackers to access or sabotage networks change
frequently and generally are not recognized until launched against a target, we
may be unable to anticipate these techniques.
If we are unable to prevent attacks on our internal network system by computer
hackers, public perception of our products and services will be harmed.
Because we provide Internet security, we have become a greater target of
attacks by computer hackers. We have experienced attacks by computer hackers in
the past and expect attacks to continue. If attacks on our internal network
system are successful, public perception of our products and services will be
harmed.
Failure to address strain on our resources caused by our rapid growth will
result in our inability to effectively manage our business.
Our current systems, management and resources will be inadequate if we
continue to grow. Our business has grown rapidly in size and complexity in the
last three years. This rapid expansion has placed significant strain on our
administrative, operational and financial resources and has resulted in ever-
increasing responsibilities for our management personnel. We will be unable to
effectively manage our business if we are unable to timely and successfully
alleviate the strain on our resources caused by our rapid growth.
We may be unable to adequately expand our operational systems to accommodate
growth, which could harm our ability to deliver our products and services.
Our operational systems have not been tested at the customer volumes that may
be required in the future. We may encounter performance difficulties when
operating with a substantially greater number of customers. In implementing our
LiveSecurity products, we have experienced periodic interruptions affecting all
or a portion of our systems, and we believe that interruptions will continue to
occur from time to time. These interruptions
9
<PAGE>
could harm our ability to deliver our products and services. An inability to
add software and hardware or to develop and upgrade existing technology or
operational systems to handle increased traffic may cause unanticipated system
disruptions, slower response times and poor customer service, including
problems filling customer orders.
We may be unable to adequately protect our operational systems from damage,
failure or interruption, which could harm our reputation and our ability to
attract and retain customers.
Our operations, customer service, reputation and ability to attract and
retain customers depend on the uninterrupted operation of our operational
systems. Although we have off-site backup facilities and take other precautions
to prevent damage, failure or interruption of our systems, our precautions may
be inadequate. Any damage, failure or interruption of our computer or
communications systems could lead to service interruptions, delays, loss of
data and inability to accept and fill customer orders and provide customers
with LiveSecurity updates.
We may be unable to deliver our products and services if we cannot continue to
license third-party technology that is important for the functionality of our
products.
Our success will depend in part on our continued ability to license
technology that is important for the functionality of our products. A
significant interruption in the supply of a third-party technology could delay
our development and sales until we can find, license and integrate equivalent
technology. This could damage our brand and result in loss of current and
potential customers. Although we believe that we could find other sources for
the technology we license, alternative technologies may be unavailable on
acceptable terms, if at all. We depend on our third-party licensers to deliver
reliable, high-quality products, develop new products on a timely and cost-
effective basis and respond to evolving technology and changes in industry
standards. We also depend on the continued compatibility of our third-party
software with future versions of our products.
We may be unable to deliver our products and services if our single-source
manufacturers fail to supply hardware with acceptable quality, quantity and
cost.
We outsource all of our hardware manufacturing and assembly for each of our
SME and larger-enterprise solutions and our SOHO and telecommuter solutions to
single-source motherboard manufacturers and assembly houses. While the single-
source vendors for our SME and larger-enterprise products have produced
hardware with acceptable quality, quantity and cost in the past, they may be
unable to meet our future demands. Our relationships with the single-source
vendor for our SOHO and telecommuter products are new and unproven. Although we
believe that we could find another manufacturer and assembly house for each of
our product lines, our operations could be disrupted if we have to switch to a
replacement vendor or if our hardware supply is interrupted for an extended
period. This could result in loss of customer orders and revenue.
We may have to reduce or cease operations if we are unable to obtain the
funding necessary to meet our working capital requirements.
Our future revenues may be insufficient to support the expenses of our
operations and the expansion of our business. We may therefore need additional
equity or debt capital to finance our operations. If we are unable to generate
sufficient cash flow from operations or obtain funds through additional
financing, we may have to reduce some or all of our development and sales and
marketing efforts or cease operations. We believe that the net proceeds from
this offering, together with our existing cash balances and our existing lines
of credit, should be sufficient to meet our capital requirements for at least
the next 18 months. Our capital requirements depend on several factors,
however, including the rate of market acceptance of our products and services,
our ability to expand our customer base and the growth of our sales and
marketing capabilities. If our capital requirements vary from our current
plans, we may require additional financing sooner than we anticipate. Financing
may be unavailable to us when needed or on acceptable terms.
10
<PAGE>
We may be unable to adequately protect our proprietary rights, which may limit
our ability to compete effectively.
Despite our efforts to protect our proprietary rights, unauthorized parties
may misappropriate or infringe on our trade secrets, copyrights, trademarks,
service marks and similar proprietary rights. We face additional risk when
conducting business in countries that have poorly developed or inadequately
enforced intellectual property laws. While we are unable to determine the
extent to which piracy of our software products exists, we expect piracy to be
a continuing concern, particularly in international markets and as a result of
the growing use of the Internet. In any event, competitors may independently
develop similar or superior technologies or duplicate the technologies we have
developed, which could substantially limit the value of our intellectual
property.
Intellectual property claims and litigation could subject us to significant
liability for damages and invalidation of our proprietary rights.
In the future, we may have to resort to litigation to protect our
intellectual property rights, to protect our trade secrets or to determine the
validity and scope of the proprietary rights of others. Any litigation,
regardless of its success, would probably be costly and require significant
time and attention of our key management and technical personnel. Litigation
could also force us to
. stop or delay selling, incorporating or using products that incorporate
the challenged intellectual property;
. pay damages;
. enter into licensing or royalty agreements, which may be unavailable on
acceptable terms; or
. redesign products or services that incorporate infringing technology.
Although we have not been sued for intellectual property infringement, we may
face infringement claims from third parties in the future. The software
industry has seen frequent litigation over intellectual property rights, and we
expect that participants in the Internet security industry will be increasingly
subject to infringement claims as the number of products, services and
competitors grows and functionality of products and services overlaps.
Undetected product errors or defects could result in loss of revenues, delayed
market acceptance and claims against us.
Our products and services may contain undetected errors or defects,
especially when first released. Despite extensive testing, some errors are
discovered only after a product has been installed and used by customers. Any
errors discovered after commercial release could result in loss of revenues or
claims against us.
Governmental controls over the export or import of encryption technology could
cause us to lose sales.
Any additional governmental regulation of imports or exports or failure to
obtain required export approval of our encryption technologies could adversely
affect our international and domestic sales. The United States and various
foreign governments have imposed controls, export license requirements and
restrictions on the import or export of some technologies, especially
encryption technology. In addition, from time to time governmental agencies
have proposed additional regulation of encryption technology, such as requiring
the escrow and governmental recovery of private encryption keys. Additional
regulation of encryption technology could delay or prevent the acceptance and
use of encryption products and public networks for secure communications. This,
in turn, could result in decreased demand for our products and services.
In addition, some foreign competitors are subject to less stringent controls
on exporting their encryption technologies. As a result, they may be able to
compete more effectively than we can in the U.S. and international Internet
security markets.
11
<PAGE>
If we do not retain our key employees, our ability to execute our business
strategy will be impaired.
Our future success will depend largely on the efforts and abilities of our
senior management and our key development, technical, operations, information
systems, customer support and sales and marketing personnel and our ability to
retain them. These employees are not obligated to continue their employment
with us and may leave us at any time.
If we do not expand our international operations and successfully overcome the
risks inherent in international business activities, the growth of our business
will be limited.
Our ability to grow will depend in part on the expansion of our international
sales and operations, which are expected to continue to account for a
significant portion of our revenues. Sales to customers outside of North
America accounted for approximately 56% of our net revenues in 1997, 35% in
1998 and 50% in the nine months ended September 30, 1999. The failure of our
resellers and distributors to sell our products internationally would limit our
ability to increase our revenues. In addition, our international sales are
subject to the risks inherent in international business activities, including
. cost of customizing products for foreign countries;
. export and import restrictions, such as those affecting encryption
commodities and software;
. difficulties in acquiring and authenticating customer information;
. reduced protection of intellectual property rights and increased
liability exposure; and
. regional economic and political conditions.
Our international sales currently are U.S. dollar-denominated. As a result, an
increase in the value of the U.S. dollar relative to foreign currencies could
make our products less competitive in international markets.
Undiscovered year 2000-related computer problems could disrupt our operations.
We believe that the current versions of the internally developed software
technologies incorporated in our products and services, as well as our internal
management and other administrative and external information systems, are year
2000 compliant. When the century changed, we experienced no disruption to our
business operations and no product failures as a result of year 2000 compliance
issues or otherwise. Nonetheless, some year 2000 problems may not appear until
several months after January 1, 2000. As a result, we may still face claims for
undiscovered year 2000 errors in our own products or for year 2000 issues
arising from third-party products that we integrate into our products and
services or with which our systems and products exchange data. In addition, if
our suppliers, vendors or distributors encounter year 2000 software, firmware
and hardware problems, our ability to deliver our products and services could
be disrupted.
The integration of BeadleNet, LLC and any future acquisitions may be difficult
and disruptive.
In October 1999, we acquired BeadleNet, LLC, a privately held developer of
Internet security solutions for small offices and home offices. We are
currently in the process of integrating the BeadleNet business with our
business. This integration is subject to risks commonly encountered in making
acquisitions, including
. loss of key personnel;
. difficulties in assimilating BeadleNet's technologies, products,
personnel and operations;
. disruption of our ongoing business; and
. the inability of our sales force, consultants and development staff to
adapt to the new product line.
We may not successfully overcome these or any other problems encountered in
connection with the integration of BeadleNet. As part of our business strategy,
we expect to consider acquiring other companies. We may be unable to
successfully integrate the technologies, products, personnel or operation of
companies that we may acquire in the future.
12
<PAGE>
The concentrated ownership of our common stock could delay or prevent a change
of control, which could reduce the market price of our common stock.
After this offering, our directors, executive officers and their affiliates
will beneficially own, in the aggregate, approximately 57.37% of our
outstanding common stock, or 55.96% if the underwriters exercise their over-
allotment option in full. As a result, these stockholders are able to exercise
control over all matters requiring stockholder approval, including the election
of directors and approval of significant corporate transactions such as
acquisitions, and to block unsolicited tender offers. This concentration of
ownership therefore could have the effect of delaying or preventing a third
party from acquiring control over us at a premium over the then-current market
price of our common stock, which could result in a decrease in our stock price.
You may be unable to resell your shares at or above the public offering price,
and the price of our stock is volatile.
You may be unable to resell your shares at or above the public offering price
for a number of reasons, including
. actual or anticipated variations in quarterly or annual operating
results;
. changes in analysts' earning projections or analysts' recommendations;
. our inability to successfully implement our business strategy;
. changes in business conditions affecting our customers, our competitors
and us; and
. changes in accounting standards that adversely affect our revenues and
earnings.
In recent years, moreover, the stock market in general and the market for
Internet-related technology companies in particular have experienced extreme
price and volume fluctuations, often unrelated to the operating performance of
the affected companies. Our common stock has experienced, and is likely to
continue to experience, these fluctuations in price, regardless of our
performance. Market fluctuations or volatility could cause the market price of
our common stock to decline.
Future sales of our common stock may depress our stock price.
Sales of a substantial number of shares of our common stock in the public
market following this offering could adversely affect the market price of our
common stock. After this offering, we will have outstanding 21,136,752 shares
of common stock. All the shares sold in this offering will be freely tradable.
Of the remaining 18,136,752 shares of common stock that will be outstanding
after this offering, 14,010,545 are restricted as a result of securities laws
or lock-up agreements signed by the holder and will be available for sale in
the public market as follows:
<TABLE>
<CAPTION>
Number of
Date of Availability for Sale Shares
----------------------------- ----------
<S> <C>
On the date of this prospectus..................................... 1,110,053
90 days after the date of this prospectus.......................... 12,491,185
At various times thereafter on the expiration of one-year holding
periods........................................................... 409,307
</TABLE>
Credit Suisse First Boston Corporation may, in its sole discretion and at any
time without prior notice, release all or any portion of the common stock
subject to lock-up agreements.
13
<PAGE>
FORWARD-LOOKING STATEMENTS
Some of our statements in this prospectus, including those under the captions
"Prospectus Summary," "Risk Factors," "Use of Proceeds," "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Business," are forward-looking statements that involve risks and
uncertainties. These forward-looking statements include statements about our
plans, objectives, expectations, intentions, future financial performance and
other statements that are not historical facts. We use words such as
anticipates, believes, expects, future and intends, and similar expressions, to
identify forward-looking statements, but the absence of these words does not
mean that the statement is not forward-looking. You should not unduly rely on
these forward-looking statements, which apply only as of the date of this
prospectus. Our actual results could differ materially from those anticipated
in the forward-looking statements for many reasons, including the risks
described under "Risk Factors."
14
<PAGE>
USE OF PROCEEDS
We estimate that we will receive approximately $43.3 million in net proceeds
from the sale of the 1,500,000 shares of common stock we sell in this offering
at an assumed public offering price of $30.75 per share, after deducting
underwriting discounts and commissions and estimated offering expenses we
expect to pay. We will not receive any proceeds from any shares sold by the
selling stockholders.
We intend to use the net proceeds from this offering primarily for additional
working capital, relocation or expansion of our corporate facilities, possible
repayment of debt and other general corporate purposes, as well as the possible
acquisition of or investment in complementary businesses or technologies. We
expect to use up to $2.5 million of the net proceeds for initial leasehold
improvements and acquisition of furniture and fixtures associated with the
expected relocation and expansion of our corporate headquarters within the next
six to eight months. We may use approximately $400,000 of the net proceeds from
this offering to repay the entire outstanding balance on our term loan
facilities. As of December 31, 1999, the outstanding balances on our two term
loans were $288,000 and $95,000. The first of these term loans bears interest
at prime plus 1.5% per year, which was 10.0% as of December 31, 1999, and
matures on March 5, 2001. The second of these term loans bears interest at
prime plus 1% per year, which was 9.5% as of December 31, 1999, and matures on
December 31, 2002. The amounts that we actually spend for working capital
purposes will vary significantly depending on a number of factors, including
any future revenue growth, the amount of cash we generate from operations and
the progress of our product development efforts. Although we have no present
plans, agreements or proposals to do so, we may also use a portion of the net
proceeds to license or acquire new products or technologies or to acquire or
invest in businesses complementary to our own. As a result, we will retain
broad discretion in allocating the net proceeds from this offering. Pending
their use, we will invest the net proceeds in interest-bearing, investment-
grade securities.
PRICE RANGE OF COMMON STOCK
Our common stock began trading on The Nasdaq National Market on July 30, 1999
under the symbol WGRD. The following table lists, for the periods indicated,
the high and low sales prices per share of our common stock as reported on The
Nasdaq National Market.
<TABLE>
<CAPTION>
Price Range of
Common Stock
---------------
High Low
------- -------
<S> <C> <C>
Year Ended December 31, 1999
Third quarter (beginning July 30, 1999)................... $ 18.38 $ 10.38
Fourth quarter............................................ 40.00 13.81
Year Ending December 31, 2000
First quarter (through January 26, 2000).................. $ 38.25 $ 22.63
</TABLE>
The last reported sale price of our common stock on The Nasdaq National
Market was $30.44 per share on January 26, 2000. As of December 31, 1999, there
were approximately 75 holders of record of our common stock. This does not
include the number of persons whose stock is in nominee or "street name"
accounts through brokers.
DIVIDEND POLICY
We have never paid cash dividends on our common stock. We currently intend to
retain any future earnings to fund the development and growth of our business
and therefore do not anticipate paying any cash dividends in the foreseeable
future. Furthermore, our line of credit agreement prohibits the payment of
dividends without the bank's prior written consent.
15
<PAGE>
CAPITALIZATION
The following table shows
. our actual capitalization on September 30, 1999; and
. our capitalization as adjusted to reflect the sale by us of 1,500,000
shares of common stock at an assumed public offering price of $30.75 per
share, after deducting underwriting discounts and commissions and
estimated offering expenses we expect to pay.
You should read this table in conjunction with "Management's Discussion and
Analysis of Financial Condition and Results of Operations," our historical
financial statements and the notes to the financial statements included in this
prospectus.
<TABLE>
<CAPTION>
September 30, 1999
---------------------
Actual As Adjusted
-------- -----------
(unaudited)
(In thousands)
<S> <C> <C>
Stockholders' equity:
Preferred stock: 10,000,000 shares authorized; no
shares issued and outstanding......................... $ -- $ --
Common stock: 80,000,000 shares authorized; 19,027,920
shares issued and outstanding, actual; 20,527,920
shares issued and outstanding, as adjusted............ 19 21
Additional paid-in capital............................. 57,624 100,891
Deferred stock-based compensation...................... (931) (931)
Accumulated deficit.................................... (23,368) (23,368)
-------- --------
Total capitalization and stockholders' equity........ $ 33,344 $ 76,613
======== ========
</TABLE>
The number of shares of common stock issued and outstanding excludes
. 1,067,329 shares available for grant under our stock option plan as of
September 30, 1999;
. 6,026,372 shares of common stock issuable upon exercise of options
outstanding under our stock option plan as of September 30, 1999, at a
weighted average exercise price of $3.57 per share, of which options to
purchase 2,032,754 shares were exercisable;
. 255,000 shares of common stock issuable upon exercise of warrants
outstanding as of September 30, 1999, at a weighted average exercise
price of $0.82 per share, all of which were exercisable; and
. 600,000 shares of common stock available for issuance under our employee
stock purchase plan as of September 30, 1999.
16
<PAGE>
DILUTION
If you invest in our common stock, your interest will be diluted to the
extent of the difference between the public offering price per share and the
net tangible book value per share after this offering. We calculate net
tangible book value per share by dividing the net tangible book value, which is
total assets less intangible assets and total liabilities, by the number of
outstanding shares of common stock.
Our net tangible book value at September 30, 1999 was $33.3 million, or $1.75
per share of common stock. After giving effect to the sale by us of 1,500,000
shares of common stock in this offering at an assumed public offering price of
$30.75 per share, less underwriting discounts and commissions and estimated
offering expenses we expect to pay, our net tangible book value at September
30, 1999 would have been $76.6 million, or $3.73 per share. This represents an
immediate increase in the net tangible book value of $1.98 per share to
existing stockholders and an immediate dilution of $27.02 per share to new
investors, or approximately 88% of an assumed public offering price of $30.75
per share. The following table illustrates this per-share dilution:
<TABLE>
<S> <C> <C>
Assumed public offering price per share......................... $30.75
Net tangible book value per share as of September 30, 1999.... $1.75
Increase per share attributable to new investors.............. 1.98
-----
Net tangible book value per share after this offering........... 3.73
------
Dilution per share to new investors............................. $27.02
======
</TABLE>
The following table shows, as of September 30, 1999, the number of shares of
common stock purchased from us, the total consideration paid to us and the
average price per share paid by existing stockholders and by new investors
purchasing common stock in this offering at the assumed public offering price.
<TABLE>
<CAPTION>
Shares Purchased Total Consideration Average
------------------ -------------------- Price Per
Number Percent Amount Percent Share
---------- ------- ------------ ------- ---------
<S> <C> <C> <C> <C> <C>
Existing stockholders...... 19,027,920 92.7% $ 59,047,000 56.1% $ 3.10
New investors.............. 1,500,000 7.3 46,125,000 43.9 30.75
---------- ----- ------------ -----
Total.................... 20,527,920 100.0% $105,172,000 100.0%
========== ===== ============ =====
</TABLE>
The foregoing table assumes that no options or warrants were exercised after
September 30, 1999. As of September 30, 1999, we had outstanding options and
warrants to purchase shares of common stock as follows:
<TABLE>
<CAPTION>
Weighted
Average
Number of Exercise
Shares Price
--------- --------
<S> <C> <C>
Stock option plan..................................... 6,026,372 $ 3.57
Warrants.............................................. 255,000 0.82
---------
6,281,372 $ 3.46
=========
</TABLE>
Additionally, there were 1,067,329 option shares available for future grant
under our stock option plan and 600,000 shares available for issuance under our
employee stock purchase plan. There will be further dilution to new investors
to the extent that option and warrant holders exercise these outstanding
options and warrants or any options or warrants we grant in the future.
17
<PAGE>
SELECTED FINANCIAL DATA
The statement of operations data for the period from February 14, 1996
(inception) to December 31, 1996 and for the years ended December 31, 1997 and
1998, and the balance sheet data as of December 31, 1997 and 1998 are derived
from our financial statements, which have been audited by Ernst & Young LLP,
independent auditors, and are included elsewhere in this prospectus. The
balance sheet data as of December 31, 1996 are derived from audited financial
statements not included in this prospectus. The financial data for the nine
months ended September 30, 1998 and 1999 and as of September 30, 1999 are
derived from unaudited financial statements included elsewhere in this
prospectus. We have prepared this unaudited information on the same basis as
the audited financial statements and have included all adjustments, consisting
only of normal recurring adjustments, that we consider necessary for a fair
presentation of our financial position and operating results for those periods.
When you read this selected financial data, it is important that you also read
the historical financial statements and related notes included in this
prospectus, as well as the section of this prospectus entitled "Management's
Discussion and Analysis of Financial Condition and Results of Operations." The
historical results are not necessarily indicative of future results. See note 6
of Notes to Financial Statements for an explanation of the method used to
determine the number of shares used in computing pro forma basic and diluted
net loss per share.
<TABLE>
<CAPTION>
Period From Year Ended Nine Months Ended
February 14, 1996 December 31, September 30,
(Inception) to ------------------ ------------------
December 31, 1996 1997 1998 1998 1999
----------------- -------- -------- -------- --------
(In thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Revenues, net:
Product................ $ 329 $ 4,975 $ 10,678 $ 7,404 $ 11,832
Service................ 2 123 701 362 2,264
------ -------- -------- -------- --------
Total revenues....... 331 5,098 11,379 7,766 14,096
Cost of revenues....... 104 1,610 3,925 2,529 5,566
------ -------- -------- -------- --------
Gross margin........... 227 3,488 7,454 5,237 8,530
Operating expenses:
Sales and marketing.... 224 4,369 8,520 6,072 9,695
Research and
development........... 274 2,192 4,442 3,012 4,740
General and
administrative........ 191 1,323 2,453 1,590 2,616
Stock-based
compensation.......... -- -- 1,039 452 697
------ -------- -------- -------- --------
Total operating
expenses............ 689 7,884 16,454 11,126 17,748
------ -------- -------- -------- --------
Operating loss......... (462) (4,396) (9,000) (5,889) (9,218)
Interest income
(expense), net........ (6) 62 (119) (59) (229)
------ -------- -------- -------- --------
Net loss............... $ (468) $ (4,334) $ (9,119) $ (5,948) $ (9,447)
====== ======== ======== ======== ========
Basic and diluted net
loss per share........ N/A $ (17.17) $ (11.34) $ (8.01) $ (1.76)
====== ======== ======== ======== ========
Shares used in
calculation of basic
and diluted net loss
per share............. N/A 252 804 743 5,379
====== ======== ======== ======== ========
Pro forma basic and
diluted net loss per
share (unaudited)..... $ (0.68) $ (0.60)
======== ========
Shares used in
calculation of pro
forma basic and
diluted net loss per
share (unaudited)..... 13,366 15,755
======== ========
</TABLE>
<TABLE>
<CAPTION>
December 31,
---------------------- September 30,
1996 1997 1998 1999
------ ------ ------- -------------
(In thousands)
<S> <C> <C> <C> <C>
Balance Sheet Data:
Cash and cash equivalents................ $ 232 $ 603 $ 1,712 $ 32,468
Working capital (deficit) ............... (464) 658 (274) 31,543
Total assets............................. 597 3,303 9,032 40,306
Total stockholders' equity (deficit)..... (318) 1,382 881 33,344
</TABLE>
18
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
WatchGuard is a leading provider of Internet security solutions designed to
protect enterprises or telecommuters using the Internet for electronic commerce
and communications. Our core market is small- to medium-sized enterprises, or
SMEs, and we have recently expanded our marketing focus to include larger
enterprises as well as small offices and home offices, or SOHOs, and
telecommuters, particularly those using broadband Internet connections. Our
innovative subscription-based LiveSecurity solution broadcasts threat
responses, software updates, information alerts, expert editorials, support
flashes and virus alerts over the Internet, enabling enterprises to keep their
security systems current with minimal effort.
Since our inception, we have invested heavily in the development of our
products and services. In September 1996, we introduced our initial Internet
security appliance and began selling our products both domestically and
internationally. In 1997, we significantly expanded our sales force, adding 12
sales employees to recruit indirect channel partners around the world, and
expanded our distribution efforts in the European and Asia/Pacific markets. In
September 1998, we launched our managed security service offering for ISPs. We
also continued to recruit and hire additional employees in marketing,
development, technical support and finance and invested in our operational
infrastructure to support our growth. In February 1999, we launched the
broadcast portion of our LiveSecurity products. In July 1999, we completed the
initial public offering of our common stock. In October 1999, we acquired
BeadleNet, LLC, a developer of Internet security solutions for SOHOs, and
formed our new broadband Internet security division. In January 2000, we
announced the introduction of our security solutions for SOHOs and
telecommuters, which we expect to begin shipping in the first quarter of 2000,
and in the second quarter of 2000, we expect to introduce MSS solutions for
SOHOs and telecommuters.
Our revenues totaled $331,000 in 1996 and grew significantly to $5.1 million
in 1997. Our revenues totaled $11.4 million in 1998, representing a 123%
increase over 1997. Product revenues as a percentage of total revenues were 99%
in 1996, 98% in 1997 and 94% in 1998. Service revenues, although small, are
growing and are expected to be a significant component of our revenues in the
future as we expand our LiveSecurity subscription-based broadcast service.
Service revenues as a percentage of total revenues were 2.4% in 1997, 6.2% in
1998 and 16.1% for the nine months ended September 30, 1999. As a result of our
investments in our worldwide sales and distribution channels, development of
new products and services, brand development and our operational
infrastructure, we have incurred net losses in each fiscal quarter. As of
September 30, 1999, we had an accumulated deficit of approximately $23.4
million. We anticipate significant growth in our operating expenses as we
continue to expand our business, particularly with respect to the expected
expansion of our corporate facilities in the next six to eight months. In the
future, however, we expect our operating expenses to begin to decline as a
percentage of total revenues.
Sources of Revenues and Revenue Recognition Policy
We generate revenues through
. sales of products and service subscriptions through our indirect
distribution partners at a discount from list price, which historically
has averaged approximately 40%;
. sales of products and service subscriptions directly and, from time to
time, indirectly through our distributors, to our ISP customers at
volume pricing rates; and
. from time to time, sales of service subscription renewals directly to
our enterprise customers at list price.
Product revenues include perpetual software license fees and sales of our
security appliance. Service revenues include fees for access to our
LiveSecurity broadcast service for product updates, security threat responses,
general security information and technical support. Service revenues also
include annual fees for our
19
<PAGE>
LiveSecurity for MSS, which allows our ISP customers access to the LiveSecurity
broadcast service and the ability to manage and update a specific number of
their customers' security appliances. To date, service subscription renewals
directly from our enterprise customers have not been material.
We recognize revenues only when a contract or agreement has been executed,
delivery has occurred, the fee is fixed and determinable and we believe
collection is probable. We recognize product revenues upon shipment and service
subscription revenues ratably on a monthly basis, generally over a one-year
period.
Recent Developments
Recent Operating Results
On January 20, 2000, we announced our unaudited operating results for the
three-month period and the year ended December 31, 1999. Total revenues
increased from $3.6 million in the three months ended December 31, 1998 to $6.5
million in the three months ended December 31, 1999, an increase of 81%, and
from $11.4 million in 1998 to $20.6 million in 1999, an increase of 81%.
Product revenues increased from $3.3 million in the three months ended
December 31, 1998 to $5.5 million in the three months ended December 31, 1999,
an increase of 68%, and from $10.7 million in the year ended December 31, 1998
to $17.3 million in the year ended December 31, 1999, an increase of 62%.
Service revenues increased from $339,000 in the three months ended December 31,
1998 to $1.0 million in the three months ended December 31, 1999, an increase
of 203%, and from $701,000 in the year ended December 31, 1998 to $3.3 million
in the year ended December 31, 1999, an increase of 369%.
Net loss increased from $3.2 million, or $0.22 per share, in the three months
ended December 31, 1998 to $6.6 million, or $0.34 per share, in the three
months ended December 31, 1999, and from $9.1 million, or $0.68 per share, in
the year ended December 31, 1998 to $16.0 million, or $0.96 per share, in the
year ended December 31, 1999. Pro forma net loss, excluding costs associated
with our October 1999 acquisition of BeadleNet, LLC and noncash stock-based
compensation, increased to $2.7 million, or $0.14 per share, for the three
months ended December 31, 1999, from $2.6 million, or $0.18 per share, for the
three months ended December 31, 1998. Pro forma net loss increased to $11.5
million, or $0.69 per share, for the year ended December 31, 1999 from $8.1
million, or $0.60 per share, for the year ended December 31, 1998. The number
of pro forma shares used in the computation of pro forma loss per share was
14.4 million for the three months ended December 31, 1998, 19.4 million for the
three months ended December 31, 1999, 13.4 million for the year ended December
31, 1998 and 16.7 million for the year ended December 31, 1999. The losses
reflect our continued investment in new product development and the expansion
of our international sales and marketing efforts.
Recent Acquisition
In October 1999, we acquired substantially all of the assets of BeadleNet for
approximately $3.4 million in cash and 335,931 unregistered shares of our
common stock, which were valued at $4.85 million. In addition, we agreed to pay
BeadleNet an additional $1.0 million if specified technology items were
completed and released to market on or before January 1, 2000. These technology
items were completed on schedule, and in January 2000 we made the additional
payment, consisting of $400,000 in cash and 20,189 unregistered shares of our
common stock, which were valued at $600,000.
In connection with the acquisition, we entered into an employment agreement
and a stock vesting agreement with Danny M. Beadle, the founder and principal
member of BeadleNet, under which we issued to Mr. Beadle 51,948 shares of our
common stock, which were valued at $750,000. Of these shares, 34,632 shares are
subject to forfeiture if we terminate Mr. Beadle's employment for cause or if
he resigns. The forfeiture restrictions lapse over a period of two years.
20
<PAGE>
Results of Operations
The following table provides financial data for the periods indicated as a
percentage of total revenues:
<TABLE>
<CAPTION>
Year Ended
Period From December Nine Months Ended
February 14, 1996 31, September 30,
(Inception) to ------------- -------------------
December 31, 1996 1997 1998 1998 1999
----------------- ----- ----- -------- --------
<S> <C> <C> <C> <C> <C>
Revenues:
Product................ 99.4 % 97.6 % 93.8 % 95.3 % 83.9 %
Service................ 0.6 2.4 6.2 4.7 16.1
------ ----- ----- -------- --------
Total revenues....... 100.0 100.0 100.0 100.0 100.0
Cost of revenues........ 31.4 31.6 34.5 32.6 39.5
------ ----- ----- -------- --------
Gross margin............ 68.6 68.4 65.5 67.4 60.5
Operating expenses:
Sales and marketing.... 67.7 85.6 74.9 78.2 68.8
Research and
development........... 82.8 43.0 39.0 38.8 33.6
General and
administrative........ 57.7 26.0 21.6 20.5 18.6
Stock-based
compensation.......... 0.0 0.0 9.1 5.8 4.9
------ ----- ----- -------- --------
Total operating
expenses............ 208.2 154.6 144.6 143.3 125.9
------ ----- ----- -------- --------
Operating loss.......... (139.6) (86.2) (79.1) (75.8) (65.4)
Interest income
(expense), net......... (1.8) 1.2 (1.0) (0.8) (1.6)
------ ----- ----- -------- --------
Net loss................ (141.4)% (85.0)% (80.1)% (76.6)% (67.0)%
====== ===== ===== ======== ========
</TABLE>
Nine Months Ended September 30, 1999 and 1998
Total Revenues
Total revenues, which consist of product revenues and service revenues,
increased from $7.8 million in the nine months ended September 30, 1998 to
$14.1 million in the nine months ended September 30, 1999, an increase of 82%.
During these periods, no one customer accounted for 10% or more of total
revenues. The increase in total revenues was primarily due to increases in
sales volume caused by increased distribution in the European, Asia/Pacific and
North American markets. Total international revenues represented approximately
35% of total revenues in the nine months ended September 30, 1998 and 50% in
the nine months ended September 30, 1999.
Product revenues include (1) the perpetual software license fees for our
security management system and the sale of our security appliance as part of
the LiveSecurity System and (2) the sale of our NOC, or network operations
center, security suite software license and our security appliance as part of
LiveSecurity for MSS. Product revenues increased from $7.4 million in the nine
months ended September 30, 1998 to $11.8 million in the nine months ended
September 30, 1999, an increase of 60%. As a percentage of total revenues,
product revenues decreased from 95% in the nine months ended September 30, 1998
to 84% in the nine months ended September 30, 1999. We do not believe that the
historical percentage growth rates of product revenues will be sustainable as
our revenue base increases. Historically, we have generated the majority of our
revenues from our product sales, which, until the introduction of LiveSecurity
for MSS in late 1998, consisted primarily of the sale of our LiveSecurity
System for the enterprise. Product revenues from LiveSecurity for MSS are
growing and are expected to be a more significant component of our revenues in
the future.
Service revenues include the annual fee for our LiveSecurity broadcast
service, which is sold as a part of the LiveSecurity System and LiveSecurity
for MSS. Service revenues increased from $362,000 in the nine months ended
September 30, 1998 to $2.3 million in the nine months ended September 30, 1999,
an
21
<PAGE>
increase of 525%. As a percentage of total revenues, service revenues increased
from 5% in the nine months ended September 30, 1998 to 16% in the nine months
ended September 30, 1999.
We established a returns and allowances reserve in 1998 to address the return
rights and pricing protection rights of some of our customers, primarily
related to anticipated returns originating from the introduction of a new
version of our security appliance, the Firebox II, during the last half of
1998. The provision for sales returns and allowances was $1.4 million, or 18%
of total revenues, for the nine months ended September 30, 1998 and $915,000,
or 6% of total revenues, for the nine months ended September 30, 1999. Returns
and allowances before that time were immaterial. The provision, as a percentage
of total revenues, for the nine months ended September 30, 1999 as compared to
the nine months ended September 30, 1998, reflects a reduction in the expected
returns and pricing protection allowances based on actual results over the last
several quarters and no recent introduction of replacement products.
Cost of Revenues
Cost of revenues consists of product and service costs, which include the
costs of manufacturing our security appliance, product packaging, third-party
product licensing fees and our technical support organization, including costs
associated with our LiveSecurity broadcast service. Historically, cost of
revenues has increased in total dollar amount and as a percentage of total
revenues in each year. Cost of revenues increased from $2.5 million in the nine
months ended September 30, 1998 to $5.6 million in the nine months ended
September 30, 1999. As a percentage of total revenues, cost of revenues
increased from 33% in the nine months ended September 30, 1998 to 39% in the
nine months ended September 30, 1999.
The dollar increases in cost of revenues were primarily due to increases in
sales volume. The increase in cost of revenues as a percentage of total
revenues reflects an increase in the cost of manufacturing our Firebox II
security appliance and an increase in personnel-related costs of our service
organization, but is offset by the increased leverage of our service costs
against an increasing rate of service revenues. In the third quarter of 1998,
we released an enhanced version of our security appliance, the Firebox II,
which incorporated additional features required to support our LiveSecurity for
MSS product. The Firebox II is more expensive to manufacture than the previous
version of our security appliance, which increased our cost of revenues. Over
time, as volume levels increase, we expect the unit cost to manufacture the
Firebox II to decrease. However, we cannot predict if or when this reduction
will occur.
We expect service costs to increase in total dollar amount as our enterprise
customer base expands and our LiveSecurity for MSS product for ISPs is
deployed. Depending on our product and service mix, which may affect our
margins, we expect our gross margin to remain at or slightly above our third
quarter 1999 level for the short term. For the longer term, as revenues from
service subscriptions increase and become a greater percentage of total
revenues, we expect our gross margin to increase.
Operating Expenses
Sales and Marketing. Sales and marketing expenses include salaries,
commissions and related expenses and some variable marketing expenses,
including public relations costs, marketing collateral and trade show expenses.
Overall sales and marketing expenses increased from $6.1 million in the nine
months ended September 30, 1998 to $9.7 million in the nine months ended
September 30, 1999, an increase of 60%. As a percentage of total revenues,
sales and marketing expenses decreased from 78% in the nine months ended
September 30, 1998 to 69% in the nine months ended September 30, 1999. The
dollar increase in sales and marketing expenses was primarily due to
recruiting, training and supporting our domestic and international resellers
and distributors and, to a lesser extent, to establishing brand recognition of
our products and services. Specifically, major components of the increase
included
. an increase in payroll and related expenses from $2.7 million to $4.7
million;
. an increase in travel expenses from $1.0 million to $1.8 million; and
. an increase in marketing costs from $1.6 million to $2.4 million.
22
<PAGE>
The decrease in sales and marketing expenses as a percentage of total
revenues reflects both increased productivity of and efficiencies in managing
our indirect channel network and realization of our previous investments to
expand distribution, capture market share and establish brand recognition of
our products. We expect to see a gradual reduction in sales and marketing
expenses as a percentage of total revenues.
Research and Development. Research and development expenses consist of
salaries, computing equipment and software tools, nonrecurring costs associated
with our security appliance prototypes and payment of designers and
contractors. Research and development expenses increased from $3.0 million in
the nine months ended September 30, 1998 to $4.7 million in the nine months
ended September 30, 1999, an increase of 57%. As a percentage of total
revenues, research and development expenses decreased from 39% in the nine
months ended September 30, 1998 to 34% in the nine months ended September 30,
1999. The dollar increase in research and development expenses reflects the
growth of our research and development organization to expand our enterprise
product line, development of our LiveSecurity for MSS product and our efforts
in researching and evaluating new and emerging security threats through our
LiveSecurity broadcast service. Specifically, major components of the increase
included
. an increase in payroll and related expenses from $1.9 million to $3.7
million; and
. an increase in contract labor and consulting services from $270,000 to
$438,000.
We will continue to increase our research and development expenses in total
dollar amounts to enhance and expand our current product offerings, develop new
products and enhance our rapid response team and advisory council, which
analyze new security vulnerabilities and threats and provide continuing
education to our employees on Internet security. We expect that research and
development expenses will continue to increase in total dollar amounts but will
decrease as a percentage of total revenues.
General and Administrative. General and administrative expenses include costs
of executive, human resource, finance and administrative support functions,
provision for uncollectable accounts and legal and accounting professional
services. General and administrative expenses increased from $1.6 million in
the nine months ended September 30, 1998 to $2.6 million in the nine months
ended September 30, 1999, an increase of 65%. As a percentage of total
revenues, general and administrative expenses decreased slightly from 21% in
the nine months ended September 30, 1998 to 19% in the nine months ended
September 30, 1999. The dollar increase in general and administrative expenses
reflects the expansion of our infrastructure to manage the growth of our
operations. Specifically, major components of the increase included
. an increase in payroll and related expenses from $597,000 to $1.0
million; and
. an increase in professional fees from $167,000 to $523,000, related to
legal and accounting costs incurred primarily in conjunction with the
revision and implementation of our employee benefit plans and the
expansion of our international operations.
We expect that these expenses will continue to increase in total dollar
amounts but will decrease as a percentage of total revenues.
Stock-Based Compensation. Deferred compensation is recorded as the difference
between the exercise price of options we granted and the deemed fair value for
financial reporting purposes of our common stock during the periods in which
the options were granted. We recorded $162,000 of deferred compensation in the
nine months ended September 30, 1999 and $2.5 million of deferred compensation
in the year ended December 31, 1998, including $628,000 in stock-based
compensation related to options exchanged for services from a former employee.
Deferred compensation is amortized over the vesting periods of the options.
Amortization of deferred compensation, or stock-based compensation, expenses
were $452,000 for the nine months ended September 30, 1998 and $697,000 for the
nine months ended September 30, 1999. The allocation of the stock-based
compensation expense associated with the functional operating expense
categories of sales and marketing, research and development and general and
administrative was $63,000, $362,000 and $27,000, respectively, for the nine
months ended September 30, 1998 and $255,000, $339,000 and $103,000,
respectively, for the nine months ended September 30, 1999.
23
<PAGE>
Interest Income (Expense)
Interest expense of $119,000 in the nine months ended September 30, 1998
resulted from borrowings on our bank line of credit and our equipment term
loan, and was offset by $60,000 of interest income generated from our
investment of proceeds from the sale of preferred stock. Interest expense of
$497,000 in the nine months ended September 30, 1999 resulted from borrowings
on our bank line of credit, our equipment term loan and our convertible note
agreements, and was offset by $268,000 of interest income generated from our
investment of proceeds from the sale of preferred stock in private transactions
and the sale of common stock in our initial public offering.
Income Taxes
We have experienced losses since inception, resulting in a net operating loss
carryforward position of approximately $19 million as of September 30, 1999.
These carryforwards, if not utilized, will begin to expire in 2011, and may be
subject to limitations under Section 382 of the Internal Revenue Code.
Period Ended December 31, 1996 and Years Ended December 31, 1997 and 1998
The following discussion and analysis includes revenue and cost information
for the period ended December 31, 1996 and the years ended December 31, 1997
and 1998. We do not discuss in detail the results of operations for the period
ended December 31, 1996. During 1996, WatchGuard was a startup operation
focused on validating the technological feasibility of its products. We
introduced our initial Internet security appliance on a preproduction basis in
September 1996 and shipped our first production model, the Firebox 10, in
December 1996. Beginning in early 1997, we began to implement our business
model and develop our operational infrastructure. Due to the limited nature of
our operations in the period ended December 31, 1996, we believe that further
comparisons between 1996 and 1997 would not be meaningful.
Total Revenues
Total revenues increased from $331,000 in 1996 to $5.1 million in 1997 and to
$11.4 million in 1998, an increase of 123% from 1997 to 1998. During these
periods, no one customer accounted for 10% or more of total revenues. Product
revenues increased from $329,000 in 1996 to $5.0 million in 1997 and to $10.7
million in 1998, an increase of 115% from 1997 to 1998. As a percentage of
total revenues, product revenues decreased from 99% in 1996 to 98% in 1997 and
to 94% in 1998. Service revenues increased from $2,000 in 1996 to $123,000 in
1997 and to $701,000 in 1998. As a percentage of total revenues, service
revenues increased from 1% in 1996 to 2% in 1997 and to 6% in 1998.
The increase in total revenues from 1996 to 1998 was primarily due to
increases in sales volume caused by increased distribution in the European and
Asia/Pacific markets and increased market awareness of our products in North
America. Total international revenues represented 56% of total revenues in 1997
and 35% in 1998.
The establishment of reserves for sales returns and allowances negatively
impacted our revenues for 1998. The provision for sales returns and allowances
in 1998 was $1.7 million, or approximately 14% of total revenues before giving
effect to the provision. The returns and allowances reserve was established in
1998 primarily to address return rights and price protection rights for some of
our customers, including anticipated returns originating from the introduction
of the Firebox II. Before 1998, we did not experience any material returns and
therefore provided no reserve.
Cost of Revenues
Cost of revenues increased from $104,000 in 1996 to $1.6 million in 1997 and
to $3.9 million in 1998. As a percentage of total revenues, cost of revenues
increased from 31% in 1996 to 32% in 1997 and to 35% in 1998. The dollar
increases in cost of revenues from 1996 to 1998 were primarily due to increases
in sales volume. The increase in cost of revenues as a percentage of total
revenues from 1997 to 1998 was primarily
24
<PAGE>
due to an increase in the cost of manufacturing our security appliance. As
discussed above, the Firebox II, which we released in the third quarter of
1998, is more expensive to manufacture than the previous version of our
security appliance.
Operating Expenses
Sales and Marketing. Sales and marketing expenses increased from $224,000 in
1996 to $4.4 million in 1997 and to $8.5 million in 1998. As a percentage of
total revenues, sales and marketing expenses increased from 68% in 1996 to 86%
in 1997, and decreased to 75% in 1998.
The dollar increase in sales and marketing expenses was primarily due to
recruiting, training and supporting our domestic and international resellers
and distributors and, to a lesser extent, to establishing brand recognition of
our products and services. Specifically, components of the increase from 1997
to 1998 included
. an increase in payroll and related expenses from $2.0 million to $3.9
million;
. an increase in travel expenses from $771,000 to $1.4 million;
. an increase in marketing costs from $1.1 million to $2.0 million; and
. a $470,000 charge for a common stock warrant in 1998 issued to a
customer.
The decrease in 1998 sales and marketing expenses as a percentage of total
revenues reflects increased productivity of and efficiencies in managing our
indirect channel network and our utilization of our prior years' investment to
expand distribution, capture market share and establish brand recognition of
our products.
Research and Development. Research and development expenses increased from
$274,000 in 1996 to $2.2 million in 1997 and to $4.4 million in 1998. As a
percentage of total revenues, research and development expenses decreased from
83% in 1996 to 43% in 1997, and decreased to 39% in 1998.
The dollar increase in research and development expenses reflects the growth
of our research and development organization to expand our enterprise product
line, development of our LiveSecurity for MSS product and our efforts to
respond to new and emerging security threats through our LiveSecurity broadcast
service. Specifically, components of the increase from 1997 to 1998 included an
increase in payroll and related expenses from $1.5 million to $2.5 million.
General and Administrative. General and administrative expenses increased
from $191,000 in 1996 to $1.3 million in 1997 and to $2.5 million in 1998. As a
percentage of total revenues, general and administrative expenses decreased
from 58% in 1996 to 26% in 1997 and to 22% in 1998.
The dollar increases in general and administrative expenses primarily reflect
the increase in personnel and related expenses and other overhead items in
connection with the expansion of our business. Specifically, components of the
increase from 1997 to 1998 included
. an increase in payroll and related expenses from $516,000 to $786,000;
. an increase in the provision for uncollectable amounts from $122,000 to
$418,000, reflecting additional exposure related to the overall growth
of our operations; and
. an increase in professional fees from $150,000 to $218,000.
The decrease in expenses as a percentage of total revenues from 1996 to 1998
reflects increased efficiencies of scale resulting from a larger revenue base.
Stock-Based Compensation. Amortization of deferred compensation totaled $1.0
million for 1998. The allocation of the stock-based compensation expense
associated with the functional operating expense categories of sales and
marketing, research and development and general and administrative was
$146,000, $831,000 and $62,000, respectively.
25
<PAGE>
Interest Income (Expense)
Interest expense of $6,000 in 1996 resulted from borrowings on our bank line
of credit. Interest income of $88,000 in 1997 was generated from our investment
of proceeds from the sale of preferred stock, and was partially offset by
$26,000 of interest expense that resulted from borrowings. Interest expense of
$203,000 in 1998 resulted from borrowings on our bank line of credit and
equipment term loan, and was partially offset by $84,000 of interest income
generated from our investment of proceeds from the sale of preferred stock.
Quarterly Results of Operations
The following tables provide our unaudited results of operations both in
dollar amounts and expressed as a percentage of total revenues for each quarter
in the five-quarter period ended September 30, 1999. In our opinion, this
unaudited information has been prepared on the same basis as our audited
financial statements. This information includes all adjustments, consisting
only of normal recurring adjustments, necessary for a fair presentation of the
information for the quarters presented, when read in conjunction with our
financial statements and the notes to the financial statements. The results of
operations for any quarter are not necessarily indicative of our future
results.
<TABLE>
<CAPTION>
Three Months Ended
------------------------------------------------
Sept. Dec. 31, Mar. 31, June 30, Sept.
30, 1998 1998 1999 1999 30, 1999
-------- -------- -------- -------- --------
(In thousands)
<S> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Revenues, net:
Product................... $ 2,544 $ 3,274 $ 3,387 $ 3,831 $ 4,614
Service................... 205 339 551 806 907
-------- -------- -------- -------- --------
Total revenues.......... 2,749 3,613 3,938 4,637 5,521
Cost of revenues............ 1,038 1,396 1,635 1,846 2,085
-------- -------- -------- -------- --------
Gross margin................ 1,711 2,217 2,303 2,791 3,436
Operating expenses:
Sales and marketing....... 2,258 2,447 2,841 3,242 3,612
Research and development.. 1,233 1,430 1,426 1,614 1,700
General and
administrative........... 622 864 912 862 842
Stock-based compensation.. 312 587 253 258 186
-------- -------- -------- -------- --------
Total operating
expenses............... 4,425 5,328 5,432 5,976 6,340
-------- -------- -------- -------- --------
Operating loss.............. (2,714) (3,111) (3,129) (3,185) (2,904)
Interest income (expense),
net........................ 24 (60) (84) (263) 118
-------- -------- -------- -------- --------
Net loss.................... $ (2,690) $ (3,171) $ (3,213) $ (3,448) $ (2,786)
======== ======== ======== ======== ========
</TABLE>
26
<PAGE>
<TABLE>
<CAPTION>
Three Months Ended
-------------------------------------------------
Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30,
1998 1998 1999 1999 1999
--------- -------- -------- -------- ---------
<S> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Revenues, net:
Product................... 92.5 % 90.6 % 86.0 % 82.6 % 83.6 %
Service................... 7.5 9.4 14.0 17.4 16.4
----- ----- ----- ----- -----
Total revenues.......... 100.0 100.0 100.0 100.0 100.0
Cost of revenues............ 37.8 38.6 41.5 39.8 37.8
----- ----- ----- ----- -----
Gross margin................ 62.2 61.4 58.5 60.2 62.2
Operating expenses:
Sales and marketing....... 82.1 67.7 72.1 69.9 65.4
Research and development.. 44.9 39.6 36.2 34.8 30.8
General and
administrative........... 22.6 23.9 23.1 18.6 15.3
Stock-based compensation.. 11.3 16.2 6.4 5.5 3.4
----- ----- ----- ----- -----
Total operating
expenses............... 161.0 147.5 137.9 128.9 114.8
----- ----- ----- ----- -----
Operating loss.............. (98.8) (86.1) (79.5) (68.7) (52.6)
Interest income (expense),
net........................ 0.9 (1.7) (2.1) (5.7) 2.1
----- ----- ----- ----- -----
Net loss.................... (97.9)% (87.8)% (81.6)% (74.3)% (50.5)%
===== ===== ===== ===== =====
</TABLE>
Liquidity and Capital Resources
Since our inception, we have financed our operations primarily through
private placements of convertible preferred stock, and most recently through
the sale of common stock in our initial public offering. Through September 30,
1999, net proceeds from private placements of preferred stock and our initial
public offering totaled $54.0 million. We have also financed our operations
through equipment financing, traditional accounts receivable financing
arrangements, bridge financing arrangements and convertible notes.
We have a working-capital revolving line of credit with a bank, secured by
our accounts receivable. The amount available under this facility is limited to
the greater of our borrowing base or $4.5 million. For purposes of this loan,
the borrowing base means the sum of 75% of the net amount of our eligible
domestic accounts receivable and 50% of the net amount of our eligible foreign
accounts receivable. As of September 30, 1999, we had no borrowings on this
line of credit, which expires in November 2000 and bears interest at prime plus
2% per year. At September 30, 1999, our borrowing base was $1.9 million. We are
currently renegotiating this line of credit.
We also have two term-loan facilities with the same bank to finance new
capital equipment purchases. The first facility closed to further advances on
March 5, 1998 and is being repaid in 36 equal monthly payments beginning April
5, 1998. The loan, which bears interest at prime plus 1.5% per year, matures on
March 5, 2001, at which time all unpaid principal and interest will be due and
payable. The second facility closed to further advances on December 31, 1998
and is being repaid in 36 equal monthly payments beginning January 1999. The
loan, which bears interest at prime plus 1% per year, matures on December 31,
2002, at which time all unpaid principal and interest will be due and payable.
As of September 30, 1999, we had a combined principal balance of $462,000 due
under these term loans.
The agreements under which the line of credit and term loans were established
contain financial covenants, including a provision requiring us to maintain
specified financial ratios. At December 31, 1998, we were not in compliance
with the financial covenants, but we obtained waivers for noncompliance at
December 31, 1998 and through our initial public offering date. After our
initial public offering, we projected that we would not be in compliance with
one of the financial covenants during our fourth quarter of 1999 due to
expenses associated with our acquisition of BeadleNet, LLC. We have obtained a
waiver for noncompliance with the financial covenant.
27
<PAGE>
As of September 30, 1999, we had $32.5 million in cash and cash equivalents,
invested primarily in high-quality money market accounts. We held $31.5 million
in high-quality instruments at one financial institution. We believe that the
market risk arising from our holdings of these financial instruments is not
material. During the fourth quarter of 1999 the majority of our cash was
invested in various high-quality marketable securities. Our working capital as
of September 30, 1999 was $31.5 million.
Operating Activities
Our operating activities resulted in net cash outflows of $5.2 million for
the nine months ended September 30, 1998 and $6.6 million for the nine months
ended September 30, 1999. The operating cash outflows in these periods in 1998
and 1999 resulted primarily from significant investments in sales and marketing
and research and development, all of which led to operating losses. Cash used
in operating activities was net of noncash charges totaling $2.4 million for
the nine months ended September 30, 1998 and $2.3 million for the nine months
ended September 30, 1999. These noncash charges were primarily associated with
depreciation and amortization of capital assets, provisions for bad debts and
sales returns and allowances, and compensation charges resulting from the
issuance of stock options and warrants. Cash used in operating activities from
working capital components impacting operating activities was $1.7 million for
the nine months ended September 30, 1998, and cash provided from working
capital components for operating activities was $515,000 for the nine months
ended September 30, 1999. For the nine months ended September 30, 1999, there
were large fluctuations within some major working capital components, as
described below.
Receivables. Our receivables remained relatively constant at $3.5 million at
both December 31, 1998 and September 30, 1999, while revenues increased from
$3.6 million in the three months ended December 31, 1998 to $5.5 million in the
three months ended September 30, 1999. We implemented enhanced credit and
collection processes during 1999 that contributed to improved collection
periods. Days sales outstanding, or DSO, were 87 days for the quarter ended
December 31, 1998 compared to 54 days for the quarter ended September 30, 1999.
Based upon sales mix, timing differences arising from varying payment cycles
and terms in our customer agreements, we expect our DSO to generally range from
50 days to 70 days. Reserves for uncollectable accounts were $449,000 at
December 31, 1998 and $304,000 at September 30, 1999. The decrease reflects
reduced exposure attributed to our improved credit and collection processes
referred to above. Our returns and allowance reserve was $615,000 at December
31, 1998 and $510,000 at September 30, 1999, and reflects our estimate of
returns and allowances associated with the return rights and price protection
rights of some of our customers. The reserve may fluctuate from time to time
depending upon the timing of product introductions and pricing program changes.
Deferred revenue. Deferred revenue increased from $1.8 million at December
31, 1998 to $3.4 million at September 30, 1999. The increase reflects service
subscriptions and annual client licenses associated with the continued growth
of product sales and, to a lesser extent, with service subscription renewals.
Deferred revenue from service subscriptions and annual client licenses is
generally amortized ratably over a one-year period.
Investing Activities
Cash used in investing activities totaled $719,000 for the nine months ended
September 30, 1998 and $993,000 for the nine months ended September 30, 1999,
and reflects capital expenditures for computing equipment and furniture.
Financing Activities
Cash provided by financing activities totaled $8.6 million for the nine
months ended September 30, 1998 and $38.4 million for the nine months ended
September 30, 1999. These activities primarily reflect proceeds from the sale
of preferred stock, borrowings on our line of credit during 1998 and proceeds
from our initial public offering in 1999, offset to some extent by borrowing
and repayments under our bank line of credit and various bridge financing
arrangements.
28
<PAGE>
We believe that existing cash and cash equivalents balances and our lines of
credit, together with the net proceeds from this offering, will be sufficient
to meet our anticipated cash needs for working capital and capital expenditures
for at least the next 18 months. The underlying assumed levels of revenues and
expenses may prove to be inaccurate, however, and we may need to seek
additional funding through public or private financings or other arrangements
before that time.
Year 2000 Compliance
We believe that we have successfully rendered our products, internal
management and other administrative systems and external information systems
year 2000 compliant. In addition, we surveyed the vendors of the third-party
technologies we incorporate into our products and services and applied updates
or arrangements to correct potential year 2000 compliance problems. Since
January 1, 2000, we have experienced no disruptions in our business operations
as a result of year 2000 compliance problems or otherwise, and we have received
no reports of any year 2000 compliance problems with our products and services.
We are continuing to monitor third-party vendors of incorporated technologies
for additional recommended year 2000 upgrades, which we will apply as soon as
they become available. To date, the total cost of our efforts to address year
2000 compliance has not been material.
Nonetheless, some problems related to year 2000 risks may not appear until
several months after January 1, 2000. Year 2000 issues could include problems
with our own products and services or with third-party products or technology
that we use or with which our products exchange data. Any problems that are not
identified and corrected successfully and completely could adversely affect our
business. We expect that the cost to fix any year 2000 problems that may be
identified, however, will involve internal labor-hours and will not be
material.
29
<PAGE>
BUSINESS
Overview
WatchGuard is a leading provider of Internet security solutions that protect
enterprises or telecommuters using the Internet for electronic commerce and
communications. Our core market is small- to medium-sized enterprises, or SMEs,
and we have recently expanded our marketing focus to include larger enterprises
as well as small offices and home offices, or SOHOs, and telecommuters,
particularly those using broadband Internet connections. According to
The Yankee Group, SMEs represent 98% of U.S. businesses, and account for
approximately 50% of the gross national product. SMEs are increasingly
utilizing the Internet to maintain a competitive advantage and to compete
effectively against enterprises with greater resources. International Data
Corporation, or IDC, estimated that, in the United States alone, approximately
3.5 million SMEs would be connected to the Internet by the end of 1999,
increasing to approximately 4.7 million by the end of 2000.
Our innovative subscription-based LiveSecurity solution broadcasts threat
responses, software updates, information alerts, expert editorials, support
flashes and virus alerts over the Internet, enabling enterprises to keep their
security systems current with minimal effort. The dynamic nature of our
solution is made possible through an updatable security appliance that executes
software sent from the remote management system receiving our LiveSecurity
broadcasts. Our comprehensive, fully integrated LiveSecurity solution for SMEs
and larger enterprises features a firewall, encryption, user authentication,
virtual private networking, web surfing control and our LiveSecurity broadcast
service. In January 2000, we announced the introduction of our security
solutions for SOHOs and telecommuters, which we expect to begin shipping in the
first quarter of 2000. Our solutions for SOHOs and telecommuters will feature a
firewall, virtual private networking, Internet protocol, or IP, sharing and our
LiveSecurity broadcast service. We make installing, configuring and monitoring
our solutions easy with point-and-click security management.
With our recent acquisition of BeadleNet, LLC and the formation of our new
broadband Internet security division, we have expanded our product line to
include security solutions for SOHOs and telecommuters, particularly those
individuals or SOHOs using broadband Internet connections. We will market this
expanded product line to both SOHOs that operate as a stand-alone business and
SOHOs and telecommuters that act as a branch office or extension of a larger
organization and share corporate resources through remote access to their
company's computing systems. According to IDC, in the United States alone,
approximately 10.9 million home offices will have broadband Internet access at
the end of 2000, up from an estimated 636,000 at the end of 1998.
Our recently introduced higher-performance security appliance for larger
enterprises enables the WatchGuard LiveSecurity System to support up to 5,000
simultaneously authenticated users and over 50 simultaneously connected virtual
private networks, or VPNs, and delivers faster VPN throughput. The expanded
capacity represents a ten-fold increase in the number of possible connected
users and a five-fold increase in VPN throughput as compared to our security
appliance designed for SMEs. This higher-performance security appliance,
combined with our new security solution designed for SOHOs and telecommuters
and our existing SME security solution, will allow us to offer larger
enterprises integrated solutions to protect the main office, large and small
branch offices, and employees who telecommute.
Our LiveSecurity solution gives enterprises a security management choice. An
enterprise can manage its own Internet security through our LiveSecurity System
or outsource its security management to an ISP implementing our LiveSecurity
for MSS. Enterprises using the LiveSecurity System may rapidly distribute
security protection from their desktop personal computer to all security
appliances on their corporate network, while retaining centralized control and
administration. Enterprises that do not want to be directly involved with their
security management may outsource the function to an ISP. For the ISP, our
technology improves the economics of managed security services through a
scalable delivery platform that enables the ISP to remotely configure and
manage thousands of sites quickly, easily and economically.
We sell our Internet security solutions directly and indirectly to ISPs and
indirectly to end-users through more than 310 distributors and resellers
covering 54 countries. We have established relationships with a
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number of ISPs to implement LiveSecurity for MSS, including AlphaNet Solutions,
Inc., AT&T Asia/Pacific Group Ltd., GTE Internetworking, Inc., Internet
Initiative Japan, Internet Security Systems, Inc., Interpath Communications,
Inc., MIS Corporate Defense Solutions, Nextcom K.K., PSINet Inc., sunrise
communications AG, Verio, Inc. and You Tools Corporation/FASTNET. As of
September 30, 1999, we had shipped over 12,000 of our security appliances.
Industry Background
The growth of the Internet
The Internet has experienced rapid growth and has developed into a
significant tool for global communications, commerce and media, enabling
millions of people to share information and transact business electronically.
IDC estimates that there were over 38 million web users in the United States
and over 86 million worldwide at the end of 1997. IDC projects the number of
web users to increase to over 177 million users in the United States and 502
million worldwide by the end of 2003. IDC also estimates that the number of
customers buying goods and services on the Internet will grow from
approximately 15 million worldwide in 1997 to 182 million in 2003, with the
value of electronic commerce transactions growing from $15 billion to over $1.3
trillion in the same period.
The growth in the Internet provides enterprises, regardless of size, with new
revenue opportunities through global distribution of products and services and
with significant reductions of sales and marketing costs through automation and
instantaneous access. Because of its affordability, global reach and
versatility, the Internet is a particularly powerful and necessary tool for
enterprises. Enterprises are increasingly required to establish secure Internet
access to facilitate and support strategic business objectives. In a
marketplace that is becoming more competitive, enterprises are increasingly
utilizing new business tools and initiatives such as remote access, e-commerce,
online customer service and supply chain management to gain competitive
advantage.
The need for Internet security
The increased importance of electronic commerce and the proliferation and
growth of corporate intranets have dramatically increased the openness of
computer networks, with the Internet becoming a widely accepted platform for
many business-to-business and direct-to-consumer transactions. The
accessibility and the relative anonymity of users in open computing
environments, however, make systems and the integrity of information stored on
them increasingly vulnerable to security threats. Open systems present inviting
opportunities for computer hackers, curious or disgruntled employees,
contractors and competitors to compromise or destroy sensitive information
within the system or to disrupt operations and Internet access. In addition,
open computing environments are complex and typically involve a variety of
hardware, operating systems and applications supplied by a variety of vendors,
making these networks difficult to manage, monitor and protect from
unauthorized access. With the advent of "always on" broadband Internet
connections that leave a user's computer much more vulnerable to security
breaches than a traditional dial-up connection, even SOHOs and telecommuters
face security threats similar to those faced by larger enterprises connected to
the Internet.
The annual Computer Security Institute survey conducted in early 1999
highlights the potential risks faced by organizations connected to the
Internet. The CSI poll of 521 computer security specialists at U.S.
corporations, government agencies, financial institutions and universities
revealed that 62% of respondents had experienced security breaches within the
past 12 months. The damage caused by a security breach is often difficult to
quantify and may include the loss of irreplaceable proprietary information or
data, damage to business reputation or undetected theft or alteration of
information. The 163 organizations in the CSI poll that were able to quantify
losses reported an average total loss of over $650,000 per organization.
Breached computer security has become such an extensive problem that the U.S.
Federal Bureau of Investigation has recently established the National
Infrastructure Protection Center to prevent and respond to cyber attacks on the
nation's infrastructure.
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The Internet security challenge
Internet security begins with a firewall, a security component of varying
complexity designed to provide a barrier and control the flow of information
between a company's internal network and the Internet. Firewalls, however, are
often difficult to install, must be configured by skilled personnel and, to
maximize effectiveness, must be continually monitored and updated. A
comprehensive security solution also typically integrates several other
sophisticated security components, such as virtual private networking, which
secures encrypted communications between two points on the Internet, and access
control mechanisms. These components use a complex mixture of technologies,
including user authentication, passwords, packet filters, proxies and
encryption.
Because enterprises increasingly depend on the Internet for external and
internal communications and for facilitating and conducting business, they need
comprehensive Internet security solutions. Traditional Internet security
solutions, however, are generally difficult to install and expensive to
maintain. Additionally, the technological complexity of traditional solutions
introduces a new set of risks--their many interacting components can easily be
misconfigured. The CSI poll revealed that more than 75% of the reported
successful break-ins took place despite the presence of a firewall. Enterprises
therefore face increasing pressure to hire trained security personnel to ensure
that traditional security solutions are installed and maintained properly. The
scarcity of skilled network and Internet security personnel, however, makes the
cost of hiring in-house personnel prohibitive for many enterprises,
particularly SMEs and SOHOs. Because of the financial and technical resources
necessary to implement, maintain and update these complex security solutions,
they tend to be better suited for larger enterprises than for SMEs, SOHOs and
individual telecommuters.
Traditional security solutions are also expensive to maintain because they
must be updated continually to maximize effectiveness. These security solutions
tend to be static, while the dangers against which they must protect are
dynamic, with new types of intrusion schemes and other security threats and
vulnerabilities emerging constantly. The Computer Emergency Response Team, a
federally funded research and development center, handled 8,268 security
incidents in 1999, an average of nearly one per hour and more than double the
3,734 security incidents handled in 1998. Even if updates are available to
allow an enterprise's security systems to respond to the changing security
landscape, the enterprise needs dedicated security experts to proactively
identify, obtain and manually implement these updates quickly and correctly.
The Internet security gap
The expense and complexity of traditional security solutions incorporating a
firewall puts protection out of the reach of millions of enterprises that do
not have the resources to adopt these solutions, contributing to a security
gap. Comprising 98% of U.S. businesses, SMEs exemplify this gap. Despite the
obvious and compelling reasons for Internet security, most SMEs on the Internet
do not even have a firewall.
IDC estimated that approximately 3.5 million SMEs in the United States would
be connected to the Internet by the end of 1999. According to IDC projections,
however, from 1995, when IDC reports that firewalls first became widely
available, until the end of 1999, less than 450,000 firewalls would be shipped,
leaving more than 3 million SMEs without a firewall. This security gap is
increasing, with IDC projecting that in the United States more than 1.1 million
new SMEs will connect to the Internet in the year 2000, but less than 260,000
firewalls will be shipped during the same period. We believe that the security
gap for SMEs results from the cost and complexity of traditional comprehensive
solutions, combined with the ineffectiveness of lower-end firewall solutions,
which lead many SMEs to choose not to adopt any Internet security solution.
Moreover, many enterprises that have installed security systems continue to
experience significant security breaches because their systems are either
configured improperly or are not timely or properly updated in response to the
latest security threats. SOHOs and telecommuters that adopt "always-on"
broadband Internet connections, particularly those accessing the corporate
resources of a larger enterprise, face a similar security threat but may have
more limited resources to dedicate to an Internet security solution.
Enterprises require an easy-to-use, highly effective, fully integrated
Internet security solution with low installation and maintenance costs that can
be installed quickly and kept up to date easily. In addition, many enterprises
would rather outsource the management of any Internet security system to
vendors such as ISPs.
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ISPs, however, face challenges in economically delivering affordable security
services that can be rapidly deployed to thousands of customer sites and easily
managed from a central location.
The WatchGuard Solution
WatchGuard's LiveSecurity products and services offer a fundamentally new
approach to Internet security. We provide enterprises with a comprehensive,
easy-to-use and cost-effective Internet security solution that we keep up to
date through our innovative Internet-based broadcast service. Our solution has
the following key benefits:
<TABLE>
<C> <S>
Comprehensive, fully integrated For SMEs and larger enterprises, we offer a
security tailored to the needs of comprehensive security solution integrated
the user into a single package that includes (1) a
firewall, (2) virtual private networking for
secure, encrypted communication between
remote offices, mobile employees and trading
partners, (3) authentication functions that
identify network users and define user-group
security policies, (4) web surfing control
and (5) our LiveSecurity broadcast service.
Our recently announced solution for SOHOs
and telecommuters will offer a more
affordable, comprehensive and integrated
security solution that includes (1) a
firewall, (2) virtual private networking,
(3) IP sharing and (4) our LiveSecurity
broadcast service.
Dynamic protection Our subscription-based Internet broadcast
service is designed to keep our security
solutions up to date with (1) security
threat responses that specifically address
newly discovered security vulnerabilities or
hacker techniques, (2) software updates, (3)
information alerts concerning current news
in Internet security, (4) expert editorials
containing Internet security-related feature
articles, (5) support flashes with answers
to commonly asked questions about our
products and services and (6) virus alerts
containing information about the latest
virus threats and access to Trend Micro's
virus protection products. Our SOHO and
telecommuter solutions will initially
include only access to security threat
responses and software updates. We expect to
offer the remaining LiveSecurity broadcast
service channels as an option for SOHOs and
telecommuters in the second quarter of 2000.
Easy installation and use We offer (1) a security appliance with plug-
in installation, (2) management and security
software with an automated installation
guide and (3) point-and-click centralized
management. These features make it easy for
the non-security professional to install,
configure and monitor our security system
and to receive and implement our
LiveSecurity broadcasts.
Viable ISP outsourcing Through its centralized configuration and
management capabilities, LiveSecurity for
MSS enables ISPs to provide outsourced
Internet security services to thousands of
customers quickly, easily and at a price
enterprises can afford.
Affordability We minimize the overall ownership cost of
our security solution with easy deployment
and management that reduces the requirements
for information technology personnel. Our
broadcast updating enables users of
LiveSecurity to address their security needs
by leveraging our team of security experts.
</TABLE>
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Strategy
Our objective is to be the leading provider of Internet security systems and
services to enterprises worldwide. Our strategy to achieve this goal is based
on the following key elements:
Extend our SME market leadership position in comprehensive security into the
large-enterprise and SOHO/telecommuter markets.
We intend to maintain our leadership position in comprehensive security for
SMEs by expanding and enhancing our Internet security product and service
offerings. In September 1999, we introduced our security solution for larger
enterprises and, in January 2000, we announced the introduction of our new
security solutions for SOHOs and telecommuters, which we expect to begin
shipping in the first quarter of 2000. We expect to deliver new versions of our
major products, including products designed for the emerging broadband Internet
connectivity market, approximately two to three times per year. We were the
first, and remain the leader, in developing updatable security appliances that
execute software sent from a remote management system. Our architecture allows
enterprises to quickly and easily deploy new products and services from the
central management system, which utilizes a familiar Windows- or web-based
interface. Our distributed architecture also facilitates the scalability
necessary for ISPs to provide our products and services to their customers at a
price enterprises can afford. We intend to continue to enhance our technology
and architecture, hire additional network and Internet security experts and
continue to invest in product development and product and service enhancements.
Expand our strategic relationships with leading Internet service providers.
To capitalize on the desire of many enterprises to outsource their Internet
security management, we have established relationships with industry-leading
ISPs, including AlphaNet, FASTNET, GTE, Interpath, ISS, PSINet and Verio in the
United States, MIS and sunrise in Europe and AT&T Asia/Pacific Group Ltd., IIJ
and Nextcom in the Asia/Pacific region. We intend to continue to establish
similar relationships with ISPs and expect that these relationships will
facilitate the widespread adoption of our LiveSecurity solution by enabling us
to capitalize on the brand recognition and customer bases of the ISPs. In
addition, these strategic relationships should enhance WatchGuard brand
awareness and provide a powerful endorsement of our security technology and
services. For example, GTE and PSINet use LiveSecurity for MSS to provide
managed security services to their customer bases, and their marketing of these
services prominently features the WatchGuard brand.
Expand and enhance our innovative LiveSecurity broadcast service.
We have created an innovative LiveSecurity solution that broadcasts threat
responses, software updates, information alerts, expert editorials and support
flashes over the Internet directly to our subscribers and ISP partners. We plan
to expand and enhance our LiveSecurity broadcast content, and therefore the
value of our subscription service, through additional investment in three
areas:
. continued expansion of our rapid response team of internal security
experts;
. expansion of our LiveSecurity advisory council of industry experts,
including the addition of two outside experts by the end of 2000; and
. continued development of one to four third-party industry relationships
that will allow us to broadcast third-party software and content to our
subscribers.
As we expand and enhance our broadcast content, we plan to ensure that it
remains easy to implement and use by enterprises and ISPs.
Continue to expand WatchGuard brand awareness.
We believe that we have an opportunity to make the WatchGuard brand
synonymous with Internet security worldwide. We intend to increase our
telemarketing and direct mail programs to companies that fit our target
subscriber profile. We also plan to develop our web site as a security portal
for enterprises with the goal of establishing www.watchguard.com as the first
location enterprises will visit with questions about Internet
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security. Our web site currently features links to the web sites of PSINet and
GTE. We plan to add additional links in 2000 and to further integrate our web
sites with the web sites of our ISP partners. In addition, we intend to
continue to invest in marketing programs jointly executed with our distribution
partners around the world. These programs include WatchGuard web site content
and links placed on many of our reseller sites, regionally targeted public
relations activities and events worldwide, and use of the WatchGuard brand name
when ISP partners market their managed security services.
Continue to expand worldwide sales and distribution.
We intend to continue to expand our international distribution capabilities
to allow any enterprise with an Internet connection to purchase the WatchGuard
LiveSecurity solution, no matter where the enterprise is located. Our goal is
to make our security solutions the easiest to purchase and deploy, whether by
the enterprise or by the ISP. We plan to expand our base of resellers,
distributors and ISP partners and make our solution available for purchase
through our resellers' web sites. We will continue to invest in web-based
training programs that educate our worldwide resellers and subscribers about
our product and service features and benefits and that assist our customers in
deploying our products and services.
We have not determined a schedule for the continuing expansion of our
international distribution capabilities or for implementing other components of
our strategy. The timing for executing these strategies will depend on market
conditions, the availability of strategic opportunities and the availability of
management resources.
Products and Services
Our comprehensive LiveSecurity solutions include an integrated suite of
security and management software, an Internet security appliance and a dynamic
broadcast service to keep security defenses current. Enterprises may use our
LiveSecurity System to internally manage their Internet security or elect to
outsource security management to an ISP implementing our LiveSecurity for MSS.
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The LiveSecurity System for enterprise-managed security.
We designed our LiveSecurity System for use by enterprises that want to
manage their own Internet security. With the LiveSecurity System, an enterprise
can quickly and affordably deploy comprehensive security protection to all
sites on its network, while retaining centralized control and administration.
Our LiveSecurity broadcast service enables enterprises to augment their
information technology staff with our security experts, which we believe
substantially reduces personnel costs. Every new LiveSecurity System includes a
one-year subscription to our broadcast service.
[Diagram depicting the LiveSecurity System of enterprise-managed security:
WatchGuard sends LiveSecurity broadcast over the Internet to the Firebox and
the security manager at SME headquarters; the SME security manager manages the
Fireboxes at the large and small branch offices and the telecommuter's home
from SME headquarters while a mobile user connects to company headquarters with
a VPN]
SMEs and larger enterprises
For SMEs and larger enterprises, the LiveSecurity System has three key
components: our security management system software with security and
management features, our security appliance and a subscription to our Internet-
based broadcast service.
Security features. The LiveSecurity System for SMEs and larger enterprises
contains the following security features:
. Firewall. Our firewall controls incoming and outgoing traffic between
the Internet and an enterprise's systems and data. The firewall
incorporates access control and detection and blocking features.
. Authentication. Our authentication features identify network users and
define user and user-group security policies.
. Virtual private networking. Our software enables enterprises to create
virtual private networks by using encryption technology to allow data to
flow securely across the Internet between two
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<PAGE>
predetermined points. Our remote user VPN secures communications with
telecommuters and traveling employees, while our branch office VPN
secures communications with branch offices and trading partners. Our
virtual private networking solutions implement industry standard
protocols.
. Web surfing control. Our web-blocking feature enables enterprises to
restrict site access privileges by user, group, time of day, site type
or particular site.
Management features. Our Windows-based software manages and monitors an
enterprise's Internet security with an intuitive, point-and-click user
interface.
. Integrated suite of system management tools. Our security management
system packages, configures and deploys security software, security
policies and the operating system to an enterprise's security
appliances. Featuring logging and notification functions and real-time
monitoring and historical reporting of network, service and bandwidth
usage, our management tools allow management of multiple security
appliances from a single location.
. Automated installation guide. Our automated installation guide enables
enterprises to install our system and define user and user-group
security policies in as quickly as 30 minutes.
Security appliance. Our security appliances for SMEs and larger enterprises,
the WatchGuard Firebox II, Firebox II Plus and Firebox II Plus with FastVPN,
are standalone Internet security appliances that run the security functions of
the LiveSecurity System. The security capabilities of these security appliances
come entirely from the operating system, security software and security
policies directed to them from the remote management software. They simply plug
in and reside between an enterprise's Internet router and its internal network
of servers and workstations. These Fireboxes have three independent, separately
monitored connections: one to the enterprise's network, one to the Internet and
one to the enterprise's public network for hosting web and email servers. The
LiveSecurity System encrypts communications between the security appliance and
the management software on the in-house manager's desktop.
Broadcast service. We keep our security solution current and our customers
informed through a subscription-based broadcast service that securely transmits
new security content over the Internet directly to the in-house manager's
desktop computer. Our broadcasts include
. Threat responses. When our rapid response team discovers and neutralizes
a security vulnerability or new hacker technique, we broadcast software
that specifically addresses that security threat.
. Software updates. We broadcast software updates that enhance the
function of the LiveSecurity System as a whole.
. Information alerts. We notify our customers of breaking Internet
security news and upcoming enhancements.
. Expert editorials. Our team of industry-leading security advisors offer
their views and provide continuing education on the rapidly changing
field of Internet security.
. Support flashes. Interactive technical tutorials provide our customers
with answers to frequently asked questions about managing the
LiveSecurity System and information about new software updates.
. Virus alerts. Trend Micro provides information on the latest virus
threats and offers access to its virus protection products.
SOHOs and telecommuters
Our recently announced LiveSecurity System for SOHOs and telecommuters has
three key components: security and management software, our security appliance
and a subscription to our Internet-based broadcast service.
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Security features. The LiveSecurity System for SOHOs and telecommuters
contains the following security features:
. Firewall. Our firewall controls incoming and outgoing traffic between
the Internet and a SOHO's or telecommuter's systems and data. The
firewall incorporates access control, detection and blocking features
and IP sharing.
. Virtual private networking. Our software enables SOHOs and telecommuters
to create virtual private networks by using encryption technology to
allow data to flow securely across the Internet between two
predetermined points.
Management features. Our web-based security management software manages and
monitors the SOHO's or telecommuter's Internet security with an intuitive,
point-and-click user interface.
. Integrated suite of system management tools. Our web-based security
management system packages, configures and deploys security software,
security policies and the operating system to a SOHO's or telecommuter's
security appliance.
. Automated installation guide. Our automated installation guide enables a
SOHO or telecommuter to install our system and define a security policy
in as quickly as 15 minutes.
Security appliance. Our security appliances for SOHOs and telecommuters, the
WatchGuard Firebox SOHO and Firebox Telecommuter, are standalone Internet
security appliances that run the security functions of the LiveSecurity System.
The security capabilities of these security appliances come entirely from the
operating system, security software and security policies directed to them from
the remote management software. They simply plug in and reside between the
SOHO's or telecommuter's Internet router and cable or digital service line
modem and its internal network of servers and workstations. These Fireboxes
have two independent, separately monitored connections: one to the SOHO's or
telecommuter's network and one to the Internet.
Broadcast service. We will keep our SOHO and telecommuter security solutions
current and our customers informed through a subscription-based broadcast
service that initially will transmit over the Internet to the SOHO manager's or
telecommuter's desktop computer the threat response and software update
channels of our LiveSecurity broadcast service for SMEs and larger enterprises.
We expect to offer the remaining channels of our LiveSecurity broadcast service
as an option for SOHOs and telecommuters in the second quarter of this year.
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LiveSecurity for MSS for Internet service providers
To serve the needs of SMEs and larger enterprises that want to outsource
their Internet security and the needs of ISPs that want to provide this
service, we have created LiveSecurity for MSS. We expect to introduce a
LiveSecurity for MSS solution for SOHOs and telecommuters in the second quarter
of 2000. LiveSecurity for MSS allows an ISP to centrally configure, monitor and
update the Internet security of thousands of managed customers. The ISP can
economically deliver a full range of security services while their subscribing
customers enjoy the benefit of our up-to-date protection at an affordable
price.
[Diagram depicting LiveSecurity for MSS for Internet service providers:
WatchGuard sends LiveSecurity broadcast to the ISP security manager at the ISP
network operations center; ISP security manager manages and monitors Fireboxes
at the premises of the ISP's subscribing customers.]
LiveSecurity for MSS has three main components: our network operations center
security suite software with security and management features, our security
appliances and our LiveSecurity broadcast service. In addition, we offer
optional monitoring software for the ISP's customers.
Security features. LiveSecurity for MSS includes the same comprehensive set
of security features offered with our LiveSecurity System for SMEs and larger
enterprises.
Management features. Centrally located at the ISP's network operations
center, our global policy manager software provides security intelligence and
configuration for all customer sites under management. Our software allows the
ISP to create and store various security policy configurations for different
customer groups or service plans. Our scalable WatchGuard event processor
software provides monitoring and reporting for customer sites.
Security appliances. One or more of our security appliances resides on the
ISP customer's premises. The appliances receive and implement the operating
system, security software and security policies that the ISP sends.
Broadcast service. Through our LiveSecurity broadcast service, the ISP's
network operations center receives threat responses, system updates,
information alerts, expert editorials and support flashes. The ISP then updates
the security policy of its customers and transmits these policy updates over
its network to those customers.
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Monitoring software for the ISP's customers. The optional Firebox monitor
software allows the ISP's customer to view its network activity on-site while
otherwise leaving the management of its Internet security to the ISP.
Receiving the benefits of our security solution through an ISP gives an
enterprise a number of added advantages. ISPs
. monitor and manage customers' security 24 hours a day, 7 days a week;
. define and implement professional, customized Internet security
policies;
. automatically install software updates and threat responses;
. regularly review customers' security and provide detailed reporting and
analysis; and
. mitigate the up-front cost of security system purchase and setup.
Implementation
The WatchGuard LiveSecurity System. Once an enterprise registers on one of
our LiveSecurity web sites, its registration information is automatically
transferred to our LiveSecurity database. Upon verification, the enterprise can
download and install or access our security management system software and
begin receiving our LiveSecurity broadcasts. The security management system
software configures the LiveSecurity System, implements security protection and
manages the installed security features with a point-and-click user interface.
Our LiveSecurity broadcasts go directly to the desktop of the person
responsible for Internet security, who follows our easy installation
instructions to send the updated security software, security policy or
operating system to all of the enterprise's security appliances for automatic
implementation. We send our LiveSecurity broadcasts using technologies such as
digital certificates and public key encryption or emails containing links to
the secured broadcast server.
LiveSecurity for MSS. Our scalable network operations center, or NOC,
security suite software enables an ISP to economically and efficiently
configure, monitor and update the Internet security of thousands of managed
customers from its network operations center. The ISP uses our global policy
manager's security policy templates to streamline initialization and
configuration of security policies to match the ISP's specific service
offerings and customer needs. The global policy manager then sends the desired
operating system, security software or policy configuration to subscribing
customers' security appliances. The security appliances implement the new
security policies and forward activity logs to WatchGuard event processor
software, which monitors network activity and reports back to the global policy
manager. Communications between the network operations center, the event
processors and the security appliances are encrypted, and we have implemented
automatic failover features to protect valuable log information against being
lost due to hardware or network failure. ISP personnel at the network
operations center use our suite of real-time monitoring tools to track each
security appliance on the ISP's network and transmit LiveSecurity broadcast
content to all ISP subscribers. In addition, the ISP can offer its customers
Firebox monitor software, a Windows-based monitoring tool that allows
subscribers to view their network activity and defenses in real time while
leaving management of the system to the ISP.
Customer service. We make customer service a priority. Our staff of support
representatives serves our end-users and ISP partners by phone and email from
6:00 a.m. to 5:00 p.m. Pacific standard time, Monday through Friday, excluding
national holidays. As of December 31, 1999, we had 21 customer support
representatives. We also offer 24-hour-a-day, 7-day-a-week web support tools.
Our computerized customer center manages all support requests and allows
customers to check resolution status on-line. We provide on-line answers to
frequently asked questions about our products, descriptions of how to configure
WatchGuard products to work with other products and other technical
information.
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The WatchGuard team of experts
Rapid response team. Our rapid response team identifies, analyzes and
generates responses to new Internet security threats. To identify new threats,
the team continually monitors a wide variety of Internet sources related to
network security, including news groups, vendor web sites and hacker bulletin
boards. When the rapid response team identifies a new security threat, we send
an advisory to our LiveSecurity subscribers while software or configuration
changes to neutralize the threat are developed and tested. We then broadcast
the software updates or configuration recommendations to our subscribers. The
team sends other information of interest as information alerts, which include
cautionary notices, general usage guidelines and other important announcements.
LiveSecurity advisory council. Our LiveSecurity advisory council provides
continuing education and editorials on the rapidly changing subject of Internet
security. The council also oversees and contributes to the efforts of our rapid
response team. We intend to expand the council as opportunities arise.
Currently, the council is composed of Messrs. Frederick Avolio and Rik Farrow.
Frederick Avolio. Mr. Avolio has been involved in Internet computing and
communication since the early 1980s and has worked with Internet security
systems for over 10 years. He assisted in the creation of the first commercial
Internet firewall offering and helped create the commercial security products
division of Trusted Information Systems. His areas of expertise include
firewalls, intrusion detection, cryptography, security management and email
systems. Mr. Avolio is the co-author, with Paul Vixie, of Sendmail Theory and
Practice, published by Digital Press. He holds a B.S. in computer science from
the University of Dayton and an M.S. in computer science from Indiana
University.
Rik Farrow. Mr. Farrow provides UNIX and Internet security consulting and
training. He has been working with UNIX system security since 1984 and with
TCP/IP networks since 1988. He has taught in a number of countries and for a
variety of organizations. He also consults with firms in designing and
implementing security applications. Mr. Farrow is the author of UNIX System
Security, published by Addison-Wesley, and is the co-author, with Rebecca
Thomas, of UNIX Administrator's Guide to System V, published by Prentice Hall.
He writes a column for ;login:, the magazine of the USENIX Association, and a
network security column for Network magazine.
Licensing and pricing
For an SME, larger enterprise, SOHO or telecommuter purchasing our
LiveSecurity System, we include in the system price a perpetual license for the
security and management software. Each end-user also receives a renewable one-
year subscription to our LiveSecurity broadcast service, through which it
receives threat responses, software updates, information alerts, expert
editorials and support flashes.
For LiveSecurity for MSS, an ISP buys a license to use our NOC security suite
management and security software and makes an annual license payment for each
customer security appliance it manages. The licenses, the cost of which varies
depending on the ISP's volume commitment, allow the ISP to manage its
subscribers' security appliances from its network operations center. Each
annual license includes a subscription to our LiveSecurity broadcast service.
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<PAGE>
The following table lists our current end-user product prices. We offer
reseller discounts, educational discounts and occasional promotional pricing.
<TABLE>
<CAPTION>
Product Components List Price
- ------------------------------------------------------------------------------------------------------
<C> <S> <C>
LiveSecurity System for SMEs $ 4,990
Security management system software
Firebox II security appliance
12-month LiveSecurity subscription
-------------------------------------------------------------------------------
Live Security System for larger enterprises $ 9,990
Security management system software (Firebox II Plus)
Firebox II Plus security appliance
Firebox II with VPN accelerator security $ 12,990
appliance (Firebox II with FastVPN)
12-month LiveSecurity subscription
-------------------------------------------------------------------------------
LiveSecurity Live Security System for SOHOs $ 449
System Web-based management and security software
Firebox SOHO security appliance (10 users)
Firebox Telecommuter security appliance
12-month LiveSecurity subscription
-------------------------------------------------------------------------------
Firebox SOHO user-capability upgrades
25 users $ 198
50 users $ 449
Firebox SOHO VPN $ 449
-------------------------------------------------------------------------------
LiveSecurity System for telecommuters $ 649
Web-based management and security software
Firebox
Telecommuter security appliance
12-month LiveSecurity subscription
-------------------------------------------------------------------------------
LiveSecurity subscription renewal
Firebox II $ 995
Firebox II Plus $ 1,495
SOHO $ 95
Telecommuter $ 65
- ------------------------------------------------------------------------------------------------------
LiveSecurity for MSS platform pack $ 64,475
NOC security suite
Firebox II for MSS: 5 appliances
MSS client licenses: 5 licenses
MSS technical certification class: 1 attendee
LiveSecurity broadcast service
-------------------------------------------------------------------------------
NOC security suite software $ 50,000
-------------------------------------------------------------------------------
Firebox II for MSS security appliance $ 1,300
-------------------------------------------------------------------------------
Firebox II Plus for MSS security appliance $ 2,900
-------------------------------------------------------------------------------
LiveSecurity Firebox II Plus for MSS with VPN accelerator $ 4,400
for MSS security appliance
-------------------------------------------------------------------------------
MSS technical certification class $ 2,500
-------------------------------------------------------------------------------
Firebox monitor software $ 195
-------------------------------------------------------------------------------
MSS annual client license
Block of 25: $1,695 per license $ 42,375
Block of 50: $1,495 per license 74,750
Block of 100: $1,395 per license 139,500
Block of 250: $1,295 per license 323,750
Block of 500: $1,095 per license 547,500
Block of 1,000: $945 per license 945,000
- ------------------------------------------------------------------------------------------------------
</TABLE>
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<PAGE>
Sales, Marketing and Distribution
We employ a global marketing strategy. Because the need for Internet security
crosses geographic and economic boundaries, our business opportunity extends
worldwide to all business segments. Since our inception, we have invested
heavily in worldwide sales and marketing. We currently sell our products and
services in 54 countries. International sales generated over 35% of our
revenues in 1998 and approximately 50% of our revenues in the nine months ended
September 30, 1999.
We sell our LiveSecurity System through distributors and value-added
resellers. We may also sell some Firebox SOHO and Firebox Telecommuter products
through retail channels. We sell our LiveSecurity for MSS products and services
directly to ISPs, which resell our products and services to end-users. Over 310
companies resell our products and services, including
. distributors, such as Eltrax Systems, Inc., Fujitsu Business Systems,
Ltd., Ingram Micro, Otsuka Shokai Co., Ltd., Tech Data and Wick Hill
Group, Plc;
. value-added resellers, such as CDW Computer Centers, Inc., Integrated
Network Technologies, Kent DataComm, Network Computing Architects, Inc.
and Solunet; and
. ISPs, such as AlphaNet, AT&T Asia/Pacific Group Ltd., FASTNET, GTE, IIJ,
Interpath, ISS, MIS, Nextcom, PSINet, sunrise and Verio.
Our agreements with our resellers are nonexclusive and provide for discounts
based on the reseller's minimum purchase commitment or the volume that the
reseller purchases or resells.
We divide our sales organization regionally among North America, Latin
America, Europe and Asia/Pacific, and also between the enterprise and managed
security market segments. In North America, we have sales personnel located in
California, Colorado, Connecticut, Georgia, Illinois, Massachusetts, New
Jersey, Texas and Washington. Internationally, we have sales personnel located
in Argentina, Australia, Germany, Japan, the Netherlands, Sweden and the United
Kingdom. Assisting our reseller network within a specific region is a central
responsibility of our regional sales representatives. Regional sales
representatives manage our relationships with our network of distributors,
resellers and ISPs, help our reseller network sell and support key customer
accounts, and act as liaison between our reseller network and our marketing and
product development organizations. We expect to continue to expand our field
sales organization in support of both the managed security and enterprise
market segments.
We conduct a number of marketing programs to support the sale and
distribution of our products. These programs inform existing and potential
resellers, distributors, ISPs and end-user customers about the capabilities and
benefits of our products. Marketing activities include advertising, publishing
technical and educational articles in industry journals, participating in
industry tradeshows and product technology conferences, sales training and
marketing on our web site. As of December 31, 1999, we had 50 employees in our
sales and marketing organization.
As an additional sales tool, we offer end-users, resellers and distributors
free interactive training on our LiveSecurity System solutions through our web
site. Our interactive training system guides customers through the
installation, setup and management of the LiveSecurity System and provides new
product information.
WatchGuard LiveSecurity alliance
In September 1998, we launched a LiveSecurity alliance, a technology and
marketing program designed to support the LiveSecurity concept and WatchGuard
products and services. The purpose of the alliance program is to enhance the
interoperability of our LiveSecurity products and services with alliance
partner products and services and to engage in cooperative marketing. Vendors
in the alliance include BackWeb Technologies, Clarent Corporation, CRYPTOCard,
FASTNET, Funk Software, IIJ, Interpath, ISS Group, Inc., Netrex, PSINet,
Rainbow Technologies, RSA Data Security, Inc., The Learning Company, Trend
Micro, WebTrends Corporation, Verio and Virtual Media.
43
<PAGE>
Customers
As of September 30, 1999, we had shipped over 12,000 of our security
appliances to our reseller network, which resold our products and services to
end-users spanning a wide variety of countries and industries. The following is
a representative list of our ISP and end-user customers:
Internet Service Media Retail
Providers KSTW-UPN 11 Television Norm Thompson
AlphaNet Solutions, Inc. Reader's Digest Outfitters, Inc.
AT&T Asia/Pacific Group Australia Rebel Sport Limited
Ltd. The Everett Herald
GTE Internetworking, University of Toronto Manufacturing
Inc. Press Bolle Inc.
Internet Initiative Durkan Patterned Carpet,
Inc. Technology Ferguson Metals/Aerospace
Japan, IIJ AlphaBlox Corporation Alloys Inc.
Internet Security Inc. Graham Steel Corporation
Systems, Inc. Bentley Systems, J.E. Dunn Construction
Interpath Incorporated Company
Communications, Inc. e-DOCS.net The Mitchell Gold
MIS Corporate Defense JDA Software Group, Inc. Company
Solutions Pentax Technologies
Nextcom KK Corporation Government
PSINet Inc. Sheridan Software City of Bellingham, WA
sunrise communications Systems, Inc. City of Dandenong,
AG Australia
Verio, Inc. Education City of Garden Grove, CA
You Tools Corporation/ Boston Architectural Lenoir County, NC
FASTNET Center Mornington Peninsula
Canon City Schools Shire
Services Huntsville Intermediate Council, Australia
Boullioun Aviation School District North Carolina State
Services Summit Board of Ports
Bull Housser & Tupper Education Pierce County, WA
Camp, Inc. Woodridge School Library Service
Catholic Charities District #68
Digital Magic
hawthorne direct inc. Financial Services Entertainment
Javelin Technology Atlantic Mortgage & Argosy Gaming Company
Investment Corp. Black Hawk Gaming &
Medical Hudson Valley Federal Development Company
Bendigo Health Care Credit Union Crave Entertainment,
Group KDP Investment Advisors Inc.
CoreCare Systems, Inc. McMahan Securities Co., Everton Football Club
Health Technologies Pty LP
Ltd Seritis Services Group, Utilities and
NeoTherapeutics, Inc. LLC Telecommunications
PATH Sunflower Bank Globecomm Systems, Inc.
Southeast Alabama MACtel
Medical Center
Unimed Pharmaceuticals,
Inc.
Case Studies
The following are profiles of two WatchGuard customers that have successfully
implemented our products and services:
GTE Internetworking, Inc. -- An ISP providing managed Internet security
services
GTE Internetworking, Inc., part of one of the largest publicly held
telecommunications companies in the world, has been providing managed Internet
access and related services worldwide for more than 20 years. In April 1999,
GTE introduced a new LiveSecurity for MSS-based security service, GTE Security
Advantage(TM), which enables GTE to offer a cost-effective managed Internet
security service to SMEs and branch offices of large corporations.
GTE has integrated LiveSecurity for MSS into its sophisticated $6 million,
5,000-square-foot network operations center in Burlington, Massachusetts, and
offers GTE Security Advantage to both current and new
44
<PAGE>
customers. In the past, GTE focused its managed security services on Fortune
500 corporations. By partnering with WatchGuard, however, GTE can expand its
range of services by offering SMEs the same level of security it could only
offer in the past to large enterprises, due to the cost and complexity of its
previous service offerings.
GTE is a member of our preferred service provider program, which enables GTE
and WatchGuard to combine our marketing expertise and resources in joint
marketing activities that promote GTE Security Advantage through various media.
GTE will also promote the GTE Security Advantage service through its network of
independent local exchange carriers, which deliver telephone service and
Internet connectivity to SMEs.
Bentley Systems, Incorporated -- An enterprise using the WatchGuard
LiveSecurity System
Bentley Systems, Incorporated is a worldwide leader in quality engineering
software products and user services, serving over 300,000 professionals in
building engineering, geoengineering and mechanical engineering. Its
MicroStation(TM) and ModelServer products, used by over 70% of the largest
engineering firms in the United States, are used to design buildings, airports,
hospitals, facilities, highways, bridges and industrial plants throughout the
world.
Bentley uses the WatchGuard LiveSecurity System, deploying 11 WatchGuard
Fireboxes. The company has implemented WatchGuard's branch office VPN software
to secure communications between its headquarters in Exton, Pennsylvania and
its branch offices in Huntsville, Alabama and Littleton, Massachusetts, and
uses WatchGuard's remote user VPN software to encrypt communications between
its offices and approximately 55 traveling salespeople. Now that Bentley has
established interconnectivity between offices with its network of WatchGuard
security appliances, it is in the process of moving from a private-frame wide
area network to a virtual private network of Internet sites, which will reduce
its remote access costs by over 60%.
Technology and Architecture
Our LiveSecurity solution utilizes an innovative distributed architecture
through which a basic processor in a security appliance receives and executes
software directed to it from a remote management system. Because the security
intelligence resides in the software and not in the hardware, we can keep our
customers' Internet security up to date with periodic broadcasts of new
security software and operating system configurations. Our LiveSecurity
solutions come in two forms: solutions for SMEs and larger enterprises and
solutions for SOHOs and telecommuters.
LiveSecurity for SMEs and larger enterprises
Our LiveSecurity solution for SMEs and larger enterprises encrypts and
authenticates communications between WatchGuard, the management system software
and the security appliance. This allows the management system and the appliance
to be separated within an enterprise's local or wide area network or between an
ISP and its subscriber. Typically, to install software on a computer using a
general-purpose operating system such as Windows, a person must be physically
present at the computer. Our distributed architecture, however, allows our
customers to remotely install our software on the security appliances and
receive updated software broadcasts over the Internet.
45
<PAGE>
The diagram below depicts the core technologies we use to deliver our
products and services. Our approach gives us flexibility, reliability and
scalability.
[Diagram depicting the components of WatchGuard's SME and larger enterprise
security appliance, operating system software, security software, management
software and Internet distribution.]
Security appliance. Our security appliance uses a standard Intel Pentium
processor, which is dedicated solely to running security functions. The
security appliance has no other function and no hard drive memory storage.
Operating system software. Our security appliance's operating system is a
custom-configured Linux kernel. Using Linux under an open source license, we
have been able to review the source code and generate a flexible, robust and
secure operating system. We use specially designed application programming
interfaces to facilitate secure loading of new operating system and security
software that our management software sends to the appliance.
Security features. The LiveSecurity solution implements our security features
in a number of software modules. Each module provides the specific function
that the management system defines in security rules and transmits to the
appliance. For example, the firewall features that control network traffic are
based around an extensible set of network service protocols, such as HTTP and
SMTP. The appliance applies the security policies defined by the management
system to all incoming or outgoing traffic. Those network services that require
special security, such as mail and file transfers, are directed to specific
modules. Additional modules implement other security features, such as
authentication and web surfing control, which also are defined in the security
policies that the management system transmits to the appliance. If web surfing
control is activated, for example, the web surfing control software module will
automatically check the details of all outgoing web traffic to make sure it
complies with the defined policies.
We use an open architectural structure to allow integration with common
standards for network security. For example, our virtual private networking
component currently supports IPSec and PPTP standards, and our authentication
module supports a variety of standard authentication methods. We intend to
adopt additional standards as they mature in the market.
Management features. Because enterprise and ISP environments are very
different, we designed a separate management system for each. Our LiveSecurity
System management software allows for quick installation and management by a
typical in-house manager using a standard Windows-based system. We
46
<PAGE>
designed the LiveSecurity for MSS management software, on the other hand, for a
trained operator using a dedicated management console to configure and manage
the security of a large subscriber base. Both management systems have the
ability to remotely deploy new security software to the appliances or update
their security engines from the management console. Our ISP customers can
choose to separately and remotely deploy certain security features, such as
virtual private networking and web blocking. This gives ISPs the ability to
incrementally add for-fee services to their basic service offering, without the
expense of sending personnel to their customers' sites.
To enable ISPs to configure, monitor and manage the Internet security of
thousands of customers, LiveSecurity for MSS includes scalable logging and
monitoring software called WatchGuard event processors. The event processors
run on UNIX-based workstations and can be located in the network operations
center or distributed at the ISP's point of presence. Each event processor
manages the logging and notification features of up to 500 security appliances
through commands issued from the global policy manager at the network
operations center.
LiveSecurity broadcast. Our scalable LiveSecurity broadcast system is a
collection of secured servers that registers subscribers, facilitates
downloading our software to the desktop computers of registered subscribers and
broadcasts threat responses, software updates, information alerts, expert
editorials, support flashes and virus alerts to subscribers. To facilitate a
high level of security and authenticity, we protect our servers with our own
security system and strongly encrypt data communication between servers. We
also encrypt and digitally sign broadcasts to ensure that subscribers receive
only authentic LiveSecurity broadcast content. We can replicate and distribute
our LiveSecurity servers throughout the world, which should enable us to meet
growth in demand for our LiveSecurity service. We have initially deployed one
primary server and two replicated servers to reach North America, Asia and
Europe.
LiveSecurity for SOHOs and telecommuters
Our LiveSecurity solutions for SOHOs and telecommuters are based on a common
hardware and software architecture.
[Diagram depicting the components of WatchGuard's SOHO and telecommuter
security appliance, operating system software, security software, management
software and Internet distribution]
47
<PAGE>
Security Appliance. Our SOHO and telecommuter security appliances use an
industry-standard MIPS processor, which is dedicated solely to running the
security functions. The security appliances have no other function and no hard
drive memory storage. These solutions provide network address translation and
port address translation, which allows a network to use a single IP address and
allows an Internet service provider to conserve IP addresses while still
accommodating local networks.
Operating System Software. Our SOHO and telecommuter solutions utilize
WindRiver's industry-standard VxWorks Real Time operating system. These
appliances' architecture includes data encryption hardware that allows high-
speed IPSec performance.
Security Features. Our SOHO and telecommuter solutions use the same industry-
compatible IPSec protocols found in our solutions for SMEs and larger
enterprises. The firewall is based on stateful packet inspection technology,
which allows the user to access the Internet without exposing the network to
external attacks. Our telecommuter solution includes virtual private networking
to allow the home-based employee to connect to the office via an encrypted,
secure channel. While our SOHO base product does not include virtual private
networking, it may be ordered as an option or obtained as an upgrade.
Management Features. We have designed our SOHO and telecommuter solutions for
very simple installation and configuration, using a web-based interface. We
anticipate that all telecommuter sites and many SOHO sites will require end-
user installation without the availability of information technology
professional support, and we have designed these products accordingly. In
addition, our SOHO and telecommuter solutions management interfaces allow
customers to immediately download updates into the product with minimal user
intervention. This process is protected with advanced cryptography and is tied
to the serial number of the appliance for additional security. Customers may
also order new features, such as additional user capability or virtual private
networking, from our web site.
Our SOHO and telecommuter products allow local configuration. The security
appliances may be managed with an Internet browser, such as Netscape Navigator
or Internet Explorer. The systems may also be configured to allow management by
one of our security solutions for SMEs or larger enterprises or, in the near
future, by an ISP using our LiveSecurity for MSS.
Subscription Services. In addition to accessing our LiveSecurity broadcasts,
SOHOs and telecommuters will be able to subscribe to our URL tracking service.
This service allows those persons supervising the use of Internet access, such
as parents or system administrators, to track sites visited by user, time of
visit, location, frequency of visits or other parameters.
Research and Development
To maintain our product and service leadership position, we focus our
research and development efforts on enhancing our existing products, developing
new products based on our innovative distributed appliance architecture and
developing services that capitalize on our LiveSecurity broadcast
infrastructure. We utilize a modular design, which allows us to develop new
applications that plug into our existing product line. As a result, our
products can be deployed in stages, whether directly by an enterprise or by an
ISP if the enterprise has outsourced its security management. As we develop new
products, our LiveSecurity end-users and ISP partners can incorporate the new
products into their systems with minimal system interruption.
As of December 31, 1999, we employed 75 people on our research and
development staff. Research and development expenses were approximately
$274,000 in 1996, $2.2 million in 1997, $4.4 million in 1998 and $4.7 million
in the nine months ended September 30, 1999. We conduct our product development
activities related to our security solutions for SMEs and larger enterprises at
our principal facility in Seattle, Washington. We conduct our product
development activities related to our security solutions for SOHOs and
telecommuters at our broadband Internet security division in Laguna Hills,
California and at our facility in Seattle.
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<PAGE>
Competition
We compete in a market that is new, intensely competitive, highly fragmented
and rapidly changing. We face competition in sales both of products and
services designed for enterprises and of those designed for ISPs. We have
experienced and will continue to experience increased competition from current
and emerging competitors, many of which have significantly greater financial,
technical, marketing and other resources.
In the market for Internet security solutions, we compete on the basis of
technological expertise and functionality, breadth of service and product
features, ease of installation and management, updatability, scalability, brand
recognition, price and customer support. Currently, the dominant competitors in
our industry are Cisco Systems, Inc., Check Point Software Technologies Ltd.
and Nokia Corporation. We expect the introduction of our SOHO and telecommuter
products to increase competition with SonicWALL Inc., a developer of security
appliances for SOHOs and home users. Other competitors offering security
products include hardware and software vendors such as Axent Technologies,
Inc., Lucent Technologies, Inc. and Network Associates, Inc., operating system
vendors such as Microsoft Corporation, Novell, Inc. and Sun Microsystems, Inc.
and a number of smaller companies.
Our competitors may be able to respond more quickly to new or emerging
technologies and changes in customer requirements than we can. In addition, our
current and future competitors may bundle their products with other software or
hardware, including operating systems and browsers, in a manner that may
discourage users from purchasing the products and services we offer. Many of
our current and potential competitors have greater name recognition, larger
customer bases to leverage and access to proprietary technology, and could
therefore gain market share to our detriment. In addition, our current and
potential competitors may establish cooperative relationships among themselves
or with third parties that may further enhance their resources, such as the
partnership between Check Point and Nokia. We expect additional competition as
other established and emerging companies enter the Internet security market and
new products and technologies are introduced.
While most of our competitors have generally targeted large-enterprise
security needs, using complex products that run on general purpose hosts such
as UNIX or Windows NT and require full training and support programs, these
vendors could adapt their existing products to make them more attractive to
SMEs. If our competitors were to focus their greater financial, technical and
marketing resources on the SME market, our business could be adversely
affected. While none of our competitors currently offer a technology similar to
our LiveSecurity solution architecture to address changing security threats,
they could develop such technology as part of any appliance offering. Increased
competition in any of our markets could result in price reductions, fewer
customer orders, reduced gross margins and loss of market share.
Proprietary Rights
To protect our proprietary rights, we rely primarily on
. copyright, trademark, service mark and trade secret laws;
. license agreements with third parties, including a standard software
license included with our products;
. confidentiality agreements with our employees and third parties;
. invention assignment agreements with our employees and contractors;
. protective contractual provisions in our agreements with some of our
consultants, resellers and customers; and
. limited access to our software, documentation and other proprietary
information.
WatchGuard(R) is a registered trademark in the United States, Norway, New
Zealand and Japan. Applications to register the WatchGuard trademark are
pending in other foreign jurisdictions. Firebox(TM) and LiveSecurity(TM) are
trademarks in use in the United States, and applications are pending in the
United States for registration of these trademarks. We have no patents, but we
have eight patents pending.
49
<PAGE>
We currently license and use the following technologies in our products and
services:
. BSAFE encryption toolkit from RSA Data Security, Inc. This industry-
standard product provides us with encryption functions that we use in
our remote office VPN product. We pay a fee for this perpetual license,
which we may terminate for any reason with 90 days' notice.
. Cyber Patrol database from The Learning Company. This database provides
blocking of particular web addresses as part of our web-blocking module.
. Linux kernel. We use a customized version of the Linux operating system
for our security appliance platform. This license is a no-cost, open-
source license.
. BackWeb Technologies client software and server. We use this technology
to facilitate the distribution of our LiveSecurity content.
. Internet Security Systems Inc. Internet scanner. We sell an OEM version
of this software as an optional scanning module for our LiveSecurity for
MSS ISP customers.
. WebTrends Corporation Inc. WebTrends for Firewalls and VPNs. We sell an
OEM version of this software as an optional reporting module for our
LiveSecurity for MSS ISP customers.
. US Software TCP/IP stack. We use a customized version of this basic
TCP/IP stack in source code form in our SOHO and telecommuter products.
. General Software MS-DOS work-alike. This product provides a file system
and program-launching services in our SOHO and telecommuter products.
. WindRiver VxWorks Real Time operating system. We use this operating
system in our SOHO and telecommuter products.
U.S. Government Export Regulation Compliance
Our products are subject to federal regulations governing the export of
encryption commodities and software. To comply with these regulations, we have
developed two versions of our products: one for the U.S. and Canadian markets
and one for international markets. Recent federal legislation, however, has
relaxed export controls on encryption. U.S. law now allows the export of
encryption commodities and software of any strength to nongovernmental end-
users located in any country except those designated as embargoed or otherwise
restricted by the U.S. government, subject to streamlined reporting
requirements. To satisfy these encryption export reporting requirements, we use
data gathered from end-users during product registration. Encryption
commodities and software previously approved for export by the federal Bureau
of Export Administration, or BXA, under an export license or encryption
licensing arrangement are immediately eligible for export under the revised
regulations without further technical review by the BXA. These commodities and
software include our branch office and remote user VPN software and the VPN
accelerator in our Firebox II Plus security appliance. Our Firebox Telecommuter
and Firebox SOHO products, which also utilize this encryption in branch office
VPN software, are currently under review by the BXA for retail export status.
If we obtain retail export status, we would be eligible to export these
products to all nonembargoed and nonrestricted foreign end-users, including
government entities. We anticipate a favorable ruling by the BXA for export of
the telecommuter and SOHO products as retail encryption commodities.
Manufacturing
We currently outsource all hardware manufacturing and assembly for our
Firebox II product lines to two companies in California: Smart Modular
Technologies, Inc., our motherboard manufacturer, and Streamlined Electronics
Manufacturing, our final assembly house. The motherboard manufacturer designed
and manufactures the motherboard to our specifications. The manufacturer may
terminate the agreement for breach or insolvency of WatchGuard. For our Firebox
SOHO and Firebox Telecommuter product lines, we currently outsource all
hardware manufacturing and assembly to Productivity Enhancement Products, Inc.
in California.
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We then distribute the finished products worldwide from our Seattle
distribution center. All three manufacturers test our hardware to confirm that
all components function properly. All three manufacturers are certified as
meeting the International Organization for Standardization's quality assurance
standards: Smart Modular Technologies against ISO 9001 and 9002, Streamlined
Electronics Manufacturing against ISO 9002 and Productivity Enhancement
Products against ISO 9001 and 9002.
Employees
As of December 31, 1999, we had 165 employees. Of these, 50 were employed in
sales and marketing, 19 in finance and administration, 21 in customer support
and 75 in development and operations. We are not parties to any collective
bargaining agreements with our employees and we have not experienced any work
stoppages. We believe we have good relations with our employees.
Facilities
Our principal administrative, marketing, sales, development and operations
facility is located in Seattle, Washington. We occupy approximately 30,000
square feet in this facility, under two leases that expire in April 2001. We
also maintain a small office in Laguna Hills, California for our broadband
Internet security division and a 3,000-square-foot warehouse in Seattle for
product fulfillment and distribution. We have the right to lease the Laguna
Hills office on a month-to-month basis until October 2000, but we may terminate
this option before that date. We expect to move our broadband Internet security
division to new offices before that time. The warehouse lease expires in August
2000, but has two one-year renewal options. We will be relocating or expanding
our general office space in both Seattle and Laguna Hills within the next six
to eight months, and we expect adequate space to be available on commercially
reasonable terms.
Legal Proceedings
We currently are not a party to any material legal proceeding.
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MANAGEMENT
Executive Officers, Directors and Key Employees
The following table lists the executive officers, directors and key employees
of WatchGuard as of December 31, 1999.
<TABLE>
<CAPTION>
Name Age Position
---- --- --------
<C> <C> <S>
Executive Officers and Directors
Christopher G. Slatt............ 41 President, Chief Executive Officer and
Chairman of the Board
Steven N. Moore................. 41 Executive Vice President of Finance,
Chief Financial Officer, Secretary,
Treasurer and Director
Vice President and Chief Operating
R. Michael Peronto.............. 43 Officer
Stuart J. Ellman................ 33 Director
Andrew W. Verhalen.............. 43 Director
Charles P. Waite, Jr. .......... 44 Director
Key Employees
Danny M. Beadle................. 50 Vice President, General Manager of
Broadband Internet Security Division
David W. Bonn................... 36 Chief Technology Officer
Dennis R. Cloutier.............. 49 Executive Vice President of Sales
Todd A. Hooper.................. 34 Vice President of Business Development
Michael V. Martucci............. 41 Vice President of Marketing
</TABLE>
Christopher G. Slatt cofounded WatchGuard in February 1996. Mr. Slatt has
served WatchGuard as president, chief executive officer and director since its
inception, and as chairman of the board since April 1999. From September 1993
to October 1995, he served as a vice president and a general manager of Legent
Corporation, a computer software company. Legent Corporation was acquired by
Computer Associates International, Inc., a computer software company, in August
1995. He is also a director of a privately held company. Mr. Slatt holds a
B.S.E.E. from the University of Notre Dame.
Steven N. Moore cofounded WatchGuard in February 1996. Mr. Moore has served
WatchGuard as executive vice president of finance since March 1999, chief
financial officer, secretary, treasurer and director since inception, and as
vice president of finance and operations from inception until March 1999. From
September 1993 to September 1995, he served as a director of finance of Legent
Corporation. Mr. Moore holds a B.S. in finance from Central Washington
University.
R. Michael Peronto joined WatchGuard as vice president and chief operating
officer in March 1999. From February 1997 to November 1998, Mr. Peronto served
as president and chief executive officer of Endura Software Corporation, a
management software supply company. From September 1994 to February 1997, he
served as vice president of publishing products and site manager of Adobe
Systems Incorporated, a desktop publishing and graphics software company. From
July 1992 to September 1994, he served as general manager of graphic products
of Aldus Corporation, a desktop publishing and graphics software company that
was acquired by Adobe Systems Incorporated. Mr. Peronto holds a B.A. in
economics from UCLA and an M.B.A. from the University of Washington.
Stuart J. Ellman has served as a director of WatchGuard since April 1998. Mr.
Ellman cofounded RRE Ventures LLC, a venture capital firm, and since August
1994 has served as general partner of RRE Ventures LLC and its affiliates and
predecessors. He serves as managing director of RRE Investors, LLC and as a
member of RRE Investors II, LLC. He is also a director of several privately
held companies. Mr. Ellman holds a B.A. in economics from Wesleyan University
and an M.B.A. from Harvard University.
52
<PAGE>
Andrew W. Verhalen has served as a director of WatchGuard since May 1997.
Since April 1992, Mr. Verhalen has been a partner of Matrix Partners, a venture
capital firm. He currently is a director of Copper Mountain Networks, Unwired
Planet, Alteon WebSystems Inc., Turnstone Systems and several privately held
technology companies. Before Matrix, Mr. Verhalen held senior management
positions at 3Com Corporation and Intel Corporation. He holds a B.S.E.E., an
M.E. and an M.B.A. from Cornell University.
Charles P. Waite, Jr. has served as a director of WatchGuard since May 1997.
Since December 1987, Mr. Waite has served as a general partner of Olympic
Venture Partners. He is also a director of Cardima, Inc., CellPro Incorporated,
Verity, Inc. and several privately held companies. Mr. Waite holds an A.B. in
history from Kenyon College and an M.B.A. from Harvard University.
Danny M. Beadle joined WatchGuard in October 1999 as vice president, general
manager of our broadband Internet security division. From May 1999 to October
1999, Mr. Beadle served as chief executive officer of BeadleNet, LLC, which was
acquired by WatchGuard in October 1999. From November 1988 to May 1999, he
served as chief executive officer of Productivity Enhancement Products, Inc.,
an OEM product development company. Mr. Beadle holds a B.A. in physics and a
B.A. in social science with an emphasis in economics from the University of
California, Irvine and an M.B.A. from Pepperdine University.
David W. Bonn joined WatchGuard in March 1996 and has served WatchGuard as
chief technology officer since March 1999. From May 1997 to March 1999, Mr.
Bonn served as WatchGuard's vice president of engineering, and from February
1997 to May 1997, he served as WatchGuard's chief technology officer. From
March 1996 to February 1997, he served as WatchGuard's vice president of
security products. He cofounded Mazama Software Labs, Inc., a computer software
company, in 1995, and served as its president until the acquisition of Mazama's
technology by WatchGuard in March 1996. From November 1993 to January 1995, he
served as senior software engineer of Legent Corporation. Mr. Bonn holds a B.S.
in computer science from the University of Washington.
Dennis R. Cloutier joined WatchGuard in March 1997 as executive vice
president of sales. From March 1994 to September 1996, Mr. Cloutier served as
vice president of sales of Sierra On-Line, an education and entertainment
computer software publisher. Mr. Cloutier holds a B.S. in marketing from
Central Connecticut University.
Todd A. Hooper joined WatchGuard in June 1998 and has served WatchGuard as
vice president of business development since February 1999. From June 1998 to
February 1999, Mr. Hooper served as WatchGuard's director of market
development. From March 1996 to May 1998, he served as manager of Internet and
open systems of AlphaWest Pty. Ltd., a provider of information technology-based
services. From January 1994 to March 1996, he served as chief executive officer
and managing director of Momentum Pty. Ltd., a management consulting company.
Mr. Hooper holds a Bachelor of Business in information processing from Curtin
University.
Michael V. Martucci joined WatchGuard in May 1997 as vice president of
marketing. From February 1996 to May 1997, Mr. Martucci served as director of
sales and marketing worldwide of Corbis Corporation, an Internet delivery and
sales company. From August 1994 to February 1996, he served as director of
sales and marketing worldwide of Knight-Ridder's Presslink, Inc., an Internet
delivery and sales company. From August 1993 to August 1994, he served as vice
president of marketing of Telepad Corporation, a wireless and hand-held
computer company. Mr. Martucci holds a B.C.E. in civil engineering and an
M.S.I.M. in marketing and financial management from Georgia Institute of
Technology.
53
<PAGE>
Committees of the Board of Directors
The compensation committee of our board of directors consists of Messrs.
Ellman, Verhalen and Waite. The compensation committee
. reviews and approves the compensation and benefits for our executive
officers and grants stock options under our stock option plan; and
. makes recommendations to the board of directors regarding these matters.
The audit committee consists of Messrs. Ellman, Verhalen and Waite. The audit
committee
. makes recommendations to the board of directors regarding the selection
of independent auditors;
. reviews the results and scope of the audit and other services provided
by our independent auditors; and
. reviews and evaluates our audit and control functions.
We established these committees in February 1999.
Director Compensation
We do not pay cash compensation to our directors for their services as
directors or members of committees of the board of directors, but we do
reimburse them for reasonable expenses they incur in attending meetings of the
board of directors. Directors of WatchGuard are eligible to participate in our
stock option plan.
Director and Officer Indemnification and Liability
Our certificate of incorporation limits the liability of directors to the
full extent permitted by Delaware law. Delaware law provides that a
corporation's certificate of incorporation may eliminate or limit the personal
liability of directors for monetary damages for breach of their fiduciary
duties as directors, except for liability for
. any breach of their duty of loyalty to the corporation or its
stockholders;
. acts or omissions not in good faith or that involve intentional
misconduct or a knowing violation of law;
. unlawful payments of dividends or unlawful stock repurchases or
redemptions; or
. any transaction from which the director derived an improper benefit.
Our bylaws provide that we shall indemnify our directors and officers and may
indemnify our employees and agents to the fullest extent permitted by law. In
addition, we maintain directors' and officers' liability insurance, under which
our directors and officers may be indemnified against liability they incur for
serving in their capacities as directors and officers of WatchGuard.
The Securities and Exchange Commission has advised us that, in its opinion,
any indemnification of our directors and officers for liabilities arising under
the Securities Act of 1933 is against public policy as expressed in the
Securities Act and is therefore unenforceable.
We believe that the limitation of liability provision in our certificate of
incorporation, the indemnification provisions in our bylaws and the liability
insurance will facilitate our ability to continue to attract and retain
qualified individuals to serve as directors and officers of WatchGuard.
54
<PAGE>
Compensation Committee Interlocks and Insider Participation
Our board of directors' compensation committee currently consists of Messrs.
Ellman, Verhalen and Waite. None of these individuals has at any time been an
employee or officer of WatchGuard. Until the compensation committee was formed
in February 1999, the full board of directors made all decisions regarding
executive compensation. No member of our board of directors or of its
compensation committee serves as a member of the board of directors or
compensation committee of any entity that has one or more executive officers
serving as members of its board of directors or its compensation committee.
Mr. Ellman is a general partner of RRE Ventures LLC and a member of RRE
Investors II, LLC, the managing member of RRE Investors, L.P., which purchased
500,241 shares of our Series C preferred stock. RRE Investors II, LLC is also
the indirect manager of RRE Investors Fund L.P., which purchased 275,403 shares
of our Series C preferred stock. Mr. Verhalen is the general partner of Matrix
IV Management Co., L.P., the general partner of Matrix Partners IV, L.P., which
purchased 1,100,416 shares of our Series B preferred stock and 276,324 shares
of our Series C preferred stock. Matrix IV Management Co., L.P. is also the
general partner of Matrix IV Entrepreneurs Fund, L.P., which purchased 57,917
shares of our Series B preferred stock and 14,543 shares of our Series C
preferred stock. Mr. Waite is the general partner of OVMC III, L.P., the
general partner of Olympic Venture Partners III, L.P., which purchased 489,685
shares of our Series B preferred stock and 122,964 shares of our Series C
preferred stock. OVMC III, L.P. is also the general partner of OVP III
Entrepreneurs Fund, L.P., which purchased 25,773 shares of our Series B
preferred stock and 6,472 shares of our Series C preferred stock. Mr. Waite is
also the managing member of OVMC IV, LLC, the general partner of Olympic
Venture Partners IV, L.P., which purchased 610,731 shares of our Series B
preferred stock and 153,360 shares of our Series C preferred stock. OVMC IV,
LLC is also the general partner of OVP IV Entrepreneurs Fund, L.P., which
purchased 32,144 shares of our Series B preferred stock and 8,071 shares of our
Series C preferred stock.
We sold the Series B preferred stock on May 9, 1997 at $2.59 per share. We
sold the Series C preferred stock on April 24, 1998 at $5.16 per share.
Executive Compensation
The following table provides information concerning the compensation received
for services rendered to WatchGuard in all capacities during the year ended
December 31, 1999, by our chief executive officer and the other executive
officers of WatchGuard whose compensation exceeded $100,000 in 1999.
Summary Compensation Table
<TABLE>
<CAPTION>
Long-Term
Compensation
Awards
------------
Annual Compensation Securities
--------------------- Underlying
Name and Principal Position Salary($) Bonus($)(1) Options)(#)
- --------------------------- --------- ----------- ------------
<S> <C> <C> <C>
Christopher G. Slatt, Chief Executive
Officer and President ..................... $ 190,000 $ 29,703 40,000
Steven N. Moore, Executive Vice President of
Finance, Chief Financial Officer, Secretary
and Treasurer ............................. 171,250 29,703 40,000
R. Michael Peronto, Vice President and Chief
Operating Officer (2)...................... 142,019 14,851 440,564
</TABLE>
- --------
(1) Represents bonus payment made as of January 14, 2000. We expect to make
additional bonus payments for services rendered during 1999 after the
completion of our annual performance reviews, but the amount of these
additional payments has not yet been determined.
(2) Mr. Peronto joined WatchGuard in March 1999. His annual salary is $175,000.
55
<PAGE>
The following table provides information regarding stock options we granted
in 1999 to our chief executive officer and the other executive officers whose
compensation exceeded $100,000 in 1999. The table includes the potential
realizable value over the term of the options, based on assumed rates of stock
appreciation of 5% and 10%, compounded annually. The assumed rates of
appreciation are prescribed by the Securities and Exchange Commission for
illustrative purposes only and are not intended to forecast or predict future
stock prices. Any actual gains on option exercises will depend on the future
performance of our stock.
Option Grants in Last Fiscal Year
<TABLE>
<CAPTION>
Individual Grants
------------------------
Potential Realizable
Value at Assumed
Number of Percent of Annual Rates of Stock
Securities Total Options Price Appreciation
Underlying Granted to for Option Term
Options Employees in Exercise Expiration ----------------------
Name Granted(#) Fiscal Year Price ($/Sh) Date 5%($) 10%($)
---- ---------- ------------- ------------ ---------- ---------- -----------
<S> <C> <C> <C> <C> <C> <C>
Christopher G. Slatt.... 40,000 1.78% $14.30 6/17/04 $ 158,000 $ 349,000
Steven N. Moore......... 40,000 1.78 14.30 6/17/04 158,000 349,000
R. Michael Peronto...... 439,564 19.55 13.00 4/12/09 3,594,000 9,107,000
1,000 * 13.00 7/30/09 8,000 21,000
</TABLE>
- --------
* Less than 1%
Approximately 2% of Mr. Slatt's and Mr. Moore's options vest and become
exercisable each month, commencing July 17, 1999. Approximately 25% of Mr.
Peronto's options granted on April 12, 1999 vest and become exercisable on
April 12, 2000, and approximately 2% of the remaining options vest and become
exercisable each month after that date. Approximately 2% of Mr. Peronto's
options granted on July 30, 1999 vest and become exercisable each month,
commencing on August 30, 1999. In 1999, we granted options to purchase up to an
aggregate of 2,248,314 shares to employees. We granted all options under our
stock option plan at exercise prices at the fair market value of our common
stock on the date of grant, as determined in good faith by our board of
directors.
The following table provides information regarding unexercised options held
as of December 31, 1999 by our chief executive officer and the other executive
officers whose compensation exceeded $100,000 in 1999. The value of unexercised
options is calculated on the basis of the closing sales price of our common
stock on The Nasdaq National Market on December 31, 1999, which was $30.25 per
share. These individuals did not exercise any options in 1999.
FY-End Option Values
<TABLE>
<CAPTION>
Number of
Securities Underlying Value of Unexercised
Unexercised Options at In-the-Money Options at
Fiscal Year End(#) Fiscal Year-End($)
------------------------- -------------------------
Name Exercisable Unexercisable Exercisable Unexercisable
---- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C>
Christopher G. Slatt........ 38,541 71,459 $1,089,569 $1,655,921
Steven N. Moore............. 38,541 71,459 1,089,569 1,655,921
R. Michael Peronto.......... 104 440,460 1,794 7,597,935
</TABLE>
Change-of-Control Arrangements
Under Mr. Peronto's stock option letter agreement, if a change of control of
WatchGuard occurs, half of the unvested shares subject to the option granted on
April 12, 1999 for 439,564 shares will vest and become exercisable.
56
<PAGE>
Employee Benefit Plans
1996 Stock Incentive Compensation Plan
In March 1996, our board of directors and stockholders adopted our 1996 stock
incentive compensation plan, which was amended and restated on May 26, 1999.
The purpose of the stock option plan is to enhance long-term stockholder value
by offering opportunities to selected persons to participate in our growth and
success, and to encourage them to remain in our service or in the service of
our subsidiaries and to acquire and maintain ownership in WatchGuard. The stock
option plan provides for awards, which may include incentive stock options,
nonqualified stock options and stock awards. The board has reserved a total of
8,634,986 shares of common stock under the plan, of which 524,999 remain
available for grant as of December 31, 1999. In addition, the plan provides for
an automatic annual increase to be added on the first day of each fiscal year,
the first of which occurred on January 1, 2000, equal to the least of
. 750,000 shares;
. 3% of the average number of outstanding common shares used to calculate
fully diluted earnings per share as reported in our annual financial
statements for the preceding year; and
. a lesser amount determined by our board of directors.
As of December 31, 1999, 1,607,307 shares had been issued upon the exercise
of stock options granted under the stock option plan and 6,502,680 shares were
subject to outstanding options.
The compensation committee of our board of directors serves as the plan
administrator of the stock option plan. Unless the plan administrator permits
otherwise, no awards granted under the stock option plan may be assigned or
transferred by the holder other than by will or the applicable laws of descent
and distribution. During the holder's lifetime, awards generally may be
exercised only by the holder. The board may suspend or terminate the stock
option plan at any time. Unless sooner terminated by the board, the plan will
terminate on May 26, 2009.
Stock Option Grants. The plan administrator has the authority to select
individuals to receive options under the stock option plan and to specify the
terms and conditions of each option granted, the exercise price, the vesting
provisions and the option term. For incentive stock options, the exercise price
must be equal to at least the fair market value of the common stock on the
grant date and, for nonqualified stock options, must be not less than 85% of
the fair market value of the common stock on the grant date. Unless otherwise
provided by the plan administrator, options granted under the stock option plan
will expire 10 years from the grant date.
Stock Awards. The stock option plan authorizes the plan administrator to
award shares of common stock subject to terms, conditions and restrictions
established by the plan administrator in its sole discretion. The terms,
conditions and restrictions that the plan administrator has the power to
determine include the manner in which shares subject to stock awards are held
during the periods they are subject to restrictions and the circumstances under
which forfeiture of restricted stock will occur because of termination of the
holder's services. Holders of restricted stock are stockholders of WatchGuard
and generally have all the rights of stockholders with respect to those shares.
Corporate Transactions. Unless individual letter agreements provide
otherwise, if certain corporate transactions, such as a merger or sale of
WatchGuard, occur, each outstanding option will automatically accelerate and
become 100% vested and exercisable immediately before the corporate
transaction, unless the option is assumed, continued or replaced with a
comparable award by the successor corporation or the parent of the successor
corporation. If option vesting is accelerated, any forfeiture provisions
applicable to the stock awards will lapse. Any option or stock award that is
assumed, continued or replaced with a comparable award in the corporate
transaction will accelerate if the holder's employment or services are
terminated by the successor corporation without cause or by the holder
voluntarily and with good reason within two years.
57
<PAGE>
1999 Employee Stock Purchase Plan
In May 1999, our board of directors and stockholders approved our 1999
employee stock purchase plan. We implemented our stock purchase plan on July
30, 1999 in conjunction with our initial public offering, to encourage
employees to remain in our employ or the employ of our subsidiaries. We intend
for the plan to qualify under Section 423 of the Internal Revenue Code.
Our stock purchase plan permits our eligible employees and eligible employees
of our subsidiaries to purchase common stock through payroll deductions of up
to 15% of their salary or wage compensation. Under our stock purchase plan, no
employee may purchase common stock with a fair market value of more than
$25,000 in any calendar year, or purchase more than 1,000 shares of common
stock in any single purchase period.
We implemented the stock purchase plan with two-year offering periods. Each
two-year offering period has four consecutive six-month purchase periods. The
first offering period commenced on July 30, 1999 and will end on August 31,
2001. The first purchase period under the first offering period commenced on
July 30, 1999 and will end on February 29, 2000. Subsequent purchase periods
will begin on each March 1 and September 1 and end on the next August 31 and
February 28, or February 29 in the case of leap years. The plan administrator
generally may establish a different term and different commencing and ending
dates for future offerings.
The price of the common stock purchased under the stock purchase plan will be
the lesser of 85% of the fair market value on the first day of the applicable
offering period and 85% of the fair market value on the last day of the
applicable purchase period. The purchase price for the first offering period,
however, will be equal to the lesser of $13.00, the initial public offering
price of our common stock, and 85% of the fair market value on the last day of
the first purchase period. The stock purchase plan terminates 10 years after
the date of adoption by our board of directors, but the board may terminate it
at any earlier time. We have not yet issued any shares of common stock under
the stock purchase plan.
Employees generally will be eligible to participate in the stock purchase
plan if they are customarily employed by WatchGuard for 20 hours or more per
week and are not, as of the beginning of a purchase period, holders of 5% or
more of our common stock or the common stock of our subsidiaries. Options
granted under the stock purchase plan generally are not transferable and are
exercisable only during the optionee's lifetime.
We initially authorized the issuance under the stock purchase plan of a total
of 600,000 shares of common stock. In addition, the plan provides for automatic
annual increases to be added on the first day of each fiscal year, the first of
which occurred on January 1, 2000, equal to the least of
. 400,000 shares;
. 1.5% of the average outstanding common shares used to calculate fully
diluted earnings per share as reported in our annual financial
statements for the preceding year; and
. a lesser amount determined by our board of directors.
If a merger or consolidation resulting in a change of control or acquisition
by another corporation of all or substantially all of our assets occurs, each
outstanding option to purchase shares under the stock purchase plan will be
assumed or an equivalent option substituted by the successor corporation. If
the successor corporation refuses to assume or substitute for the option, the
offering period during which a participant may purchase stock will be shortened
to a specified date before the proposed transaction. Similarly, if a
liquidation or dissolution of WatchGuard is proposed, the offering period
during which a participant may purchase stock will be shortened to a specified
date before the date of the proposed liquidation or dissolution.
58
<PAGE>
401(k) Plan
We maintain a 401(k) plan that covers all our employees who satisfy the
plan's eligibility requirements relating to minimum age, length of service and
hours worked. We may make an annual contribution for the benefit of eligible
employees in an amount determined by our board of directors. We have not made
any contribution to date and have no current plans to do so. Eligible employees
may make pretax elective contributions of up to 15% of their compensation,
subject to maximum limits on contributions prescribed by law.
59
<PAGE>
RELATED-PARTY TRANSACTIONS
Since our inception in February 1996, we issued shares of preferred stock in
private placement transactions, as the following table summarizes:
<TABLE>
<CAPTION>
Number of Shares of
Preferred Stock
Price ---------------------------
Issuance per Series
Purchaser Date Share Series A Series B C
--------- ---------- ----- --------- --------- -------
<S> <C> <C> <C> <C> <C>
Christopher G. Slatt............. March and $0.05 1,500,002
July 1996
Steven N. Moore.................. March and 0.05 1,500,002
July 1996
Entities affiliated with Matrix
IV Management Co., L.P. ........ May 1997 2.59 1,158,333
April 1998 5.16 290,867
Olympic Venture Partners III,
L.P. and
OVP III Entrepreneurs Fund...... May 1997 2.59 515,458
April 1998 5.16 129,436
Olympic Venture Partners IV, L.P.
and
OVP IV Entrepreneurs Fund,
L.P. ........................... May 1997 2.59 642,875
April 1998 5.16 161,431
MLS-I, L.C. .................... March 1998 2.59 38,610
Entities affiliated with RRE
Investors II, LLC............... April 1998 5.16 775,644
</TABLE>
Christopher G. Slatt and Steven N. Moore are executive officers and directors
of WatchGuard. Stuart J. Ellman, a director of WatchGuard, is a member of RRE
Investors II, LLC, which is the managing member of RRE Investors, L.P. and the
indirect managing member of RRE Investors Fund, L.P. Andrew W. Verhalen, a
director of WatchGuard, is the general partner of Matrix IV Management Co.,
L.P., which is the general partner of Matrix Partners IV, L.P. and of Matrix IV
Entrepreneurs Fund, L.P. Charles P. Waite, Jr., a director of WatchGuard, is a
general partner of OVMC III, L.P., which is the general partner of Olympic
Venture Partners III, L.P. and of OVP III Entrepreneurs Fund, L.P. Mr. Waite is
also a managing member of OVMC IV, LLC, which is the general partner of Olympic
Venture Partners IV, L.P. and of OVP IV Entrepreneurs Fund, L.P. All
outstanding shares of preferred stock converted into an aggregate of
13,425,316 shares of common stock on the closing of our initial public
offering. These investors are entitled to registration rights with respect to
these shares of common stock.
Mr. Slatt and Mr. Moore are guarantors of the lease agreement between COM
Realty, Inc. and WatchGuard Technologies Inc., dated as of March 16, 1996. Mr.
Slatt and Mr. Moore were guarantors of our loan with Commerce Bank of
Washington, which we have repaid. Mr. Slatt was, but is no longer, a guarantor
of the cell phone service contract between WatchGuard and AT&T Wireless.
60
<PAGE>
On March 9, 1999, we borrowed an aggregate of $1,500,000 from entities
affiliated with Olympic Venture Partners and an aggregate of $1,500,000 from
entities affiliated with Matrix IV Management Co., L.P. We issued each entity a
promissory note, which bore interest at 6% per year and would have matured on
March 9, 2000, and a warrant to purchase our common stock at an exercise price
of $7.00 per share. The table below states the amount of each loan and the
number of shares for which each warrant was exercisable. At the closing of our
initial public offering, all of these warrants were exercised and the loans
were repaid. The entities affiliated with Olympic Venture Partners exercised
their warrants on a cash exercise basis, while the entities affiliated with
Matrix Management Co., L.P. exercised their warrants on a net issuance basis.
<TABLE>
<CAPTION>
Number of Shares
Amount of for Which Warrant
Name of Investor Loan Was Exercisable
---------------- ---------- -----------------
<S> <C> <C>
Olympic Venture Partners III, L.P. ............. $ 647,500 9,244
OVP III Entrepreneurs Fund, L.P. ............... 20,000 296
Olympic Venture Partners IV, L.P. .............. 774,225 11,060
OVP IV Entrepreneurs Fund, L.P. ................ 58,275 828
Matrix Partners IV, L.P. ....................... 1,425,000 20,356
Matrix IV Entrepreneurs Fund, L.P. ............. 75,000 1,072
</TABLE>
On June 29, 1999, we amended our loan and security agreement with our bank to
make available to us additional funds under our secured bridge loan facility.
Each of Matrix Partners IV, L.P., Matrix IV Entrepreneurs Fund, L.P., Olympic
Venture Partners III, L.P., Olympic Venture Partners IV, L.P. and
RRE Investors, L.P. jointly and severally guaranteed a portion of the loan, in
the amounts shown below.
<TABLE>
<CAPTION>
Maximum Amount
Name of Guarantor of Guaranty
----------------- --------------
<S> <C>
Matrix Partners IV, L.P. ..................................... $633,334
Matrix IV Entrepreneurs Fund, L.P. ........................... 33,334
Olympic Venture Partners III, L.P. ........................... 333,334
Olympic Venture Partners IV, L.P. ............................ 333,334
RRE Investors, L.P. .......................................... 666,667
</TABLE>
We believe that we made all of the transactions described above on terms no
less favorable to us than we could have obtained from unaffiliated third
parties. Any future transactions between us and our officers, directors and
principal stockholders will be approved by a majority of our board of
directors, including a majority of the independent and disinterested directors,
and will be on terms no less favorable to us that we could obtain from
unaffiliated third parties.
Dain Rauscher Incorporated, the parent company of one of our underwriters,
Dain Rauscher Wessels, is a limited partner in Olympic Venture Partners IV,
L.P., a stockholder of WatchGuard.
61
<PAGE>
PRINCIPAL AND SELLING STOCKHOLDERS
Principal Stockholders
The following table provides information regarding the actual beneficial
ownership of our outstanding common stock as of December 31, 1999, and as
adjusted to reflect the sale of common stock offered by this prospectus, for
. each person or group that we know beneficially owns more than 5% of our
common stock;
. each of our directors;
. our chief executive officer;
. the other executive officers whose compensation exceeded $100,000 in
1999;
. all of our directors and executive officers as a group; and
. the selling stockholders.
The table includes percentage ownership data reflecting ownership both before
and after this offering. The pre-offering percentage ownership is based on
19,511,752 shares of WatchGuard common stock outstanding as of December 31,
1999. The post-offering percentage ownership is based on 21,136,752 shares
outstanding after this offering. Under the rules of the Securities and Exchange
Commission, beneficial ownership includes shares over which the indicated
beneficial owner exercises voting and/or investment power. Shares of common
stock subject to options that are currently exercisable or will become
exercisable within 60 days are deemed outstanding for computing the percentage
ownership of the person holding the option, but are not deemed outstanding for
purposes of computing the percentage ownership of any other person. Unless
otherwise indicated in the footnotes below, we believe that the persons and
entities named in the table have sole voting and investment power with respect
to all shares beneficially owned, subject to applicable community property
laws. Unless otherwise indicated, the following beneficial owners can be
reached at our principal offices.
62
<PAGE>
<TABLE>
<CAPTION>
Number of Percentage of
Number of Shares of Number of Shares of Common
Shares Common Shares Stock Outstanding
Beneficially Stock Beneficially -----------------
Owned Before Being Owned After Before After
Name and Address Offering Offered Offering Offering Offering
---------------- ------------ --------- ------------ -------- --------
<S> <C> <C> <C> <C> <C>
5% Holders, Directors
and Executive Officers
Entities affiliated with
Matrix IV Management
Co., L.P.(1) .......... 2,908,291 0 2,908,291 14.91% 13.84%
2500 Sand Hill Road
Menlo Park, CA 94025
Entities affiliated with
Olympic Venture
Partners(2). 2,919,828 100,000 2,819,828 14.96 13.42
2420 Carillon Point
Kirkland, WA 98033
Entities affiliated with
RRE Investors II,
LLC(3) ................ 1,551,288 350,000 1,201,288 7.95 5.72
126 East 56th St., 22nd
Floor
New York, NY 10022
Stuart J. Ellman(4) .... 1,551,288 350,000 1,201,288 7.95 5.72
Andrew W. Verhalen(5)
....................... 2,908,291 0 2,908,291 14.91 13.84
Charles P. Waite, Jr.(6)
....................... 2,919,828 100,000 2,819,828 14.96 13.42
Christopher G. Slatt(7)
....................... 2,952,753 330,000 2,622,753 15.10 12.46
Steven N. Moore(8) ..... 2,952,753 330,000 2,622,753 15.10 12.46
Michael C. Peronto(9)
....................... 145 0 0 * *
Directors and executive
officers as a group (6
persons)(10) .......... 13,285,058 1,110,000 12,175,058 67.79 57.71
Other Selling
Stockholders
Dennis R. Cloutier(11).. 692,886 175,000 517,886 3.51 2.44
Michael V.
Martucci(12)........... 439,007 125,000 314,007 2.21 1.47
David W. Bonn(13)....... 649,655 90,000 559,655 3.25 2.60
</TABLE>
- --------
* Less than 1%
(1) Matrix IV Management Co., L.P. is the general partner of Matrix Partners
IV, L.P. and of Matrix IV Entrepreneurs Fund, L.P., and thus is deemed to
beneficially own the shares held by these entities. Andrew W. Verhalen, a
director of WatchGuard, is a general partner of Matrix IV Management Co.,
L.P.
(2) Includes 1,299,328 shares held by Olympic Venture Partners III, L.P. and
OVP III Entrepreneurs Fund, L.P. OVMC III, L.P. is the general partner of
Olympic Venture Partners III, L.P. and of OVP III Entrepreneurs Fund,
L.P., and thus is deemed to beneficially own the shares held by these
entities. Also includes 1,620,500 shares held by Olympic Venture Partners
IV, L.P. and OVP IV Entrepreneurs Fund, L.P. OVMC IV, LLC is the general
partner of Olympic Venture Partners IV, L.P. and of OVP IV Entrepreneurs
Fund, L.P., and thus is deemed to beneficially own the shares held by
these entities. OVMC III, L.P. and OVMC IV, LLC disclaim beneficial
ownership of these shares except to the extent of their pecuniary
interests in these shares. Charles P. Waite, Jr., a director of
WatchGuard, is a general partner of OVMC III, L.P. and a managing member
of OVMC IV, LLC.
(3) RRE Investors II, LLC is the managing member of RRE Investors, L.P. and
the indirect managing member of RRE Investors Fund, L.P., and thus is
deemed to beneficially own the shares held by these entities. Stuart J.
Ellman, a director of WatchGuard, is a member of RRE Investors II, LLC.
63
<PAGE>
(4) Mr. Ellman is a member of RRE Investors II, LLC, which is the direct or
indirect managing member of each of the entities affiliated with it. Mr.
Ellman disclaims beneficial ownership of the shares held by the entities
affiliated with RRE Investors II, LLC, except to the extent of his
pecuniary interest arising from his interest in RRE Investors II, LLC.
(5) Represents 2,908,291 shares held by entities affiliated with Matrix IV
Management Co., L.P. Mr. Verhalen is a general partner of Matrix IV
Management Co., L.P., which is the general partner of each of the
entities affiliated with it. Mr. Verhalen disclaims beneficial ownership
of the shares held by the entities affiliated with Matrix IV Management
Co., L.P., except to the extent of his pecuniary interest arising from
his interest in Matrix IV Management Co., L.P.
(6) Represents 2,919,828 shares held by affiliates of OVMC III, L.P. and OVMC
IV, LLC. Mr. Waite is a general partner of OVMC III, L.P., which is the
general partner of Olympic Venture Partners III, L.P. and of OVP III
Entrepreneurs Fund. Mr. Waite is also a managing member of OVMC IV, LLC,
which is the general partner of Olympic Venture Partners IV, L.P. and of
OVP IV Entrepreneurs Fund, L.P. Mr. Waite disclaims beneficial ownership
of the shares held by Olympic Venture Partners III, L.P., OVP III
Entrepreneurs Fund, L.P., Olympic Venture Partners IV, L.P. and OVP IV
Entrepreneurs Fund, L.P., except to the extent of his pecuniary interest
arising from his interest in these entities.
(7) Includes 300,000 shares held by Venus Capital LLC and 43,123 shares
subject to options exercisable within 60 days of December 31, 1999.
(8) Includes 300,000 shares held by Baja Investment Co. LLC and 43,123 shares
subject to options exercisable within 60 days of December 31, 1999.
(9) Represents 145 shares subject to an option exercisable within 60 days of
December 31, 1999.
(10) Includes 86,391 shares subject to options exercisable within 60 days of
December 31, 1999.
(11) Includes 232,371 shares subject to options exercisable within 60 days of
December 31, 1999.
(12) Includes 385,506 shares subject to options exercisable within 60 days of
December 31, 1999.
(13) Includes 474,655 shares subject to options exercisable within 60 days of
December 31, 1999.
Selling Stockholders
If the underwriters exercise their over-allotment option in full, the
following directors, officers and stockholders will sell the number of shares
indicated below:
<TABLE>
<CAPTION>
Percentage of
Shares of
Beneficial Number Beneficial Common Stock
Ownership of Ownership Outstanding
Before Shares After After
Over-Allotment Being Over-Allotment Over-Allotment
Name Exercise Offered Exercise Exercise
---- -------------- ------- -------------- --------------
<S> <C> <C> <C> <C>
Entities affiliated with
Olympic Venture
Partners................ 2,819,828 110,000 2,709,828 12.82%
Entities affiliated with
RRE Investors II, LLC... 1,201,288 100,000 1,101,288 5.21
Christopher G. Slatt..... 2,622,753 30,000 2,592,753 12.24
Steven N. Moore.......... 2,622,753 30,000 2,592,753 12.24
Dennis R. Cloutier....... 517,886 100,000 417,886 1.96
Michael V. Martucci...... 314,007 50,000 264,007 1.23
David W. Bonn............ 559,655 30,000 529,655 2.45
</TABLE>
64
<PAGE>
DESCRIPTION OF CAPITAL STOCK
We are authorized to issue up to 80,000,000 shares of common stock and
10,000,000 shares of preferred stock. You should carefully read our restated
certificate of incorporation, which is included as an exhibit to the
registration statement of which this prospectus is a part.
Common Stock
As of December 31, 1999, there were 19,511,752 shares of common stock
outstanding, held of record by approximately 75 stockholders. Following this
offering, there will be 21,136,752 shares of common stock outstanding, assuming
no exercise of the underwriters' over-allotment option and no exercise of
outstanding options or warrants. The holders of common stock are entitled to
one vote for each share held of record on all matters submitted to a vote of
stockholders. Subject to preferences of any outstanding shares of preferred
stock, the holders of common stock are entitled to receive ratably any
dividends the board of directors declares out of funds legally available for
paying dividends. If WatchGuard is liquidated, dissolved or wound up, the
holders of common stock are entitled to share ratably in all assets remaining
after paying liabilities and liquidation preferences of any outstanding shares
of preferred stock. Holders of common stock have no preemptive rights or rights
to convert their common stock into any other securities. There are no
redemption or sinking fund provisions applicable to the common stock. All
outstanding shares of common stock are fully paid and nonassessable, and the
shares of common stock to be issued upon completion of this offering will be
fully paid and nonassessable.
Preferred Stock
There are no shares of preferred stock outstanding. Under our certificate of
incorporation, the board of directors has the authority, without further action
by the stockholders, to issue up to 10,000,000 shares of preferred stock in one
or more series and to fix the price, rights, privileges, preferences and
restrictions of that preferred stock, any or all of which may be greater than
the rights of the common stock. The board of directors, without stockholder
approval, can issue preferred stock with voting, conversion or other rights
that could adversely affect the voting power and other rights of the holders of
common stock. Preferred stock could thus be issued quickly with terms that
could delay or prevent a change of control of WatchGuard or make removal of
management more difficult. Additionally, the issuance of preferred stock may
decrease the market price of the common stock and may adversely affect the
voting and other rights of the holders of common stock. We have no current
plans to issue any preferred stock.
Warrants
As of December 31, 1999, there were outstanding warrants to purchase 225,000
shares of common stock. The warrants expire and are exercisable as follows:
. 15,000 shares at an exercise price of $0.03 per share, expiring on July
24, 2001;
. 200,000 shares at an exercise price of $0.39 per share, expiring on June
17, 2003; and
. 10,000 shares at an exercise price of $13.00 per share, expiring on May
26, 2004.
Antitakeover Effects of Provisions of Our Certificate of Incorporation, Our
Bylaws, Delaware Law and Washington Law
Preferred Stock. Our board of directors, without stockholder approval, has
the authority under our certificate of incorporation to issue preferred stock
with rights superior to the rights of the holders of common stock. As a result,
preferred stock could be issued quickly and easily, could adversely affect the
rights of holders of common stock and could be issued with terms calculated to
delay or prevent a change of control of WatchGuard or make removal of
management more difficult.
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<PAGE>
Election and Removal of Directors. Our bylaws provide, effective with our
next annual meeting of stockholders, for the division of our board of directors
into three classes, as nearly equal in number as possible. The directors in the
first class will serve an initial term of one year, the directors in the second
class an initial term of two years, and the directors in the third class an
initial term of three years. After the initial term, all classes of directors
will serve for a three-year term, and one class will be elected each year by
our stockholders. Directors may be removed only for cause. Because this system
of electing and removing directors generally makes it more difficult for
stockholders to replace a majority of directors, it may tend to discourage a
third party from making a takeover bid or attempting to gain control of
WatchGuard and may maintain the incumbency of our board of directors.
Approval for Certain Business Combinations. Our certificate of incorporation
requires that certain business combinations, including a merger, share exchange
and the disposition or encumbrance of a substantial part of our assets other
than in the usual course of business, be approved by the holders of at least
two-thirds of the outstanding shares. If the business combination has been
approved by a majority of the board of directors, however, the affirmative vote
required is a majority of the outstanding shares.
Stockholder Meetings. Under our certificate of incorporation and bylaws, our
stockholders may call a special meeting only upon the request of holders of at
least 25% of the outstanding shares. Additionally, the board of directors, the
chairman of the board and the president may call special meetings of
stockholders.
Requirements for Advance Notification of Stockholder Nominations and
Proposals. Our bylaws establish advance notice procedures for stockholder
proposals and the nomination of candidates for election as directors, other
than nominations made by or at the direction of the board of directors or a
committee of the board of directors.
Washington Law. The laws of Washington, where our principal executive offices
are located, impose restrictions on transactions between foreign corporations
and significant stockholders. Chapter 23B.19 of the Washington Business
Corporation Act generally prohibits a target corporation from engaging in
significant business transactions with an acquiring person. An acquiring person
is defined as a person or group of persons that beneficially owns 10% or more
of the voting securities of the target corporation, for a period of five years
after the acquisition, unless a majority of the members of the target
corporation's board of directors approves the transaction before the
acquisition. Prohibited transactions include
. a merger or consolidation with, disposition of assets to, or issuance or
redemption of stock to or from, the acquiring person;
. termination of 5% or more of the employees of the target corporation as
a result of the acquiring person's acquisition of 10% or more of the
shares; and
.allowing the acquiring person to receive any disproportionate benefit as a
stockholder.
After the five-year period, a significant business transaction may take place
so long as it complies with the fair price provisions of the statute or is
approved at an annual or special meeting of stockholders. A target corporation
includes a foreign corporation if
.the corporation's principal executive office is located in Washington;
. any of (a) more than 10% of the corporation's stockholders of record are
Washington residents, (b) more than 10% of its shares of record are
owned by Washington residents or (c) 1,000 or more of its stockholders
of record are Washington residents;
. a majority of the corporation's employees are Washington residents or
more than 1,000 Washington residents are employees of the corporation;
and
. a majority of the corporation's tangible assets are located in
Washington or the corporation has more than $50 million of tangible
assets located in Washington.
66
<PAGE>
A corporation may not opt out of this statute. If WatchGuard continues to
meet the definition of a target corporation, Chapter 23B.19 of the Washington
Business Corporation Act may have the effect of delaying, deferring or
preventing a change of control of WatchGuard.
Delaware Law. WatchGuard is subject to Section 203 of the Delaware General
Corporation Law, which prohibits a publicly held Delaware corporation from
engaging in a business combination with an interested stockholder for a period
of three years after the date of the transaction in which the person became an
interested stockholder, unless
. before that date, the board of directors of the corporation approves
either the business combination or the transaction that resulted in the
stockholder's becoming an interested stockholder;
. upon consummation of the transaction that resulted in the stockholder's
becoming an interested stockholder, the interested stockholder owns at
least 85% of the outstanding voting stock, excluding shares held by
directors, officers and employee stock plans; or
. on or after the consummation date, the business combination is approved
by the board of directors and by the affirmative vote at an annual or
special meeting of stockholders of at least 66 2/3% of the outstanding
voting stock that is not owned by the interested stockholder.
For purposes of Section 203, a business combination includes a merger, asset
sale or other transaction resulting in a financial benefit to the interested
stockholder. An interested stockholder is generally a person who, together with
affiliates and associates of that person, (a) owns 15% or more of the
corporation's voting stock or (b) is an affiliate or associate of the
corporation and was the owner of 15% or more of the outstanding voting stock of
the corporation at any time within the prior three years.
These charter provisions and provisions of Washington and Delaware law may
have the effect of delaying, deterring or preventing a change of control of
WatchGuard.
Registration Rights
After this offering, the holders of 13,198,667 shares of common stock will
have rights with respect to the registration of those shares under the
Securities Act, under a registration rights agreement among the holders and
WatchGuard, dated as of April 24, 1998. Under the terms of the registration
rights agreement, if we propose to register any of our securities under the
Securities Act, either for our own account or for the account of other security
holders exercising registration rights, the holders are entitled to notice of
the registration and to include shares of common stock in the registration at
our expense. Additionally, the holders are entitled to demand registration
rights under which they may require us to file a registration statement under
the Securities Act at our expense for their shares of common stock. Further,
the holders may require us to file additional registration statements on Form
S-3 at our expense. All of these registration rights are subject to conditions
and limitations, including the right of the underwriters of an offering to
limit the number of shares included in the registration and our right to
decline to effect such a registration before January 1, 2000.
Transfer Agent and Registrar
The transfer agent and registrar for the common stock is ChaseMellon
Shareholder Services, L.L.C.
Nasdaq National Market Listing
Our common stock is quoted on The Nasdaq National Market under the symbol
WGRD. The last reported price of our common stock on January 26, 2000 was
$30.44 per share.
67
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Future sales of substantial amounts of our common stock in the public market,
or the possibility of these sales occurring, could adversely affect prevailing
market prices for our common stock or our future ability to raise capital
through an offering of equity securities.
After this offering, we will have outstanding 21,136,752 shares of common
stock, or 21,186,752 shares if the underwriters exercise their over-allotment
option in full. Of these shares, the 3,000,000 shares that we and the selling
stockholders expect to sell in this offering, or 3,450,000 shares if the
underwriters exercise their over-allotment option in full, will be freely
tradable in the public market without restriction under the Securities Act,
unless the shares are acquired by affiliates of WatchGuard, as that term is
defined in Rule 144 under the Securities Act. In general, affiliates include
directors, officers and 10% stockholders.
Of the remaining 18,136,752 shares of common stock that will be outstanding
after this offering, 13,799,815 shares are restricted shares. We issued and
sold the restricted shares in private transactions in reliance on exemptions
from registration under the Securities Act. Restricted shares may be sold in
the public market only if they are registered or if they qualify for an
exemption from registration under Rule 144 or 701 under the Securities Act,
which are summarized below.
Our executive officers and directors, and the selling stockholders, who
collectively hold an aggregate of 12,491,185 restricted shares, have agreed not
to offer, sell, contract to sell, grant any option to purchase or dispose of
their shares by any other means for a period of 90 days from the date of this
prospectus. This 90-day period is known as the lock-up period. We also have
entered into an agreement with Credit Suisse First Boston Corporation that we
will not offer, sell or dispose of common stock by any other means during the
lock-up period.
On the date of this prospectus, 1,110,053 shares that are not subject to
lock-up agreements will be eligible for sale in the public market under Rules
144 and 701. On the date the lock-up agreements expire, an additional
12,491,185 restricted shares will be eligible for immediate sale, of which
12,067,239 shares will be subject to the volume, manner of sale and other
limitations of Rule 144. The remaining 409,307 restricted shares will be
eligible for sale under Rule 144 when one-year holding periods expire.
Some of the shares issued upon exercise of options we granted before the date
of this prospectus will also be available for sale in the public market under
Rule 701 under the Securities Act. Rule 701 permits resales of those shares in
reliance on Rule 144 but without compliance with some of the restrictions
imposed by Rule 144, including the holding period requirement. Under Rule 144,
a person who has beneficially owned restricted shares for at least one year
would be entitled to sell within any three-month period up to the greater of
. 1% of the then-outstanding shares of common stock, which will be
approximately 211,368 shares immediately after this offering; and
. the average weekly trading volume of the common stock during the four
calendar weeks preceding the filing of a Form 144 with respect to the
sale.
Sales under Rule 144 are also subject to manner of sale and notice
requirements and to the availability of current public information about
WatchGuard. Under Rule 144(k), a person who is not deemed to have been an
affiliate of WatchGuard during the 90 days preceding a sale and who has
beneficially owned the restricted shares for at least two years may sell them
without complying with the manner of sale, public information, volume
limitation or notice provisions of Rule 144.
The 10,610,796 shares of common stock reserved for issuance under our stock
option plan and our employee stock purchase plan have been registered on a
registration statement on Form S-8, which became effective at the time of our
initial public offering in July 1999. Shares issued under our stock option plan
and
68
<PAGE>
our employee stock purchase plan therefore may be sold in the open market. Some
holders, however, will be subject to the Rule 144 limitations applicable to
affiliates, the lock-up agreements and vesting restrictions imposed by us.
In addition, following this offering, the holders of an aggregate of
13,198,667 shares of outstanding common stock will have rights to require us to
register their shares for future sale.
69
<PAGE>
UNDERWRITING
Under the terms and subject to the conditions contained in an underwriting
agreement dated 2000, we and the selling stockholders have agreed to
sell to the underwriters named below, for whom Credit Suisse First Boston
Corporation, Dain Rauscher Wessels, a division of Dain Rauscher Incorporated,
SoundView Technology Group, Inc. and Wit Capital Corporation are acting as
representatives, the following respective numbers of shares of common stock:
<TABLE>
<CAPTION>
Number
Underwriter of Shares
----------- ---------
<S> <C>
Credit Suisse First Boston Corporation.............................
Dain Raucher Wessels...............................................
SoundView Technology Group, Inc. ..................................
Wit Capital Corporation............................................
---------
Total ........................................................... 3,000,000
=========
</TABLE>
The underwriting agreement provides that the underwriters are obligated to
purchase all the shares of common stock in the offering if any are purchased,
other than those shares covered by the over-allotment option described below.
The underwriting agreement also provides that if an underwriter defaults, the
purchase commitments of nondefaulting underwriters may be increased or the
offering of common stock may be terminated.
The selling stockholders have granted the underwriters a 30-day option to
purchase up to an aggregate of 450,000 additional outstanding shares from the
selling stockholders at the public offering price less the underwriting
discounts and commissions. The option may be exercised only to cover any over-
allotments of common stock.
The underwriters propose to offer the shares of common stock initially at the
public offering price on the cover page of this prospectus and to selling group
members at that price less a concession of $ per share. The underwriters
and selling group members may allow a discount of $ per share on sales to
other broker/dealers. After the public offering, the public offering price and
concession and discount to broker/dealers may be changed by the
representatives.
The following table summarizes the compensation and estimated expenses we and
the selling stockholders will pay.
<TABLE>
<CAPTION>
Per Share Total
----------------------------- -----------------------------
Without With Without With
Over-Allotment Over-Allotment Over-Allotment Over-Allotment
-------------- -------------- -------------- --------------
<S> <C> <C> <C> <C>
Underwriting discounts
and commissions paid by
us .................... $ $ $ $
Expenses payable by us
....................... $ $ $ $
Underwriting discounts
and commissions paid by
selling stockholders... $ $ $ $
Expenses payable by the
selling stockholders... $ $ $ $
</TABLE>
We have agreed that we will not offer, sell, contract to sell, pledge or
otherwise dispose of, directly or indirectly, or file with the Securities and
Exchange Commission a registration statement under the Securities Act relating
to, any additional shares of our common stock or securities convertible into or
exchangeable or exercisable for any shares of our common stock, or publicly
disclose the intention to make any such offer, sale, pledge, disposition or
filing, without the prior written consent of Credit Suisse First Boston
Corporation for a period of 90 days after the date of this prospectus, except
grants of employee stock options and issuances upon the exercise of employee
stock options outstanding on the date of this prospectus.
70
<PAGE>
Our officers and directors and some of our stockholders, including the
selling stockholders, have agreed that they will not offer, sell, contract to
sell, pledge or otherwise dispose of, directly or indirectly, any shares of our
common stock or securities convertible into or exchangeable or exercisable for
any shares of our common stock, enter into a transaction which would have the
same effect, or enter into any swap, hedge or other arrangement that transfers,
in whole or in part, any of the economic consequences of ownership of our
common stock, whether any such transaction is to be settled by delivery of our
common stock or other securities, in cash or otherwise, or publicly disclose
the intention to make any such offer, sale, pledge or disposition, without the
prior written consent of Credit Suisse First Boston Corporation, for a period
of 90 days after the date of this prospectus.
We and the selling stockholders have agreed to indemnify the underwriters
against liabilities under the Securities Act, or contribute to payments that
the underwriters may be required to make in that respect.
Our common stock is quoted on The Nasdaq National Market.
The representatives may engage in over-allotment, stabilizing transactions,
syndicate covering transactions, penalty bids and passive market making in
accordance with Regulation M under the Exchange Act.
. Over-allotment involves syndicate sales in excess of the offering size,
which creates a syndicate short position.
. Stabilizing transactions permit bids to purchase the underlying security
so long as the stabilizing bids do not exceed a specified maximum.
. Syndicate covering transactions involve purchases of the common stock in
the open market after the distribution has been completed in order to
cover syndicate short positions.
. Penalty bids permit the representatives to reclaim a selling concession
from a syndicate member when the common stock originally sold by the
syndicate member is purchased in a stabilizing or syndicate covering
transaction to cover syndicate short positions.
. In passive market making, market makers in the common stock who are
underwriters or prospective underwriters may, subject to limitations,
make bids for or purchases of the common stock until the time, if any,
at which a stabilizing bid is made.
These stabilizing transactions, syndicate covering transactions and penalty
bids may cause the price of the common stock to be higher than it would
otherwise be absent these transactions. These transactions may be effected on
The Nasdaq National Market or otherwise and, if commenced, may be discontinued
at any time.
A prospectus in electronic format is being made available on an Internet web
site maintained by Wit Capital. In addition, all dealers purchasing shares from
Wit Capital in this offering have agreed to make a prospectus in electronic
format available on web sites maintained by each of these dealers. Wit Capital,
a member of the National Association of Securities Dealers, Inc., will
participate in this offering as one of the underwriters. The National
Association of Securities Dealers, Inc. approved the membership of Wit Capital
on September 4, 1997.
Dain Rauscher Incorporated, the parent of Dain Rauscher Wessels, is a limited
partner in Olympic Venture Partners IV, L.P., which is one of the entities that
invested in our preferred stock and now holds shares of our common stock. On
March 9, 1999, Olympic Venture Partners IV, L.P. loaned $774,225 to us under a
promissory note bearing interest at the rate of 6% each year, which was repaid
on August 2, 1999. As part of the loan, Olympic Venture Partners IV, L.P.
received a warrant to purchase 11,060 shares of our common stock, which it
exercised for common stock at the closing of our initial public offering. All
shares owned by Olympic Venture Partners IV, L.P., other than the shares being
sold in this offering, are subject to an agreement preventing them from being
sold until the expiration of 90 days following the date of this prospectus. The
shares that Dain Rauscher Incorporated beneficially owns through its interest
in Olympic Venture Partners IV, L.P. are also restricted from sale or transfer
under Rule 2710(c)(7) of the National Association of Securities Dealers'
conduct rules. The shares underlying the warrants exercised at the time of our
initial public offering are restricted under the securities laws until August
2, 2001.
71
<PAGE>
NOTICE TO CANADIAN RESIDENTS
Resale Restrictions
The distribution of the common stock in Canada is being made only on a
private placement basis exempt from the requirement that we and the selling
stockholders prepare and file a prospectus with the securities regulatory
authorities in each province where trades of common stock are effected.
Accordingly, any resale of the common stock in Canada must be made in
accordance with applicable securities laws, which will vary depending on the
relevant jurisdiction and which may require resales to be made in accordance
with available statutory exemptions or under a discretionary exemption granted
by the applicable Canadian securities regulatory authority. Purchasers should
seek legal advice before any resale of the common stock.
Representations of Purchasers
Each purchaser of common stock in Canada who receives a purchase confirmation
will be deemed to represent to us, the selling stockholders and the dealer from
whom the purchase confirmation is received that (i) the purchaser is entitled
under applicable provincial securities laws to purchase common stock without
the benefit of a prospectus qualified under the securities laws, (ii) where
required by law, the purchaser is purchasing as principal and not as agent and
(iii) the purchaser has reviewed the text above under "Resale Restrictions."
Rights of Action (Ontario Purchasers)
The securities being offered are those of a foreign issuer and Ontario
purchasers will not receive the contractual right of action prescribed by
Ontario securities law. As a result, Ontario purchasers must rely on other
remedies that may be available, including common law rights of action for
damages or rescission or rights of action under the civil liability provisions
of the U.S. federal securities laws.
Enforcement of Legal Rights
All of the issuer's directors and officers as well as the experts named
herein and the selling stockholders may be located outside of Canada and, as a
result, Canadian purchasers may be unable to effect service of process within
Canada upon the issuer or such persons. All or a substantial portion of the
assets of the issuer and such persons may be located outside of Canada and, as
a result, it may not be possible to satisfy a judgment against the issuer or
such persons in Canada or to enforce a judgment obtained in Canadian courts
against such issuer or persons outside of Canada.
Notice to British Columbia Residents
A purchaser of common stock to whom the Securities Act (British Columbia)
applies is required to file a report with the British Columbia Securities
Commission within ten days of the sale of any common stock acquired by such
purchaser pursuant to this offering. The report must be in the form attached to
British Columbia Securities Commission Blanket Order BOR #95/17, a copy of
which may be obtained from us. Only one report must be filed for common stock
acquired on the same date and under the same prospectus exemption.
Taxation and Eligibility for Investment
Canadian purchasers of common stock should consult their own legal and tax
advisors with respect to the tax consequences of an investment in the common
stock in their particular circumstances and with respect to the eligibility of
the common stock for investment by the purchaser under relevant Canadian
legislation.
72
<PAGE>
LEGAL MATTERS
WatchGuard's legal counsel is Perkins Coie LLP of Seattle, Washington. The
underwriters' legal counsel is Gray Cary Ware & Freidenrich LLP of Palo Alto,
California.
EXPERTS
Ernst & Young LLP, independent auditors, have audited our financial
statements and schedule at December 31, 1997 and 1998, for the period from our
inception on February 14, 1996 to December 31, 1996 and for the years ended
December 31, 1997 and 1998, as described in their reports. We have included our
financial statements and schedule in this prospectus and elsewhere in the
registration statement in reliance on Ernst & Young LLP's reports, given on
their authority as experts in accounting and auditing.
The financial statements of BeadleNet, LLC and its predecessor included in
this prospectus have been audited by Deloitte & Touche LLP, independent
auditors, as stated in their report. We have included the financial statements
in this prospectus and elsewhere in the registration statement in reliance on
Deloitte & Touche LLP's report, given on their authority as experts in
accounting and auditing.
WHERE YOU CAN FIND MORE INFORMATION
We have filed a registration statement on Form S-1 with the Securities and
Exchange Commission. This prospectus, which is part of the registration
statement, does not contain all the information included in the registration
statement. Because some information is omitted, you should refer to the
registration statement and its exhibits. For copies of actual contracts or
documents referred to in this prospectus, you should refer to the exhibits
attached to the registration statement. You may review a copy of the
registration statement, including the attached exhibits and schedule, at the
SEC's public reference facilities in Room 1024, Judiciary Plaza, 450 Fifth
Street, N.W., Washington, D.C. 20549, and at the regional offices of the SEC at
7 World Trade Center, Suite 1300, New York, New York 10048, and Citicorp
Center, 500 West Madison Street, Suite 1400, Chicago, Illinois 60661. You may
also obtain copies of these materials from the Public Reference Room of the
SEC, Room 1024, Judiciary Plaza, 450 Fifth Street, N.W., Washington, D.C.
20549, at prescribed rates. You may obtain information on the operation of the
Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains a
web site at http://www.sec.gov that contains reports, proxy and information
statements and other information regarding registrants, such as WatchGuard,
that file electronically with the SEC.
73
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
INDEX TO FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Audited Financial Statements: WatchGuard Technologies, Inc.
Report of Ernst & Young LLP, Independent Auditors......................... F-2
Balance Sheets............................................................ F-3
Statements of Operations.................................................. F-4
Statements of Stockholders' Equity........................................ F-5
Statements of Cash Flows.................................................. F-6
Notes to Financial Statements............................................. F-7
Audited Financial Statements of Business Acquired: BeadleNet, LLC
Report of Deloitte & Touche LLP, Independent Auditors..................... F-22
Balance Sheets............................................................ F-23
Statements of Operations.................................................. F-24
Statements of Capital Deficiency.......................................... F-25
Statements of Cash Flows.................................................. F-26
Notes to Financial Statements............................................. F-27
Unaudited Pro Forma Financial Information
Unaudited Pro Forma Combined Condensed Balance Sheet...................... F-33
Unaudited Pro Forma Combined Condensed Statements of Operations........... F-34
Notes to Unaudited Pro Forma Combined Condensed Financial Statements...... F-35
</TABLE>
F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
Board of Directors and Stockholders
WatchGuard Technologies, Inc.
We have audited the accompanying balance sheets of WatchGuard Technologies,
Inc. as of December 31, 1997 and 1998 and the related statements of operations,
stockholders' equity, and cash flows for the period from February 14, 1996
(date of inception) to December 31, 1996 and for the years ended December 31,
1997 and 1998. These financial statements are the responsibility of
WatchGuard's management. Our responsibility is to express an opinion on these
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally
accepted in the United States. Those standards require that we plan and perform
the audit to obtain reasonable assurance about whether the financial statements
are free of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of WatchGuard Technologies, Inc.
at December 31, 1997 and 1998, and the results of its operations and its cash
flows for the period from February 14, 1996 (date of inception) to December 31,
1996 and for the years ended December 31, 1997 and 1998, in conformity with
accounting principles generally accepted in the United States.
ERNST & YOUNG LLP
Seattle, Washington
March 26, 1999, except as to Note 11,
as to which the date is July 8, 1999.
F-2
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
BALANCE SHEETS
(In thousands, except share data)
<TABLE>
<CAPTION>
December 31,
----------------- September 30,
1997 1998 1999
------- -------- -------------
(unaudited)
ASSETS
<S> <C> <C> <C>
Current assets:
Cash and cash equivalents................... $ 603 $ 1,712 $ 32,468
Trade accounts receivable, net.............. 1,596 3,491 3,530
Inventories................................. 218 2,156 1,906
Prepaid expenses and other.................. 162 450 601
------- -------- --------
Total current assets.......................... 2,579 7,809 38,505
Equipment and furniture, net.................. 372 1,140 1,702
Deposits, intangibles, and other assets....... 352 83 99
------- -------- --------
Total assets.................................. $ 3,303 $ 9,032 $ 40,306
======= ======== ========
<CAPTION>
LIABILITIES AND STOCKHOLDERS' EQUITY
<S> <C> <C> <C>
Current liabilities:
Line of credit.............................. $ 500 $ 2,500 $ --
Equipment term loan......................... -- 609 462
Accounts payable............................ 682 2,185 1,748
Accrued expenses............................ 426 1,016 1,321
Deferred revenue............................ 313 1,773 3,431
------- -------- --------
Total current liabilities..................... 1,921 8,083 6,962
Deferred revenue.............................. -- 68 --
Commitments
Stockholders' equity:
Preferred stock, $0.001 par value:
Authorized shares: 10,000,000
Shares issued and outstanding: 5,316,670,
6,712,658 and 0 at December 31, 1997 and
1998 and September 30, 1999, respectively
Liquidation preference: $13,250 at
December 31, 1998........................ 5 6 --
Common stock, $0.001 par value:
Authorized shares: 80,000,000
Shares issued and outstanding: 532,916,
1,362,744 and 19,027,920 at December 31,
1997 and 1998 and September 30, 1999,
respectively............................. -- 1 19
Additional paid-in capital.................. 6,179 16,261 57,624
Stock-based compensation.................... -- (1,466) (931)
Accumulated deficit......................... (4,802) (13,921) (23,368)
------- -------- --------
Total stockholders' equity................ 1,382 881 33,344
------- -------- --------
Total liabilities and stockholders'
equity................................... $ 3,303 $ 9,032 $ 40,306
======= ======== ========
</TABLE>
See accompanying notes.
F-3
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
STATEMENTS OF OPERATIONS
(In thousands, except per share data)
<TABLE>
<CAPTION>
Period from
February 14, 1996
(Inception) to Year Ended Nine Months Ended
December 31, December 31, September 30,
----------------- ------------------ ------------------
1996 1997 1998 1998 1999
----------------- -------- -------- -------- --------
(unaudited)
<S> <C> <C> <C> <C> <C>
Revenues:
Product............... $ 329 $ 4,975 $ 10,678 $ 7,404 $ 11,832
Service............... 2 123 701 362 2,264
------ -------- -------- -------- --------
Total revenues...... 331 5,098 11,379 7,766 14,096
Cost of revenues........ 104 1,610 3,925 2,529 5,566
------ -------- -------- -------- --------
Gross margin............ 227 3,488 7,454 5,237 8,530
Operating expenses:
Sales and marketing... 224 4,369 8,519 6,072 9,695
Research and
development.......... 274 2,192 4,442 3,012 4,740
General and
administrative....... 191 1,323 2,454 1,590 2,616
Stock-based
compensation......... -- -- 1,039 452 697
------ -------- -------- -------- --------
Total operating
expenses........... 689 7,884 16,454 11,126 17,748
------ -------- -------- -------- --------
Operating loss.......... (462) (4,396) (9,000) (5,889) (9,218)
Interest income......... -- 88 84 60 268
Interest expense........ (6) (26) (203) (119) (497)
------ -------- -------- -------- --------
Net loss................ $ (468) $ (4,334) $ (9,119) $ (5,948) $ (9,447)
====== ======== ======== ======== ========
Basic and diluted net
loss per share......... N/A $ (17.17) $ (11.34) $ (8.01) $ (1.76)
====== ======== ======== ======== ========
Shares used in
calculation of basic
and diluted net loss
per share.............. N/A 252 804 743 5,379
====== ======== ======== ======== ========
Pro forma basic and
diluted net loss per
share (unaudited)...... $ (0.68) $ (0.60)
======== ========
Shares used in
calculation of pro
forma basic and diluted
net loss per share
(unaudited)............ 13,366 15,755
======== ========
</TABLE>
See accompanying notes.
F-4
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
(In thousands, except share data)
<TABLE>
<CAPTION>
Preferred Stock Common Stock Additional Deferred
------------------ ----------------- Paid-in Stock-Based Accumulated
Shares Amount Shares Amount Capital Compensation Deficit Total
---------- ------ ---------- ------ ---------- ------------ ----------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Sale of Series A
preferred stock........ 3,000,004 $ 3 -- $-- $ 147 $ -- $ -- $ 150
Net loss................ -- -- -- -- -- -- (468) (468)
---------- ----- ---------- ---- -------- ------ --------- --------
Balance, December 31,
1996................... 3,000,004 3 -- -- 147 -- (468) (318)
Sale of Series B
preferred stock, net
of issuance costs of
$21................... 2,316,666 2 -- -- 5,977 -- -- 5,979
Issuance of common
stock in settlement of
royalty payments...... -- -- 400,000 -- 52 -- -- 52
Exercise of common
stock options and
warrants.............. -- -- 132,916 -- 3 -- -- 3
Net loss............... -- -- -- -- -- -- (4,334) (4,334)
---------- ----- ---------- ---- -------- ------ --------- --------
Balance, December 31,
1997................... 5,316,670 5 532,916 -- 6,179 -- (4,802) 1,382
Sales of Series B
preferred stock....... 38,610 -- -- -- 100 -- -- 100
Sales of Series C
preferred stock, net
of issuance costs of
$25................... 1,357,378 1 -- -- 6,974 -- -- 6,975
Issuance of stock
warrant to a
customer.............. -- -- -- -- 470 -- -- 470
Stock-based
compensation.......... -- -- -- -- 2,505 (2,505) -- --
Amortization of stock-
based compensation.... -- -- -- -- -- 1,039 -- 1,039
Exercise of common
stock options and
warrants.............. -- -- 829,828 1 33 -- -- 34
Net loss............... -- -- -- -- -- -- (9,119) (9,119)
---------- ----- ---------- ---- -------- ------ --------- --------
Balance, December 31,
1998................... 6,712,658 6 1,362,744 1 16,261 (1,466) (13,921) 881
Proceeds from issuance
of common stock from
initial public
offering, net of
offering costs
(unaudited)........... -- -- 3,500,000 4 40,806 -- -- 40,810
Conversion of preferred
stock into common
stock (unaudited)..... (6,712,658) (6) 13,425,316 13 (7) -- -- --
Stock-based
compensation
(unaudited)........... -- -- -- -- 162 (162) -- --
Amortization of stock-
based compensation
(unaudited)........... -- -- -- -- -- 697 -- 697
Issuance of stock
warrants (unaudited).. -- -- -- -- 195 -- -- 195
Exercise of common
stock options and
warrants (unaudited).. -- -- 739,860 1 207 -- -- 208
Net loss (unaudited)... -- -- -- -- -- -- (9,447) (9,447)
---------- ----- ---------- ---- -------- ------ --------- --------
Balance, September 30,
1999 (unaudited)....... -- $ -- 19,027,920 $ 19 $ 57,624 $ (931) $ (23,368) $ 33,344
========== ===== ========== ==== ======== ====== ========= ========
</TABLE>
See accompanying notes.
F-5
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
STATEMENTS OF CASH FLOWS
(In thousands)
<TABLE>
<CAPTION>
Period from
February 14, 1996 Year Ended Nine Months Ended
(date of inception) December 31, September 30,
to December 31, ------------------ -------------------
1996 1997 1998 1998 1999
------------------- -------- -------- --------- --------
(unaudited)
<S> <C> <C> <C> <C> <C>
Operating activities:
Net loss................ $ (468) $ (4,334) $ (9,119) $ (5,948) $ (9,447)
Adjustments to reconcile
net loss to net cash
used in operating
activities:
Depreciation and
amortization......... 23 207 235 144 430
Warrant issued in
exchange for
services............. -- -- 470 239 --
Amortization of stock-
based compensation... -- -- 1,039 452 697
Provision for sales
returns and
allowances........... -- -- 1,655 1,395 915
Provision for bad debt
expense.............. 8 122 418 203 79
Noncash interest
expense.............. -- -- -- -- 195
Changes in operating
assets and
liabilities:
(Increase) in
accounts
receivable.......... (175) (1,551) (3,968) (4,960) (1,034)
(Increase) decrease
in inventories...... -- (214) (1,938) (483) 250
(Increase) in prepaid
expenses and other.. (52) (113) (288) (46) (150)
(Increase) decrease
in deposits,
intangibles and
other assets........ (41) (273) 269 87 (15)
Increase (decrease)
in accounts payable
and accrued
expenses............ 240 868 2,093 1,611 (132)
Increase (decrease)
in deferred
revenue............. 334 (22) 1,528 2,088 1,591
------ -------- -------- --------- --------
Net cash used in
operating activities... (131) (5,310) (7,606) (5,218) (6,621)
Investing activities:
Purchase of equipment
and furniture.......... (77) (391) (1,003) (719) (993)
Purchase of intangible
assets................. (10) (70) -- -- --
------ -------- -------- --------- --------
Net cash used in
investing activities... (87) (461) (1,003) (719) (993)
Financing activities:
Borrowings on line of
credit and long-term
debt................... 300 700 2,663 1,480 7,280
Issuance of warrants.... -- -- -- -- 195
Principal repayments on
line of credit......... -- (500) (54) (35) (3,522)
Repayment of note
payable................ -- (40) -- -- (6,600)
Proceeds from sale of
preferred stock........ 150 5,979 7,075 7,100 --
Proceeds from sale of
common stock, net of
expenses............... -- -- -- -- 40,810
Proceeds from exercise
of common stock options
and warrants........... -- 3 34 14 207
------ -------- -------- --------- --------
Net cash provided by
financing activities... 450 6,142 718 8,559 38,370
------ -------- -------- --------- --------
Net increase in cash and
cash equivalents....... 232 371 1,109 2,622 30,756
Cash and cash
equivalents at
beginning of period ... -- 232 603 603 1,712
------ -------- -------- --------- --------
Cash and cash
equivalents at end of
period................. $ 232 $ 603 $ 1,712 $ 3,225 $ 32,468
====== ======== ======== ========= ========
Supplementary disclosure
of cash flow
information:
Cash paid for interest.. $ 6 $ 21 $ 179 $ 116 $ 520
====== ======== ======== ========= ========
Supplemental schedule of
noncash investing and
financing activities:
Issuance of note
payable for purchase
of intangible
assets............... $ 40 $ -- $ -- $ -- $ --
====== ======== ======== ========= ========
Issuance of common
stock for purchase of
intangible assets.... $ -- $ 52 $ -- $ -- $ --
====== ======== ======== ========= ========
</TABLE>
See accompanying notes.
F-6
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
1. Accounting Policies
Description of Business
WatchGuard Technologies, Inc. is a provider of Internet security solutions
designed to protect enterprises or telecommuters using the Internet for
electronic commerce and communications. WatchGuard was incorporated in the
state of Washington on February 14, 1996 and maintains its headquarters in
Seattle, Washington. In May 1997, WatchGuard reincorporated in the state of
Delaware. In conjunction with the reincorporation, WatchGuard changed its name
from Seattle Software Labs, Inc. to WatchGuard Technologies, Inc. in August
1997.
Basis of Presentation and Liquidity
The accompanying financial statements have been prepared on a going-concern
basis. This basis of accounting contemplates the realization of assets and the
satisfaction of liabilities in the normal course of business operations.
WatchGuard recorded losses of $9.1 million and used $7.6 million to fund
operations during the year ended December 31, 1998. At December 31, 1998,
WatchGuard had cash and cash equivalents of $1.7 million, a working capital
deficit of $274,000 and an accumulated deficit of $13.9 million.
WatchGuard has financed its operations to date through the issuance of equity
securities and debt financing. Further development and establishment of
WatchGuard's business will require additional equity or debt financing.
WatchGuard believes that equity or debt financing can be obtained from existing
or new sources. WatchGuard's current investors have indicated that they will
provide sufficient financing in order for WatchGuard to continue to operate
through 1999. (See Note 12 regarding cash proceeds raised in WatchGuard's
initial public offering.)
Unaudited Interim Financial Information
The financial information as of September 30, 1999 and for the nine months
ended September 30, 1998 and 1999 is unaudited, but includes all adjustments,
consisting only of normal recurring adjustments, that WatchGuard considers
necessary for a fair presentation of the financial position at those dates and
of the operations and cash flows for the periods then ended. Operating results
for the nine months ended September 30, 1999 are not necessarily indicative of
results that may be expected for the entire year.
Revenue Recognition
Statement of Position 97-2, "Software Revenue Recognition" (SOP 97-2), was
issued in October 1997 by the American Institute of Certified Public
Accountants (AICPA) and was amended by Statement of Position 98-4 (SOP 98-4).
In December 1998, the AICPA issued SOP 98-9, which amends SOP 97-2 and 98-4 and
is effective for transactions entered into after March 15, 1999. WatchGuard
adopted SOP 97-2, as amended by SOP 98-9, effective January 1, 1998. Based upon
its interpretation of SOP 97-2 and SOP 98-9, WatchGuard believes its current
revenue recognition policies and practices are consistent with the SOPs.
However, full implementation guidelines for this standard have not yet been
issued. Once available, implementation guidance could lead to unanticipated
changes in current revenue accounting practices, and these changes could
materially adversely affect the timing of WatchGuard's future revenues and
earnings.
F-7
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
WatchGuard generates revenues through sales of its Firebox products,
including related software licenses, and subscriptions for its LiveSecurity
broadcast service, which includes threat responses, information alerts,
software updates and maintenance. Software license revenues are generated from
licensing the rights to use WatchGuard's products directly to end-users, from
sublicense fees from resellers, distributors and, beginning in late 1998, from
sales of its products to Internet service providers (ISPs), which utilize the
product to provide managed security services to the ISPs' customers. Revenues
from LiveSecurity subscriptions are recognized ratably over the term of the
contract, typically one year.
Revenues from software license agreements are generally recognized upon
delivery of software if persuasive evidence of an arrangement exists,
collection is probable and the fee is fixed or determinable, and vender-
specific objective evidence exists to allocate the total fee to elements of the
arrangement. Payment terms do not extend beyond a year. A limited number of
WatchGuard's distributors have the right to delay payment until the product is
sold to the end-user. Revenues from these arrangements are not recognized until
sale to the end-user occurs. WatchGuard provides unspecified upgrades on a when
and if available basis. These upgrades are considered post-contract customer
support (PCS) and are recognized as revenues ratably over the terms of the PCS
arrangement. Vendor-specific objective evidence is typically based on the price
charged when an element is sold separately or, in the case of an element not
sold separately, on the price established by authorized management, if it is
probable that the price, once established, will not change before market
introduction. WatchGuard uses the residual method, as defined in SOP 98-9, to
allocate revenue to delivered elements once it has established vendor-specific
objective evidence for all undelivered elements. Under the residual method, any
discount in the arrangement is allocated to the delivered element. WatchGuard
provides for return rights and pricing protection rights for some of its
customers. The return rights included in these customer agreements are
generally limited to a percentage of purchases by these customers for the
previous quarter. The pricing protection rights in these agreements are
generally limited to 60 to 90 days after notification of a price change.
Revenues are reduced by the provision for estimated returns and allowance at
the time the sale is made. The reserves are reviewed and revised as needed.
Fair Values of Financial Instruments
At December 31, 1998, WatchGuard had the following financial instruments:
cash and cash equivalents, accounts receivable, accounts payable, accrued
liabilities and equipment loans. The carrying value of cash and cash
equivalents, accounts receivable, accounts payable and accrued liabilities
approximates their fair value based on the liquidity of these financial
instruments or based on their short-term nature. The carrying value of long-
term debt approximates fair value based on the market interest rates available
to WatchGuard for debt of similar risk and maturities.
Cash Equivalents
WatchGuard considers all highly liquid investments purchased with an initial
maturity of three months or less to be cash equivalents. Cash equivalents are
carried at fair market value.
Inventories
Inventories are stated at the lower of cost (first-in, first-out basis) or
market. WatchGuard outsources all of its hardware manufacturing and assembly to
one manufacturer and one assembler. The inability of the manufacturer and
assembler to supply product in a timely manner and on terms acceptable to
WatchGuard could severely affect WatchGuard's ability to meet customers'
demands.
F-8
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
Equipment and Furniture
Equipment and furniture is stated at cost, less accumulated depreciation.
Equipment and furniture is depreciated using the straight-line method over
estimated useful lives ranging from three to five years.
Research and Development
Research and development costs are expensed as incurred and consist primarily
of software development costs. Financial accounting standards require the
capitalization of certain software development costs after technological
feasibility of the software is established. In the development of WatchGuard's
new products and enhancements to existing products, the technological
feasibility of the software is not established until substantially all product
development is complete, including the development of a working model. Internal
software development costs that were eligible for capitalization were
insignificant and were charged to research and development expense in the
accompanying statements of operations.
Net Loss per Share
Basic and diluted net loss per share is calculated using the average number
of shares of common stock outstanding. Other common stock equivalents,
including preferred stock, stock options and warrants, are excluded from the
computation as their effect is antidilutive. See Note 6.
Upon the completion of WatchGuard's proposed initial public offering, all
convertible preferred stock will automatically convert into common stock.
Accordingly, pro forma net loss per share is computed using the weighted
average number of shares of common stock outstanding and the weighted average
convertible preferred stock outstanding as if these shares were converted to
common stock at the time of issuance. (See Note 12 regarding the conversion of
all convertible preferred stock into common stock at the completion of
WatchGuard's initial public offering.)
Advertising Costs
WatchGuard expenses advertising costs as incurred. Total expenses were $900,
$199,500, and $60,000 in 1996, 1997, and 1998, respectively.
Concentration of Credit Risk
WatchGuard is subject to concentrations of credit risk primarily from cash
investments. WatchGuard's credit risk is managed by investing its excess cash
in high-quality money market instruments. In addition, substantially all of
WatchGuard's accounts receivable are due from WatchGuard's resellers,
distributors and ISPs located throughout the world. International sales were
$46,000, $2.8 million and $4.0 million for 1996, 1997 and 1998, respectively,
and were $7.1 million for the nine months ended September 30, 1999. No single
customer, foreign country, or geographic area accounted for more than 10% of
revenues in the periods presented. WatchGuard does not believe there are any
significant concentrations of credit risk as of December 31, 1998. At September
30, 1999, WatchGuard held $31.5 million in high-quality instruments at one
financial institution.
Stock Compensation
WatchGuard has elected to apply the disclosure-only provisions of Statement
of Financial Accounting Standards No. 123, "Accounting for Stock-Based
Compensation" (SFAS 123). Accordingly, WatchGuard accounts for stock-based
compensation using the intrinsic value method prescribed in Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees,"
and related interpretations. Compensation cost for stock options is measured as
the excess, if any, of the fair value of WatchGuard's common stock at the date
of grant over the stock option exercise price.
F-9
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
Income Taxes
WatchGuard recognizes deferred tax assets and liabilities based on
differences between the financial reporting and tax bases of assets and
liabilities using the enacted tax rates and laws that are expected to be in
effect when the differences are expected to be recovered. WatchGuard provides a
valuation allowance for deferred tax assets that cannot be currently recognized
due to WatchGuard's losses and the uncertainty of future profitability.
Reclassifications
Certain prior-year items have been reclassified to conform to the current-
year presentation.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the amounts reported in the financial statements and accompanying
notes. Actual results could differ from those estimates.
New Accounting Pronouncements
In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive Income,"
which establishes standards for reporting and display of comprehensive income
and its components (revenues, expenses, gains and losses) in a full set of
general-purpose financial statements. This statement requires that all items
that are required to be recognized under accounting standards as components of
comprehensive income be reported in a financial statement that is displayed
with the same prominence as other financial statements. This statement, adopted
by WatchGuard on January 1, 1998, does not affect results of operations or
financial position, as WatchGuard had no items that would have been classified
as other comprehensive income.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivatives and
Hedging Activities," which establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments embedded in
other contracts (collectively referred to as derivatives), and for hedging
activities. Because WatchGuard has never used nor currently intends to use
derivatives, management does not anticipate that the adoption of this new
standard will have a significant effect on earnings or the financial position
of WatchGuard.
2. Balance Sheet Account Detail
Trade Accounts Receivable
Trade accounts receivable consisted of the following:
<TABLE>
<CAPTION>
December 31, September 30,
--------------- -------------
1997 1998 1999
------- ------ -------------
(In thousands)
<S> <C> <C> <C>
Trade accounts receivable........................ $ 1,700 $4,522 $4,136
Reserve for returns.............................. -- (615) (510)
Allowance for uncollectable accounts............. (124) (449) (304)
------- ------ ------
Trade accounts receivable, net................... 1,576 3,458 3,322
Other accounts receivable........................ 20 33 208
------- ------ ------
$ 1,596 $3,491 $3,530
======= ====== ======
</TABLE>
F-10
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
Inventories
Inventories consisted of the following:
<TABLE>
<CAPTION>
December 31, September 30,
------------- -------------
1997 1998 1999
----- ------- -------------
<S> <C> <C> <C>
<CAPTION>
(In thousands)
<S> <C> <C> <C>
Finished goods.................................. $ 218 $ 1,203 $ 1,122
Components...................................... -- 953 784
----- ------- -------
$ 218 $ 2,156 $ 1,906
===== ======= =======
</TABLE>
Equipment and Furniture
Equipment and furniture consisted of the following:
<TABLE>
<CAPTION>
December 31, September 30,
------------- -------------
1997 1998 1999
----- ------- -------------
(In thousands)
<S> <C> <C> <C>
Computer equipment............................... $ 361 $ 831 $ 1,447
Furniture and fixtures........................... 57 337 507
Software......................................... 50 302 508
----- ------- -------
468 1,470 2,462
Less accumulated depreciation.................... 96 330 760
----- ------- -------
$ 372 $ 1,140 $ 1,702
----- ------- -------
</TABLE>
3. Acquisition of Intangibles
In March 1996, WatchGuard acquired certain technology (source code for its
software products) from Mazama Software Labs, Inc. (Mazama) for $50,000.
Additionally, WatchGuard was required for a three-year period to make royalty
payments on the sale of products that utilized the Mazama technology, with the
total royalty payments not to exceed $4 million. In June 1997, WatchGuard and
Mazama agreed to a buy-out of the royalty payments due Mazama, with WatchGuard
paying $70,000 in cash and issuing 400,000 shares of its common stock valued at
$52,000, the deemed fair value at that date, which was based on the board of
directors' best estimate of fair value. This amount is included in other
assets, net of accumulated amortization of $157,600 at December 31, 1998, and
is being amortized over its useful life of three years.
4. Debt
At December 31, 1998, WatchGuard had borrowings outstanding under (a) a $2.5
million working capital revolving line of credit (increased to $4.5 million
available on January 7, 1999); (b) a $177,000 equipment term loan; and (c) a
$432,000 equipment term loan. All three facilities are from a commercial bank.
The revolving line of credit is for operating needs and expires on September
30, 1999. Principal and interest are due at maturity. Borrowings under the line
of credit bear interest at the bank's prime interest rate plus 1.0% (8.75% at
December 31, 1998). The borrowing base for the line is to be monitored on a
monthly basis and is to consist of the sum of up to 75% of eligible domestic
and 50% of eligible foreign accounts receivable. There was $2.5 million
outstanding on this line at December 31, 1998 and no additional amounts were
available.
F-11
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
The $177,000 term loan bears interest at the bank's prime interest rate plus
1.5% (9.25% at December 31, 1998) and matures in March 2001. The $432,000 term
loan bears interest at the bank's prime interest rate plus 1% (8.75% at
December 31, 1998) and matures in December 2001. The term loans require monthly
principal and interest payments of $6,327 and $11,995, respectively, and are
collateralized by equipment.
At December 31, 1998, WatchGuard was not in compliance with certain covenants
related to the line of credit and term loans, but has obtained a waiver for
noncompliance at December 31, 1998. In addition, the bank has deleted these
covenants through the earlier of July 31, 1999, as amended (see Note 11) or the
completion of an initial public offering of WatchGuard's stock. WatchGuard has
classified the outstanding balance of long-term debt as current on the
accompanying balance sheets.
The contractual maturities of the term loans are as follows:
<TABLE>
<S> <C>
1999................................................................. $ 216
2000................................................................. 220
2001................................................................. 173
-----
$ 609
=====
</TABLE>
(See Notes 11 and 12 regarding the bridge loan and subsequent repayment of
these notes.)
Convertible Note Financing and Warrants
In March 1999, WatchGuard entered into convertible note agreements with its
existing investors for an aggregate of $3,000,000. The notes bear interest at
6% and are due on demand after March 2000. The notes will automatically be due
upon an initial public offering or converted into Series D preferred stock (new
series) if a subsequent private equity financing is completed before the
initial public offering, on the same terms and conditions offered to the other
investors in the private financing. WatchGuard also issued warrants to purchase
42,856 shares of common stock (21,428 to each group of funds), at an exercise
price of $7.00 per share, which are exercisable immediately. These warrants, if
not exercised before the closing of an initial public offering, will
automatically convert into common stock on a net exercise basis upon completion
of the initial public offering. The warrants were assigned a fair value of
$155,139 based upon the Black Scholes pricing model, based upon a fair value of
the underlying stock of $8.00 per share, a risk-free interest rate of 6%, a
dividend yield rate of 0%, volatility of .6 and an expected life of one year.
WatchGuard is amortizing the resulting discount on the notes over the expected
term of the notes. (See Note 12 regarding completion of WatchGuard's initial
public offering, the repayment of these notes payable to investors and the
exercise of these warrants.)
5. Stockholders' Equity
Reincorporation
WatchGuard was incorporated as Seattle Software Labs, Inc. in the state of
Washington in February 1996. In March 1996, WatchGuard sold 1,000,000 shares of
Series A preferred stock to its two cofounders for $0.05 per share, resulting
in aggregate proceeds of $50,000. In July 1996, WatchGuard sold 350,878 shares
of what was originally characterized as Series B preferred stock to the
cofounders for $0.29 per share, resulting in aggregate proceeds of $100,000. In
connection with the restatement of its Articles of Incorporation in March 1997,
WatchGuard reclassified the preferred shares originally characterized as Series
B preferred stock into 2,000,004 Series A preferred shares. The financial
statements have been restated to reflect this recapitalization.
F-12
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
Preferred Stock
In May 1997, WatchGuard completed a Series B preferred stock offering by
selling 2,316,666 shares at $2.59 per share, aggregating gross proceeds of $6.0
million. In March 1998, WatchGuard issued an additional 38,610 shares of Series
B preferred stock at $2.59 per share, aggregating gross proceeds of $100,000.
In April 1998, WatchGuard completed a Series C preferred stock offering by
selling 1,357,378 shares at $5.16 per share, aggregating gross proceeds of
approximately $7.0 million.
Holders of Series A, B, and C preferred stock have preferential rights to
dividends when and if declared by the board of directors. Series A, B and C
preferred stockholders have the right to one vote for each share of common
stock into which these Series A, B, and C preferred stock could then be
converted and, with respect to that vote, have full voting rights and powers
equal to those of the holders of common stock.
In the event of liquidation, the holders of Series A, B, and C preferred
stock have preferential rights to liquidation payments of $0.05, $2.59, and
$5.16 per share, respectively, plus any declared, but unpaid, dividends. Series
A, B, and C preferred stock is convertible into common stock at a price per
share of $0.05, $2.59, and $5.16, respectively, at the option of the holder, or
automatically upon the vote or written consent of a majority of the preferred
stockholders in the case of Series A or Series B, or 75% in the case of Series
C, or upon the closing of an initial public offering of WatchGuard's common
stock from which the aggregate proceeds are not less than $15 million and a
price per share is paid by the public of at least $10.31. Each share of Series
A, B, and C preferred stock will convert into two shares of common stock.
The following is a summary of terms and conditions for each series of
preferred stock as of December 31, 1998:
<TABLE>
<CAPTION>
Approximate Annual
Aggregate Dividend
Shares Shares Stated Liquidation Rate--
Designated Outstanding Value Value Non-Cumulative
---------- ----------- ------ ----------- --------------
<S> <C> <C> <C> <C> <C>
Series A .......... 3,000,004 3,000,004 $ 0.05 $ 150,000 $ 0.01
Series B .......... 2,374,581 2,355,276 2.59 6,100,000 0.16
Series C .......... 1,357,378 1,357,378 5.16 7,000,000 0.31
</TABLE>
(See Note 12 regarding the conversion of all convertible preferred stock into
common stock at the completion of WatchGuard's initial public offering.)
Stock Options
In 1996, WatchGuard adopted the 1996 Stock Incentive Compensation Plan (the
Plan), which provides for the granting of incentive and nonqualified stock
options to employees, officers, directors, agents, consultants and independent
contractors. As of December 31, 1998, WatchGuard had authorized 7,734,986
shares of common stock for possible grants under the Plan. Options under the
Plan generally are granted at fair market value on the date of grant. Of the
shares of common stock covered by the options, 25% become vested on the first
anniversary of the date of grant, with the remaining shares covered by the
option vesting at 2.08% every month thereafter, and with all shares becoming
fully vested on the fourth anniversary date of the date of grant. Stock options
under the Plan have a term of ten years unless modified by the plan
administrator.
F-13
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
The following table summarizes WatchGuard's stock option activity:
<TABLE>
<CAPTION>
December 31, 1996 December 31, 1997 December 31, 1998 September 30, 1999
------------------ ------------------- ------------------- -------------------
Weighted Weighted Weighted Weighted
Average Average Average Average
Exercise Exercise Exercise Exercise
Options Price Options Price Options Price Options Price
--------- -------- --------- -------- --------- -------- --------- --------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at beginning of
period................. -- $ -- 1,156,994 $ 0.03 5,227,580 $ 0.08 5,145,268 $ 0.16
Granted................. 1,156,994 0.03 4,970,526 0.08 1,212,500 0.44 1,680,314 12.48
Exercised............... -- -- (12,916) 0.03 (819,828) 0.04 (708,541) 0.08
Canceled ............... -- -- (887,024) 0.04 (474,984) 0.09 (90,669) 2.55
--------- --------- ---------
Balance at end of
period................. 1,156,994 0.03 5,227,580 0.08 5,145,268 0.16 6,026,372 3.57
========= ========= ========= =========
Exercisable at end of
period................. -- 428,300 1,618,038 2,032,754
Shares of common stock
available for grant
under the plan......... 1,756,974 1,067,329
Weighted average fair
value of options
granted during period
Granted at fair
value................ 1,156,994 0.01 4,970,526 0.02 308,000 0.01 1,518,314 13.01
Granted at below fair
value................ -- -- -- -- 904,500 2.08 162,000 7.00
</TABLE>
The weighted average remaining contractual life and weighted average exercise
price of options outstanding and options exercisable at December 31, 1998 for
selected exercise price ranges is as follows:
<TABLE>
<CAPTION>
Options
Options Outstanding Exercisable
----------------------------------- ------------------
Weighted Average Weighted Weighted
Remaining Average Average
Contractual Exercise Exercise
Exercise Prices Shares Life (in years) Price Shares Price
--------------- --------- ---------------- -------- --------- --------
<S> <C> <C> <C> <C> <C>
$ 0.03-0.14........ 4,501,392 8.08 $ 0.09 1,582,370 $ 0.08
$ 0.39-0.55........ 516,876 9.54 0.54 33,481 0.55
$ 1.13-2.25........ 127,000 9.74 1.29 2,187 1.13
--------- ---------
5,145,268 8.27 8.27 1,618,038 $ 0.09
========= =========
</TABLE>
WatchGuard uses the intrinsic value-based method to account for all its
employee stock-based compensation arrangements. Accordingly, no compensation
cost has been recognized for its stock options in the accompanying financial
statements because the fair value of the underlying common stock equals or
exceeds the exercise price of the stock options at the date of grant, except
with respect to certain options granted during the year ended December 31,
1998. WatchGuard has recorded deferred stock compensation expense of
$2.5 million relating to options granted during the year ended December 31,
1998, which includes $628,000 related to the 48,000 option shares described
below. This amount represents the difference between the exercise price and the
deemed fair value for financial reporting purposes of WatchGuard's common stock
on the date the options were granted. An additional expense of $162,000 was
recorded in the first quarter of 1999 related to options granted during that
period. Amounts recorded as deferred stock compensation expense are generally
being amortized over a four-year vesting period using a graded vesting
approach. Under this approach, 52% of the deferred stock compensation is
amortized in the first year after grant, 27% in the second year, 15% in the
third year and the remaining 6% in the fourth year. Amortization of deferred
stock compensation of $1.0 million was recognized for the year ended December
31, 1998.
F-14
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
Amortization of deferred stock compensation will be $852,000 in 1999, $461,000
in 2000, $237,000 in 2001 and $78,000 in 2002, respectively. (Such amounts
include the deferred compensation recorded in the first quarter of 1999.)
The following pro forma information regarding stock-based compensation has
been determined as if WatchGuard had accounted for its employee stock options
under the fair market value method of SFAS 123. The fair value of these options
was estimated at the date of grant using a minimum value option pricing model
with the following weighted average assumptions: risk-free interest rates range
from 6.0% to 5.0% in 1996, 1997, and 1998; a dividend yield rate of 0% for all
periods; and an expected life of five years.
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting periods. WatchGuard's
pro forma information is as follows:
<TABLE>
<CAPTION>
Year Ended December 31,
-----------------------------------------
1996 1997 1998
------------ ------------- -------------
(In thousands, except per share data)
<S> <C> <C> <C>
Net loss--as reported......... $ (468) $ (4,334) $ (9,119)
Net loss--pro forma........... (470) (4,368) (9,182)
Net loss per share--as
reported..................... N/A (17.17) (11.34)
Net loss per share--pro
forma........................ N/A (17.30) (11.42)
</TABLE>
Under SFAS 123, compensation expense representing the fair value of the
option grant is recognized over the vesting period. The initial impact on pro
forma net loss may not be representative of compensation expense in future
years, when the effect of amortization of multiple awards would be reflected in
pro forma earnings.
In December 1997 WatchGuard granted approximately 48,000 options with
exercise prices ranging from $0.05 to $0.26 to a consultant in connection with
a one-year consulting agreement. The options vested at the December 1998
termination date of the consulting agreement. WatchGuard has recorded
compensation expense of approximately $628,000 based on the fair value of the
options at the termination of the consulting agreement.
Common Stock Warrants
During 1996, WatchGuard issued warrants for 145,000 shares of common stock at
an exercise price of $0.03 per share to various consultants and vendors for
technical and marketing services, including public relations and technical
writing. The warrants expire five years from date of issuance, beginning in
July 2001. During 1997 and 1998, 100,000 and 10,000 shares, respectively, of
these warrants were exercised.
In January 1997, WatchGuard granted warrants for 20,000 shares at an exercise
price at $0.03 per share to an individual for recruiting services. In July
1997, the warrant was exercised for all 20,000 shares.
In March 1998, WatchGuard granted a warrant to purchase 10,000 shares of
common stock at an exercise price of $0.13 per share to a bank in connection
with a debt financing.
WatchGuard performed an analysis to value all warrants using the Black
Scholes pricing model based upon the exercise prices described above, a risk-
free interest rate of 6%, a dividend yield rate of 0%, volatility of .6 and an
expected life of one year. The fair value associated with these warrants was
immaterial.
F-15
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
In June 1998, WatchGuard entered into a two-year license and sales agreement
with a customer, under which the customer has committed to minimum purchase
quantities. This agreement may be terminated by either party for
nonperformance. The only recourse for nonperformance is the return of all
product and promotional material. Because of the promotional value of this
customer, WatchGuard granted it a warrant to purchase 200,000 shares of common
stock at an exercise price of $0.39 per share. The warrant is fully vested,
nonforfeitable and fully exercisable at the date of grant. The fair value of
the warrant, approximately $470,000, was recorded as sales and marketing
expense during the last six months of 1998, the period in which WatchGuard
derived its promotional value from its customer. The warrant is not tied to any
performance commitments under the license and sales agreement.
Common Shares Reserved
At December 31, 1998 common stock reserved for future issuance was as
follows:
<TABLE>
<S> <C>
Conversion of preferred stock................................... 13,425,316
Exercise of common stock options................................ 6,902,242
Exercise of common stock warrants............................... 245,000
----------
20,572,558
==========
</TABLE>
6. Net Loss per Share
Basic and diluted net loss per common share is calculated by dividing net
loss by the weighted average number of common shares outstanding. Pro forma net
loss per share is computed using the weighted average number of shares used for
basic and diluted per share amounts and the weighted average convertible
preferred stock outstanding as if such shares were converted to common stock at
the time of issuance.
<TABLE>
<CAPTION>
Period from
February 14,
1996 (date of Years Ended Nine Months Ended
inception) to December 31, September 30,
December 31, ------------------ ------------------
1996 1997 1998 1998 1999
------------- -------- -------- -------- --------
(In thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Net loss................ $ (468) $ (4,334) $ (9,119) $ (5,948) $ (9,447)
====== ======== ======== ======== ========
Basic and diluted net
loss per common share.. N/A $ (17.17) $ (11.34) $ (8.01) $ (1.76)
====== ======== ======== ======== ========
Weighted average number
of common shares used
for basic and diluted
per share amounts...... N/A 252 804 743 5,379
====== ======== ======== ======== ========
Weighted average common
shares issuable upon
pro forma conversion of
preferred
stock (unaudited)...... 12,570 13,425
-------- --------
Weighted average number
of shares used for pro
forma per share amounts
(unaudited)............ 13,366 15,755
-------- --------
Pro forma basic and
diluted net loss per
share (unaudited)...... $ (0.68) $ (0.60)
======== ========
</TABLE>
F-16
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
At December 31, 1998, options to purchase 5,145,268 shares of common stock
and warrants to purchase 245,000 shares of common stock were excluded from the
computation of actual and pro forma diluted net loss per common share, as their
effect is antidilutive.
7. Income Taxes
At December 31, 1998, WatchGuard had a net operating loss carryforward for
federal tax purposes of approximately $9,875,000. The carryforwards begin to
expire in 2011. Utilization of net operating loss carryforwards may be subject
to certain limitations under Section 382 of the Internal Revenue Code. A
valuation allowance has been established to reflect the uncertainty of future
taxable income to utilize available tax loss carryforwards.
Deferred income taxes reflect the net tax effect of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components
of WatchGuard's deferred tax assets and liabilities are as follows:
<TABLE>
<CAPTION>
December 31,
----------------
1997 1998
------- -------
(In thousands)
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards....................... $ 1,423 $ 3,358
Research and development tax credit.................... 92 218
Returns reserve........................................ -- 215
Allowance for bad debts................................ 42 153
Accrued expenses....................................... 43 102
------- -------
Total deferred tax assets................................ 1,600 4,046
Valuation allowance...................................... (1,600) (4,046)
------- -------
Net deferred taxes....................................... $ -- $ --
======= =======
</TABLE>
WatchGuard's valuation allowance increased $159,000, $1,441,000, and
$2,446,000 for 1996, 1997, and 1998, respectively.
8. 401(k) Retirement Plan
WatchGuard sponsors a 401(k) plan that is available to all employees who
satisfy certain eligibility requirements relating to minimum age, length of
service and hours worked. Eligible employees may elect to contribute up to 15%
of their pre-tax gross earnings, subject to statutory limitations regarding
maximum contributions. WatchGuard may also make a discretionary contribution to
the plan. No such contributions have been made by WatchGuard.
F-17
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
9. Commitments
WatchGuard leases office space and equipment under noncancelable operating
leases. Future minimum payments at December 31, 1998 under these leases are as
follows (in thousands):
<TABLE>
<S> <C>
1999................................................................ $ 489
2000................................................................ 441
2001................................................................ 155
2002................................................................ 23
2003 and thereafter................................................. 14
------
$1,122
======
</TABLE>
Two of the officers of WatchGuard are guarantors of part of the office lease.
Rent expense for 1996, 1997 and 1998 was $67,000, $134,000 and $273,000,
respectively.
10. International Revenues
WatchGuard licenses and markets its Internet security products and services
throughout the world, and operates in a single industry segment. While certain
expenses for sales and marketing activities are incurred in various
geographical regions, substantially all of WatchGuard's assets are located, and
the majority of its operating expenses are incurred, at its corporate
headquarters. Revenue information by geographic region is the only segment
information presented as follows:
<TABLE>
<CAPTION>
Nine Months Ended
Year Ended December 31, September 30,
------------------------- ------------------
1996 1997 1998 1998 1999
--------------- --------- -------- ---------
(In thousands)
<S> <C> <C> <C> <C> <C>
United States................ $ 285 $ 2,262 $ 7,401 $ 5,029 $ 6,983
Rest of World
Europe..................... 42 1,140 2,049 1,363 3,656
Asia....................... 2 1,209 1,106 786 2,219
Other...................... 2 487 823 588 1,238
------ -------- --------- -------- ---------
46 2,836 3,978 2,737 7,113
------ -------- --------- -------- ---------
Total.................... $ 331 $ 5,098 $ 11,379 $ 7,766 $ 14,096
====== ======== ========= ======== =========
</TABLE>
11. Subsequent Events
Stock Split
On May 26, 1999, the board of directors authorized a 2-for-1 stock split of
WatchGuard's common stock and approved an amendment to the certificate of
incorporation to increase the number of authorized common and preferred shares
to 80,000,000 and 10,000,000 shares, respectively. The stock split was effected
on July 8, 1999. The related common share, preferred share and per share data
in the accompanying financial statements have been retroactively restated to
reflect the stock split, including preferred share data on an assumed converted
to common stock basis.
F-18
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
Bridge Loan
In May and June 1999, WatchGuard amended its loan and security agreement with
its bank. The amendments primarily provide for a secured bridge loan facility
that immediately makes available to WatchGuard an additional $4.25 million, of
which $2.0 million is guaranteed by existing investors. The loan carries a
commitment fee of up to 2%, an interest rate of prime plus 2% and a maturity
date of the earlier of WatchGuard's initial public offering closing date or
August 26, 1999. WatchGuard granted the bank warrants to purchase up to 14,500
shares of common stock. The exercise price of these warrants is the initial
public offering price, or $13.00 per share. (See Note 12 regarding completion
of WatchGuard's initial public offering and repayment of the bridge loan.)
In connection with the amendments, the bank has extended the waiver and
deletion of certain debt covenants, as described in Note 4 above through the
closing of the initial public offering. Also, in connection with the amendment,
the $4.5 million line of credit, as discussed in Note 4 above, was reduced to
$3.5 million.
Stock Option Grants
On April 12, 1999, R. Michael Peronto, WatchGuard's chief operating officer,
was granted an option to purchase 439,564 shares of common stock at the initial
public offering price of $13.00 per share. If a change of control of WatchGuard
occurs, half of the unvested shares subject to this option will vest and become
exercisable.
1999 Employee Stock Purchase Plan
In May 1999, the board of directors and stockholders approved the 1999
Employee Stock Purchase Plan (ESPP). WatchGuard implemented the ESPP upon the
effectiveness of the initial public offering. The ESPP, subject to certain
limitations, permits eligible employees of WatchGuard to purchase common stock
through payroll deductions of up to 15% of their compensation. WatchGuard
authorized the issuance under the ESPP of a total of 600,000 shares of common
stock, plus an automatic annual increase to be added on the first day of each
fiscal year, the first of which occurred on January 1, 2000, equal to the
lesser of (a) 400,000 shares, (b) 1.5% of the average common shares outstanding
as used to calculate fully diluted earnings per share as reported in
WatchGuard's annual financial statements for the preceding year, or (c) a
lesser amount determined by the board of directors.
Amended 1996 Stock Incentive Compensation Plan
In May 1999, the board of directors and stockholders approved amendments to
the Stock Incentive Compensation Plan (SICP). The amendment provides for the
expansion of the SICP by 900,000 shares, plus an automatic increase to be added
on the first day of each fiscal year, the first of which occurred on January 1,
2000, equal to the lesser of (a) 750,000 shares, (b) 3.0% of the average common
shares outstanding as used to calculate fully diluted earnings per share as
reported in WatchGuard's annual financial statements for the preceding year, or
(c) a lesser amount determined by the board of directors.
12. Completion of Initial Public Offering (unaudited)
On July 30, 1999, WatchGuard issued 3,500,000 shares of its common stock at
an initial public offering price of $13.00 per share. The proceeds to
WatchGuard from the offering were approximately $40.8 million, net of $4.7
million in offering expenses, underwriting discounts and commissions.
Concurrent with the offering,
F-19
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
all 6,712,658 shares of preferred stock automatically converted into 13,425,316
shares of common stock. In addition, selling stockholders sold 379,570 shares
of common stock in the offering, upon the exercise of the underwriters' over-
allotment option. Some of the proceeds of the initial public offering were used
to repay notes payable to investors in the amount of $3 million (Note 4) and to
repay the bridge loan payable to a bank in the amount of $3.6 million (Note
11). The amount available under the bridge loan was increased to $4.5 million
after the completion of the initial public offering.
13. Acquisition of Business (unaudited)
On October 19, 1999, WatchGuard acquired the assets of BeadleNet, LLC
("BeadleNet"), a California limited liability company, pursuant to an Asset
Purchase Agreement dated as of October 19, 1999, among BeadleNet, Productivity
Enhancement Products, Inc. ("PEP"), a member of BeadleNet, Danny M. Beadle, the
founder and a member of BeadleNet, and WatchGuard. WatchGuard accounted for the
acquisition using the purchase method of accounting. The results of operations
of BeadleNet and the fair value of the assets acquired will be included in the
financials statements beginning on the acquisition date.
The total BeadleNet acquisition cost of $9,556,000 is comprised of: (1)
$3,406,000 in cash paid at closing, including $1,000,000 paid to PEP in
satisfaction of BeadleNet's outstanding liabilities to PEP; (2) 335,931
unregistered shares of WatchGuard common stock issued at closing with a fair
value of $4,850,000; (3) an additional $1 million in contingent consideration,
comprised of $400,000 in cash and 20,189 unregistered shares of WatchGuard
common stock with a fair value of $600,000, which became due upon completion of
certain technology items in late December 1999; and (4) estimated direct
acquisition costs of $300,000.
The aggregate purchase price was allocated, based on estimated fair values on
the acquisition date, as follows:
<TABLE>
<S> <C>
Inventory....................................................... $ 5,000
Equipment....................................................... 69,000
Intangibles:
Acquired workforce............................................ 204,000
Tradenames.................................................... 409,000
Developed technology.......................................... 503,000
Goodwill...................................................... 4,985,000
----------
Total intangibles........................................... 6,101,000
Acquired in-process research and development.................... 3,381,000
----------
Total purchase price............................................ $9,556,000
==========
</TABLE>
Values assigned to the acquired in-process research and development,
developed technology and tradenames were determined using a discounted cash
flow analysis. The value assigned to the workforce in place was based on
replacement cost.
To determine the value of the in-process research and development, WatchGuard
considered, among other factors, the state of development of each project, the
time and cost needed to complete each project, expected income, and associated
risks, which included the inherent difficulties and uncertainties in completing
the project and achieving technological feasibility and risks related to the
viability of and potential changes in future target markets. This analysis
resulted in amounts assigned to in-process research and development projects
that had
F-20
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
NOTES TO FINANCIAL STATEMENTS--(Continued)
(Information as of September 30, 1999 and for each of the nine-month
periods ended September 30, 1998 and 1999 is unaudited.)
not yet reached technological feasibility or do not have alternative future
uses. The entire $3,381,000 allocated to acquired in-process research and
development was expensed on the date of acquisition.
The lives assigned to the identified intangible assets ranged from two to
four years and the life assigned to goodwill was five years. Amortization
expense for these intangibles was $245,000 in the fourth quarter of 1999.
In connection with the acquisition, WatchGuard entered into an employment
agreement and a stock vesting agreement with Mr. Beadle. Pursuant to the
employment agreement, WatchGuard granted Mr. Beadle an option, vesting over a
period of four years, to purchase 250,000 shares of WatchGuard common stock at
an exercise price of $14.44, the fair value of the stock on the date the option
was granted. In consideration of certain of Mr. Beadle's obligations in the
employment agreement, including his agreement not to compete with WatchGuard
for a period of three years after his employment terminates, WatchGuard also
issued to Mr. Beadle 51,948 unregistered shares of WatchGuard common stock,
valued at $750,000 on the closing date of the acquisition. The value of this
stock has been recorded as deferred stock compensation expense and is being
amortized on a straight-line basis over the two-year employment agreement
period. Amortization of this deferred stock compensation was $73,000 in the
fourth quarter of 1999. Under the stock vesting agreement, 34,632 of these
shares will be subject to forfeiture if Mr. Beadle's employment is terminated
for cause or if he resigns. One half of these shares will no longer be subject
to forfeiture on October 19, 2000 and the remainder will no longer be subject
to forfeiture on October 19, 2001.
F-21
<PAGE>
REPORT OF DELOITTE & TOUCHE LLP, INDEPENDENT AUDITORS
To the Board of Directors of BeadleNet, LLC:
We have audited the accompanying balance sheets of BeadleNet, LLC (the
Company) and its predecessor as of October 3, 1999 and December 31, 1998, and
the related statements of operations, capital deficiency, and cash flows for
the period from January 1, 1999 (date of incorporation) through October 3,
1999, and the period from June 1, 1998 (date of inception) through December 31,
1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of BeadleNet, LLC as of October 3, 1999, and
of its predecessor as of December 31, 1998, and the results of operations and
cash flows of the Company for the period from January 1, 1999 (date of
incorporation) through October 3, 1999, and of its predecessor for the period
from June 1, 1998 (date of inception) through December 31, 1998, in conformity
with generally accepted accounting principles.
As discussed in Note 7, the Company sold substantially all of its assets on
October 19, 1999 and ceased operations. Effective November 25, 1999, the
Company was dissolved.
DELOITTE & TOUCHE LLP
Costa Mesa, California
December 24, 1999
F-22
<PAGE>
BEADLENET, LLC
BALANCE SHEETS
As of October 3, 1999 and December 31, 1998
<TABLE>
<CAPTION>
1998
1999 (Predecessor)
----------- -------------
<S> <C> <C>
ASSETS
Current assets:
Cash.............................................. $ 8,337 $ --
Accounts receivable, net of allowance for doubtful
accounts of $17,062 (1999)....................... 23,097 --
----------- ---------
Total current assets............................ 31,434 --
Property and equipment, net......................... 58,464 25,068
----------- ---------
Total assets.................................... $ 89,898 $ 25,068
=========== =========
LIABILITIES AND CAPITAL DEFICIENCY
Current liabilities:
Accounts payable.................................. $ 45,732 $ --
Accrued expenses.................................. 50,163 --
Deferred revenue.................................. 136,829 --
Note payable to Productivity Enhancement Products,
Inc.............................................. 910,785 212,291
----------- ---------
Total current liabilities........................... 1,143,509 212,291
Commitments (Note 5)
Capital deficiency:
Member units, no par value: 100,000,000 units
authorized; 10,000,000 units issued and
outstanding (1999)............................... 658,291 --
Accumulated deficit............................... (1,711,902) (187,223)
----------- ---------
Net capital deficiency............................ (1,053,611) (187,223)
----------- ---------
Total liabilities and capital deficiency........ $ 89,898 $ 25,068
=========== =========
</TABLE>
See accompanying notes.
F-23
<PAGE>
BEADLENET, LLC
STATEMENTS OF OPERATIONS
For the period from January 1, 1999 (date of incorporation) through October 3,
1999,
and the period from June 1, 1998 (date of inception) through December 31, 1998
<TABLE>
<CAPTION>
January 1, 1999 June 1, 1998
(Incorporation) (Inception) through
through December 31, 1998
October 3, 1999 (Predecessor)
--------------- -------------------
<S> <C> <C>
Operating expenses:
Research and development.................. $ 380,332 $ 187,223
Selling, general and administrative....... 1,117,064 --
----------- ---------
Total operating expenses................ 1,497,396 187,223
----------- ---------
Other expense, net.......................... 27,283 --
----------- ---------
Net loss.................................... $(1,524,679) $(187,223)
=========== =========
</TABLE>
See accompanying notes.
F-24
<PAGE>
BEADLENET, LLC
STATEMENTS OF CAPITAL DEFICIENCY
For the period from January 1, 1999 (date of incorporation) through October 3,
1999,
and the period from June 1, 1998 (date of inception) through December 31, 1998
<TABLE>
<CAPTION>
Members' Units
-------------------- Accumulated
Units Amount Deficit Total
---------- --------- ------------ ------------
<S> <C> <C> <C> <C>
Balance, June 1, 1998 (date of
inception)................... -- $ -- $ -- $ --
Net loss...................... -- -- (187,223) (187,223)
------------ ------------
Balance, December 31, 1998.... -- -- (187,223) (187,223)
---------- --------- ------------ ------------
Conversion of note payable
to Productivity Enhancement
Products, Inc. into
members' units............. 6,751,000 212,291 -- 212,291
Issuance of members' units
to an officer.............. 2,894,000 91,000 -- 91,000
Members' contributions for
cash....................... 355,000 355,000 -- 355,000
Net loss.................... -- -- (1,524,679) (1,524,679)
---------- --------- ------------ ------------
Balance, October 3, 1999...... 10,000,000 $ 658,921 $ (1,711,902) $ (1,053,611)
========== ========= ============ ============
</TABLE>
See accompanying notes.
F-25
<PAGE>
BEADLENET, LLC
STATEMENTS OF CASH FLOWS
For the period from January 1, 1999 (date of incorporation) through October 3,
1999,
and the period from June 1, 1998 (date of inception) through December 31, 1998
<TABLE>
<CAPTION>
Period from
January 1, 1999
(Incorporation) Period from June 1, 1998
through (Inception) through
October 3, 1999 December 31, 1998
--------------- ------------------------
<S> <C> <C>
Cash flows from operating activities:
Net loss.............................. $ (1,524,679) $ (187,223)
Adjustments used to reconcile net loss
to net cash used in operating
activities:
Depreciation and amortization....... 16,335 7,613
Members' contribution in the form of
services in exchange for note
payable to Productivity Enhancement
Products, Inc...................... 910,785 179,610
Compensation expense related to the
issuance of members' units to an
officer.............................. 91,000 --
Changes in operating assets and
liabilities:
Accounts receivable................. (23,097) --
Accounts payable.................... 45,732 --
Accrued expenses.................... 50,163 --
Deferred revenue.................... 136,829 --
------------ ----------
Net cash used in operating
activities........................... (296,932) --
Cash flows from investing activities:
Purchases of property and equipment... (49,731) --
------------ ----------
Cash flows from financing activities:
Proceeds from members' contributions.. 355,000 --
------------ ----------
Net increase in cash.................. 8,337 --
Cash, beginning of period.............
------------ ----------
Cash, end of period................... $ 8,337 $ --
============ ==========
Noncash items:
Conversion of note payable to
Productivity Enhancement Products,
Inc. into members' units............. $ 212,291 $ --
============ ==========
Acquisition of property and equipment
in exchange for note payable to
Productivity Enhancement Products,
Inc.................................. $ -- $ 32,681
============ ==========
</TABLE>
See accompanying notes.
F-26
<PAGE>
BEADLENET, LLC
NOTES TO FINANCIAL STATEMENTS
1. Nature of Operations
BeadleNet, LLC (BeadleNet, which includes its predecessor) is a provider of
secure Internet and networking solutions that are designed to meet the changing
technology needs of small- and medium-sized businesses and households with
multiple computers. BeadleNet's headquarters are located in Laguna Hills,
California.
BeadleNet was incorporated on January 1, 1999 as a majority-owned subsidiary
of Productivity Enhancement Products, Inc. (PEP). From June 1, 1998 (the date
of inception of BeadleNet's business) through December 31, 1998, research and
development efforts towards new technology products were conducted by PEP and
some of its key employees. The financial statements as of December 31, 1998 and
for the period from June 1, 1998 through December 31, 1998 reflect the
operations of the predecessor while they were a part of PEP. On January 1,
1999, certain technology products developed from these efforts were transferred
from PEP to BeadleNet for further development and marketing in connection with
the formation of BeadleNet, LLC.
The financial statements include expenses, which have been allocated to
BeadleNet by PEP on a specific identification basis, plus its allocated share
of the costs associated with resources BeadleNet shares with PEP. Allocations
from PEP for those shared resources have been made primarily on a proportional
cost method based on space occupied. Management believes these allocations are
reasonable. The financial statements of BeadleNet do not necessarily reflect
the results of operations or financial position that would have existed had
BeadleNet been an independent company.
2. Summary of Significant Accounting Policies
Property and Equipment
Property and equipment are stated at cost, less accumulated depreciation and
amortization. Depreciation and amortization are computed using the straight-
line method over the assets' lives, which range from three to five years.
When assets are retired or otherwise disposed of, the cost and the related
accumulated depreciation are removed from the accounts and any resulting gain
or loss is recognized in operations for the period. Renewals and betterments
that extend the life of an existing asset are capitalized, while normal repairs
and maintenance costs are expensed as incurred.
Revenue Recognition
BeadleNet offers its customers the right to free software upgrades and
customer support on an unlimited basis. Because the value of these upgrades and
customer support is not readily determinable under the requirements of SOP 97-
2, "Software Revenue Recognition," BeadleNet has deferred all revenues in the
amount of $136,829 as of October 3, 1999.
Income Taxes
As a limited liability company, BeadleNet is not subject to federal and state
income taxes. BeadleNet's taxable income or loss is allocated to each of its
members based on the member's ownership interest in BeadleNet. Each member's
tax status, in turn, determines the appropriate income tax for its allocated
share of BeadleNet's taxable income or loss. BeadleNet is subject to a minimum
California franchise tax of $800.
Stock-Based Compensation
BeadleNet accounts for equity-based awards to employees using the intrinsic
value method in accordance with Accounting Principles Board (APB) Opinion No.
25, "Accounting for Stock Issued to Employees."
F-27
<PAGE>
BEADLENET, LLC
NOTES TO FINANCIAL STATEMENTS--(Continued)
Concentration of Credit Risk
BeadleNet's revenues will be generated primarily from product sales.
BeadleNet performs ongoing credit evaluations of its customers and does not
require collateral for its receivables. BeadleNet establishes an allowance for
doubtful accounts based on factors surrounding the credit risk of specific
customers, historical trends, and other information.
Software Development Costs
Costs incurred in the research and development of new software products and
enhancements to existing software products are expensed as incurred until
technological feasibility has been established. After technological feasibility
has been established, any additional costs are capitalized in accordance with
SFAS No. 86, "Accounting for the Costs of Computer Software to Be Sold, Leased,
or Otherwise Marketed." Because BeadleNet believes that its current process for
developing software is essentially completed concurrently with the
establishment of technological feasibility, no software development costs have
been capitalized as of October 3, 1999 and December 31, 1998.
Research and Development
BeadleNet incurs costs in connection with research and development programs.
These costs are expensed as incurred. Research and development expenses were
$380,332 and $187,223 for the period from January 1, 1999 (date of
incorporation) through October 3, 1999 and the period from June 1, 1998 (date
of inception) through December 31, 1998, respectively.
Customer Concentration
During the period from January 1, 1999 (date of incorporation) through
October 3, 1999, deferred revenues from two customers accounted for
approximately 16% and 12% of total deferred revenues, respectively. The loss
of, or reduction in, deferred revenues to these customers would have a material
adverse effect on BeadleNet's business, operating results, and financial
condition.
Use of Estimates
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of the financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
New Accounting Pronouncements
For the periods presented in the accompanying financial statements, BeadleNet
has adopted SFAS No. 130, "Reporting Comprehensive Income." There was no
difference between comprehensive loss and amounts currently reported in the
accompanying financial statements.
BeadleNet has adopted SFAS No. 131, "Disclosures About Segments of an
Enterprise and Related Information." Under the requirements of SFAS No. 131,
BeadleNet operates under a single segment based on information used by
management to run the business.
F-28
<PAGE>
BEADLENET, LLC
NOTES TO FINANCIAL STATEMENTS--(Continued)
3. Property and Equipment
Property and equipment at October 3, 1999 and December 31, 1998 consists of
the following:
<TABLE>
<CAPTION>
1999 1998
-------- --------
<S> <C> <C>
Machinery and other equipment............................ $ 40,115 $ 32,681
Office equipment......................................... 30,678 --
Leasehold improvements................................... 11,619 --
-------- --------
82,412 32,681
Less accumulated depreciation and amortization........... (23,948) (7,613)
-------- --------
$ 58,464 $ 25,068
======== ========
</TABLE>
4. Note Payable to Productivity Enhancement Products, Inc.
Beginning on January 1, 1999 (the date of BeadleNet's incorporation), PEP
charged BeadleNet a management fee for administrative functions performed by
PEP. Total management fees charged to BeadleNet were $97,855 for the period
from January 1, 1999 (date of incorporation) through October 3, 1999. No
management fees were allocated to BeadleNet prior to January 1, 1999. These
management fees have been included in the note payable due to PEP in the
accompanying financial statements.
At October 3, 1999, the note payable due to PEP totaled $910,785. The note
payable bears interest at 9% and all outstanding principal and interest is due
and payable by January 1, 2001. BeadleNet recorded interest expense on this
note payable in the amount of $30,817 for the period from January 1, 1999 (date
of incorporation) through October 3, 1999.
The note payable was paid in full as part of the Asset Purchase Agreement
described in Note 7.
5. Commitments
BeadleNet leases office space under an operating lease that expires during
August 2000. At October 3, 1999, future annual minimum lease payments under
this noncancelable operating lease arrangement are as follows:
<TABLE>
<S> <C>
1999 (through December 31, 1999)................................... $ 4,587
2000............................................................... 12,232
--------
$ 16,819
========
</TABLE>
Rental expense under this operating lease was approximately $15,519 for the
period from January 1, 1999 (date of incorporation) through October 3, 1999.
Rental expense for the periods prior to January 1, 1999, (date of
incorporation), were allocated from PEP based on space occupied.
6. Capital Deficiency
Contributions
During the period from June 1, 1998 (date of inception of BeadleNet's
business) through December 31, 1998, PEP and some of its key employees
conducted research and development efforts to develop new technology products.
The cost of these services was $179,610. In exchange for these services and
certain
F-29
<PAGE>
BEADLENET, LLC
NOTES TO FINANCIAL STATEMENTS--(Continued)
property and equipment with a cost of $32,681, BeadleNet issued PEP a note
payable in the amount of $212,291. On January 1, 1999 (incorporation date),
BeadleNet issued to PEP a total of 6,751,000 members' units in exchange for the
note payable. On the same date, BeadleNet also issued a total of 2,894,000
members' units to an officer of BeadleNet for no consideration. BeadleNet has
recorded compensation expense of $91,000 for this issuance during the period
from January 1, 1999 (date of incorporation) through October 3, 1999.
From May 1999 to September 1999, BeadleNet received $355,000 in cash for the
sale of members' units, at $1.00 per unit, to unrelated parties.
Equity Incentive Plan
In January 1999, BeadleNet adopted the 1999 Equity Incentive Plan (the Plan),
which provides for the granting of up to 1,500,000 incentive and nonstatutory
equity options to purchase members' units to officers, key employees, Board
members, and service providers. The incentive and nonstatutory equity options
may not be issued at prices less than 85% of the fair market value at the date
of grant. All options expire at a maximum of 10 years from the date of grant.
Incentive and nonstatutory equity options vest ratably over five years. As of
October 3, 1999, there were 613,990 equity options available for grant under
the Plan.
Equity option activity under the Plan is as follows:
<TABLE>
<CAPTION>
Weighted
Shares average
under exercise price
option per share
------- --------------
<S> <C> <C>
Outstanding, January 1, 1999 (date of
incorporation).................................... -- $ --
Granted............................................ 886,010 $1.00
-------
Outstanding, October 3, 1999....................... 886,010 $1.00
=======
</TABLE>
The following table summarizes information about equity options outstanding
as of October 3, 1999:
<TABLE>
<CAPTION>
Weighted
average Weighted Weighted
Number remaining average Number average
Exercise price outstanding contractual life exercise price exercisable exercise price
-------------- ----------- ---------------- -------------- ----------- --------------
<S> <C> <C> <C> <C> <C>
$1.00 866,010 9.56 $ 1.00 -- $ 1.00
</TABLE>
BeadleNet applies APB Opinion No. 25, "Accounting for Stock Issued to
Employees," and related interpretations to account for the Plan. Had
compensation cost for the Plan been determined based on the fair value at the
date of grant consistent with the method of SFAS No. 123, BeadleNet's net loss
for the period from January 1, 1999 (date of incorporation) through October 3,
1999, would have been the pro forma amount indicated below:
<TABLE>
<S> <C>
Net loss, as reported......................................... $ (1,524,679)
Net loss, pro forma........................................... $ (1,631,499)
</TABLE>
The weighted average fair value of options granted during the period from
January 1, 1999 (date of incorporation) through October 3, 1999 was $0.45 per
share. The fair value of options granted under the Plan was estimated on the
date of grant using the Black-Scholes option-pricing model, with the following
weighted average assumptions: expected volatility of zero, no dividend yield,
risk-free interest rate of 6.0% and an expected life of 10 years.
F-30
<PAGE>
BEADLENET, LLC
NOTES TO FINANCIAL STATEMENTS--(Continued)
On June 1, 1999, BeadleNet granted 80,000 equity options to a service
provider. As a result, BeadleNet will record a total of $35,328 in expense
related to these options over the vesting period. As of October 3, 1999, none
of these options were vested and BeadleNet has recorded no compensation expense
related to these equity options.
7. Subsequent Events
On October 19, 1999, BeadleNet sold substantially all of its assets to
WatchGuard Technologies, Inc. (WatchGuard) under an Asset Purchase Agreement
and BeadleNet's operations ceased. Under the terms of the Asset Purchase
Agreement, WatchGuard paid an aggregate purchase price of $7,256,000,
consisting of $2,406,000 in cash and $4,850,000 in common stock of WatchGuard,
in exchange for substantially all of the assets of BeadleNet. The proceeds were
distributed to the holders of BeadleNet's members' units based on percentage
ownership. WatchGuard also assumed and repaid $1,000,000 of the outstanding
intercompany indebtedness owed by BeadleNet to PEP as of the date of the Asset
Purchase Agreement.
WatchGuard will make an additional payment of $400,000 in cash and $600,000
in common stock of WatchGuard to the holders of BeadleNet's member units based
on percentage ownership, if software technology items specified in the Asset
Purchase Agreement are completed and released to market before January 1, 2000.
Effective November 25, 1999, BeadleNet was dissolved.
F-31
<PAGE>
UNAUDITED PRO FORMA FINANCIAL INFORMATION
The following unaudited pro forma combined condensed financial statements
give effect to the BeadleNet acquisition, which occurred on October 19, 1999,
using the purchase method of accounting. Under the purchase method of
accounting, the purchase price is allocated to the assets acquired and
liabilities assumed based on their estimated fair values. The estimated fair
values of the assets and liabilities of BeadleNet have been combined with the
recorded values of the assets and liabilities of WatchGuard in the unaudited
combined condensed financial statements. The unaudited pro forma combined
condensed balance sheet gives effect to the purchase as if it had occurred on
September 30, 1999. The unaudited pro forma combined condensed statement of
operations for the year ended December 31, 1998 for WatchGuard and the period
from June 1, 1998 (date of inception) through December 31, 1998 for BeadleNet
and the nine-month period ended September 30, 1999 for WatchGuard and the
period from January 1, 1999 (date of incorporation) through October 3, 1999 for
BeadleNet, give effect to the BeadleNet acquisition as if it had occurred on
June 1, 1998.
The unaudited pro forma combined condensed financial statements are for
illustrative purposes only and do not purport to represent what WatchGuard's
financial position or results of operations would have been if the acquisition
had occurred on such dates or to project WatchGuard's financial position or
results of operations as of any future date or for any future period. The
unaudited pro forma combined condensed financial statements, including the
related notes, are qualified in their entirety by reference to, and should be
read in conjunction with, the historical financial statements of WatchGuard for
the year ended December 31, 1998 and for the nine months ended September 30,
1999, as well as the historical financial statements and the related notes of
BeadleNet.
The unaudited pro forma adjustments have been applied to the financial
information derived from the financial statements of WatchGuard and BeadleNet
to account for the acquisition as a purchase and, accordingly, the assets
acquired and liabilities assumed are reflected at their estimated fair values.
The unaudited pro forma financial information has been prepared based on the
assumptions described in the notes to the financial statements and includes
assumptions relating to the allocation of the consideration paid for the assets
of WatchGuard based on the estimates of their fair value. In the opinion of
WatchGuard, all adjustments necessary to present fairly such unaudited pro
forma financial information have been made based on the terms and structure of
the acquisition.
F-32
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
UNAUDITED PRO FORMA COMBINED CONDENSED BALANCE SHEET
As of September 30, 1999
(In thousands)
<TABLE>
<CAPTION>
Pro Forma Pro Forma
WatchGuard BeadleNet Adjustments Balances
---------- --------- ----------- ---------
<S> <C> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents.... $ 32,468 $ 8 $(3,414) a,b $ 29,062
Accounts receivable, net..... 3,530 23 (23) b 3,530
Inventories.................. 1,906 -- -- 1,906
Prepaid expenses and other... 601 -- -- 601
Total current assets......... 38,505 31 (3,437) 35,099
Equipment and furniture,
net......................... 1,702 59 -- 1,761
Goodwill and other
intangibles, net............ -- -- 5,101 d 5,101
Deposits and other assets.... 99 -- -- 99
-------- ------- ------- --------
Total assets............... $ 40,306 $ 90 $ 1,664 $ 42,060
======== ======= ======= ========
LIABILITIES AND STOCKHOLDERS'
EQUITY (DEFICIENCY)
Current liabilities:
Note payable to PEP.......... $ -- $ 911 $ (911) a $ --
Equipment term loan.......... 462 -- -- 462
Accounts payable............. 1,748 46 (46) b 1,748
Accrued expenses............. 1,321 50 250 a,b 1,621
Deferred revenue............. 3,431 137 (137) b 3,431
Total current liabilities.. 6,962 1,144 (844) 7,262
Stockholders' equity
(deficiency):
Members' capital, no par
value....................... -- 658 (658) c --
Common stock, $.001 par value 19 -- -- 19
Additional paid-in capital... 57,624 -- 5,585 a,b,d 63,209
Stock-based compensation....... (931) -- (750) d (1,681)
Accumulated deficit............ (23,368) (1,712) (1,669) c,d (26,749)
Total stockholders' equity
(deficiency).............. 33,344 (1,054) 2,508 34,798
-------- ------- ------- --------
Total liabilities and
stockholders' equity
(deficiency).............. $ 40,306 $ 90 $ 1,664 $ 42,060
======== ======= ======= ========
</TABLE>
See accompanying notes.
F-33
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
UNAUDITED PRO FORMA COMBINED CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
<TABLE>
<CAPTION>
Nine months ended September 30, 1999
--------------------------------------------
Pro Forma Pro Forma
WatchGuard BeadleNet Adjustments Balances
---------- --------- ----------- ---------
<S> <C> <C> <C> <C> <C>
Revenues....................... $ 14,096 $ -- $ -- $ 14,096
Cost of revenues............... 5,566 -- -- 5,566
-------- -------- -------- ---------
Gross margin................... 8,530 -- -- 8,530
Operating expenses:
Operating expenses, excluding
acquisition costs........... 17,748 1,498 188 d 19,434
Acquisition related costs,
including amortization of
goodwill and purchased
intangibles................. -- -- 965 d 965
-------- -------- -------- ---------
Total operating expenses....... 17,748 1,498 1,153 20,399
-------- -------- -------- ---------
Loss from operations........... (9,218) (1,498) (1,153) (11,869)
Other expense:
Interest expense, net........ (229) -- -- (229)
Other expense, net........... -- (27) -- (27)
-------- -------- -------- ---------
Net loss....................... $ (9,447) $ (1,525) $ (1,153) $ (12,125)
======== ======== ======== =========
Net loss per share: basic and
diluted....................... $ (1.76) $ (2.11)
======== =========
Weighted average number of
common shares outstanding..... 5,379 361 5,740
======== ======== =========
<CAPTION>
Year ended December 31, 1998
--------------------------------------------
Pro Forma Pro Forma
WatchGuard BeadleNet Adjustments Balances
---------- --------- ----------- ---------
<S> <C> <C> <C> <C> <C>
Revenues....................... $ 11,379 $ -- $ -- $ 11,379
Cost of revenues............... 3,925 -- -- 3,925
-------- -------- -------- ---------
Gross margin................... 7,454 -- -- 7,454
Operating expenses:
Operating expenses, excluding
acquisition costs........... 16,454 187 146 16,787
Acquisition related costs,
including amortization of
goodwill and purchased
intangibles................. -- -- 750 750
-------- -------- -------- --------- ---
Total operating expenses....... 16,454 187 896 17,537
Loss from operations........... (9,000) (187) (896) (10,083)
-------- -------- -------- --------- ---
Other expense:
Interest expense, net........ (119) -- -- (119)
Other expense, net........... -- -- -- --
-------- -------- -------- ---------
Net loss....................... $ (9,119) $ (187) $ (896) $ (10,202)
======== ======== ======== =========
Net loss per share: basic and
diluted....................... $ (11.34) $ (9.90)
======== =========
Weighted average number of
common shares outstanding..... 804 206 1,010
======== ======== =========
</TABLE>
See accompanying notes.
F-34
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
UNAUDITED NOTES TO PRO FORMA COMBINED FINANCIAL STATEMENTS
1. Basis of Presentation
On October 19, 1999, WatchGuard acquired the assets of BeadleNet, LLC
("BeadleNet"), a California limited liability company, pursuant to an Asset
Purchase Agreement dated as of October 19, 1999, among BeadleNet, Productivity
Enhancement Products, Inc. ("PEP"), a member of BeadleNet, Danny M. Beadle, the
founder and a member of BeadleNet, and WatchGuard. WatchGuard accounted for the
acquisition using the purchase method of accounting. The results of operations
of BeadleNet and the fair value of the assets acquired will be included in the
financial statements beginning on the acquisition date.
The total BeadleNet acquisition cost of $9,556,000 is comprised of: (1)
$3,406,000 in cash paid at closing, including $1,000,000 paid to PEP in
satisfaction of BeadleNet's outstanding liabilities to PEP; (2) 335,931
unregistered shares of WatchGuard common stock issued at closing with a fair
value of $4,850,000; (3) an additional $1 million in contingent consideration,
comprised of $400,000 in cash and 20,189 unregistered shares of WatchGuard
common stock with a fair value of $600,000, which became due upon completion of
certain technology items in late December 1999; and (4) estimated direct
acquisition costs of $300,000.
The aggregate purchase price was allocated, based on estimated fair values on
the acquisition date, as follows:
<TABLE>
<S> <C>
Inventory....................................................... $ 5,000
Equipment....................................................... 69,000
Intangibles:
Acquired workforce............................................ 204,000
Tradenames.................................................... 409,000
Developed technology.......................................... 503,000
Goodwill...................................................... 4,985,000
----------
Total intangibles........................................... 6,101,000
Acquired in-process research and development.................... 3,381,000
----------
Total purchase price............................................ $9,556,000
==========
</TABLE>
Values assigned to the acquired in-process research and development,
developed technology and tradenames were determined using a discounted cash
flow analysis. The value assigned to the workforce in place was based on
replacement cost.
To determine the value of the in-process research and development, WatchGuard
considered, among other factors, the state of development of each project, the
time and cost needed to complete each project, expected income, and associated
risks, which included the inherent difficulties and uncertainties in completing
the project and achieving technological feasibility and risks related to the
viability of and potential changes in future target markets. This analysis
resulted in amounts assigned to in-process research and development projects
that had not yet reached technological feasibility or do not have alternative
future uses. Estimates of fair values of the assets and liabilities of
BeadleNet have been combined with the WatchGuard column in the unaudited pro
forma combined condensed financial statements.
The $3,381,000 allocated to acquired in-process research and development was
expensed on the date of acquisition. These costs were not included in the pro
forma combined condensed statements of operations because they are considered
to be a one-time nonrecurring charge. The lives assigned to the identified
intangible assets ranged from two to four years and the life assigned to
goodwill was five years. Amortization expense for these intangibles was
$245,000 in the fourth quarter of 1999.
F-35
<PAGE>
WATCHGUARD TECHNOLOGIES, INC.
UNAUDITED NOTES TO PRO FORMA COMBINED FINANCIAL STATEMENTS--(Continued)
In connection with the acquisition, WatchGuard entered into an employment
agreement and a stock vesting agreement with Mr. Beadle. Pursuant to the
employment agreement, WatchGuard granted Mr. Beadle an option, vesting over a
period of four years, to purchase 250,000 shares of WatchGuard common stock at
an exercise price of $14.44 per share, the fair value of the stock on the date
the option was granted. In consideration of certain of Mr. Beadle's obligations
in the employment agreement, including his agreement not to compete with
WatchGuard for a period of three years after his employment terminates,
WatchGuard also issued to Mr. Beadle 51,948 unregistered shares of WatchGuard
common stock, valued at $750,000 on the closing date of the acquisition. The
value of this stock has been recorded as deferred stock compensation expense
and is being amortized on a straight-line basis over the two-year employment
agreement period. Amortization of this deferred stock compensation was $73,000
in the fourth quarter of 1999. Under the stock vesting agreement, 34,632 of
these shares will be subject to forfeiture if Mr. Beadle's employment is
terminated for cause or if he resigns. One half of these shares will no longer
be subject to forfeiture on October 19, 2000, and the remainder will no longer
be subject to forfeiture on October 19, 2001.
2. Pro Forma Adjustments for BeadleNet
Pro forma adjustments, excluding the $1.0 million contingent on completion of
specific technology in late December 1999, were made to:
(a) record the purchase of BeadleNet, including the issuance of WatchGuard
common stock having an aggregate value of $4.85 million, and payment in
cash of $2.4 million, including repayment of the note payable in the
amount of $911,000 to PEP at October 3, 1999 (amount was $1.0 million
as of the actual acquisition date);
(b) eliminate the historical assets and liabilities not included in the
BeadleNet acquisition;
(c) eliminate the historical equity of BeadleNet; and
(d) record the excess of the purchase price over the estimated fair value
of assets and liabilities acquired in connection with the BeadleNet
acquisition and the related amortization.
The intangible components of the consideration for this transaction, which
include goodwill and other purchased intangibles, will be amortized on a
straight-line basis over a period ranging between 26 months to five years. The
deferred stock-based compensation, which was the result of restricted shares
issued pursuant to the employment agreement entered into by WatchGuard and one
key employee of BeadleNet, will be amortized over two years. In-process
research and development costs in the amount of $3,381,000 were immediately
expensed upon purchase, as reflected in the pro forma combined balance sheet at
September 30, 1999.
3. Pro Forma Loss per Common Share
Basic and diluted pro forma earnings per share is computed using the weighted
average number of WatchGuard common shares outstanding during the period plus
shares of WatchGuard common stock issued in connection with the BeadleNet
acquisition, which are not subject to forfeiture. Shares issued in connection
with the BeadleNet acquisition are assumed to be issued and outstanding on June
1, 1998 (the date of inception for BeadleNet).
4. Conforming and Reclassification Adjustments
There were no adjustments required to conform the accounting policies of
BeadleNet. There have been no intercompany transactions.
F-36
<PAGE>
[LOGO OF WATCHGUARD TECHNOLOGIES, INC.]
<PAGE>
PART II
INFORMATION NOT REQUIRED IN PROSPECTUS
Item 13. Other Expenses of Issuance and Distribution
The following table states the costs and expenses, other than the
underwriting discounts and commissions, payable by the registrant in connection
with the sale of the common stock being registered by this registration
statement. All amounts shown are estimates, except the Securities and Exchange
Commission registration fee, the NASD filing fee and the Nasdaq National Market
listing fee.
<TABLE>
<S> <C>
Securities and Exchange Commission registration fee.............. $ 26,760
NASD filing fee.................................................. 10,637
Nasdaq National Market fee for listing of additional shares...... 17,500
Blue Sky fees and expenses....................................... 10,000
Printing and engraving expenses.................................. 150,000
Legal fees and expenses.......................................... 200,000
Accounting fees and expenses..................................... 100,000
Transfer agent and registrar fees................................ 15,000
Miscellaneous expenses........................................... 20,103
--------
Total.......................................................... $550,000
========
</TABLE>
Item 14. Indemnification of Directors and Officers
Section 145 of the Delaware General Corporation Law (the "DGCL") provides
that a corporation may indemnify directors and officers, as well as other
employees and individuals, against expenses (including attorneys' fees),
judgments, fines and amounts paid in settlement in connection with specified
actions, suits or proceedings, whether civil, criminal, administrative or
investigative (other than an action by or in the right of the corporation--a
"derivative action"), if they acted in good faith and in a manner they
reasonably believed to be in or not opposed to the best interests of the
corporation, and, with respect to any criminal action or proceeding, had no
reasonable cause to believe their conduct was unlawful. A similar standard
applies in the case of derivative actions, except that indemnification extends
only to expenses (including attorneys' fees) incurred in connection with the
defense or settlement of such actions, and the statute requires court approval
before there can be any indemnification where the person seeking
indemnification has been found liable to the corporation. The statute provides
that other indemnification may also be granted by a corporation's charter,
bylaws, disinterested director vote, stockholder vote, agreement or otherwise.
Section 10 of the registrant's restated bylaws (Exhibit 3.2) requires
indemnification to the full extent permitted under Delaware law. Subject to any
restrictions imposed by Delaware law, the registrant's bylaws provide an
unconditional right to indemnification for all expense, liability and loss
(including attorneys' fees, judgment, fines, ERISA excise taxes or penalties
and amounts paid in settlement) actually and reasonably incurred or suffered by
any person in connection with any actual or threatened action, suit or
proceeding, whether civil, criminal, administrative or investigative
(including, to the extent permitted by law, any derivative action) by reason of
the fact that the person is or was serving as a director or officer of the
registrant or that, being or having been a director or officer of the
registrant, the person is or was serving at the registrant's request as a
director, officer, employee or agent of another corporation, partnership, joint
venture, trust or other enterprise, including service with respect to an
employee benefit plan. The bylaws also provide that the registrant may, by
action of the registrant's board of directors, provide indemnification to its
employees and agents with the same scope and effect as the above
indemnification of directors and officers.
Section 102(b)(7) of the DGCL permits a corporation to provide in its
certificate of incorporation that a director of the corporation shall not be
personally liable to the corporation or its stockholders for monetary
II-1
<PAGE>
damages for breach of fiduciary duty as a director, except for liability for
(i) any breach of the director's duty of loyalty to the corporation or its
stockholders, (ii) acts or omissions not in good faith or which involve
intentional misconduct or a knowing violation of law, (iii) payments of
unlawful dividends or unlawful stock repurchases or redemptions, or (iv) any
transaction from which the director derived an improper personal benefit.
Article 10 of the registrant's Restated Certificate of Incorporation (Exhibit
3.1) provides that to the full extent that the DGCL permits the limitation or
elimination of the liability of directors, the registrant's directors shall not
be liable to the registrant or its stockholders for monetary damages for breach
of fiduciary duty as a director. Any amendment to or repeal of Article 10 shall
not adversely affect any right or protection of the registrant's directors for
or with respect to any acts or omissions of the directors occurring before the
amendment or repeal.
The registrant maintains directors' and officers' liability insurance, under
which the registrant's directors and officers may be indemnified against
liability they may incur for serving in their capacities as directors and
officers of the registrant.
Item 15. Recent Sales of Unregistered Securities
Since the registrant's inception in February 1996, the registrant has issued
and sold unregistered securities as follows. The numbers below reflect the 2-
for-1 split of the registrant's common stock on May 26, 1999.
1. On March 11, 1996, the registrant issued 1,000,000 shares of Series A
Preferred Stock to the registrant's two cofounders for a consideration of $0.05
per share, or an aggregate of $50,000. On July 18, 1996 the registrant issued
350,878 shares of Series B Preferred Stock, which were later reclassified into
2,000,004 shares of Series A Preferred Stock, to the registrant's two
cofounders, for a consideration of $0.05 per share, or an aggregate of
$100,000. These 3,000,004 shares of Series A Preferred Stock converted into
3,000,004 shares of common stock at the time of our initial public offering.
2. On May 9, 1997, May 29, 1997 and March 12, 1998, the registrant issued
2,355,276 shares of Series B Preferred Stock, which converted into 2,355,276
shares of common stock at the time of our initial public offering, to seven
investors for a consideration of $2.59 per share, or an aggregate of
$6,100,165.
3. On June 11, 1997, in accordance with an Asset Purchase Agreement among the
registrant, Mazama Software Labs, Inc. and the shareholders of Mazama, the
registrant issued 400,000 shares of common stock to Mazama in connection with
the registrant's purchase of certain of Mazama's assets.
4. On July 24, 1996, September 24, 1996, September 25, 1996 and January 28,
1997, the registrant issued warrants for the purchase of an aggregate of
165,000 shares of common stock, with an exercise price of $0.025 per share, to
five consultants in exchange for services. Of these warrants, warrants for
149,972 shares have been exercised and warrants for 15,000 shares remain
outstanding.
5. On March 23, 1998, the registrant issued a warrant for the purchase of
10,000 shares of common stock, with an exercise price of $0.13 per share, to a
bank in connection with a debt financing. This warrant was exercised for 9,959
shares.
6. On April 24, 1998, the registrant issued 1,357,378 shares of Series C
Preferred Stock, which converted into 1,357,378 shares of common stock at the
time of our initial public offering, to eight investors for a consideration of
$5.157 per share, or an aggregate of $6,999,998.
7. On June 17, 1998, the registrant issued a warrant for the purchase of
200,000 shares of common stock, with an exercise price of $0.39 per share, to a
service provider in exchange for assistance with product specifications and
design.
8. From March 8, 1996 through December 31, 1999, the registrant granted stock
options to purchase 9,588,334 shares of common stock, with exercise prices
ranging from $0.025 to $32.31 per share, to employees under the registrant's
1996 Stock Option Plan. Of these options, options for 1,478,347 shares have
been
II-2
<PAGE>
canceled without being exercised, options for 1,607,307 shares have been
exercised and options for 6,502,680 shares remain outstanding.
9. On March 9, 1999, the registrant issued warrants for the purchase of an
aggregate of 42,856 shares of common stock, with an exercise price of $7.00 per
share, to six investors in connection with a debt financing. Of these warrants,
warrants for 31,319 shares were exercised.
10. On May 26, 1999, the registrant issued warrants for the purchase of
14,500 shares of common stock, with an exercise price of $13.00 per share, to a
bank in connection with a debt financing. Of these warrants, warrants for
10,000 shares remain outstanding and warrants for 4,500 shares were cancelled.
11. On October 19, 1999, the registrant issued 335,931 shares of common stock
to BeadleNet, LLC in connection with the acquisition of substantially all of
BeadleNet's assets.
12. On October 19, 1999, the registrant granted a stock option to purchase
250,000 shares of common stock at an exercise price of $14.44 per share and
issued 51,948 shares of restricted stock to an employee, in connection with an
employment agreement.
13. In January 2000, the registrant issued 20,189 shares of common stock to
BeadleNet, LLC in connection with the acquisition of substantially all of
BeadleNet's assets.
The sales and issuances of securities described in paragraphs 1, 2, 3, 5, 6,
7, 9, 10, 11 and 13 above were exempt from Securities Act registration under
Section 4(2) of the Securities Act, on the basis that the transactions did not
involve a public offering.
The sales and issuances of securities described in paragraphs 4, 8 and 12
above were exempt from Securities Act registration under Rule 701 under the
Securities Act, on the basis that these options were offered and sold either in
accordance with a written compensatory benefit plan or in accordance with
written contracts relating to compensation.
No underwriters were used in connection with these sales and issuances.
II-3
<PAGE>
Item 16. Exhibits and Financial Statement Schedules
(a) Exhibits
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Number Description
------ -----------
<C> <S>
1.1D Form of Underwriting Agreement.
3.1* Restated Certificate of Incorporation of the registrant.
3.2* Restated Bylaws of the registrant.
5.1 Opinion of Perkins Coie LLP as to the legality of the shares.
Lease Agreement, dated as of March 15, 1996, between COM Realty, Inc.
10.1* and the registrant.
Lease Agreement, dated as of October 10, 1997, between Burke-State
10.2* Bldg. LLC and the registrant.
Lease Agreement, dated as of August 17, 1998, between Cederstrand
10.3* Rentals and the registrant.
10.4* Amended and Restated Loan and Security Agreement, dated as of March
20, 1998, between Silicon Valley Bank and the registrant.
10.5* Loan Modification Agreement, dated as of September 18, 1998, between
Silicon Valley Bank and the registrant.
10.6* 1996 Stock Incentive Compensation Plan.
10.7* Standardized Adoption Agreement Prototype Cash or Deferred Profit-
Sharing Plan and Trust (401(k) plan), effective as of September 1,
1998.
10.8+* Development and Supply Agreement, dated as of March 25, 1998, between
SMART Modular Technologies, Inc. and the registrant.
10.9+* OEM Master License Agreement, dated as of August 14, 1997, between
RSA Data Security, Inc. and the registrant.
10.10W Asset Purchase Agreement dated as of October 19, 1999, by and among
BeadleNet, LLC, Productivity Enhancement Products, Inc., Danny M.
Beadle and WatchGuard Technologies, Inc.
10.11W Employment Agreement dated as of October 19, 1999, by and between
Danny M. Beadle and WatchGuard Technologies, Inc.
10.12W Stock Vesting Agreement dated as of October 19, 1999, by and between
Danny M. Beadle and WatchGuard Technologies, Inc.
23.1 Consent of Ernst & Young LLP, independent auditors.
23.2 Consent of Deloitte & Touche LLP, independent auditors.
23.3 Consent of Perkins Coie LLP (contained in the opinion filed as
Exhibit 5.1).
24.1++ Power of Attorney.
99.1++ Report of Ernst & Young LLP, independent auditors, on financial
statement schedule.
</TABLE>
- --------
D To be filed by amendment.
+ Portions of these exhibits have been omitted based on a grant of
confidential treatment by the Securities and Exchange Commission. The
omitted portions of the exhibits have been filed separately with the SEC.
* Incorporated by reference to the Registration Statement on Form S-1 (No.
333-76587) filed by the registrant on April 20, 1999, as amended.
W Incorporated by reference to the Current Report on Form 8-K (File No. 000-
26819) filed by the registrant on November 2, 1999, as amended.
++ Previously filed.
II-4
<PAGE>
(b) Financial Statement Schedules
Schedule II--Valuation and Qualifying Accounts
All financial statement schedules not listed are omitted because they are
inapplicable or the requested information is shown in the financial statements
of the registrant or in the related notes to the financial statements.
Item 17. Undertakings
Insofar as indemnification for liabilities arising under the Securities Act
of 1993 may be permitted to directors, officers and controlling persons of the
registrant pursuant to the foregoing provisions, or otherwise, the registrant
has been advised that in the opinion of the Securities and Exchange Commission
such indemnification is against public policy as expressed in the Act, and is
therefore unenforceable. In the event that a claim for indemnification against
such liabilities (other than the payment by the registrant of expenses incurred
or paid by a director, officer or controlling person of the registrant in the
successful defense of any action, suit or proceeding) is asserted against such
director, officer or controlling person in connection with the securities being
registered, the registrant will, unless in the opinion of its counsel the
matter has been settled by controlling precedent, submit to a court of
appropriate jurisdiction the question of whether such indemnification by it is
against public policy as expressed in the Securities Act, and will be governed
by the final adjudication of such issue.
The undersigned registrant hereby undertakes to provide to the underwriters
at the closing specified in the Underwriting Agreement, certificates in such
denominations and registered in such names as required by the underwriters to
permit prompt delivery to each purchaser.
The undersigned registrant hereby undertakes that
(1) for purposes of determining any liability under the Securities Act of
1933, the information omitted from the form of prospectus filed as part of
this registration statement in reliance upon Rule 430A and contained in a
form of prospectus filed by the registrant pursuant to Rule 424(b)(1) or
(4) or 497(h) under the Securities Act shall be deemed to be part of this
registration statement as of the time it was declared effective; and
(2) for the purpose of determining any liability under the Securities Act
of 1933, each post-effective amendment that contains a form of prospectus
shall be deemed to be a new registration statement relating to the
securities offered therein, and the offering of such securities at that
time shall be deemed to be the initial bona fide offering thereof.
II-5
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, as amended, the
registrant has duly caused this Registration Statement to be signed on its
behalf by the undersigned, thereunto duly authorized, in the City of Seattle,
State of Washington, on the 27th day of January, 2000.
WATCHGUARD TECHNOLOGIES, INC.
/s/ Christopher G. Slatt
By: _________________________________
Christopher G. Slatt
President and Chief Executive
Officer
Pursuant to the requirements of the Securities Act of 1933, as amended, this
Amendment No. 1 to the Registration Statement has been signed by the following
persons in the capacities indicated below on the 27th day of January, 2000.
<TABLE>
<S> <C>
/s/ Christopher G. Slatt President, Chief Executive Officer and
______________________________________ Chairman of the Board (Principal Executive
Christopher G. Slatt Officer)
/s/ Steven N. Moore Executive Vice President of Finance, Chief
______________________________________ Financial Officer, Secretary Treasurer and
Steven N. Moore Director (Principal Financial and
Accounting Officer)
* Stuart J. Ellman Director
______________________________________
Stuart J. Ellman
* Andrew W. Verhalen Director
______________________________________
Andrew W. Verhalen
* Charles P. Waite, Jr. Director
______________________________________
Charles P. Waite, Jr.
</TABLE>
II-6
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Number Description
------ -----------
<C> <S>
1.1D Form of Underwriting Agreement.
3.1* Restated Certificate of Incorporation of the registrant.
3.2* Restated Bylaws of the registrant.
5.1 Opinion of Perkins Coie LLP as to the legality of the shares.
Lease Agreement, dated as of March 15, 1996, between COM Realty, Inc.
10.1* and the registrant.
Lease Agreement, dated as of October 10, 1997, between Burke-State
10.2* Bldg. LLC and the registrant.
Lease Agreement, dated as of August 17, 1998, between Cederstrand
10.3* Rentals and the registrant.
10.4* Amended and Restated Loan and Security Agreement, dated as of March
20, 1998, between Silicon Valley Bank and the registrant.
10.5* Loan Modification Agreement, dated as of September 18, 1998, between
Silicon Valley Bank and the registrant.
10.6* 1996 Stock Incentive Compensation Plan.
10.7* Standardized Adoption Agreement Prototype Cash or Deferred Profit-
Sharing Plan and Trust (401(k) plan), effective as of September 1,
1998.
10.8+* Development and Supply Agreement, dated as of March 25, 1998, between
SMART Modular Technologies, Inc. and the registrant.
10.9+* OEM Master License Agreement, dated as of August 14, 1997, between
RSA Data Security, Inc. and the registrant.
10.10W Asset Purchase Agreement dated as of October 19, 1999, by and among
BeadleNet, LLC, Productivity Enhancement Products, Inc., Danny M.
Beadle and WatchGuard Technologies, Inc.
10.11W Employment Agreement dated as of October 19, 1999, by and between
Danny M. Beadle and WatchGuard Technologies, Inc.
10.12W Stock Vesting Agreement dated as of October 19, 1999, by and between
Danny M. Beadle and WatchGuard Technologies, Inc.
23.1 Consent of Ernst & Young LLP, independent auditors.
23.2 Consent of Deloitte & Touche LLP, independent auditors.
23.3 Consent of Perkins Coie LLP (contained in the opinion filed as
Exhibit 5.1).
24.1++ Power of Attorney.
99.1++ Report of Ernst & Young LLP, independent auditors, on financial
statement schedule.
</TABLE>
- --------
D To be filed by amendment.
+ Portions of these exhibits have been omitted based on a grant of
confidential treatment by the Securities and Exchange Commission. The
omitted portions of the exhibits have been filed separately with the SEC.
* Incorporated by reference to the Registration Statement on Form S-1 (No.
333-76587) filed by the registrant on April 20, 1999, as amended.
W Incorporated by reference to the Current Report on Form 8-K (File No. 000-
26819) filed by the registrant on November 2, 1999, as amended.
++ Previously filed.
<PAGE>
EXHIBIT 5.1
[PERKINS COIE LLP LETTERHEAD]
January 28, 2000
WatchGuard Technologies, Inc.
316 Occidental Avenue South, Suite 200
Seattle, WA 98104
Ladies and Gentlemen:
We have acted as counsel to you in connection with the proceedings for the
authorization and issuance by WatchGuard Technologies, Inc. (the "Company") of
up to 1,500,000 shares (the "Company Firm Shares") of the Company's common
stock, $.001 par value per share (the "Common Stock"), and as special counsel to
certain of the Company's stockholders (the "Selling Stockholders") in connection
with the sale of 1,500,000 shares by the Selling Stockholders (the "Stockholder
Firm Shares" and, together with the Company Firm Shares, the "Firm Shares"),
together with an additional 425,000 shares of Common Stock if and to the extent
the underwriters exercise an over-allotment option granted by the Selling
Stockholders (the "Option Shares"), and in connection with the preparation and
filing of a registration statement on Form S-1 (the "Registration Statement")
under the Securities Act of 1933, as amended (the "Securities Act"), which you
are filing with the Securities and Exchange Commission with respect to the Firm
Shares and the Option Shares.
We have examined the Registration Statement and such documents and records
of the Company and other documents as we have deemed necessary for the purpose
of this opinion. Based upon the foregoing, we are of the opinion that upon the
happening of the following events:
(a) the effectiveness of the Registration Statement and any amendments
thereto;
(b) due issuance by the Company and registration by its transfer agent of
the Company Firm Shares;
(c) due action by the Selling Stockholders authorizing the sale of the
Stockholder Firm Shares and the Option Shares;
<PAGE>
(d) the offering and sale of the Firm Shares and, to the extent the
underwriters exercise the over-allotment option, the Option Shares, as
contemplated by the Registration Statement and the Underwriting
Agreement and in accordance with the resolutions of the Board of
Directors of the Company authorizing the sale and issuance of the
Company Firm Shares and with the Stockholder actions authorizing the
sale of Stockholder Firm Shares and Option Shares; and
(e) receipt by the Company of the consideration for the Company Firm
Shares as contemplated by the Registration Statement and the
Underwriting Agreement and receipt by the Selling Stockholders of the
consideration for the Stockholder Firm Shares and, to the extent the
underwriters exercise their over-allotment option, for the Option
Shares, as contemplated by the Registration Statement and the
Underwriting Agreement;
the Firm Shares and, to the extent the underwriters exercise their over-
allotment option, the Option Shares, will be duly authorized, validly issued,
fully paid and nonassessable.
We hereby consent to the filing of this opinion as an exhibit to the
Registration Statement and any amendment thereto, including any and all post-
effective amendments and any registration statement relating to the same
offering that is to be effective upon filing pursuant to Rule 462(b) under the
Securities Act, and to the reference to our firm in the prospectus of the
Registration Statement under the heading "Legal Matters." In giving this
consent, we do not thereby admit that we are in the category of persons whose
consent is required under Section 7 of the Securities Act.
Very truly yours,
/s/ PERKINS COIE LLP
-2-
<PAGE>
Exhibit 23.1
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the reference to our firm under the captions "Selected
Financial Data" and "Experts" and to the use of our reports dated March 26,
1999 except as to Note 11, as to which the date is July 8, 1999, in the
Registration Statement (Form S-1) and related Prospectus of WatchGuard
Technologies, Inc. for the registration of 3,450,000 shares of its common
stock.
ERNST & YOUNG LLP
Seattle, Washington
January 27, 2000
<PAGE>
Exhibit 23.2
CONSENT OF DELOITTE & TOUCHE LLP, INDEPENDENT AUDITORS
We consent to the use in this Registration Statement on Form S-1 of
WatchGuard Technologies, Inc. of our report related to BeadleNet, LLC dated
December 24, 1999, appearing in the Prospectus, which is part of this
Registration Statement. We also consent to the reference to us under the
heading "Experts" in such Prospectus.
DELOITTE & TOUCHE LLP
Costa Mesa, California
January 27, 2000
