<PAGE>
Filed pursuant to Rule 424(b)(1)
Registration No. 333-76051
4,000,000 Shares
[LOGO OF CLARENT(TM) CORPORATION]
Common Stock
------------
Prior to this offering, there has been no public market for our common
stock. Our common stock has been approved for listing on The Nasdaq National
Market under the symbol "CLRN."
The underwriters have an option to purchase up to 600,000 additional shares
of common stock to cover over-allotments of shares.
Investing in the common stock involves risks. See "Risk Factors" on page 8.
<TABLE>
<CAPTION>
Underwriting
Price to Discounts and Proceeds to
Public Commissions Clarent
-------------- -------------- -----------
<S> <C> <C> <C>
Per Share.................................. $15.00 $1.05 $13.95
Total...................................... $60,000,000 $4,200,000 $55,800,000
</TABLE>
Delivery of the shares of common stock will be made on or about July 7,
1999.
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
BancBoston Robertson Stephens
Thomas Weisel Partners LLC
U.S. Bancorp Piper Jaffray
This prospectus is dated July 1, 1999.
<PAGE>
[A bar chart comparing us and other IP telephony service providers placed over
a graphic featuring a world map]
More minutes travel over Clarent IP telephony
technology worldwide than that of any other supplier.*
IP telephone technology permits the simultaneous transmission of voice, fax and
data over Internet protocol-based data networks, such as the Internet.
*Global IP Voice/Fax Market 1999,
March 1999
iLocus (Industry Analysts)
Notes:
1) Less than 1% of all call minutes, including voice, fax and data, are
currently transmitted using IP telephony.
2) This illustration shows market share based on minutes travelling over
different vendors' technology. This data was one of four market share measures
reported by iLocus. The other three measures were: a) number of service
providers using the vendor equipment; b) vendor ports operational in the
service market; and c) vendor ports operational in the corporate market.
<PAGE>
[Artwork illustrating the connection between our customers and our technology]
Enabling IP telephony service providers worldwide.
Clarent: Cutting-edge Technology
. Simultaneous voice, fax and data transmission with traditional telephone
voice quality
. Dynamic routing of calls, real-time billing and network management
. Robust architecture designed for growth and delivery of advanced features
Clarent: Global Customers
. Approximately 100 telecommunications companies in 50 countries
. A number of the world's leading long distance service providers
. Worldwide network coverage by partnering with each other
<PAGE>
------------
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
Prospectus Summary................... 4
Risk Factors......................... 8
Use of Proceeds...................... 18
Dividend Policy...................... 18
Capitalization....................... 19
Dilution............................. 20
Selected Consolidated Financial
Data................................ 21
Management's Discussion and Analysis
of Financial Condition and Results
of Operations....................... 22
Business............................. 34
</TABLE>
<TABLE>
<CAPTION>
Page
----
<S> <C>
Management....................... 46
Certain Transactions............. 56
Principal Stockholders........... 57
Description of Capital Stock..... 59
Shares Eligible for Future Sale.. 61
Underwriting..................... 63
Notice to Canadian Residents..... 65
Legal Matters.................... 66
Experts.......................... 66
Where You Can Find More
Information..................... 66
Index to Consolidated Financial
Statements...................... F-1
</TABLE>
------------
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 only be used where it is
legal to sell these securities. The information in this document may only be
accurate on the date of this document.
"Clarent" is a registered trademark and the Clarent logo and the Clarent
Command Center are trademarks of Clarent Corporation in the United States and
other jurisdictions. All other trademarks or service marks appearing in this
prospectus are trademarks or service marks of the respective companies that
use them.
Dealer Prospectus Delivery Obligation
Until July 26, 1999 (25 days after the commencement of this offering), all
dealers that effect transactions in these securities, whether or not
participating in this offering, may be required to deliver a prospectus. This
is in addition to the dealer's obligation to deliver a prospectus when acting
as an underwriter and with respect to unsold allotments or subscriptions.
3
<PAGE>
PROSPECTUS SUMMARY
This summary highlights selected information contained elsewhere in this
prospectus and does not contain all of the information that you should consider
before investing in our common stock. You should read the entire prospectus
carefully, including "Risk Factors" and the Consolidated Financial Statements
and the related Notes before making an investment decision.
Clarent Corporation
We are a leading provider of Internet protocol or IP telephony systems. IP
telephony systems permit the simultaneous transmission of voice, fax and data
over the Internet and similar communications networks. Using our technology to
simultaneously transmit voice, fax and data, our customers are able to more
efficiently and cost-effectively use the available capacity of their networks.
These customers are service providers, including traditional, local,
international and wholesale long distance telephone companies, as well as new
telecommunications service providers. The IP telephony market is relatively
new. Less than 1% of all voice calls worldwide are currently transmitted using
IP telephony. According to Frost & Sullivan, between 1997 and 2002, the number
of call minutes, including voice, fax and data, transmitted using IP telephony
is expected to have a compound annual growth rate of 325%.
IP telephony technology and the technology used by traditional telephone
services differ fundamentally in the way the information travels from point to
point through their networks. Using IP telephony, a dedicated connection, or
circuit, between the callers is not required. Instead, the caller's voice is
divided into numerous small packages of information called packets. These
packets are sent over the network intermixed with other packets of data, such
as fax, email or Internet content, to be reassembled at the destination of the
call. In contrast, traditional telephone technology requires that a circuit
between the callers be established and maintained during the length of the
call, and voice, fax and data cannot be transmitted simultaneously over this
circuit.
Using our IP telephony product, the Clarent system, service providers can
deliver a level of voice quality that is indistinguishable from the voice
quality over the traditional telephone system. In addition, the Clarent system
enables the simultaneous transmission of voice, fax and data. The Clarent
system features a modular architecture that permits our customers to add new
product and service features without extensive product cost or development
time. Based on publicly available data provided by large telecommunications
service providers, we believe our modular architecture enables service
providers to provide their customers with communications services at a lower
cost than traditional telephone companies.
The Clarent system consists of three distinct components:
. the Clarent Gateway, an integrated hardware and software product that
includes network server software that is based on industry standards;
. the Clarent Command Center, a proprietary client/server software package;
and
. a relational database, which is supplied by a third party.
The Clarent Gateway converts voice, fax and data into packets that can be
transmitted over an IP network, then converts them back into a form recognized
by the traditional telephone system. The Clarent Command Center is the software
that processes the data stored in the third-party relational database. The
Clarent Command Center supports all network management and administration
functions, including the routing and pricing of calls, authentication of
callers and billing, as well as network diagnostic and maintenance functions.
4
<PAGE>
Our products enable service providers to deliver IP telephony services to
end user customers who can use their existing telephones. Since our products
are integrated by telephone companies and other service providers into systems
that take calls from the traditional telephone system and send these calls over
the Internet and similar communications networks before returning these calls
to the traditional telephone system, the use of IP telephony is transparent to
end user customers.
Our strategic objective is to be the leading provider of comprehensive IP
telephony solutions to telecommunications service providers worldwide.
Key elements of our strategy include:
. provide the core technology enabling the delivery of a broad range of IP
telephony services;
. increase our penetration of the service provider market;
. target key growth markets worldwide;
. promote strategic relationships between our customers;
. extend our technology leadership position; and
. deliver added value through customer support and services.
We began commercial shipment of the Clarent system in March 1997. As of
March 31, 1999, we had shipped the Clarent system to approximately 100
telecommunications companies in 50 countries worldwide. The Clarent system has
been installed in some of the world's leading service provider networks,
including those of AT&T Corporation, Chunghwa Telecom (Taiwan), Ji-Tong
Communications (People's Republic of China), KDD (Japan), Korea Telecom (South
Korea), KPN Telecom Netherlands, Singapore Telecom, Star Telecom (United
States) and Telia Telecom (Sweden). In 1998, sales to these customers
represented approximately 48% of our $14.6 million in revenue. As of March 31,
1999, we had an accumulated deficit of $13.6 million.
We were originally incorporated under the name NetiPhone, Incorporated in
California in July 1996. We changed our name to Clarent Corporation in May
1997, and we reincorporated in Delaware in June 1999. Our headquarters are
located at 700 Chesapeake Drive, Redwood City, California 94063, and our
telephone number is (650) 306-7511. The address of our web site is
"www.clarent.com." Information contained on our web site should not be
considered a part of this prospectus.
5
<PAGE>
The Offering
<TABLE>
<S> <C>
Common stock offered.............. 4,000,000 shares
Common stock to be outstanding
after this offering.............. 26,302,944 shares(1)
Use of proceeds................... We intend to use the estimated proceeds for
working capital and general corporate
purposes, including increased research and
development, sales and marketing and
general and administrative expenditures. We
may also use a portion of the proceeds for
acquisitions of products and technologies
or for strategic alliances.
Nasdaq National Market symbol..... CLRN
</TABLE>
- --------
(1) The number of shares of common stock to be outstanding after this offering
is based on the number of shares outstanding as of March 31, 1999, and does
not include the following:
. 7,631,842 shares subject to options outstanding as of March 31, 1999, at
a weighted average exercise price of $0.80 per share;
. 3,200,000 shares that we could issue under stock plans, of which
1,755,170 shares were approved by the board of directors on April 8,
1999, subject to stockholder approval;
. 202,000 shares reserved for issuance on the exercise of warrants
outstanding as of March 31, 1999 to purchase Series C preferred stock and
the automatic conversion of this preferred stock into common stock. These
warrants will not be exercised and will expire upon the completion of
this offering; and
. 600,000 shares that may be purchased by the underwriters to cover over-
allotments, if any.
----------------
Except as otherwise indicated, all information in this prospectus assumes:
. no exercise of the underwriters' over-allotment option;
. the issuance of a total of 1,084,806 shares of common stock immediately
prior to the completion of this offering upon the exercise of warrants
outstanding as of March 31, 1999, using some of the shares covered by
these warrants to pay the exercise price at the initial public offering
price of $15.00 per share; of which
-- 96,440 shares of common stock will be issued upon the exercise of
outstanding Series C preferred stock warrants; and
-- 988,366 shares of common stock will be issued upon the exercise of an
outstanding common stock warrant;
. the automatic conversion of each outstanding share of preferred stock
into shares of common stock immediately prior to the completion of this
offering;
. a two-for-one stock split of the common stock to be completed prior to
the effectiveness of this offering; and
. the filing of our amended and restated certificate of incorporation prior
to the closing of this offering.
Please see "Capitalization" for a more complete discussion regarding the
outstanding shares of our common stock, options and warrants to purchase common
stock and other related matters.
6
<PAGE>
Summary Consolidated Financial Data
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Year ended Three months
Period from December 31, ended March 31,
July 2, 1996 (inception) ---------------- ----------------
to December 31, 1996 1997 1998 1998 1999
------------------------ ------- ------- ------- -------
(unaudited)
<S> <C> <C> <C> <C> <C>
Consolidated Statement
of Operations Data:
Net revenue............ $ -- $ 3,359 $14,647 $ 2,396 $ 6,714
Cost of revenue........ -- 1,189 6,653 780 3,281
----- ------- ------- ------- -------
Gross profit........... -- 2,170 7,994 1,616 3,433
Operating expenses:
Research and
development.......... 136 1,044 3,356 540 1,566
Sales and marketing... -- 2,046 7,099 1,182 4,025
General and
administrative....... 140 639 2,484 176 1,357
Amortization of
compensation......... -- -- 879 2 1,980
Settlement expense.... -- 570 -- -- --
----- ------- ------- ------- -------
Total operating
expenses............ 276 4,299 13,818 1,900 8,928
----- ------- ------- ------- -------
Loss from operations... (276) (2,129) (5,824) (284) (5,495)
Other income (expense),
net................... -- 70 32 (40) 16
----- ------- ------- ------- -------
Loss before income
taxes................. (276) (2,059) (5,792) (324) (5,479)
Provision for income
taxes................. -- -- (40) -- --
----- ------- ------- ------- -------
Net loss............... $(276) $(2,059) $(5,832) $ (324) $(5,479)
===== ======= ======= ======= =======
Historical basic and
diluted net loss per
share(1).............. N/A $ (2.14) $ (1.65) $ (0.14) $ (1.00)
===== ======= ======= ======= =======
Shares used to compute
historical basic and
diluted net loss per
share(1).............. -- 962 3,544 2,326 5,481
===== ======= ======= ======= =======
Pro forma basic and
diluted net loss per
share(1).............. $ (0.42) $ (0.03) $ (0.29)
======= ======= =======
Shares used to compute
pro forma basic and
diluted net loss per
share(1).............. 14,048 10,768 19,210
======= ======= =======
</TABLE>
<TABLE>
<CAPTION>
March 31, 1999
----------------------
Actual As Adjusted(2)
------- --------------
(unaudited)
<S> <C> <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents............................... $ 7,267 $61,967
Working capital......................................... 6,996 61,696
Total assets............................................ 28,627 83,327
Long term portion of debt............................... 784 784
Total stockholders' equity.............................. 10,313 65,013
</TABLE>
- --------
(1) See Note 12 of Notes to Consolidated Financial Statements for an
explanation of the determination of the number of shares used in computing
per share data.
(2) Adjusted to reflect the sale of 4,000,000 shares of common stock in this
offering, assuming no exercise of the underwriters' over-allotment option,
at the initial public offering price of $15.00 per share and the
application of the estimated net proceeds after deducting the underwriting
discounts and commissions and our estimated offering expenses.
7
<PAGE>
RISK FACTORS
You should carefully consider the following risk factors and all other
information contained in this prospectus before purchasing our common stock.
Investing in our common stock involves a high degree of risk. The risks and
uncertainties described below are not the only ones that we face. Additional
risks and uncertainties not presently known to us or that we currently believe
are immaterial also may impair our business operations. If any of the following
risks occurs, our business, operating results and financial condition could be
seriously harmed. In addition, the trading price of our common stock could
decline due to any of these risks, and you may lose all or part of your
investment.
We have a limited operating history, which makes it difficult to evaluate our
prospects.
We are an early-stage company in the emerging IP telephony market. We were
founded in July 1996 and have not generated significant revenue to date.
Because of our limited operating history, we have limited insight into trends
that may emerge in our market and affect our business. The revenue and income
potential of the IP telephony market, and our business in particular, are
unproven. As a result of our limited operating history, we have limited
financial data that you can use to evaluate our business. You must consider our
prospects in light of the risks, expenses and challenges we might encounter
because we are at an early stage of development in a new and rapidly evolving
market.
Unless we generate significant revenue growth, our increasing expenses and
negative cash flow will significantly harm our financial position.
As of March 31, 1999, we had an accumulated deficit of $13.6 million. We
expect to incur operating losses for the foreseeable future, and these losses
may be substantial. Further, we expect to incur negative operating cash flow in
the future. We expect to continue to increase capital expenditures and our
research and development, sales and marketing and general and administrative
expenses. We will need to generate significant revenue growth to achieve
profitability and positive operating cash flow. Even if we do achieve
profitability and positive operating cash flow, we may not be able to sustain
or increase profitability or positive operating cash flow on a quarterly or
annual basis.
We have experienced operating losses in each quarterly and annual period
since inception. The following table shows our operating losses for the periods
indicated:
<TABLE>
<CAPTION>
Period Operating Loss
------ --------------
<S> <C>
July 2, 1996 (inception) to December 31, 1996................. $ (276,000)
Year ended December 31, 1997.................................. (2,129,000)
Year ended December 31, 1998.................................. (5,824,000)
Three months ended March 31, 1999............................. (5,495,000)
</TABLE>
Our operating results are volatile, and an unanticipated decline in revenue may
disproportionately affect our net income or loss in a quarter.
Our quarterly and annual operating results have varied significantly in the
past and will likely vary significantly in the future. As a result, our future
operating results are difficult to predict. Further, we incur expenses in
significant part on our expectations of our future revenue. As a result, we
expect our expense levels to be relatively fixed in the short run. Therefore,
an unanticipated decline in revenue for a particular quarter may
disproportionately affect our net income (loss) in that quarter.
Any of the above factors could harm our business, financial condition and
results of operations. We believe that period-to-period comparisons of our
results of operations are not meaningful, and you should not rely upon them as
indicators of our future performance.
8
<PAGE>
If we do not reduce costs, introduce new products or increase sales volume, our
gross margin may decline.
We have experienced significant erosion in the average selling prices of our
products due to a number of factors, including competitive pricing pressures,
rapid technological change and sales discounts. We anticipate that the average
selling prices of our products will decrease and fluctuate in the future in
response to the same factors. Therefore, to maintain or increase our gross
margin, we must develop and introduce new products and product enhancements on
a timely basis. We must also continually reduce our costs of production. As our
average selling prices decline, we must increase our unit sales volume to
maintain or increase our revenue. To date, the erosion in the average selling
prices has not had a material affect on our business. However, we cannot be
certain that the erosion in the average selling prices will not affect our
business in the future. If our average selling prices decline more rapidly than
our costs of production, our gross margin will decline, which could seriously
harm our business, financial condition and results of operations.
Our markets are highly competitive, and we cannot assure you that we will be
able to compete effectively.
We compete in a new, rapidly evolving and highly competitive and fragmented
market. We expect competition to intensify in the future. We cannot assure you
that we will be able to compete effectively. We believe that the main
competitive factors in our market are product quality, features, cost and
customer relationships. Our current principal competitors include 3Com
Corporation, Cisco Systems, Inc., Lucent Technologies Inc., Nortel Networks
Corporation and VocalTec Communications, Ltd. We also expect that other
companies may enter our market with better products and technologies.
We expect our competitors to continue to improve the performance of their
current products and introduce new products or new technologies. To be
competitive, we must continue to invest significant resources in research and
development, sales, marketing and customer support. We cannot be sure that we
will have sufficient resources to make these investments or that we will be
able to make the technological advances necessary to be competitive. Increased
competition is likely to result in price reductions, reduced gross margin and
loss of market share. Our failure to compete successfully against current or
future competitors could seriously harm our business, financial condition and
results of operations.
Our future ability to generate sales depends on the interoperability of our
products with those of other vendors.
While our products currently connect to the traditional system using
standard interfaces, an increasing number of our customers have requested that
our products interoperate with competing IP telephony products from other
vendors. The interoperability standards for IP telephony equipment are
evolving. If we are unable to provide our customers interoperable solutions,
they may seek vendors who provide product interoperability. This could
seriously harm our business, financial condition and results of operations.
If we lose key personnel, we may not be able to successfully operate our
business.
Our future success depends, in large part, on our ability to attract and
retain highly skilled personnel. The loss of the services of any of our key
personnel, the inability to attract or retain qualified personnel in the future
or delays in hiring required personnel, particularly engineers, sales personnel
and marketing personnel, may seriously harm our business, financial condition
and results of operations. We will need to expand our sales operations and
marketing operations in order to increase market awareness of our products and
generate increased revenue. New sales personnel and marketing personnel will
require training and take time to achieve full productivity. In addition, the
design and installation of IP telephony solutions can be complex. Accordingly,
we need highly trained professional services and customer support personnel. We
currently have a small professional services and customer support organization
and will need to increase our staff to support new customers and the expanding
needs of existing customers. Competition for personnel is intense, especially
in the San Francisco Bay Area where we maintain our headquarters. We cannot be
certain that we will successfully attract and retain additional qualified
personnel. In addition, our key person life insurance policy, covering some of
our key employees, may be insufficient to cover the costs associated with the
loss of one of these employees.
9
<PAGE>
Our failure to manage our rapid growth effectively could negatively affect our
results of operations.
Since we began commercial shipment of our products in March 1997, we have
experienced a period of rapid growth and expansion that is significantly
straining all of our resources. From September 30, 1998 to March 31, 1999, the
number of our employees increased from approximately 70 to 155. We expect our
anticipated growth and expansion to continue to place strain on our management,
operational and financial resources. Our inability to manage growth effectively
could seriously harm our business, financial condition and results of
operations. We may not be able to install adequate control systems in an
efficient and timely manner, and our current or planned operational systems,
procedures and controls may not be adequate to support our future operations.
Delays in the implementation of new systems or operational disruptions when we
transition to new systems would impair our ability to accurately forecast sales
demand, manage our product inventory and record and report financial and
management information on a timely and accurate basis.
The IP telephony alternative may not achieve widespread acceptance, which could
cause our business to fail.
The IP telephony market is relatively new and evolving rapidly. Less than 1%
of all voice calls worldwide are currently transmitted over IP-based data
networks. Our ability to increase revenue in the future depends on some of both
existing and future circuit-switched telephone network calls moving to IP-based
data networks. The use of IP telephony for voice calls might be hindered by
the:
. reluctance of service providers that have invested substantial resources
in the existing telephone network infrastructure to replace or expand
their current networks with this new technology; and
. lack of partnerships between service providers, keeping them from having
global IP telephony network coverage.
Accordingly, in order to achieve commercial acceptance, we will have to
educate prospective customers, including large, established telecommunications
companies, about the benefits and uses of IP telephony solutions in general,
our products in particular, and the need to partner with other IP telephony
service providers to extend the coverage of their networks. If these efforts
fail or if IP telephony does not achieve commercial acceptance, our business,
financial condition and results of operations could be seriously harmed.
Our inability to introduce new products and product enhancements could prevent
us from increasing revenue.
We expect that the IP telephony market will be characterized by rapid
technological change. We also expect that the increased use of IP telephony
will require us to rapidly evolve and adapt our products to remain competitive.
The successful operation of our business depends on our ability to develop and
introduce new products and product enhancements that respond to technological
changes or evolving industry standards on a timely and cost-effective basis. We
cannot be certain that we will successfully develop and market these types of
products and product enhancements. Our failure to produce technologically
competitive products in a cost-effective manner and on a timely basis will
seriously harm our business, financial condition and results of operations.
Future regulation or legislation could restrict our business or increase our
cost of doing business.
At present there are few laws or regulations that specifically address
access to or commerce on the Internet, including IP telephony. We are unable to
predict the impact, if any, that future legislation, legal decisions or
regulations concerning the Internet may have on our business, financial
condition and results of operations. Regulation may be targeted towards, among
other things, assessing access or settlement charges, imposing tariffs or
imposing regulations based on encryption concerns or the characteristics and
quality of products and services, which could restrict our business or increase
our cost of doing business. The increasing growth of the IP telephony market
and popularity of IP telephony products and services heighten the risk that
governments will seek to regulate IP telephony and the Internet. In addition,
large, established telecommunications companies may devote substantial lobbying
efforts to influence the regulation of the IP telephony market, which may be
contrary to our interests.
10
<PAGE>
We depend on new entrants in the service provider market to generate a portion
of our revenue and our operating results may be harmed if these new entrants
are not commercially viable.
We expect to generate a portion of our revenue from new entrants in the
telecommunications service provider market. Failure to generate revenue from
these new entrants could have a negative impact on our business. Examples of
these service providers include traditional, local, international and wholesale
long distance companies, competitive local exchange carriers and Internet
telephony service providers. Many of these new entrants are still building
their infrastructures and rolling out their services. We cannot guarantee that
any of these companies will achieve commercial viability. Given that these new
entrants may be start-up operations with uncertain financial resources, we
cannot be sure that these new entrants will be able to pay their obligations to
us for purchase of our products on a timely basis, or at all. Some of our new
entrant customers have been late in making payments to us. To date, late
payments from our customers have not significantly impacted our operations.
However, we cannot be certain that late payments from our customers will not
impact our operations in the future. The failure of these companies to achieve
commercial viability or pay their obligations to us would, in turn, seriously
harm our business, financial condition and results of operations.
A loss of one or more of our key customers could cause a significant decrease
in our net revenue.
We have historically derived the majority of our revenue from a small number
of customers, particularly various entities within AT&T. In 1998 entities
affiliated with AT&T Corporation accounted for 36% and Technet International
accounted for 12% of our net revenue. In the first quarter of 1999, entities
affiliated with AT&T Corporation accounted for 25% and Technet International
accounted for 32% of our net revenue. None of our customers is obligated to
purchase additional products or services. Accordingly, we cannot be certain
that present or future customers will not terminate their purchasing
arrangements with us or significantly reduce or delay their orders. Any
termination, change, reduction or delay in orders could seriously harm our
business, financial condition and results of operations.
We may not be able to expand our direct sales and distribution channels, which
would harm our ability to generate revenue.
We believe that our future success is dependent upon our ability to expand
our direct sales force and establish successful relationships with a variety of
international distribution partners. To date, we have entered into agreements
with only a small number of distribution partners that accounted for
approximately 18% of net revenue for 1998 and 15% of net revenue for the first
quarter of 1999. These distribution agreements typically may be terminated
without cause upon 90 days notice. We cannot be certain that we will be able to
reach agreement with additional distribution partners on a timely basis or at
all, or that these distribution partners will devote adequate resources to
marketing, selling and supporting our products. We must successfully manage our
distributor relationships. In 1997 we settled a dispute with one of our
distributors at a cost to us of $570,000, plus future specified discounts. We
cannot guarantee that we will successfully manage our distributor relationships
in the future. Our inability to generate revenue from distribution partners may
harm our business, financial condition and results of operations.
Sales to customers based outside the United States have historically accounted
for a significant portion of our revenue, which exposes us to risks inherent in
international operations.
International sales represented approximately 94% of net revenue in 1997,
48% in 1998 and 34% in the first quarter of 1999. Our international operations
are subject to a variety of risks associated with conducting business
internationally any of which could seriously harm our business, financial
condition and results of operations. These risks include:
. greater difficulty in accounts receivable collections;
. import or export licensing and product certification requirements;
. tariffs, duties, price controls or other restrictions on foreign
currencies or trade barriers imposed by foreign countries;
. potential adverse tax consequences, including restrictions on
repatriation of earnings;
11
<PAGE>
. fluctuations in currency exchange rates;
. seasonal reductions in business activity in some parts of the world;
. unexpected changes in regulatory requirements;
. burdens of complying with a wide variety of foreign laws, particularly
with respect to intellectual property and license requirements;
. difficulties and costs of staffing and managing foreign operations;
. political instability;
. the impact of recessions in economies outside of the United States; and
. limited ability to enforce agreements, intellectual property and other
rights in some foreign countries.
We may not be able to expand our international operations, which would reduce
our ability to increase revenue.
We currently have offices in Belgium, Germany, Japan, the People's Republic
of China, South Korea, Spain, Taiwan and the United Kingdom. We intend to
expand the scope of our international operations, which will require us to
enhance our communications infrastructure and may include the establishment of
overseas assembly operations. If we are unable to expand our international
operations effectively and quickly, we may be unable to successfully market,
sell, deliver and support our products internationally.
Our sales cycle is typically long and unpredictable, causing us to incur
expenditures prior to the receipt of orders.
We incur research and development, and sales and marketing, including
customer support, expenditures prior to receiving orders for our products from
any given customer. The length of the sales cycle with a particular customer is
influenced by a number of factors, including:
. a customer's experience with sophisticated telecommunications equipment,
such as our product;
. the particular telecommunications market that the customer serves; and
. the cost of purchasing our product, including the cost of converting from
installed equipment, which may be significant.
Before we receive orders, our customers typically test and evaluate our
products for a period of months or, in some cases, over a year.
We cannot be certain that the sales cycle for our products will not lengthen
in the future. In addition, the emerging and evolving nature of the IP
telephony market may cause prospective customers to delay their purchase
decisions as they evaluate new technologies and develop and implement new
systems. As the average order size for our products grows, the process for
approving purchases is likely to become more complex, leading to potential
delays in receipt of these orders. As a result, our long and unpredictable
sales cycle contributes to the uncertainty of our future operating results.
Delays in customer orders could have a negative impact on our results of
operations for any given quarter.
We have historically received a significant portion of our product orders
near the end of a quarter. Accordingly, a delay in an anticipated receipt or
delivery of a given order past the end of a particular quarter may negatively
impact our results of operations for that quarter. These delays may become more
likely given that we expect that the average size of our customer orders may
increase. As a result, a delay in the recognition of revenue, even from just
one customer, may have a significant negative impact on our results of
operations for a given period. Any delay in sales of our products could result
in a significant decrease in cash flow, which, in turn, could severely affect
our ability to make payments as they come due and could cause our operating
results to vary significantly from quarter to quarter.
12
<PAGE>
We may not be able to raise capital as needed to maintain our operations.
We expect the net proceeds from this offering, cash from operations and
borrowings under our credit facility to be sufficient to meet our working
capital and capital expenditure needs for at least the next 12 months. After
that, we may need to raise additional funds, and additional financing may not
be available on favorable terms, if at all. We may also require additional
capital to acquire or invest in complementary businesses or products or obtain
the right to use complementary technologies. If we cannot raise needed funds on
acceptable terms, we may not be able to develop or enhance our products, take
advantage of future opportunities or respond to competitive pressures or
unanticipated requirements, which could seriously harm our business, financial
condition and results of operations. If we issue additional equity securities
to raise funds, the ownership percentage of our existing stockholders would be
reduced. New investors may demand rights, preferences or privileges senior to
those of existing holders of our common stock.
Our dependence on independent manufacturers may result in product delivery
delays.
We license technology that is incorporated into our products from
independent manufacturers, including AudioCodes, Ltd. and Natural Microsystems.
If these vendors fail to supply us with their components on a timely basis, we
could experience significant delays in shipping our products. Although we
believe there are other sources for this licensed technology, any significant
interruption in the supply or support of any licensed technology could
seriously harm our sales, unless and until we can replace the functionality
provided by this licensed technology. Also, because our products incorporate
software developed and maintained by third parties, we depend on these third
parties to deliver reliable products, support these products, enhance their
current products, develop new products on a timely and cost-effective basis,
and respond to emerging industry standards and other technological changes. The
failure of these third parties to meet these criteria could seriously harm our
business, financial condition and results of operations.
Our business could be harmed if we are unable to forecast our inventory needs
accurately.
Lead times for materials and components used in the assembly of our products
vary significantly. If orders do not match forecasts, we may have excess or
inadequate inventory of some materials and components.
Our strategy to outsource assembly and test functions in the future could delay
our ability to deliver our products on a timely basis.
We assemble and test our products at our facility in Redwood City,
California. Based on volume or customer requirements, we may begin outsourcing
some of our assembly and test functions. This outsourcing strategy involves
risks, including the potential absence of adequate capacity and reduced control
over delivery schedules, manufacturing yields, quality and costs. In the event
that any significant subcontractor were to become unable or unwilling to
continue to manufacture and/or test our products in the required volumes, we
would have to identify and qualify acceptable replacements. This process could
be lengthy, and we cannot be sure that additional sources would be available to
us on a timely basis. Any delay or increase in costs in the assembly and
testing of products by third-party subcontractors, could seriously harm our
business, financial condition and results of operations.
Our facilities are vulnerable to damage from earthquakes and other natural
disasters.
Our assembly facilities are located on or near known earthquake fault zones
and are vulnerable to damage from fire, floods, earthquakes, power loss,
telecommunications failures and similar events. If such a disaster occurs while
we still assemble our products in-house, our ability to assemble, test and ship
our products would be seriously, if not completely, impaired, which would
seriously harm our business, financial condition and results of operations. We
cannot be sure that the insurance we maintain against fires, floods,
earthquakes and general business interruptions will be adequate to cover our
losses in any particular case.
13
<PAGE>
Fluctuations in the values of foreign currencies could have a negative impact
on our profitability.
Due to our international operations, we incur expenses in a number of
currencies. We do not currently engage in currency hedging activities to limit
the risks of exchange rate fluctuations. Therefore, fluctuations in the value
of foreign currencies could have a negative impact on the profitability of our
global operations, which would seriously harm our business, financial condition
and results of operations. All of our sales, including international sales are
currently denominated in U.S. dollars. However, we do not expect that future
international sales will continue to be denominated in U.S. dollars.
Fluctuations in the value of the U.S. dollar and foreign currencies may make
our products more expensive than local product offerings.
Defects in our products may seriously harm our credibility and harm our
business.
We have detected and may continue to detect errors and product defects in
connection with new product releases and product upgrades. These problems may
affect network uptime and cause us to incur significant warranty and repair
costs and cause significant customer relations problems. Service providers
require a strict level of quality and reliability from telecommunications
equipment suppliers. Traditional telecommunications equipment is expected to
provide a 99.999% level of reliability. IP telephony products are inherently
complex and frequently contain undetected software or hardware errors when
first introduced or as new versions are released. In addition, the detection of
errors in software products requires an unknown level of effort to correct and
may delay the release of new products or upgrades or revisions to existing
products, which could materially affect the market acceptance and sales of our
products. If we deliver products or upgrades with undetected material software
errors or product defects, our credibility and market acceptance and sales of
our products may be harmed. In some of our contracts, we have agreed to
indemnify our customers against certain liabilities arising from defects in our
products. While we carry insurance policies covering this type of liability,
these policies may not provide sufficient protection should a claim be
asserted. To date, product defects have not had a material negative affect on
our results of operations. However, we cannot be certain that product defects
will not have a material negative affect on our results of operations in the
future. A material product liability claim may have significant consequences on
our ability to compete effectively and generate positive cash flow and may
seriously harm our business, financial condition and results of operations.
We may have difficulty identifying the source of the problem when there is a
problem in a network.
Our products must successfully integrate with products from other vendors,
such as traditional telephone systems. As a result, when problems occur in a
network, it may be difficult to identify the source of the problem. The
occurrence of hardware and software errors, whether caused by our products or
another vendor's products, may result in the delay or loss of market acceptance
of our products and any necessary revisions may force us to incur significant
expenses. The occurrence of some of these types of problems may seriously harm
our business, financial condition and results of operations.
We may not have adequate protection for our intellectual property, which may
make it easier for others to sell competing products.
We rely on a combination of copyright, trademark and trade secret laws and
restrictions on disclosure to protect our intellectual property rights. Despite
our efforts to protect our proprietary rights, unauthorized parties may attempt
to copy or otherwise obtain and use our products or technology. Monitoring
unauthorized use of our products is difficult, and we cannot be certain that
the steps we have taken will prevent misappropriation of our technology. The
laws of some foreign countries do not protect our proprietary rights to as
great an extent as the laws of the United States, and many United States
companies have encountered substantial infringement problems in these
countries, some of which are countries in which we have sold and continue to
sell products. If we fail to adequately protect our intellectual property
rights, it would be easier for our competitors to sell competing products.
14
<PAGE>
Our products may infringe on the intellectual property rights of third parties,
which may result in lawsuits and prohibit us from selling our products.
We believe there is a risk that third parties have filed, or will file
applications for, or have received or will receive, patents or obtain
additional intellectual property rights relating to materials or processes that
we use or propose to use. As a result, from time to time, third parties may
assert exclusive patent, copyright, trademark and other intellectual property
rights to technologies that are important to us. In addition, third parties may
assert claims or initiate litigation against us or our manufacturers, suppliers
or customers with respect to existing or future products, trademarks or other
proprietary rights. Any claims against us or customers that we indemnify
against intellectual property claims, with or without merit, may be time-
consuming, result in costly litigation and diversion of technical and
management personnel or require us to develop non-infringing technology. If a
claim is successful, we may be required to obtain a license or royalty
agreement under the intellectual property rights of those parties claiming the
infringement. If we are unable to obtain the license, we may be unable to
market our products. Limitations on our ability to market our products and
delays and costs associated with monetary damages and redesigns in compliance
with an adverse judgment or settlement could harm our business, financial
condition and results of operations.
Our failure and the failure of our key suppliers and customers to be Year 2000
compliant may negatively impact our business and results of operations.
The Year 2000 computer issue creates a significant risk for us in at least
four areas:
. potential warranty or other claims arising from our products for failure
to be Year 2000 compliant;
. systems we use to run our business may fail or produce inaccurate
results;
. systems used by our suppliers may fail or produce inaccurate results,
causing operational difficulties for us; and
. potential customers may reduce spending on IP telephony products as a
result of significant information systems spending on Year 2000
remediation or to limit additional changes to their networks during the
current year.
If any of these risks materialize, it may seriously harm our business,
financial condition and results of operations.
Our existing stockholders have voting control over Clarent.
On completion of this offering, executive officers and directors and their
affiliates will beneficially own, in the aggregate, approximately 68% of our
outstanding common stock. As a result, these stockholders will be able to
exercise significant control over all matters requiring stockholder approval,
including the election of directors and approval of significant corporate
transactions, which may have the effect of delaying or preventing a third party
from acquiring control over us.
New investors in our common stock will experience immediate and substantial
dilution.
The initial public offering price is substantially higher than the book
value per share of our common stock. Investors purchasing common stock in this
offering will, therefore, incur immediate dilution of $12.53 in net tangible
book value per share of common stock. Investors will incur additional dilution
upon the exercise of outstanding stock options and warrants.
Our stock price may be volatile after this offering.
Although the initial public offering price was determined based on several
factors, the market price for our common stock will vary from the initial
offering price after this offering. The market price of our common stock may
fluctuate significantly in response to a number of factors, some of which are
beyond our control.
15
<PAGE>
We may in the future be the target of securities class action litigation, which
could be costly and time consuming to defend.
In the past, securities class action litigation has often been brought
against a company following periods of volatility in the market price of its
securities. We may in the future be the target of similar litigation.
Securities litigation may result in substantial costs and divert management's
attention and resources, which may seriously harm our business, financial
condition and results of operations.
Our certificate of incorporation and bylaws and Delaware law contain provisions
that could delay or prevent a change of control of Clarent.
Certain provisions of our certificate of incorporation and bylaws and
Delaware law may discourage, delay or prevent a merger or acquisition that a
stockholder may consider favorable. These provisions include:
. authorizing the board of directors to issue additional preferred stock;
. prohibiting cumulative voting in the election of directors;
. limiting the persons who may call special meetings of stockholders;
. prohibiting stockholder action by written consent; and
. establishing advance notice requirements for nominations for election of
the board of directors or for proposing matters that can be acted on by
stockholders at stockholder meetings.
We are also subject certain provisions of Delaware law which could delay,
deter or prevent us from entering into an acquisition, including Section 203 of
the Delaware General Corporation Law, which prohibits a Delaware corporation
from engaging in a business combination with an interested stockholder unless
specific conditions are met.
Substantial future sales of our shares in the public market may cause our stock
price to fall.
If our stockholders sell substantial amounts of our common stock, including
shares issued upon the exercise of outstanding options and warrants, in the
public market during a short period of time, our stock price may decline
significantly. These sales also might make it more difficult for us to sell
equity or equity-related securities in the future at a time and price that we
deem appropriate. After completion of this offering, we will have outstanding
26,302,944 shares of common stock. All of the shares sold in this offering will
be freely tradeable. All of the remaining shares are subject to lock-up
arrangements between the stockholders and us or the underwriters. Of the
remaining shares of common stock outstanding after this offering all will be
eligible for sale in the public market 180 days following the date of this
prospectus. Of these shares, 18,301,030 shares will be subject to volume
limitations, under federal securities laws.
In addition, on the date 180 days following the date of this prospectus,
2,163,852 shares will be subject to vested options.
We do not intend to pay dividends.
We have never declared or paid any cash dividends on our capital stock. We
currently intend to retain any future earnings for funding growth. In addition,
pursuant to our bank credit facility, we cannot pay dividends without our
bank's consent, with limited exceptions. Therefore, we do not expect to pay any
dividends in the foreseeable future.
Special note regarding forward-looking statements.
Some of the statements under the captions "Prospectus Summary," "Risk
Factors," "Use of Proceeds," "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Business" and elsewhere in this
prospectus are "forward-looking statements." These statements involve known and
unknown risks and uncertainties, such as our plans, objectives, expectations
and intentions, and other factors that
16
<PAGE>
may cause our, or our industry's actual results, levels of activity,
performance or achievements to be materially different from any future results,
levels of activity, performance or achievements expressed or implied by the
forward-looking statements. These factors are listed under "Risk Factors" and
elsewhere in this prospectus.
In some cases, you can identify forward-looking statements by terminology
such as "expects," "anticipates," "intends," "may," "should," "plans,"
"believes," "seeks," "estimates" or the negative of such terms or other
comparable terminology.
Although we believe that the expectations reflected in the forward-looking
statements are reasonable, we cannot guarantee future results, levels of
activity, performance or achievements. Our actual results and the timing of
certain events could differ materially from those anticipated in these forward-
looking statements. Moreover, neither we nor any other person assumes
responsibility for the accuracy and completeness of these statements. You
should not place undue reliance on these forward-looking statements. We are
under no duty to update any of the forward-looking statements after the date of
this prospectus to conform these statements to actual results.
17
<PAGE>
USE OF PROCEEDS
We expect to receive net proceeds of approximately $54,700,000 from the sale
of 4,000,000 shares of common stock, and an additional $8,370,000 from the sale
of 600,000 shares if the underwriters' over-allotment option is exercised in
full, at the initial public offering price of $15.00 per share.
We intend to use the net proceeds of this offering primarily for additional
working capital and other general corporate purposes, including increased
research and development expenditures, sales and marketing expenditures, and
general and administrative expenditures. We have not yet determined our
expected use of these proceeds, but we currently estimate that we will incur
approximately $11,000,000 in research and development expenditures,
approximately $30,000,000 in sales and marketing expenditures and approximately
$8,000,000 in general and administrative expenditures during the next 12
months.
The amounts and timing of these expenditures will vary depending on a number
of factors, including the amount of cash generated by our operations,
competitive and technological developments and the rate of growth, if any, of
our business. We may also use a portion of the net proceeds to acquire
additional businesses, products and technologies, to lease additional
facilities, or to establish joint ventures that we believe will complement our
current or future business. However, we have no specific plans, agreements or
commitments to do so and are not currently engaged in any negotiations for any
acquisition or joint venture.
The amounts that we actually expend for working capital and other general
corporate purposes will vary significantly depending on a number of factors,
including future revenue growth, if any, and the amount of cash we generate
from operations. As a result, we will retain broad discretion in the allocation
of the net proceeds of this offering. Pending the uses described above, we will
invest the net proceeds in short-term, interest bearing, investment-grade
securities. We cannot predict whether the proceeds will be invested to yield a
favorable return.
DIVIDEND POLICY
We have never declared or paid any cash dividends on our common stock. We
currently intend to retain any future earnings to fund the development and
growth of the our business. In addition, under our bank credit facility, we
cannot pay dividends without our bank's consent, with limited exceptions.
Therefore, we currently do not anticipate paying any cash dividends in the
foreseeable future.
18
<PAGE>
CAPITALIZATION
The following table sets forth our capitalization as of March 31, 1999:
. on an actual basis;
. on a pro forma basis to reflect the automatic conversion of all
outstanding shares of preferred stock into common stock; and
. the pro forma capitalization as adjusted to give effect to (a) the sale
of 4,000,000 shares of common stock offered in this offering and to give
effect to the receipt of the estimated net proceeds from the sale of the
shares at the initial public offering price of $15.00 per share and the
application of the net proceeds from the sale and (b) the issuance of
1,084,806 shares of common stock upon the net exercise of outstanding
warrants immediately prior to the completion of this offering.
The capitalization information set forth in the table below is qualified by,
and you should read it in conjunction with, the more detailed Consolidated
Financial Statements and Notes of Clarent and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" appearing elsewhere
in this prospectus.
<TABLE>
<CAPTION>
March 31, 1999
--------------------------------
Pro Forma
Actual Pro Forma As Adjusted
-------- --------- -----------
(in thousands)
<S> <C> <C> <C>
Long term portion of debt...................... $ 784 $ 784 $ 784
Stockholders' equity:
Preferred stock: $0.001 par value, 8,000,000
shares authorized, 6,864,241 shares issued
and outstanding, actual; no shares issued
and outstanding, pro forma and as adjusted.. 21,024 -- --
Common stock: $0.001 par value, 50,000,000
shares authorized; 7,489,656 issued and
outstanding, actual; 21,218,138 shares
issued and outstanding, pro forma;
26,302,944 shares issued and outstanding,
pro forma as adjusted....................... 14,795 35,819 90,519
Deferred compensation........................ (11,818) (11,818) (11,818)
Accumulated other comprehensive loss(1)...... (42) (42) (42)
Accumulated deficit.......................... (13,646) (13,646) (13,646)
-------- -------- --------
Total stockholders' equity................. 10,313 10,313 65,013
-------- -------- --------
Total capitalization....................... $ 11,097 $ 11,097 $ 65,797
======== ======== ========
</TABLE>
- --------
(1) See Note 1 to the Consolidated Financial Statements for an explanation of
accumulated other comprehensive loss.
This table excludes the following shares as of March 31, 1999:
. 7,631,842 shares subject to options outstanding as of March 31, 1999, at
a weighted average exercise price of $0.80 per share;
. 3,200,000 additional shares that could be issued under our stock plans,
of which 1,755,170 shares were approved by the board of directors on
April 8, 1999, subject to stockholder approval; and
. 202,000 shares reserved for issuance on the exercise of warrants
outstanding as of March 31, 1999 to purchase Series C preferred stock and
the automatic conversion of this preferred stock into common stock. These
warrants will not be exercised and will expire upon the completion of
this offering.
19
<PAGE>
DILUTION
Our pro forma net tangible book value as of March 31, 1999 was $10,313,000,
or approximately $0.46 per share after giving effect to the issuance of
1,084,806 shares of common stock upon the net exercise of outstanding warrants
and the conversion of all outstanding preferred stock into common stock on a
pro forma basis for the period immediately prior to the completion of this
offering. Pro forma net tangible book value per share represents the amount of
our total assets less total liabilities, divided by the number of shares of
common stock outstanding. Dilution in net tangible book value per share
represents the difference between the amount per share paid by purchasers of
shares of common stock in this offering and the net tangible book value per
share of common stock immediately after the completion of this offering. After
giving effect to the sale of the 4,000,000 shares of common stock in this
offering at the initial public offering price of $15.00 per share and after
deducting the estimated underwriting discounts and commissions and estimated
offering expenses payable by us, our pro forma net tangible book value at March
31, 1999 would have been $65,013,000, or approximately $2.47 per share. This
represents an immediate increase in pro forma net tangible book value of $2.01
per share to existing stockholders and an immediate dilution in net tangible
book value of $12.53 per share to new investors of common stock in this
offering. The following table illustrates this dilution on a per share basis:
<TABLE>
<S> <C> <C>
Initial public offering price per share....................... $15.00
Pro forma net tangible book value per share as of March 31,
1999....................................................... $0.46
Increase in net tangible book value per share attributable
to new investors........................................... 2.01
-----
Pro forma net tangible book value per share after offering.... 2.47
------
Dilution in net tangible book value per share to new
investors.................................................... $12.53
======
</TABLE>
The following table sets forth, on a pro forma basis as of March 31, 1999,
after giving effect to the conversion of all outstanding preferred stock into
common stock, the difference between the number of shares of common stock
purchased from us, the total consideration paid and the average price per share
paid by existing holders of common stock and by the new investors, before
deducting underwriting discounts and commissions and estimated offering
expenses payable by us, at the initial public offering price of $15.00 per
share.
<TABLE>
<CAPTION>
Shares Purchased Total Consideration Average
------------------ ------------------- Price
Number Percent Amount Percent per Share
---------- ------- ----------- ------- ---------
<S> <C> <C> <C> <C> <C>
Existing stockholders....... 22,302,944 84.8% $21,237,000 26.1% $ 0.95
New investors............... 4,000,000 15.2 60,000,000 73.9 $15.00
---------- ----- ----------- -----
Total..................... 26,302,944 100.0% $81,237,000 100.0%
========== ===== =========== =====
</TABLE>
This table excludes the following shares as of March 31, 1999:
. 7,631,842 shares subject to options outstanding as of March 31, 1999, at
a weighted average exercise price of $0.80 per share;
. 3,200,000 additional shares that could be issued under our stock plans,
of which 1,755,170 shares were approved by the board of directors on
April 8, 1999, subject to stockholder approval; and
. 202,000 shares reserved for issuance on the exercise of warrants
outstanding as of March 31, 1999 to purchase Series C preferred stock and
the automatic conversion of this preferred stock into common stock. These
warrants will not be exercised and will expire upon the completion of
this offering.
20
<PAGE>
SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated balance sheet data as of December 31,
1996 has been derived from consolidated financial statements not included in
this prospectus, which were audited by Ernst & Young LLP, independent auditors.
The selected consolidated statement of operations data for the period from July
2, 1996 (inception) to December 31, 1996 and the two years in the period ended
December 31, 1998, and the related consolidated balance sheet data as of
December 31, 1997 and 1998, are derived from the consolidated financial
statements of the company which have been audited by Ernst & Young LLP,
independent auditors, and are included elsewhere in this prospectus. The data
should be read in conjunction with the consolidated financial statements. The
selected consolidated balance sheet data at March 31, 1999 and the selected
statement of operations data for the three month periods ended March 31, 1998
and 1999 have been derived from unaudited consolidated financial statements
included elsewhere in this prospectus. The unaudited consolidated financial
statements include, in the opinion of management, all adjustments, consisting
only of normal recurring adjustments, that management considers necessary for a
fair statement of the results for those periods. The operating results for the
three months ended March 31, 1999 are not necessarily indicative of results
that may be expected for the year ending December 31, 1999 or any other interim
period or future fiscal year.
<TABLE>
<CAPTION>
Three months
Year ended ended March
Period from December 31, 31,
July 2, 1996 (inception) ---------------- ---------------
to December 31, 1996 1997 1998 1998 1999
------------------------ ------- ------- ------ -------
(unaudited)
(in thousands, except per share amounts)
<S> <C> <C> <C> <C> <C>
Consolidated Statement
of Operations Data:
Net revenue............. $ -- $ 3,359 $14,647 $2,396 $ 6,714
Cost of revenue......... -- 1,189 6,653 780 3,281
----- ------- ------- ------ -------
Gross profit............ -- 2,170 7,994 1,616 3,433
Operating expenses:
Research and
development.......... 136 1,044 3,356 540 1,566
Sales and marketing... -- 2,046 7,099 1,182 4,025
General and
administrative....... 140 639 2,484 176 1,357
Amortization of
compensation......... -- -- 879 2 1,980
Settlement expense.... -- 570 -- -- --
----- ------- ------- ------ -------
Total operating
expenses........... 276 4,299 13,818 1,900 8,928
----- ------- ------- ------ -------
Loss from operations.... (276) (2,129) (5,824) (284) (5,495)
Other income (expense),
net.................... -- 70 32 (40) 16
----- ------- ------- ------ -------
Loss before income
taxes.................. (276) (2,059) (5,792) (324) (5,479)
Provision for income
taxes.................. -- -- (40) -- --
----- ------- ------- ------ -------
Net loss................ $(276) $(2,059) $(5,832) $ (324) $(5,479)
===== ======= ======= ====== =======
Historical basic and
diluted net loss
per share(1)........... N/A $ (2.14) $ (1.65) $(0.14) $ (1.00)
===== ======= ======= ====== =======
Shares used to compute
historical basic and
diluted net loss per
share(1)............... -- 962 3,544 2,326 5,481
===== ======= ======= ====== =======
Pro forma basic and
diluted net loss per
share(1)............... $ (0.42) $(0.03) $ (0.29)
======= ====== =======
Shares used to compute
pro forma basic and
diluted net loss
per share(1)........... 14,048 10,768 19,210
======= ====== =======
</TABLE>
<TABLE>
<CAPTION>
December 31,
------------------- March 31,
1996 1997 1998 1999
---- ------ ------- -----------
(in thousands) (unaudited)
<S> <C> <C> <C> <C>
Consolidated Balance Sheet Data:
Cash and cash equivalents....................... $147 $ 474 $11,903 $ 7,267
Working capital................................. 146 781 11,531 6,996
Total assets.................................... 244 2,818 25,177 28,627
Long term portion of debt....................... -- -- -- 784
Total stockholders' equity...................... 242 1,334 13,764 10,313
</TABLE>
- --------
(1) See Note 12 of Notes to Consolidated Financial Statements for an
explanation of the determination of the number of shares used in computing
per share data.
21
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
We are a leading provider of IP telephony systems. We were incorporated in
July 1996 and commenced sales of our products in March 1997. Prior to March
1997, we had no sales and our operations consisted primarily of various start-
up activities, such as research and development, recruiting personnel and
raising capital. We first recognized revenue from product sales in March 1997.
We generated net revenue of $3.4 million in 1997, $14.6 million in 1998 and
$6.7 million in the three months ended March 31, 1999. We incurred net losses
of $276,000 in 1996, $2.1 million in 1997, $5.8 million in 1998 and $5.5
million in the three months ended March 31, 1999. As of March 31, 1999, we had
an accumulated deficit of $13.6 million.
We generate revenue from sales of our integrated hardware and software
products and from maintenance and support of those products. Revenue derived
from product sales, largely sales of our Clarent Gateway products measured in
the number of ports, constituted 99% of net revenue in 1997, 94% of net revenue
in 1998 and 91% of net revenue in the three months ended March 31, 1999. A port
is the connection between the traditional telephone system and the IP telephony
system. Each port handles a single call and can have the capacity to handle
8,000 to 10,000 call minutes per month. Telecommunications service providers
bill their customers based on the minutes transmitted through their IP
telephony systems. Although service revenue does not currently constitute a
material portion of our revenue, we believe service revenue will become an
increasing portion of our revenue. Product revenue is generally recognized upon
shipment. Service revenue includes revenue from implementation and integration
services, system management services, warranty coverage and customer support.
Revenue from implementation and system integration services is recognized as
the services are performed, while revenue from system management services,
warranty coverage and customer support is recognized ratably over the period of
the contract.
We sell our products primarily through our direct sales force and, to a
lesser extent, through distribution channels. We have sales and support offices
in Belgium, Germany, Japan, the People's Republic of China, South Korea, Spain,
Taiwan, the United Kingdom and the United States. We intend to increase sales
through distribution channels. In 1998, we expanded the breadth of our support
services by establishing a professional services group to provide product
installation and customization, technical support, customer training and
product maintenance.
Net revenue from international sales totaled $3.1 million or approximately
94% of net revenue in 1997, $7.1 million or approximately 48% of net revenue in
1998 and $2.3 million or approximately 34% of net revenue in the three months
ended March 31, 1999. We expect that over time we may derive a majority of our
revenue from foreign-based service providers, subjecting our revenue stream to
risks from economic uncertainties, currency fluctuations, political instability
and uncertain cultural and regulatory environments.
Cost of revenue consists of component and material costs, direct labor
costs, warranty costs, royalties, overhead related to manufacturing our
products and customer support costs, as well as materials, travel and labor
costs related to personnel engaged in our service operations. Our gross margin
is affected by changes in the average selling price of our products and the
proportion of our net revenue derived from the sale of software and services.
Software sales, which typically carry higher gross margin than hardware sales,
currently make up only a fraction of our net revenue. However, we expect that
the proportion of software sales will increase in the future. Service sales,
which typically carry a lower gross margin than product sales, currently make
up a small proportion of our net revenue. We expect the proportion of service
revenue to increase in the future. The net impact that the increased proportion
of sales of both software and services will have on our total gross margin
cannot be determined at this time. Furthermore, we expect to derive an
increasing proportion of our net revenue from the sale of our products through
distribution channels. Revenue derived from indirect sales typically carries a
lower gross margin than direct sales. As a result, we expect the increased
proportion of net revenue derived from indirect sales to have a negative impact
on our total gross margin in the future.
22
<PAGE>
Research and development expenses consist primarily of compensation and
related costs for research and development personnel and expenses for testing
facilities and equipment. We also make separate investments in engineering
personnel and equipment to assure timely response to problems and correction of
stability issues in our products. We expect to continue to make substantial
investments in research and development and anticipate that research expenses
will continue to increase in absolute dollars.
Sales and marketing expenses consist primarily of compensation and related
costs for sales personnel, marketing personnel, sales commissions, marketing
programs, public relations, promotional materials, travel expenses and trade
show exhibit expenses. We expect to incur substantial expenditures related to
sales and marketing activities, the recruitment of additional sales and
marketing personnel and the expansion of our domestic and international
distribution channels.
General and administrative expenses consist primarily of salaries and
related expenses, finance, accounting and human resources expenses,
professional fees, bad debt expenses and other general corporate expenses. We
expect general and administrative expenses to increase in absolute dollars as
we add personnel and incur additional costs related to the anticipated growth
of our business and operation as a public company, and increase our exposure to
bad debt expenses arising from obligations to us from our customers,
particularly new entrants.
We expect each of these operating expense categories, research and
development, sales and marketing and general and administrative, to increase in
absolute dollars. However, the percentage of net revenue that each of these
categories represents will vary depending on the rate of our revenue growth and
investments that may be required to support the development of new products and
our penetration of new markets.
We have a limited operating history and face a number of risks encountered
by early stage companies. These risks include, among others:
. the market acceptance of IP telephony solutions;
. our ability to anticipate and respond to changing market conditions,
including competition;
. our ability to retain key customers; and
. our dependence upon key personnel.
Also, we had stability issues when we released Version 3.0 of the Clarent
Gateway. These issues have been resolved. To date, product defects have not had
a material impact on our results of operations. We cannot be certain that
product defects will not occur in the future. Management has significantly
increased product development resources and quality assurance test processes to
address stability issues.
In addition, although our revenue has grown in recent quarters, we cannot be
certain that our revenue will continue to grow or that we will achieve or
maintain profitability in the future. We expect to continue to experience
significant growth in research and development, sales and marketing and general
and administrative expenses as we attempt to expand our business and maintain
or improve our market position. We cannot accurately predict the future growth
rate, if any, or the ultimate size of our market. In addition, our ability to
increase revenue and achieve or maintain profitability depends on a number of
factors outside our control, including the extent to which:
. our products are able to gain market acceptance;
. our competitors develop competing products; and
. our distributors and other marketing partners dedicate resources to
selling our products.
Furthermore, we have experienced significant erosion of average selling
prices due to a number of factors, including competitive pricing pressures,
rapid technological change and increases in sales discounts. We anticipate that
the average selling prices of our products will decrease in the future in
response to the same factors. Therefore, to maintain or increase our gross
margin, we must develop and introduce new products and
23
<PAGE>
product enhancements to stabilize our existing products, on a timely basis and
continually reduce our product costs. Our failure to do so will cause our
revenue to grow more slowly and our gross margin to decline, which will
seriously harm our business, financial condition and results of operations.
Because of continuing and substantial capital expenditures and increasing
research and development, sales and marketing and general and administrative
expenses, we will need to generate significant revenue growth to achieve
profitability and positive operating cash flow. Even if we do achieve
profitability and positive cash flow, we may not be able to sustain or increase
profitability or positive operating cash flow on a quarterly or annual basis.
Results of Operations
Prior to the first quarter of 1997, our operations were limited and
consisted primarily of start-up activities. Expenses of $276,000 for 1996 were
comprised of payroll and related costs for research and development and general
and administrative personnel. Accordingly, we believe that year-to-year
comparisons of 1996 against 1997, and 1997 against 1998, are not meaningful.
The following table presents certain consolidated statement of operations
data for the periods indicated as a percentage of total net revenue.
<TABLE>
<CAPTION>
Three
Year ended months
December ended March
31, 31,
------------- -------------
1997 1998 1998 1999
----- ----- ----- -----
<S> <C> <C> <C> <C>
As a Percentage of Net Revenue:
Net revenue................................. 100.0% 100.0% 100.0% 100.0%
Cost of revenue............................. 35.4 45.4 32.6 48.9
----- ----- ----- -----
Gross margin................................ 64.6 54.6 67.4 51.1
Operating expenses:
Research and development.................. 31.1 22.9 22.5 23.3
Sales and marketing....................... 60.9 48.4 49.4 60.0
General and administrative................ 19.0 17.0 7.3 20.2
Amortization of compensation.............. -- 6.0 -- 29.5
Settlement expense........................ 17.0 -- -- --
----- ----- ----- -----
Total operating expenses................ 128.0 94.3 79.2 133.0
----- ----- ----- -----
Loss from operations........................ (63.4) (39.7) (11.8) (81.9)
Other income (expense), net................. 2.1 0.2 (1.6) 0.3
----- ----- ----- -----
Loss before income taxes.................... (61.3) (39.5) (13.4) (81.6)
Provision for income taxes.................. -- (0.3) -- --
----- ----- ----- -----
Net loss.................................... (61.3)% (39.8)% (13.4)% (81.6)%
===== ===== ===== =====
</TABLE>
Comparison of Three Months Ended March 31, 1998 and 1999
Net Revenue
Net revenue consists of sales of both our integrated hardware and software
products, as well as revenue generated from the maintenance and support of
those products. Net revenue increased from $2.4 million in the three months
ended March 31, 1998 to $6.7 million in the three months ended March 31, 1999.
The increase in net revenue was largely due to a 608% increase in port volume
of our Clarent Gateway products sold partially offset by a decrease of
approximately 73% in our average per port selling prices for those products.
Entities affiliated with AT&T Corporation accounted for 61% and no revenue was
generated from Technet International in the three months ended March 31, 1998.
Entities affiliated with AT&T Corporation accounted for 25% and Technet
International accounted for 32% of net revenue in the three months ended March
31, 1999.
24
<PAGE>
Cost of Revenue
Cost of revenue increased from $780,000 in the three months ended March 31,
1998 to $3.3 million in the three months ended March 31, 1999. Gross margin
decreased from 67% in the three months ended March 31, 1998 to 51% in the three
months ended March 31, 1999. The decline was a result of decreases in the
average selling prices of our products, offset to a slight degree by a decrease
in the material cost of our products.
The mix of products we sell will significantly impact our gross margin. We
expect a negative impact on our gross margin from the introduction of new
integrated hardware and software products and new versions of existing
integrated hardware and software products. However, we expect that increased
sales of our software products both in absolute dollars and as a percentage of
net revenue to positively impact our gross margin. The net impact that the
increased proportion of sales of both software and services will have on our
gross margin cannot be determined at this time.
Research and Development Expenses
Research and development expenses increased from $540,000 in the three
months ended March 31, 1998 to $1.6 million in the three months ended March 31,
1999. Research and development expenses consist of payroll and related expenses
for research and development personnel, costs related to systems infrastructure
and third-party consultants. The absolute dollar increases in research and
development expenses from period to period were attributable to increases in
the number of research and development personnel. Research and development
expenses remained consistent as a percentage of net revenue at 23% in the three
months ended March 31, 1998 and March 31, 1999.
Sales and Marketing Expenses
Sales and marketing expenses increased from $1.2 million in the three months
ended March 31, 1998 to $4.0 million in the three months ended March 31, 1999.
Sales and marketing expenses consist primarily of payroll and related expenses
for personnel engaged in sales and marketing, as well as public relations and
marketing communications expenditures. The absolute dollar increase in sales
and marketing expenses from period to period was primarily attributable to a
$1.6 million or 58% increase in personnel and related expenses required to
implement our sales and marketing strategy and, to a lesser extent, increased
public relations and other promotional expenses. The growth rate of sales and
marketing expenses exceeded the growth rate of net revenue for the period
because we were adding sales and marketing personnel and spending on
promotional activities in anticipation of increased future sales.
General and Administrative Expenses
General and administrative expenses increased from $176,000 in the three
months ended March 31, 1998 to $1.4 million in the three months ended March 31,
1999. General and administrative expenses consist primarily of payroll and
related costs for general corporate functions, including finance, accounting,
business development, human resources, facilities and administration, as well
as legal fees and fees for professional services. The absolute dollar increases
in general and administrative expenses from period to period were due to a
$575,000 or 47% increase in general and administrative personnel expenses, a
$197,000 or 16% increase in professional service fees and a $354,000 or 29%
increase in the charge for the allowance for doubtful accounts. The growth rate
of general and administrative expenses exceeded the growth in net revenue for
the period because we were adding infrastructure to support a larger
organization.
Amortization of Compensation
In connection with stock option grants in 1999, an additional $11.1 million
of deferred compensation was recorded for the three months ended March 31,
1999. Amortization of compensation expense includes the amortization of stock
compensation charges resulting from the granting of stock options at prices
below the
25
<PAGE>
deemed fair value of our common stock. These amounts are being amortized using
the accelerated method over the vesting period of the stock options. Of the
total deferred compensation, approximately $1,271,000 was amortized during the
first quarter of 1999. Including those amounts recorded in the first quarter of
1999, we expect to amortize approximately $7.0 million of this deferred
compensation expense in 1999, $3.8 million in 2000, $1.7 million in 2001 and
$537,000 in 2002.
Amortization of compensation also includes compensation charges associated
with the granting of a warrant for advisory services to an investor.
Amortization of compensation totaled $709,000 for the three months ended March
31, 1999. We terminated the advisory services arrangement in June 1999 which
caused the unvested portion of the warrant to become fully vested. In
connection with this termination, we will record a compensation charge totaling
approximately $11.6 million in the quarter ending June 30, 1999.
Fiscal Years Ended December 31, 1997 and 1998
Net Revenue
We began generating net revenue in the first quarter of 1997. Net revenue
increased from $3.4 million in 1997 to $14.6 million in 1998. The increase in
net revenue was due to a 667% increase in port volume of our Clarent Gateway
products sold partially offset by a decrease of approximately 52% in our
average per port selling prices for those products. A limited number of
customers have historically accounted for a substantial portion of our net
revenue. Entities affiliated with AT&T Corporation accounted for 46% and
Wherever Computer Technology Company Limited accounted for 35% of net revenue
in 1997. Entities affiliated with AT&T Corporation accounted for 36% and
Technet International accounted for 12% of net revenue in 1998.
Cost of Revenue
Cost of revenue increased from $1.2 million in 1997 to $6.7 million in 1998.
Gross margin declined from 65% in 1997 to 55% in 1998. The decline was a result
of decreases in average selling prices in our products, offset to a slight
degree by a decrease in the material cost of our products.
Research and Development Expenses
Research and development expenses increased from $1.0 million in 1997 to
$3.4 million in 1998. The absolute dollar increases in research and development
expenses from period to period were attributable to increases in the number of
research and development personnel. Research and development expenses decreased
as a percentage of net revenue from 31% in 1997 to 23% in 1998 because the
growth rate of net revenue exceeded the growth rate of research and development
expenses for the period.
Sales and Marketing Expenses
Sales and marketing expenses increased from $2.0 million in 1997 to $7.1
million in 1998. The absolute dollar increases in sales and marketing expenses
from period to period were primarily attributable to a $3.4 million or 67%
increase in personnel and related expenses required to implement our sales and
marketing strategy and, to a lesser extent, increased public relations,
advertising and other promotional expenses. Sales and marketing expenses
decreased as a percentage of net revenue from 61% in 1997 to 49% in 1998
primarily due to increased productivity of our sales personnel and increased
net revenue in such periods.
General and Administrative Expenses
General and administrative expenses increased from $639,000 in 1997 to $2.5
million in 1998. The absolute dollar increases in general and administrative
expenses from period to period were due to a $198,000 or 11% increase in
general and administrative personnel expenses, a $371,000 or 20% increase in
professional services fees, a $733,000 or 39% increase in the charge for the
allowance for doubtful accounts and, to a lesser extent, increased facility
expenses to support the growth of our operations.
26
<PAGE>
Amortization of Compensation
In connection with some stock option grants in 1998, $2.3 million in
deferred compensation has been recorded. Amortization of compensation expense
reflects the amortization of stock compensation charges resulting from the
granting of stock options at prices below the deemed fair value of our common
stock. These amounts are being amortized using the accelerated method over the
vesting period of the stock options. Of the total deferred compensation,
approximated $522,000 was amortized in 1998.
Amortization of compensation also includes compensation charges associated
with the granting of a warrant for advisory services to an investor.
Amortization of compensation related to the warrant totaled $357,000 for the
year ended December 31, 1998.
Settlement Expense
Settlement expense totaled $570,000 in 1997 and consisted of our legal
expenses and the settlement expense that we paid in connection with a dispute
with one of our distributors. Under the terms of the settlement agreement, we
made cash payments to the distributor of $250,000 and granted the distributor a
5% increase in its existing discount rate for a specific quantity of its
purchases from us in 1998. In addition, under the terms of the settlement
agreement, we issued 45,592 shares of Series C preferred stock to the
distributor at a value of $6.58 per share in August 1998.
Income Taxes
In 1997 we incurred net losses for federal and state income tax purposes and
did not recognize any income tax provision or benefit during such period. In
1998 we recorded a provision for income taxes of $40,000 related to current
foreign income tax provided on the profits attributable to our foreign
operations. As of December 31, 1998, we had $2.0 million of federal and $1.4
million of state net operating loss carryforwards to offset future taxable
income. The difference between available net operating losses and our
accumulated deficit as reported for financial statement purposes is principally
the result of differences in the tax treatment of our deferred revenue, which
totaled $4.4 million as of December 31, 1998.
We cannot assure you that we will realize the benefit of the net operating
loss carryforwards and have therefore set up a full valuation allowance against
these deferred tax assets. The federal and state net operating loss
carryforwards will expire at various dates beginning in fiscal year 2004
through 2018, if we do not use them. Due to the "change of ownership"
provisions of the Internal Revenue Code, the availability of our pre 1998 net
operating loss and tax credit carryforwards are subject to an annual limitation
against taxable income in future periods. Post 1997 net operating loss and tax
credit carryforwards could also be subject to a substantial annual limitation
if future ownership changes should occur. It is likely that the shares to be
issued in this offering will create this type of change.
27
<PAGE>
Quarterly Results of Operations
The following tables present some consolidated statements of operations data
for our five most recent quarters ended March 31, 1999, in dollars and as a
percentage of net revenue. In management's opinion, this unaudited information
has been prepared on the same basis as the audited annual consolidated
financial statements and includes all adjustments, consisting only of normal
recurring adjustments, necessary for fair presentation of the unaudited
information for the quarters presented. You should read this information in
conjunction with the consolidated financial statements, including the related
notes, included elsewhere in this prospectus. The results of operations for any
quarter are not necessarily indicative of results that we might achieve for any
subsequent periods.
<TABLE>
<CAPTION>
Quarter Ended
---------------------------------------------------
Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31,
1998 1998 1998 1998 1999
-------- -------- --------- -------- --------
(in thousands, except percentages)
<S> <C> <C> <C> <C> <C>
Consolidated Statement of
Operations Data:
Net revenue................ $2,396 $ 3,083 $ 3,269 $ 5,899 $ 6,714
Cost of revenue............ 780 1,396 1,469 3,008 3,281
------ ------- ------- ------- -------
Gross profit............... 1,616 1,687 1,800 2,891 3,433
Operating expenses:
Research and
development............. 540 698 843 1,275 1,566
Sales and marketing...... 1,182 1,553 1,970 2,394 4,025
General and
administrative.......... 176 554 770 984 1,357
Amortization of
compensation............ 2 84 335 458 1,980
------ ------- ------- ------- -------
Total operating
expenses............... 1,900 2,889 3,918 5,111 8,928
------ ------- ------- ------- -------
Loss from operations....... (284) (1,202) (2,118) (2,220) (5,495)
Other income (expense),
net....................... (40) (101) 92 81 16
------ ------- ------- ------- -------
Loss before income taxes... (324) (1,303) (2,026) (2,139) (5,479)
Provision for income
taxes..................... -- 1 2 (43) --
------ ------- ------- ------- -------
Net loss................... $ (324) $(1,302) $(2,024) $(2,182) $(5,479)
====== ======= ======= ======= =======
As a Percentage of Net
Revenue:
Net revenue................ 100% 100% 100% 100% 100%
Cost of revenue............ 33 45 45 51 49
------ ------- ------- ------- -------
Gross margin............... 67 55 55 49 51
Operating expenses:
Research and
development............. 23 23 26 22 23
Sales and marketing...... 49 50 60 40 60
General and
administrative.......... 7 18 24 17 20
Amortization of
compensation............ -- 3 10 8 30
------ ------- ------- ------- -------
Total operating
expenses............... 79 94 120 87 133
------ ------- ------- ------- -------
Loss from operations....... (12) (39) (65) (38) (82)
Other income (expense),
net....................... (2) (3) 3 2 --
------ ------- ------- ------- -------
Loss before income taxes... (14) (42) (62) (36) (82)
Provision for income
taxes..................... -- -- -- (1) --
------ ------- ------- ------- -------
Net loss................... (14)% (42)% (62)% (37)% (82)%
====== ======= ======= ======= =======
</TABLE>
Our operating expenses have increased significantly in absolute dollars, but
not as a percentage of net revenue, in each quarter since inception as we have
transitioned from the development stage to the commercialization of our
products and services and expansion of our business. We expect to incur an
increase in operating expenses in the future as we attempt to expand our
business. To the extent that these expenses are not accompanied by an increase
in net revenue, our business, results of operations and financial condition
could be adversely affected.
28
<PAGE>
In the quarters subsequent to March 31, 1998, we experienced a significant
decrease in average selling prices which decreased our gross margin percentage
through the quarter ended December 31, 1998. Gross margin percentage for the
quarter ended March 31, 1999 increased primarily due to lower product costs.
In the quarter ended September 30, 1998, we experienced a significant
increase in operating expenses, both in absolute dollars and as a percentage of
net revenue. We hired additional employees in anticipation of customer orders
that were subsequently delayed or cancelled. These delays and cancellations
were attributable primarily to the anticipated release of a new version of our
product and the weak economic conditions in Asia.
We expect our operating results to fluctuate significantly in the future as
a result of a variety of factors, many of which are outside our control.
Consequently, we believe that period-to-period comparisons of our operating
results may not necessarily be meaningful, and as a result, you should not rely
on them as an indication of future performance.
Liquidity and Capital Resources
Since inception, we have financed our operations primarily through private
sales of convertible preferred stock, which totaled $18.5 million in aggregate
net proceeds through December 31, 1998. We have also financed our operations
through lines of credit, of which $2.5 million had been drawn down as of
December 31, 1998.
Net cash used in operating activities was $276,000 in 1996, $2.3 million in
1997, $5.8 million in 1998, $1.5 million for the three months ended March 31,
1998 and $4.0 million for the three months ended March 31, 1999. For 1997, cash
used in operating activities was attributable primarily to a net loss of $2.1
million, an increase in trade accounts receivable of $777,000 and an increase
in inventory of $889,000 due to anticipated growth in expected product
revenues, offset in part by increases in accounts payable and accrued
liabilities of $1.3 million. For 1997 the increase in accounts receivable was
entirely related to our increase in sales. For 1998, cash used in operating
activities was attributable primarily to a net loss of approximately $5.8
million, and increases in trade accounts receivable of $6.2 million and
inventory of $2.7 million. For 1998, the increase in accounts receivable was
primarily the result of higher sales levels during the fourth quarter. During
the year ended December 31, 1998, we increased our allowance for doubtful
accounts by $769,000 to address potential exposures related to an increase in
international sales and changes in the composition of our customer base to
include more international and new entrant customers. There was no deferred
revenue recognized on sales to these customers, as collectibility was probable
under the software revenue recognition rules.
In addition, we deferred recognition of revenue on some sales where
collectibility was not probable because of the fact that in some sales
arrangements, payment terms are for periods that are longer than our normal
terms. Because we have not established a payment history with some of these
customers, we concluded that the fees in these arrangements were not "fixed and
determinable" as defined by the software revenue recognition rules. For these
arrangements, we perform normal credit checks but concluded that revenue should
be deferred until such time as payments become due or probable. The amount of
deferred revenue as a result of not meeting the fixed and determinable criteria
totaled $1,366,000 at December 31, 1998 and $3,476,000 at March 31, 1999. No
provision for doubtful accounts has been established for these deferred revenue
arrangements. The cash used in operating activities was offset in part by
depreciation of approximately $516,000, amortization of compensation of
$879,000 and increases in accounts payable and accrued liabilities of
approximately $3.4 million and an increase in deferred revenue of approximately
$4.3 million.
Net cash used in operating activities for the three months ended March 31,
1998 was attributable primarily to a net loss of approximately $324,000 and
increases in trade accounts receivable of $1.7 million and inventory of
$710,000 partially offset by depreciation of $53,000, increases in accounts
payable and accrued liabilities of $538,000 and increases in deferred revenue
of $583,000. Net cash used in operating activities for the three months ended
March 31, 1999 was attributable primarily to a net loss of approximately $5.5
million
29
<PAGE>
and increases in trade accounts receivable of $4.1 million and inventory of
$2.0 million partially offset by depreciation of $346,000, amortization of
compensation of $2.0 million, increases in accounts payable of $3.0 million and
increases in deferred revenue of $2.3 million. The increase in inventory for
the three months ended March 31, 1999 was primarily in anticipation of expected
growth in product revenue as well as a greater need for evaluation units. The
increase in accounts receivable for the three months ended March 31, 1999 is
primarily the result of increased sales which occurred during the last month of
the quarter. In addition we increased our allowance for doubtful accounts to
address the increase in our accounts receivable balance.
Net cash used in investing activities was approximately $95,000 in 1996,
$555,000 in 1997, $2.2 million in 1998, $103,000 for the three months ended
March 31, 1998 and $2.2 million for the three months ended March 31, 1999. For
each of these periods, cash used in investing activities was attributable to
purchases of property and equipment.
Net cash provided by financing activities was $518,000 in 1996, $3.2 million
in 1997, $19.5 million in 1998, $2.6 million for the three months ended March
31, 1998 and $1.6 million for the three months ended March 31, 1999. For 1996
and 1997, cash provided by financing activities was attributable principally to
proceeds from the issuance of preferred stock. In 1998 cash provided by
financing activities was attributable to $14.8 million in proceeds from the
issuance of preferred stock, $2.5 million of short-term borrowings and
$2.6 million of funds received from the issuance of bridge notes convertible
into Series C preferred stock offset by $550,000 in repayment of those bridge
notes. For the three months ended March 31, 1998, cash provided by financing
activities was attributable primarily to $2.6 million in proceeds from the
issuance of bridge notes. For the three months ended March 31, 1999, cash
provided by financing activities was attributable primarily to $1.6 million in
proceeds from our line of credit and equipment term loan facility.
As of March 31, 1999, our principal commitments consisted of obligations
outstanding under operating leases. Although we have no material commitments
for capital expenditures, we anticipate a substantial increase in capital
expenditures and lease commitments consistent with our anticipated growth in
operations, infrastructure and personnel. We also may establish additional
operations as we expand globally.
From July 2, 1996 through December 31, 1998, we issued warrants to purchase
160,266 shares of Series C preferred stock at prices ranging from $5.59 to
$6.58 per share and 1,760,000 shares of common stock at a price of $0.05 per
share. Warrants for 768,238 shares of common stock have been exercised and
warrants for 59,266 shares of Series C preferred stock and 991,672 shares of
common stock are exercisable as of March 31, 1999. All of these warrants expire
upon the completion of an initial public offering and are being exercised prior
to the completion of this offering. See Notes 2 and 4 of Notes to Consolidated
Financial Statements.
In February 1998, we obtained $2.6 million in bridge financing in the form
of promissory notes from several investors and other parties. In June 1998,
approximately $2.1 million of the promissory notes were converted to Series C
preferred stock and the remainder was repaid.
In May 1998, we established a $5.0 million line of credit with a financial
institution. The effective interest rate on this credit facility is equal to
one-half of one percentage point above the prime rate. Borrowings under this
agreement are limited to our eligible receivable base. The terms of the line of
credit agreement establish affirmative and negative covenants, under which we
must maintain certain financial ratios and reporting practices. We failed to
comply with financial covenants related to the liquidity, tangible net worth
and the maximum permitted loss required under the agreement as of December 31,
1998. The financial institution waived these events of default. On February 16,
1999, the financial institution increased the line of credit to $7.0 million,
extended an additional $3.0 million equipment term loan facility, and revised
these financial ratios. At March 31, 1999 we failed to comply with the
liquidity, tangible net worth and maximum loss financial covenants. The
financial institution waived these events of default and has renegotiated new
covenants. The revised covenants require a minimum liquidity ratio of 1.25-to-
1, minimum tangible net worth of $9.5 million (increasing to $15 million
effective as of the last day of the month in which we complete our initial
public offering), minimum liquidity coverage of 2-to-1 and quarterly net
losses, adjusted to exclude the amortization of
30
<PAGE>
deferred compensation, of less than $2.75 million for the quarter ended June
30, 1999, $2.8 million for the quarter ended September 30, 1999 and $1.0
million for the quarter ended December 31, 1999. As of March 31, 1999, $2.8
million was outstanding under this line of credit and $1.3 million was
outstanding under the equipment term loan facility. At March 31, 1999, we had
$1.2 million available under our line of credit and $1.7 million unused under
our equipment term loan facility.
We believe that the net proceeds from this offering, together with our
current cash, cash equivalents and borrowing capacity will be sufficient to
meet our anticipated cash needs for working capital and capital expenditures
for at least the next 12 months. If cash generated from operations is
insufficient to satisfy our liquidity requirements, we may seek to sell
additional equity or debt securities or increase the available borrowings under
our line of credit. If additional funds are raised through the issuance of debt
securities, these securities could have rights, preferences and privileges
senior to holders of common stock, and the term of this debt could impose
restrictions on our operations. The sale of additional equity or convertible
debt securities could result in additional dilution to our stockholders, and we
cannot be certain that additional financing will be available in amounts or on
terms acceptable to us, if at all. If we are unable to obtain this additional
financing, we may be required to reduce the scope of our planned product
development and marketing efforts, which could harm our business, financial
condition and operating results.
Year 2000 Compliance
Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field. As a result, software
that records only the last two digits of the calendar year may not be able to
distinguish between 20th and 21st century dates. This may result in software
failures or the creation of erroneous results.
We have conducted the first phases of a Year 2000 readiness review for the
prior and current versions of our products. The review includes assessment,
implementation, including remediation, modifications, where necessary, of
current product versions, validation testing and contingency planning. We
continue to respond to customer questions about prior versions of our products
on a case-by-case basis.
We have largely completed all phases of this plan, except for contingency
planning, for the prior and current versions of our products. As a result, all
current versions of our products are "Year 2000 compliant," as defined below,
when configured and used in accordance with the related documentation, and
provided that the underlying operating system of the computer on which our
products run and any other software used with or in the computer on which our
products run, prior versions of our products are also Year 2000 compliant. We
are also supplying our customers who use prior versions of our products with
software updates for the third party supplied software components of our
products to make those versions Year 2000 compliant. We have not tested our
products on all platforms or all versions of operating systems that we
currently support.
We define "Year 2000 compliant" as the ability to:
. correctly handle date information needed for the December 31, 1999 to
January 1, 2000 date change;
. function according to the product documentation provided for this date
change, without changes in operation resulting from the advent of a new
century, assuming correct configuration;
. where appropriate, respond to two-digit date input in a way that resolves
the ambiguity as to century in a disclosed, defined and predetermined
manner;
. if the date elements in interfaces and data storage specify the century,
store and provide output of date information in ways that are unambiguous
as to century; and
. recognize the year 2000 as a leap year.
We have tested software obtained from third parties that is incorporated
into our products, and we are seeking assurances from our vendors that licensed
software is Year 2000 compliant. Despite testing by us and
31
<PAGE>
by current and potential clients, and assurances from developers of products
incorporated into our products, our products may contain undetected errors or
defects associated with Year 2000 date functions. Known or unknown errors or
defects in our products could result in delay or loss of revenue, diversion of
development resources, damage to our reputation, or increased service and
warranty costs, any of which could materially adversely affect our business,
operating results or financial condition. Some industry analysts have predicted
significant litigation regarding Year 2000 compliance issues, and we are aware
of such lawsuits against other software vendors. Because of the unprecedented
nature of such litigation, it is uncertain whether or to what extent we may be
affected by it.
Our internal systems include both our information technology, or IT, and
non-IT systems. We have initiated an assessment of our material internal IT
systems, including both our own software products and third-party software and
hardware technology, but we have not initiated an assessment of our non-IT
systems. We expect to complete testing of our IT systems in the third quarter
of 1999. If our IT systems are not Year 2000 compliant, we may not have allowed
sufficient time for remediation of any deficiencies. To the extent that we are
not able to test the technology provided by third-party vendors, we are seeking
assurances from vendors that their systems are Year 2000 compliant. We are
currently scheduled to complete our initial inventory/assessments of our non-IT
systems by June 30, 1999. We have completed the inventory/assessment of
licensed software included in our products and have confirmed that the licensed
software that we incorporate in our products is Year2000 compliant. This
confirmation has been achieved through a combination of internal testing,
vendor's Year2000 Readiness Disclosures, and an ongoing certification program
addressing all of our suppliers and vendors.
We are not currently aware of any material operational issues or costs
associated with preparing our internal IT and non-IT systems for the Year 2000.
Our costs incurred through December 31, 1998, have totaled less than $25,000.
We expect to incur less than $100,000 in costs to complete our Year 2000
compliance efforts. However, we may experience material unanticipated problems
and costs caused by undetected errors or defects in the technology used in our
internal IT and non-IT systems.
We do not currently have any information concerning the Year 2000 compliance
status of our customers. If our current or future customers fail to achieve
Year 2000 compliance or if they divert technology expenditures to address Year
2000 compliance problems, our business could suffer.
We have funded our Year 2000 plan from available cash and have not
separately accounted for these costs in the past. To date, these costs have not
been material. We expect to incur additional costs related to the Year 2000
plan for administrative personnel to manage the project, outside contractor
assistance, technical support for our products, product engineering and
customer satisfaction. In addition, we may experience material problems and
costs with Year 2000 compliance that could adversely affect our business,
results of operations, and financial condition.
We have not yet developed a contingency plan to address situations that may
result if we are unable to achieve Year 2000 readiness of our critical
operations. However, we have appointed a cross-functional group to develop our
plan by the end of July 1999. The overall cost of developing and implementing
our plan may be material. Finally, we are also subject to external forces that
might generally affect industry and commerce, such as utility or transportation
company Year 2000 compliance failures and related service interruptions.
Recent Accounting Pronouncements
In March 1998, the American Institute of Certified Public Accountants issued
Statement of Position 98-1, or SOP 98-1, "Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use," which establishes guidelines
for the accounting for the costs of all computer software developed or obtained
for internal use. We are required to adopt SOP 98-1 effective January 1, 1999.
The adoption of SOP 98-1 is not expected to have a material impact on our
consolidated financial statements.
32
<PAGE>
In December 1998, the American Institute of Certified Public Accountants
issued Statement of Position 98-9. "Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactions", or SOP 98-9. SOP 98-9
requires use of the "residual method" for recognition of revenue when vendor-
specific objective evidence exists for undelivered elements but does not exist
for delivered elements of a software arrangement. We will be required to comply
with the provisions of SOP 98-9 for transactions entered into beginning January
1, 2000. The adoption of SOP 98-9 is not expected to have a material impact on
our consolidated financial statements.
Financial Market Risk
Our financial market risk includes risks associated with international
operations and related foreign currencies. We anticipate that international
sales will continue to account for a significant portion of our consolidated
revenue. Our international sales are denominated in U.S. dollars and therefore
are not subject to foreign currency exchange risk. Expenses of our
international operations are denominated in each country's local currency and
therefore are subject to foreign currency exchange risk; however, through March
31, 1999, we have not experienced any significant negative impact on our
operations as a result of fluctuations in foreign currency exchange rates.
We also have financial market risk on the interest rate associated with our
short term debt. At March 31, 1999, our financial market risk related to this
debt was immaterial.
33
<PAGE>
BUSINESS
Overview
We are a leading provider of Internet protocol or IP telephony systems. IP
telephony systems permit the simultaneous transmission of voice, fax and data
over the Internet and similar communications networks. Using our technology to
simultaneously transmit voice, fax and data, our customers are able to more
efficiently and cost-effectively use the available capacity of their networks.
These customers include traditional, local, international and wholesale long
distance telephone companies, as well as new telecommunications service
providers. Traditional telecommunications service providers are companies that
have previously served as the monopoly or incumbent provider in their region.
New telecommunications service providers are companies that have started to
offer telecommunications services in the last three to five years in countries
that have deregulated their telecommunications markets. The IP telephony market
is relatively new. Less than 1% of all voice calls worldwide are currently
transmitted using IP telephony systems primarily over the Internet. According
to Frost & Sullivan, between 1997 and 2002, the number of call minutes,
including voice, fax and data, transmitted using IP telephony systems is
expected to have a compound annual growth rate of 325%.
Using our IP telephony product, the Clarent system, service providers can
deliver a level of voice quality that is indistinguishable from the voice
quality over the traditional telephone system. In addition, the Clarent system
enables the simultaneous transmission of voice, fax and data. The Clarent
system features a modular architecture that permits our customers to add new
product and service features without extensive product cost or development
time. Based on publicly available data provided by large telecommunications
service providers, we believe our modular architecture enables service
providers to provide their customers with communications services at a lower
cost than traditional telephone companies.
The Clarent system consists of three distinct components:
. the Clarent Gateway, an integrated hardware and software product that
includes network server software that is based on industry standards;
. the Clarent Command Center, a proprietary client/server software package;
and
. a relational database, which is supplied by a third party.
Our products enable service providers to deliver IP telephony services to
end user customers who can use their existing telephones. Since our products
are integrated by telephone companies and other service providers into systems
that take calls from the traditional telephone system and send these calls over
the Internet and other Internet protocol networks before returning these calls
to the traditional telephone system, the use of IP telephony is transparent to
end user customers. Our products can be accessed from cellular as well as
traditional telephones. As a result, end users do not have to purchase
additional telephone equipment to make IP telephony calls. Currently, IP
telephony is not commonly offered incorporating satellite transmissions or
using cable lines.
We began commercial shipment of the Clarent system in March 1997. As of
March 31, 1999, we had shipped the Clarent system to approximately 100
telecommunications companies in 50 countries worldwide. The Clarent system has
been installed in some of the world's leading service provider networks,
including those of AT&T Corporation, Chunghwa Telecom (Taiwan), Ji-Tong
Communications (People's Republic of China), KDD (Japan), Korea Telecom (South
Korea), KPN Telecom Netherlands, Singapore Telecom, Star Telecom (United
States) and Telia Telecom (Sweden).
Industry Background
The telecommunications industry has historically followed a path of
development based on the belief that voice and data require separate
technologies and network resources. Traditional telephone systems were, and are
still, built around an architecture that requires a dedicated connection, or
circuit, in order for a call to be completed. This technology requires the
circuit to remain dedicated between calling parties for the entire duration of
a call. Most data today is transmitted over Internet protocol-based networks.
These networks are
34
<PAGE>
more efficient because they do not require a dedicated circuit for the entire
path of the call. In a network using Internet protocol, the voice, fax or data
is divided into packets that are simultaneously sent to a final destination
where they are reassembled back to their original form. In this type of
network, multiple types of information including voice, fax and different forms
of data can travel through the network at the same time. The improvements in
the technologies used in data networks have led to an increase in use of this
type of network to transmit both voice and data. The IP telephony market
emerged from these technological advances. Recent developments in IP telephony
technology have significantly bridged the voice quality gap between the
traditional telephone system, which is commonly referred to as a circuit-
switched system, and IP telephony systems. The differences between a circuit-
switched call and an IP telephony call is illustrated in the diagram below.
[Graphic depicting the differences between a circuit-switched and IP telephony
call]
[A phone call transmits signals that direct a series of switches to open a
dedicated circuit to second phone. The dedicated circuit carries the electronic
signals through the line. The phones transists the signals back into speech.]
[Unlike the traditional circuit switched phone call, which travels on a
dedicated circuit, the electronic signals go to a Clarent Gateway, which
converts them into small packets of digital information. The packets may take
different routes to their destination. After traveling through the IP network,
the packets are converted back into electronic signals by another Clarent
Gateway and put back on the phone network.]
Today a voice call placed over an IP telephony network can sound virtually
indistinguishable from the same call made over the traditional telephone
system. What distinguishes IP telephony technology, however, is that it allows
service providers to simultaneously send voice, fax and data transmissions over
their networks and enables them to quickly add and use additional features and
services without the need for costly network upgrades. In contrast, changes to
the traditional telephone system are costly and difficult. For example, based
on estimates from the International Engineering Consortium, we believe the
recent integration of such basic services as caller ID and call return services
into the traditional telephone system took over a decade and hundreds of
millions of dollars to implement in the United States alone.
The added flexibility and cost-effectiveness of IP telephony networks are
particularly important in an increasingly deregulated and competitive market
environment. Deregulation acts as a catalyst for the rapid
35
<PAGE>
deployment of these services by allowing new service providers to quickly enter
formerly regulated markets and by forcing existing service providers to rapidly
respond to the challenge of competition. According to a 1998 Frost & Sullivan
report, the total number of worldwide voice minutes running over Internet
protocol-based data networks is expected to grow from 6.3 million in 1997 to
8.8 billion in 2002, representing a compound annual growth rate of 325% for the
period. Accordingly, spending on IP telephony equipment is projected to grow
from $47.3 million in 1997 to $3.2 billion in 2002, representing a compound
annual growth rate of 132%.
We believe a significant market opportunity now exists for the makers of IP
telephony systems. We believe that none of our competitors to date has
developed a comprehensive solution that incorporates the functionality that
service providers require to provide end-to-end service. Some vendors have
developed products that embed the instructions on where to route the IP
telephony call in the same equipment that provides the IP telephony technology.
This approach limits service providers' flexibility to make modifications to
their networks because any modification must be made at several different
points throughout the network.
Many vendors only provide limited billing and network management data. This
data is gathered and formatted in a simplistic fashion, limiting the ability of
service providers to manage sophisticated networks or to bill using any pricing
structure they desire. Also, these simplistic billing systems make it difficult
to connect service providers' networks to the networks of other service
providers.
Some router, switch and IP telephony companies have formed partnerships with
billing and network management technology providers in order to provide even
the most basic operational support solution to service providers. A router is a
device that routes packets over the Internet or other Internet protocol
networks. A switch is a device that takes multiple incoming calls and places
these calls onto fewer lines. This partnering necessitates integration, which
can be technologically difficult, time consuming and expensive.
Many IP telephony vendors require dedicated ports for voice, fax or data. A
port is the connection between the traditional telephone system and the IP
telephony system. Each port handles a single call. Systems that use dedicated
ports are inefficient and more costly because more ports are needed to handle
the different types of transmissions anticipated. In addition, many vendors do
not have the technical capability to integrate these ports with the traditional
telephone system so that the ports can correctly interpret busy signals, dial
tones and disconnects. This means that service providers cannot accurately bill
for the call. Furthermore, the inability to integrate well with the traditional
telephone system makes it more difficult for end-users to gain the benefits of
this technology because they have to dial separate phone numbers or use multi-
step dialing processes.
In order to compete effectively in the emerging market for IP telephony
services, service providers need a solution that provides the following
attributes. The solution must be cost-effective and combine a high level of
functionality with a flexible architecture designed to support growth and new
features. This solution must enable service providers to deliver clear and
robust voice quality that can be merged efficiently with fax and data IP
telephony services. The solution must also possess robust back-office features
to permit service providers to operate and manage a viable communications
business. Some service providers and their business customers will use these
features to support connections with other networks, while others will use
these features to connect to an intermediary, like an IP telephony
clearinghouse, to facilitate the exchange of IP telephony calls. These
clearinghouses enable service providers to exchange calls between multiple
destinations worldwide without having to enter into individual agreements with
other service providers in each geographic region. A clearinghouse also
performs the associated accounting and settlement services for its members. The
solution must allow service providers to centrally make changes to their
network as this technology continues to evolve. The solution must also be able
to incorporate feature enhancements because there will be many and varied new
feature requests as this technology continues to evolve. The solution must also
be transparent to end users and easy to use. Finally, we expect that customers
will prefer a solution that is technologically advanced enough to allow service
providers to quickly adapt their entire IP telephony network to emerging
standards. We believe that although some of our competitors may offer some of
these attributes, with others offering a few other attributes, none of our
competitors offers all of the above attributes.
36
<PAGE>
The Clarent Solution
We have developed a comprehensive IP telephony solution that offers the
following key benefits:
Traditional telephone system voice quality and simultaneous voice, fax and
data transmission. Calls over a Clarent network that sound indistinguishable
from a traditional telephone system call. In addition, the Clarent system
enables the simultaneous transmission of voice, fax and data traffic. These
features are enabled by using standard compression and echo cancellation
technologies and our proprietary packet technologies.
Rapid, low-cost deployment and maintenance. The Clarent system provides a
comprehensive solution that can be rapidly put into use by service providers
with a modest initial capital investment. By centralizing management and
distributing functionality, the Clarent system allows service providers to
perform network administration in an economical manner.
Transparent and secure interconnection with different networks. The Clarent
system is designed to support the seamless interconnection between other
networks that use Clarent's products and the traditional telephone system. This
includes interconnecting to the traditional telecommunications service
providers' networks, commonly known as the SS7 network. These interconnections
provide a level of security that enables service providers to exchange large
volumes of calls and billing data with each other and with their business
customers. This process requires that only relevant transaction information is
disclosed, either bilaterally or through an intermediary, such as an IP
telephony clearinghouse.
Complementary processing of calls and centralized network management
functions. The Clarent system provides centralized processing of such network
functions as the authentication of callers, billing, routing and pricing of
calls and network diagnostics and maintenance. Because we provide both the call
processing and operational support functions in a network, we can effect
system-wide enhancements and new features quickly and efficiently.
Adaptability to changing standards and technologies. The Clarent system is
comprised of distinct units that can be spread across a network. Compared to a
circuit-switched network, a network using a Clarent system may be modified
quickly to accommodate new features, support new protocols or handle new end-
user devices, such as cable modems, and new end-user equipment, such as IP
telephones, as they become widely-used or available.
Strategy
Our objective is to be the leading provider of comprehensive IP telephony
solutions to service providers worldwide. Key elements of our strategy include
the following:
Provide the core technology enabling the delivery of a broad range of IP
telephony services. We have designed the Clarent system to provide service
providers with a unified technology platform for the effective and rapid
delivery of a broad range of IP telephony services. This will enable service
providers to offer their customers a wide array of value-added services,
including virtual private networks and worldwide roaming, using the Clarent
system. An additional element of our strategy is to increase the level of
technological interoperability of our products with those of other vendors to
expand the breadth of opportunities our products can address.
Increase our penetration of service provider market. We plan to increase the
sales of our products by expanding our relationships with existing customers
and by capturing new customer relationships. We have shipped our solutions to
approximately 100 telecommunications companies, including several of the
world's leading long distance carriers. We believe the demand for our products
will increase as new and existing customers increasingly derive revenue from IP
telephony-based services.
Target key growth markets worldwide. We will continue to focus our sales,
marketing and customer service and support efforts on key growth markets for IP
telephony services. We currently maintain a global
37
<PAGE>
sales and customer service and support presence, with offices in Belgium,
Germany, Japan, the People's Republic of China, South Korea, Spain, Taiwan and
the United Kingdom. We believe that international markets represent
particularly attractive early markets for our products and services due to
rapid telecommunications deregulation and increasing demand for network
capacity. We will continue to add sales, marketing and customer service and
support resources in these regions and will respond to emerging opportunities
in these markets.
Promote strategic relationships between our customers. We will continue to
promote the formation of bilateral alliances and clearinghouse arrangements
between our customers based on the Clarent system. For example, AT&T
Corporation, Pacific Gateway Exchange and Telia Telecom have established
international IP telephony clearinghouses based on the Clarent system. We
expect other service providers in different geographic regions to continue to
establish bilateral relationships with other Clarent customers or join
additional clearinghouses. We believe these relationships will lead to
increased installations of our products in both existing and new customers'
networks.
Extend our technology leadership position. We believe we have established a
technology leadership position in the market for IP telephony solutions, and we
intend to extend this position by leveraging our distinct architecture. Our
architecture is a component-based technology that segregates the call
processing and network management functions in the Clarent system. We believe
that our architecture differentiates the Clarent system from competing vendors'
systems by enabling service providers to implement and manage new features and
services across a network with a minimum level of service disruption.
Deliver added value through customer support and services. To drive the
rapid deployment of our solutions, we will continue to assist our customers in
the installation of our IP telephony systems and provide comprehensive ongoing
technical support, training and other services. We expect to continue to build
our internal professional services organization and explore additional
relationships with potential global services partners as a means of generating
additional revenue.
38
<PAGE>
Products and Technology
The Clarent system incorporates internally-developed and third-party
technologies, including our proprietary packet handling technology. This
technology integrates all functions performed by the Clarent system in a
modular, flexible manner that enables the easy addition or alteration of system
components and features. As shown below, the Clarent system is comprised of
three distinct components:
. the Clarent Gateway;
. the Clarent Command Center; and
. a third-party relational database.
In order to implement the Clarent system, a service provider must acquire a
connection to a local central office switch owned by a local telephone company
and acquire access to the Internet or an Internet protocol network.
[Graphic depicting the architectural structure of our solution, the Clarent
System]
Clarent Gateway
The Clarent Gateway is an integrated hardware and software product that
converts voice, fax and data into packets that can be sent over Internet
protocol networks, then transmits these packets over the network. At the
destination, the Clarent Gateway converts these packets back into circuit-
switched voice, fax and data. The Clarent Gateway is connected on one side to
the traditional telephone network and on the other side to the Internet
protocol network. Each Clarent Gateway currently has the capacity to handle up
to 120 simultaneous
39
<PAGE>
calls. Typically, a service provider will deploy a number of gateways
sufficient to handle the projected call volume and for system redundancy. The
Clarent Gateway provides the following functionality:
Standard telephony interfaces. The Clarent Gateway supports many standard
telephony interfaces and signaling protocols. Available telephony interfaces
include both analog and digital. Supported signaling protocols include MFR1,
MFCR2, PRI-ISDN, Feature Group D and SS7/C7, among others.
Caller interface. Our programmable interactive voice response software
provides a voice interface for prepaid calling card applications, captures
account codes for specific calls and routes users to specific features or
options. This software also processes different call types based on the number
dialed (such as toll-free 800 numbers), the automatic number identification of
the calling party or characteristics stored as part of a user's record.
Integrated voice, fax and data. Clarent Gateways simultaneously handle
voice, fax and data transmissions through universal ports, eliminating the need
to dedicate ports to specific types of transmissions. A universal port can
handle any type of call that comes to it, either a voice, fax or data.
Conversely, a dedicated port can only handle a single type of call, either
voice or fax or data. Universal and dedicated ports each handle one call at a
time, but a universal port can handle any type of call. Universal ports are
more flexible and cost-efficient.
Compliance with major telecommunications standards. Clarent Gateways
incorporate relevant International Telecommunications Union standards,
including the H.323, G.723.1, G.729a and G.711 codecs, as well as the
proprietary AudioCodes, Ltd. NetCoder codecs, among others. We also utilize
Q.931 signaling for call setup and control between the gateways, as specified
in H.323.
Low call latency. Clarent Gateways have a measured latency, the lag between
transmission and reception of a voice message, of approximately 100
milliseconds, or ms. Even with the addition of a typical 100 ms to 150 ms of
network-induced latency, the total system latency typically experienced with
Clarent Gateways is only between 200 ms to 250 ms.
Echo cancellation. Clarent Gateways employ the G.165 standard to provide
clear, virtually echo-less voice transmission.
Clarent Command Center
The Clarent Command Center is a centralized client/server software package
that processes network management and back-office functions, including the
routing and pricing of calls, user management, gateway monitoring and billing.
A single Clarent Command Center can support more than one Clarent Gateway. The
Clarent Command Center does not have a dedicated connection to each Clarent
Gateway. Instead it communicates with Clarent Gateways over the Internet or an
Internet protocol network. By centralizing all network management and
back-office functions, networks that use the Clarent system can be configured
and modified quickly and easily. Furthermore, the Clarent Command Center is
designed to be fully redundant through the use of multiple Clarent Command
Centers to enhance network efficiency and reliability. Examples of network
management and back-office functions performed by the Clarent Command Center
include:
Dynamic routing of calls. Calls are directed to specified groups of
gateways. In the event that a specified group of gateways is unavailable for a
particular destination, the Clarent Command Center will automatically route the
call to the specified backup group of gateways for completion. Furthermore, if
there are no gateways for a particular destination, the Clarent Command Center
can always route the call through the circuit-switched network, so that call
completion can be guaranteed.
Call pricing. The Clarent Command Center supports a wide range of pricing
options that allow service providers to customize their pricing schemes to
their business needs and offer different rates for the same routes based on
individual call or user characteristics. Examples of pricing options supported
by the Clarent Command Center include time-of-day rates and drop-off rates,
which are reduced rates after the first minute of
40
<PAGE>
a call. Rates can also be varied, based on the identity of the caller, the
calling number or the called number, such as toll-free numbers.
Relational Database
The Clarent system also requires the installation of a third-party
relational database that stores operational support system data for a network
of Clarent gateways. The data stored in the database is used by the Clarent
Command Center to provide comprehensive back-office functionality. The Clarent
system is currently compatible with specific databases, including current
releases from Oracle Corporation and Microsoft Corporation. As a result,
customers using the Clarent system can develop their own customized Web
interfaces, billing systems and advanced management tools. Examples of the data
stored in the relational database include:
Billing information. Billing data is collected and stored in the relational
database and includes extensive detail on all calls made through the network.
Invoice generation and reporting programs can be developed using standard
database reporting tools.
Domain management. Service providers want to determine what calls can be
completed within their networks. The Clarent system provides service providers
with this capability to segment a network into domains, or "subnetworks" within
a larger network.
Other Clarent Products and Services
The following table provides a summary of additional Clarent products and
services:
<TABLE>
<CAPTION>
Product or Service Features
<C> <S>
Clarent Connect Provides network interconnection; real-time
account settlement; least-cost routing of
calls; balancing of calls between partners;
and connecting service providers and private
networks of companies
- -------------------------------------------------------------------------------
Clarent Clearinghouse Products Harvest, sort, group and archive billing
data from individual gateways or networks of
gateways
- -------------------------------------------------------------------------------
Clarent SS7/C7 Gateway Signaling Provides seamless connection between a
service provider's network and a Clarent
Gateway
- -------------------------------------------------------------------------------
Clarent Care Provides software upgrades and worldwide
technical support to customers seven days a
week, 24 hours a day
- -------------------------------------------------------------------------------
Clarent University Provides basic and advanced training courses
to users of Clarent technology
</TABLE>
Customers
We began commercial shipments of our products in March 1997 and, as of March
31, 1999, had already shipped Clarent Systems to approximately 100
telecommunications companies in 50 countries. We sell our products directly and
through distributors to service providers.
The following table is a list of our top 15 customers by revenue for 1998:
<TABLE>
<S> <C> <C>
AT&T Corporation Hemisphere Communications Corporation Sprint Corporation
AT&T GCSI Inc. IT&E Overseas, Inc. Star Telecom
AT&T Jens Corporation Korea Telecom International Technet International, Inc.
Bitro Telecommunications, Rapid Link Telecommunications Telecomet International Inc.
Inc.
Dacom International Inc. Singapore Telecommunications Ltd. Telia Telecom
</TABLE>
41
<PAGE>
In 1998 sales to these customers represented approximately 70% of our
revenues. Entities affiliated with AT&T Corporation accounted for 36% and
Technet International accounted for 12% of net revenue in 1998. Entities
affiliated with AT&T Corporation accounted for 25% and Technet International
accounted for 32% of net revenue in the first quarter of 1999.
Customer Case Studies
The following case studies illustrate how certain of our customers have
deployed our products.
AT&T Jens Corporation. AT&T Jens Corporation, a subsidiary of AT&T
Corporation, offered its customers IP telephony services using the Clarent
system in September 1997. Its first service offering, AT&T @Phone, is a prepaid
and postpaid calling card service that initially allowed consumers in Japan to
call 57 other countries around the world. By the fall of 1998, AT&T Jens
Corporation had expanded this service to provide voice and fax service to 224
countries. Using the Clarent system, AT&T Jens Corporation has been able to
provide international long distance telephone services to customers in Japan, a
market in which it had previously not been able to provide service using
circuit-switched technology. We believe that the success of AT&T @Phone stems
from its ability to offer a lower priced international long distance
alternative compared to existing circuit-switched services.
Rapid Link Telecommunications. Rapid Link Telecommunications, an
international telecommunications service provider based in Atlanta, Georgia,
launched commercial long distance service using the Clarent system in the fall
of 1998. The initial service launched was a prepaid long distance calling card
service between Asia, Europe and the United States. Rapid Link
Telecommunications is expanding its IP telephony network by setting up
bilateral partnerships with major international telecom carriers offering IP
telephony services in their geographic regions. The first partnership was
signed with Korea Telecom International in November 1998.
Telia Telecom. Telia Telecom, the leading telecommunications service
provider in Scandinavia and the incumbent telephone company in Sweden, began
commercial IP telephony trials in the summer of 1998 using the Clarent system.
After testing our products against those of seven other vendors, Telia Telecom
selected the Clarent system, based on its differentiating features. These
differentiating features included voice quality and the flexibility of the
Clarent Command Center. Telia launched its service in February 1999. At that
same time, Telia Telecom also launched Europe's first IP telephony
clearinghouse, using the Clarent system, for international IP telephony calls.
Since then, Telia Telecom has recruited more than nine service providers to
join the clearinghouse.
Sales, Marketing and Customer Service and Support
Sales
We currently have a global sales organization with sales and support offices
in Belgium, Germany, Japan, the People's Republic of China, South Korea, Spain,
Taiwan and the United Kingdom. Our sales force sells our products to services
providers both directly and through third-party distributors. Direct sales
accounted for 82% of our net revenue for the year ended December 31, 1998 and
85% for the quarter ended March 31, 1999. In addition, we have 11 third party
distributors in five countries. Our arrangements with these distributors
provide discount levels, target geographic sales regions and other material
terms.
Marketing
Our marketing organization develops strategies and implements programs to
support the sale of our products. Our current marketing efforts include a
number of programs designed to increase industry visibility, including
press/analyst tours, trade shows and events, speaking engagements and ongoing
interaction with analysts and the media as well as targeted marketing programs.
Additional programs include our customer summit, which provides the opportunity
for our customers to meet each other and learn more about the Clarent system.
We also undertake joint marketing programs with our clearinghouse customers to
help them build their customer base.
42
<PAGE>
Customer Service and Support
We believe that customer service and support are critical to maintaining
existing customer relationships and developing relationships with new
customers. Our professional services group performs the following functions:
. pre-sales support;
. product installation and customization;
. technical support and consulting services;
. customer training; and
. product maintenance.
In addition to our sales and support offices in North America, Asia and
Europe, we have established a support center in the United States that provides
support seven days a week, 24 hours a day. We also currently partner with
Equant Integration Services, Inc., a supplier of international network support
services, to provide global call center and technical support to our customers.
Competition
We compete in a new, rapidly evolving and highly competitive and fragmented
market. We expect competition to intensify in the future. We believe that the
main competitive factors in our market are product quality, features, cost and
customer relationships. We believe a critical component to success in this
market is the ability to establish and maintain strong customer relationships
with a wide variety of international service providers and to facilitate
relationships between those service providers to increase the geographic
coverage of their services.
Our current principal competitors include large networking equipment
manufacturers, such as 3Com Corporation and Cisco Systems, Inc., large
telecommunications equipment manufacturers, such as Lucent Technologies Inc.
and Nortel Networks Corporation, and IP telephony technology companies, such as
VocalTec Communications, Ltd. We also expect new competitors to emerge. Many of
our competitors are substantially larger than we are and have significantly
greater financial, sales and marketing, technical, manufacturing and other
resources and more established distribution channels and stronger relationships
with service providers. These competitors may be able to respond more rapidly
to new or emerging technologies and changes in customer requirements or devote
greater resources to the development, promotion and sale of their products than
we can. Furthermore, we believe some of our competitors may offer aggressive
sales terms, including financing alternatives, which we might not be able to
match. These competitors may enter our existing or future markets with
solutions that may be less expensive, provide higher performance or additional
features or be introduced earlier than our solutions. Given the market
opportunity, we also expect that other companies may enter our market with
better products and technologies. If any technology that is competing with ours
is more reliable, faster, less expensive or has other advantages over our
technology, then the demand for our products and services could decrease.
We expect our competitors to continue to improve the performance of their
current products and introduce new products or new technologies. Successful new
product introductions or enhancements by our competitors could reduce the sales
or market acceptance of our products and services, perpetuate intense price
competition or make our products obsolete. To be competitive, we must continue
to invest significant resources in research and development, sales and
marketing and customer support. We cannot be sure that we will have sufficient
resources to make these investments or that we will be able to make the
technological advances necessary to be competitive.
Increased competition is likely to result in price reductions, reduced gross
margins and loss of market share. Our failure to compete successfully against
current or future competitors could seriously harm our business, financial
condition and results of operations.
43
<PAGE>
Research and Development
To maintain our technology leadership position, we focus our research and
development efforts on improving the functionality and performance of our
existing products and developing new products. We obtain extensive product
development input from our customers and monitor our customers' needs and
changes in the marketplace. We are currently working on key areas such as ways
to improve the transmission of packets as well as the interoperability of our
products with those of other vendors. In addition we are developing
improvements to network management and enhanced end-user features.
We believe our success will depend, in part, on our ability to develop and
introduce new products and enhancements to our existing products. In the past
we have made, and intend to continue to make, significant investments in
research and development. Our engineering, research and development
expenditures totaled approximately $136,000 in 1996, $1.0 million in 1997 and
$3.4 million in 1998.
We perform our research and product development activities at our principal
offices in Redwood City, California. As of March 31, 1999, we had 32 employees
in our research and development department. If we are unable to develop new
products or enhancements to existing products on a timely basis, or if the new
products or enhancements fail to achieve market acceptance, our business,
financial condition and results of operations could be seriously harmed.
Manufacturing and Assembly
Our manufacturing operations consist of materials planning and procurement,
final assembly, product assurance testing, quality control and packaging and
shipping. We assemble and test our products at our facilities in Redwood City,
California. Based on volume, geographic or customer requirements, we may begin
outsourcing some assembly and test functions. We have developed an assembly
process that enables us to configure our products to be adapted to different
customer specifications at the final assembly stage. This flexibility is
designed to reduce both our assembly cycle time and our need to maintain a
large inventory of finished goods. We believe that the efficiency of our
assembly process to date is largely due to our product architecture and our
commitment to assembly process design. However, this assembly process involves
some risks, including the potential absence of adequate capacity and reduced
control over delivery schedules, manufacturing yields, quality and costs.
We test our products both during and after the assembly process using
internally-developed product assurance testing procedures. Although we
generally use standard components for our products and try to maintain
alternative sources of supply, some key components are purchased from sole or
single source suppliers for which alternative sources are not currently
available. We may experience supply problems in the future from any of our
suppliers, which could delay our ability to assemble and ship our products and
seriously harm our business, financial condition and results of operations.
Patents and Intellectual Property
We rely on a combination of copyright, trademark and trade secret laws and
restrictions on disclosure to protect our intellectual property rights. We
currently do not have any United States patents issued for any of our
technology, although we do have four United States applications, one German
application and one Japanese application on file.
We also enter into confidentiality and proprietary information and
inventions agreements with our employees and consultants, and control access to
and distribution of our software, documentation and other proprietary
information. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use our
products or technology. Monitoring unauthorized use of our products is
difficult, and we cannot be certain that the steps we have taken will prevent
misappropriation of our technology. The laws of some foreign countries do not
protect our proprietary rights to as great an extent as the laws of the United
States, and many United States companies have encountered substantial
infringement problems in these countries, some of which are countries in which
we have sold and continue to sell products.
44
<PAGE>
There is a risk that our means of protecting our proprietary rights may be
inadequate. For example, our competitors may independently develop similar
technology, duplicate our products or design around our patents, when or if
issued, or our other intellectual property rights. If we fail to adequately
protect our intellectual property, it would be easier for our competitors to
sell competing products.
From time to time, third parties may assert exclusive patent, copyright,
trademark and other intellectual property rights to technologies that are
important to us. In addition, third parties may assert claims or initiate
litigation against us or our manufacturers, suppliers or customers with respect
to existing or future products, trademarks or other proprietary rights. We have
not conducted an exhaustive search of patents issued to other companies or
organizations. Because of the number of patents issued and patent applications
filed relating to the transmission of voice over packet-switched networks, we
believe there is a risk that current and potential customers and other third
parties have filed, or in the future will file applications for, or have
received or in the future will receive, patents or obtain additional
intellectual property rights relating to materials or processes that we use or
propose to use. If these third-party patents or other proprietary rights have
been or are issued, or are otherwise asserted by third parties, the holders of
these patents or other proprietary rights may bring infringement claims against
us. Furthermore, former employers of our current and future employees may
assert that our employees have improperly disclosed confidential or proprietary
information to us. We may in the future initiate claims or litigation against
third parties for infringement of our proprietary rights or to determine the
scope and validity of our proprietary rights and the rights of competitors. Any
of these claims, with or without merit, may be time-consuming, result in costly
litigation and diversion of technical and management personnel or require us to
develop non-infringing technology. Alternatively, others may claim that we
infringe their intellectual property rights, and we may be required to obtain a
license or royalty agreement under the intellectual property rights of those
parties claiming the infringement. In addition, an adverse ruling could result
in substantial, including treble damages or the issuance of an injunction
against us requiring that we cease development and withdraw some products from
the marketplace. Limitations on our ability to market our products and delays
and costs associated with monetary damages and redesigns in compliance with an
adverse judgment or settlement could harm our business, financial condition and
results of operations.
Employees
As of March 31, 1999, we had a total of approximately 155 employees, of
which approximately 32 were in research and development, 82 were in sales,
marketing and customer support and 41 were in finance, administration and
operations. Our future performance depends, in significant part, upon our
ability to attract new personnel and retain existing personnel in key areas
including engineering, technical support and sales. Competition for this
personnel is intense, especially in the San Francisco Bay Area where we are
headquartered, and we cannot be sure that we will be successful in attracting
or retaining the personnel in the future. None of our employees is subject to a
collective bargaining agreement. We consider our relationship with our
employees to be satisfactory.
Facilities
We occupy approximately 39,000 square feet of space in Redwood City,
California. The term of the lease for 14,000 square feet of this facility
expires in December 1999, and the initial term for the remaining 25,000 square
feet of this facility expires as early as December 2003. In addition to our
principal office space in Redwood City, California, we also lease sales and
support offices in Illinois and internationally in Belgium, Germany, Japan, the
People's Republic of China, South Korea, Spain, Taiwan and the United Kingdom.
We believe that existing facilities are adequate for our needs through calendar
year 1999 and are currently in the process of locating additional space to meet
our expected requirements thereafter. If we require additional space, we
believe that we will be able to secure such space on commercially reasonable
terms without undue operational disruption.
Legal Proceedings
We are not currently a party to any material legal proceedings.
45
<PAGE>
MANAGEMENT
Executive Officers and Directors
Our executive officers and directors and their ages as of March 31, 1999,
are as follows:
<TABLE>
<CAPTION>
Name Age Position
- ---- --- --------
<S> <C> <C>
Jerry Shaw-Yau Chang.............. 40 Chief Executive Officer, President and
Director
Richard J. Heaps.................. 46 Chief Operating Officer, Chief Financial
Officer, General Counsel and Secretary
Michael F. Vargo.................. 38 Chief Technology Officer and Director
Mark E. McIlvane.................. 45 Vice President, Worldwide Sales
Heidi H. Bersin................... 43 Vice President, Marketing
Mong Hong (Mahan) Wu.............. 39 Vice President and General Manager, Asia
Pacific
Wen Chang Ko(1)(2)................ 49 Director
Syaru Shirley Lin(1)(2)........... 30 Director
</TABLE>
- ---------------------
(1) Member of the audit committee
(2) Member of the compensation committee
Mr. Chang, one of our co-founders, has served as our President and Chief
Executive Officer and as a director since our inception in July 1996. From
March 1996 through June 1996, Mr. Chang worked as the system architect for
Relations Software, a developer of network and applications monitoring
software. From September 1994 through February 1996, Mr. Chang served as a
Senior Software Engineer at OnLive! Technologies, Inc., a developer of on-line
communications technology. Prior to September 1994, Mr. Chang spent seven years
at Centura Software Corporation, formerly Gupta Corporation, a supplier of
client/server application development and deployment technology, as a manager
and developer of Centura Software Corporation's client/server database
solution. Mr. Chang holds a B.S. degree in control engineering from National
Chiao-Tung University and an M.S. degree in computer science from Pennsylvania
State University. Mr. Chang's brother-in-law, Shoon Shen Tony Wang, serves as
our Controller of the Asia Pacific region.
Mr. Heaps has served as our Chief Operating Officer, Chief Financial
Officer, General Counsel and Secretary since September 1998. From July 1997
through August 1998, Mr. Heaps worked as an independent consultant and headed a
private consulting firm and law practice serving Silicon Valley-based high-
technology companies. From October 1987 through July 1997, Mr. Heaps served in
various management positions at Centura, most recently serving as Senior Vice
President of Business Development and General Counsel. Mr. Heaps is a member of
the State Bar of California and a member of the board of directors of the
Children's Discovery Museum of San Jose. Mr. Heaps holds a B.A. degree in
economics and mathematics from Yale University and J.D. and M.B.A. degrees from
Stanford University.
Mr. Vargo, one of our co-founders, has served as our Chief Technology
Officer and as a director since our inception in July 1996. From April 1996
through June 1996, Mr. Vargo served as a Senior Software Engineer at Oracle
Corporation, a leading provider of relational databases. From January 1995
through April 1996, Mr. Vargo served as a Senior Software Engineer at OnLive!
Technologies, Inc. From January 1992 through December 1994, Mr. Vargo served as
a Senior Software Engineer at Centigram Corporation, a voice messaging
equipment manufacturer. Prior to Centigram Corporation, Mr. Vargo spent seven
years at Pacific Bell. Mr. Vargo holds a B.S. degree in electrical engineering
and an M.E. degree in electrical engineering from California State Polytechnic
University at Pomona.
Mr. McIlvane has served as our Vice President, Worldwide Sales since July
1997. From January 1993 through June 1997, Mr. McIlvane served as Vice
President of Sales and Marketing for Comverse Technology, Inc., a manufacturer
of high-performance voice processing computers for network-based
telecommunications
46
<PAGE>
service providers. Prior to Comverse Technology, Inc., Mr. McIlvane served in
various senior positions at Applied Communications, Inc., a wholly owned
subsidiary of U.S. WEST, Inc. and Bell & Howell Corporation. Mr. McIlvane holds
a B.S. degree in business and economics from MacMurray College.
Ms. Bersin has served as our Vice President, Marketing since February 1997.
From 1983 through January 1997, Ms. Bersin served in various management
positions at Pacific Bell and Pacific Bell Information Services, including
Director of Pacific Bell Information Services from 1986 to 1997. Ms. Bersin
holds a B.A. degree from Stanford University and an M.B.A. degree from Yale
University.
Mr. Wu has served as our Vice President and General Manager of the Asia
Pacific region since April 1997. From January 1996 through March 1997, Mr. Wu
served as the Regional Sales Manager of Computer Sales Operations for Hewlett-
Packard Company, a measurement and computer equipment manufacturer, in Asia,
except Japan, and Australia after Hewlett-Packard Company acquired Convex
Computer Corporation, a supercomputer manufacturer, where Mr. Wu served as
General Manager of the Asia Pacific region, except Japan, from January 1994
through December 1995. Mr. Wu holds a B.S. degree in electrical engineering and
an M.B.A. degree from National Chiao-Tung University.
Mr. Ko has served as a director since June 1997. Since 1990, Mr. Ko has
served as Chairman of the WK Technology Funds and also served as Chairman of
the Taipei Venture Capital Association from 1992 to 1995. From 1977 to 1990,
Mr. Ko served in various management positions at Hewlett-Packard Taiwan Ltd.,
most recently serving as Chairman and President from 1979 to 1990. From 1974 to
1977, Mr. Ko served in various positions at IBM in the United States, most
recently serving as Research and Development Project Manager from 1975 to 1977.
Mr. Ko holds a B.S. degree in electrical engineering from National Cheng Kung
University and an M.S. degree in system science from Michigan State University.
Ms. Lin has served as a director since July 1998. Since 1993, Ms. Lin has
been employed by Goldman Sachs (Asia) Limited. She currently serves as an
executive director in the Principal Investment Area, which manages several
principal investment funds. From 1990 to 1993, Ms. Lin worked for Morgan
Stanley & Co. in New York and Hong Kong. Ms. Lin is also a non-executive
director of Hung Hing Printing Group Limited, a publicly listed company on the
Hong Kong Stock Exchange. Ms. Lin holds a B.A. degree from Harvard University.
Executive officers are appointed by the board of directors and serve until
their successors are qualified and appointed. There are no family relationships
among any of our directors or executive officers.
Board Composition
Upon the closing of this offering, the number of directors will be set at
five. In accordance with the terms of our amended and restated certificate of
incorporation, the terms of the office of the board of directors will be
divided into three classes, with each class holding office for staggered three
year terms: Class I directors' terms will expire at the annual meeting of
stockholders to be held in 2000, Class II directors' terms will expire at the
annual meeting of stockholders to be held in 2001, and Class III directors'
terms will expire at the annual meeting of stockholders to be held in 2002. The
Class I director is Ms. Lin, and there is one vacancy in this class of
directors. The Class II directors are Mr. Ko and Mr. Vargo, and the Class III
director is Mr. Chang.
At each annual meeting of stockholders after the initial classification, the
successors to directors whose term will then expire will be elected to serve
from the time of election and qualification until the third annual meeting
following election. In addition, our amended and restated certificate of
incorporation provides that the authorized number of directors may be changed
only by resolution of the board of directors. Any additional directorships
resulting from an increase in the number of directors will be distributed among
the three classes so that, as nearly as possible, each class will consist of
one-third of the directors. This classification of the board of directors may
have the effect of delaying or preventing changes in control. Although our
directors may be removed for cause by the affirmative vote of the holders of a
majority of the common stock, our
47
<PAGE>
amended and restated certificate of incorporation provides that holders of two-
thirds of the common stock must vote to approve the removal of directors
without cause.
Board Committees
The compensation committee consists of Mr. Ko and Ms. Lin. The compensation
committee:
. reviews and approves the compensation and benefits for our executive
officers and grants stock options under our equity incentive plans; and
. makes recommendations to the board of directors regarding compensation
matters.
The audit committee consists of Mr. Ko and Ms. Lin. 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 professional
services provided by our independent auditors;
. reviews the independence of the independent auditors; and
. reviews and evaluates our internal control functions.
Compensation Committee Interlocks and Insider Participation
The members of our compensation committee are Mr. Ko and Ms. Lin. None of
the members of the compensation committee of the board of directors is
currently or has been, at any time since our formation, one of our officers or
employees.
On February 24, 1998, we issued secured convertible subordinated promissory
notes with an aggregate principal amount of $2,600,000 and warrants to purchase
an aggregate of 59,266 shares of Series C preferred stock at an exercise price
of $5.59, in a private placement debt and equity financing with
. WK Technology Fund and entities affiliated with WK Technology Fund,
. Alice Wang, the spouse of Mr. Chang, one of our co-founders and chief
executive officer,
. Daniel Warmenhoven, one of our directors, who has since resigned from the
board of directors, and
. one unaffiliated investor.
In connection with this financing we issued notes evidencing an aggregate
principal amount of $2,000,000 and warrants to purchase an aggregate of 45,590
shares of Series C preferred stock to entities affiliated with WK Technology
Fund. $2,050,000 of the promissory notes were converted into shares of Series C
preferred stock on June 11, 1998. The warrants expire, if not earlier
exercised, on the closing of this offering.
On June 11, 1998 and December 7, 1998, we issued an aggregate of 2,644,241
shares of Series C preferred stock, at a per share price of $6.58, in a private
placement equity financing with entities affiliated with WK Technology Fund and
several unaffiliated investors. In connection with this financing we issued an
aggregate of 312,194 shares in connection with the conversion of promissory
notes by entities affiliated with WK Technology Fund. We also entered into a
voting agreement with some of our stockholders in connection with the sale of
our Series C preferred stock. In connection with the voting agreement, we
issued warrants to purchase 101,000 shares of our Series C preferred stock at
an exercise price of $6.58 per share to each of:
. WK Technology Fund III; and
. The Goldman Sachs Group, L.P., the predecessor to The Goldman Sachs
Group, Inc., and affiliated investment partnerships, which are affiliated
with Goldman Sachs (Asia) Limited. Ms. Lin, one of our directors, is an
executive director of Goldman Sachs (Asia) Limited.
Each warrant will not be exercised and will expire upon the completion of this
offering. Neither warrant is exercisable at this time.
48
<PAGE>
Director Compensation
Directors who are also executive officers do not receive any additional
compensation for serving as members of the board of directors or any committee
of the board of directors. Non-employee directors are expected to receive an
initial option to purchase 5,000 shares of common stock and an annual option to
purchase 2,000 shares of common stock under our 1999 non-employee directors'
stock option plan.
Executive Compensation
The following table sets forth information for the year ended December 31,
1998, regarding the compensation of our chief executive officer and each of our
four most highly-compensated executive officers whose salary and bonus for the
year ended December 31, 1998 were in excess of $100,000 on an annualized basis:
Summary Compensation Table
<TABLE>
<CAPTION>
Long-Term
Annual Compensation Compensation Awards
------------------------------------- ---------------------
Name and Principal Other Annual Securities Underlying All Other
Position Salary($)(1) Bonus($) Compensation(2) Options(#) Compensation($)(3)
- ------------------ ------------ -------- --------------- --------------------- ------------------
<S> <C> <C> <C> <C> <C>
Jerry Shaw-Yau Chang
President and Chief
Executive Officer..... $110,000 -- -- -- --
Richard J. Heaps(4)
Chief Operating
Officer, Chief
Financial Officer,
General Counsel and
Secretary............. 67,500 $ 6,160 -- 400,000 --
Michael F. Vargo
Chief Technology
Officer............... 131,875 7,500 -- -- --
Mark E. McIlvane
Vice President,
Worldwide Sales....... 202,717 20,000 $7,800 160,000 $2,000
Mong Hong (Mahan) Wu
Vice President and
General Manager, Asia
Pacific............... 131,640 26,145 -- -- --
</TABLE>
- ---------------------
(1) Mr. McIlvane's salary consists of a salary of $150,000 and sales
commissions of $52,717.
(2) Consists of reimbursement of automobile expenses.
(3) Consists of life insurance premiums.
(4) Mr. Heaps started his employment with us in September 1998. Mr. Heaps would
have earned a salary of $180,000 if he had been employed by us for the
entire year.
49
<PAGE>
Option Grants in Last Fiscal Year
The following table sets forth certain information relating to stock options
awarded to each of the named executive officers during the fiscal year ended
December 31, 1998. All such options were awarded under the 1999 amended and
restated equity incentive plan.
<TABLE>
<CAPTION>
Potential Realizable
Value at Assumed
Annual Rates of Stock
Price Appreciation for
Individual Grants Stock Option Term(2)
------------------------------------------ ----------------------
Number of
Securities % of Total
Underlying Options Exercise
Options Granted Price Per Expiration
Name Granted in 1998(1) Share Date 5% 10%
- ---- ---------- ---------- --------- ---------- ---------- -----------
<S> <C> <C> <C> <C> <C> <C>
Jerry Shaw-Yau Chang.... -- -- -- -- -- --
Richard J. Heaps........ 400,000 13.2% $0.75 08/27/08 $9,473,368 $15,262,455
Michael F. Vargo........ -- -- -- -- -- --
Mark E. McIlvane........ 160,000 5.3 0.329 07/20/08 3,856,707 6,172,342
Mong Hong (Mahan) Wu.... -- -- -- -- -- --
</TABLE>
- ---------------------
(1) The total number of options granted to our employees in fiscal year 1998
was 3,030,896.
(2) In order to comply with the rules of the Securities and Exchange
Commission, we are including the gains or "option spreads" that would exist
for the respective options we granted to the named executive officers. We
calculate these gains based upon the initial public offering price of
$15.00 per share appreciating at 5% and 10% compounded annually from the
date of the option grant until the termination date of the option. These
gains do not represent our estimate or projection of the future common
stock price.
50
<PAGE>
Aggregate Option Exercises in Last Fiscal Year and Fiscal Year-end Option
Values
The following table sets forth the number and value of securities underlying
unexercised options held by the named executive officers at December 31, 1998:
<TABLE>
<CAPTION>
Number of Securities
Underlying Unexercised Value of Unexercised
Options at In-the-Money Options at
Shares December 31, 1998 December 31, 1998(1)
Acquired Value ------------------------- -------------------------
Name on Exercise Realized(1) Exercisable Unexercisable Exercisable Unexercisable
- ---- ----------- ----------- ----------- ------------- ----------- -------------
<S> <C> <C> <C> <C> <C> <C>
Jerry Shaw-Yau Chang.... -- -- -- -- -- --
Richard J. Heaps........ -- -- -- 400,000 -- $5,700,000
Michael F. Vargo........ -- -- -- -- -- --
Mark E. McIlvane........ -- -- 324,882 175,118 $4,846,790 2,589,820
Mong Hong (Mahan) Wu.... 221,664 $3,319,418 11,668 326,668 174,728 4,891,853
</TABLE>
- ---------------------
(1) The amount set forth represents the difference between the fair market
value of the underlying common stock using the initial public offering
price of $15.00 per share and the exercise price of the option, multiplied
by the number of shares underlying the option.
Employment Agreements
In June 1997, we entered into an employment agreement with Mark E. McIlvane,
Vice President, Worldwide Sales. The agreement was amended on June 1, 1998. The
amended agreement provides for an annual base salary of $150,000. Mr. McIlvane
is also eligible to receive sales commissions. The sales commissions are based
upon the sales plan that sets out the quota attainment standards and the
associated percentage of revenue to be paid as sales commissions. The sales
plan's objectives include attaining revenue that exceeds our business plan.
Under the sales plan's provisions, commissions are paid monthly based on
product and service revenue. A higher commission percentage can be earned if
revenue exceeds quota targets. There is no limit to the amount of commission
that can be earned. The agreement also provides Mr. McIlvane with incentive
stock options to purchase an aggregate of 500,000 shares of common stock. Of
those options, 40,000 shares vested immediately upon the signing of the
amendment to the employment agreement, 370,000 shares are subject to time-based
vesting over a four-year period and 90,000 shares are subject to certain
milestone-based vesting, but must vest by August 1, 2004. The agreement
provides that Mr. McIlvane is employed "at-will," and the employment
relationship may be terminated for any reason at any time, but if we terminate
Mr. McIlvane's employment without cause, we must pay Mr. McIlvane a severance
payment equal to 100% of his annual salary.
In August 1998, we entered into an employment agreement with Richard J.
Heaps, Chief Operating Officer, Chief Financial Officer, General Counsel and
Secretary. The agreement provides for an annual base salary of $180,000. Mr.
Heaps is also eligible to receive a $40,000 annual performance bonus based on
quarterly goals and objectives agreed upon by him and the chief executive
officer. The amount of the bonus will be reviewed and reset in each subsequent
year. The agreement also provides Mr. Heaps with an incentive stock option to
purchase 400,000 shares of common stock, which is subject to time-based vesting
over a four-year period. In the event Mr. Heaps is terminated without cause or
constructively terminated within 18 months of any change of control, between
50% to 100% of the outstanding options then held by Mr. Heaps will accelerate
and vest, depending on how long Mr. Heaps had been employed with us prior to
termination. "Constructive termination" is defined in the agreement as a
voluntary termination of employment after his duties or benefits are materially
reduced. The agreement provides that Mr. Heaps is employed "at-will," and the
employment relationship may be terminated for any reason at any time, but if we
terminate Mr. Heaps' employment without cause or if Mr. Heaps voluntarily
terminates his employment after his duties or benefits are materially reduced,
we must pay Mr. Heaps a severance payment equal to up to 100% of his annual
salary, depending on the amount of time Mr. Heaps has been employed by us.
51
<PAGE>
Stock Plans
1999 Amended and Restated Equity Incentive Plan. Our 1999 amended and
restated equity incentive plan was adopted in October 1996, amended in May
1997, May 1998 and October 1998, and amended and restated by the board of
directors in April 1999, subject to stockholder approval. An aggregate of
11,358,170 shares of common stock currently are authorized for issuance under
the equity incentive plan. However, on January 31 of 2000, 2001, 2002, 2003 and
2004, respectively, the aggregate number of shares of common stock that are
available for issuance under the equity incentive plan will automatically be
increased by that number of shares of common stock equal to 2.5% of our
outstanding shares of common stock on that date or a lesser amount as
determined by the board of directors for each year.
The equity incentive plan provides for the grant of incentive stock options,
as defined under the amended Internal Revenue Code of 1986, to employees,
including officers and employee directors, and non-statutory stock options,
restricted stock purchase awards, stock bonuses and stock appreciation rights
to our and our affiliates' employees, including officers and employee
directors, directors and consultants. The equity incentive plan is administered
by the compensation committee of our board of directors which determines the
recipients and types of awards to be granted, including the exercise price,
number of shares subject to the award and the exercisability thereof.
The terms of options granted under the equity incentive plan may not exceed
ten years. Our compensation committee determines the exercise price of options
granted under the equity incentive plan. However, the exercise price for an
incentive stock option and a non-statutory stock option cannot be less than
100% of the fair market value of the common stock on the date of the option
grant. Options granted under the equity incentive plan vest at the rate
specified in the option agreement. Generally, the right to exercise 25% of the
total number of shares granted vests 12 months after the date of option grant,
with the remainder vesting monthly over three years thereafter, such that an
option is fully vested on the fourth anniversary of the date of the option
grant. Generally, the optionee may not transfer a stock option other than by
will or the laws of descent or distribution. However, an optionee may designate
a beneficiary who may exercise the option in the event of the optionee's death
or disability. Unless the terms of an optionee's option agreement provide for
an earlier termination, in the event of the optionee's cessation of his or her
relationship with us due to death or disability, the optionee's beneficiary may
exercise any vested options up to 18 months after death and 12 months after
disability after the date of such cessation. If the optionee's relationship
with us ceases for any reason other than the optionee's death or disability,
the optionee may exercise any vested options during a minimum of 30 days
following such cessation. Generally, the same terms and conditions that govern
the vesting and exercise of non-statutory options shall apply to stock
appreciation rights, and stock appreciation rights shall generally be subject
to the same terms and conditions applicable to the particular option grant to
which these rights pertain.
No incentive stock option, and, prior to our stock being publicly traded, no
non-statutory stock option, may be granted to any person who, at the time of
the grant, owns, or is deemed to own, stock possessing more than 10% of our
total combined voting power or that of any of our affiliates, unless the option
exercise price is at least 110% of the fair market value of the stock subject
to the option on the date of grant and the term of the option does not exceed
five years from the date of the grant. In addition, the aggregate fair market
value, determined at the time of grant, of the shares of common stock with
respect to which incentive stock options are exercisable for the first time by
an optionee during any calendar year, under the equity incentive plan and all
of our other stock plans and those of our affiliates, may not exceed $100,000.
Pursuant to Section 162(m) of the Internal Revenue Code, no person may be
granted options under the equity incentive plan covering more than 360,000
shares of common stock in any calendar year.
Shares subject to stock awards that have expired or otherwise terminated
without having been exercised in full again become available for the grant of
awards under the equity incentive plan. Our compensation committee has the
authority to reprice outstanding options or to offer optionees the opportunity
to replace outstanding options with new options for the same or a different
number of shares. Both the original and new
52
<PAGE>
options will count toward the Section 162(m) limitations set forth above.
Shares subject to stock appreciation rights exercised in accordance with the
incentive plan will now be available for subsequent issuance under the
incentive plan.
If there is any sale of all or substantially all of our assets, any merger
or any consolidation in which we are not the surviving corporation, or a like
transaction involving us, all outstanding awards under the equity incentive
plan either will be assumed or substituted for by any surviving entity. If the
surviving entity determines not to assume or substitute for such awards, the
vesting of stock awards held by persons still serving us or our affiliate will
be accelerated as to all of the shares and the awards will terminate if not
exercised prior to the sale of assets, merger or consolidation.
As of March 31, 1999, 1,426,328 shares of common stock had been issued upon
the exercise of options granted under the equity incentive plan, options to
purchase 7,631,842 shares of common stock were outstanding and as of April 8,
1999, 2,300,000 shares remained available for future grant. The equity
incentive plan will terminate on April 7, 2009, unless terminated by our board
of directors before then. As of April 8, 1999, no stock bonus, stock
appreciation right or restricted stock has been granted under the equity
incentive plan.
1999 Non-Employee Directors' Stock Option Plan. In April 1999, our board of
directors adopted the 1999 non-employee directors' stock option plan, subject
to stockholder approval, to provide for the automatic grant of options to
purchase shares of common stock to our non-employee directors who are not any
of our affiliates' employees or consultants. Our board of directors administers
the directors' plan, but may delegate the administration to a committee.
The aggregate number of shares of common stock that may be issued under
options granted under the directors' plan is 300,000 shares. Under the terms of
the directors' plan, as of the initial public offering, each non-employee
director, and each person who is thereafter elected or appointed for the first
time to be a non- employee director automatically shall, upon the date of his
or her initial election or appointment to be a non-employee director by our
board of directors or stockholders, be granted an option to purchase 5,000
shares of common stock. In addition, on the day of each regular meeting of the
board of directors, commencing with the third regular meeting subsequent to the
date of each non-employee directors' initial grant under the director's plan,
each person who is then serving as a non-employee director automatically shall
be granted an option to purchase 2,000 shares of common stock.
The exercise price of the options granted under the directors' plan will be
equal to the fair market value of the common stock on the date of grant. No
option granted under the directors' plan may be exercised after the expiration
of ten years from the date it was granted. Options granted under the directors'
plan vest and become exercisable immediately. Options granted under the
directors' plan generally are non-transferable. However, an optionee may
designate a beneficiary who may exercise the option following the optionee's
death. An optionee whose service relationship with us or any of our affiliates,
whether as one of our non-employee directors or subsequently as our affiliates'
employee, director or consultant, ceases for any reason, the vested option may
be exercised as provided in the option agreement, which is three months
generally, 12 months in the event of optionee's disability and 18 months in the
event of optionee's death.
1999 Employee Stock Purchase Plan. In April 1999, our board of directors
approved the 1999 employee stock purchase plan, subject to stockholder
approval, covering an aggregate of 600,000 shares of common stock. The purchase
plan is intended to qualify as an employee stock purchase plan within the
meaning of Section 423 of the Internal Revenue Code. Under the purchase plan,
the board of directors or a committee may authorize participation by eligible
employees, including officers, in periodic offerings following the adoption of
the purchase plan. The offering period for any offering will be no more than 27
months.
Under the purchase plan, employees are eligible to participate if they are
employed by us or one of our affiliates designated by our board of directors
and are employed at least 20 hours per week and at least five
53
<PAGE>
months per year. Employees who participate in an offering will have the right
to purchase up to the number of shares of common stock purchasable with a
percentage designated by our board of directors, up to 10%, of an employee's
earnings withheld pursuant to the purchase plan and applied, on specified dates
determined by the board of directors, to the purchase of shares of common
stock. The price of common stock purchased under the purchase plan will be
equal to 85% of the lower of the fair market value of the common stock on the
commencement date of each offering period or the relevant purchase date.
Employees may end their participation in the offering at any time during the
offering period, and participation ends automatically on termination of
employment with us.
In the event of changes in control, our board of directors has discretion to
provide that each right to purchase common stock will be assumed or an
equivalent right will be substituted by the successor corporation, or that such
rights may continue in full force and effect, or that all sums collected by
payroll deductions will be applied to purchase stock immediately prior to the
change in control. The purchase plan will terminate at the board of directors'
discretion or when all of the shares reserved for issuance under the purchase
plan have been issued.
As of April 8, 1999, no employees have rights to purchase shares of common
stock under the purchase plan.
Description of 401(k) Plan
401(k) Plan. We maintain the Clarent Corporation 401(k) Retirement Plan for
eligible employees. In order to be a participant in the 401(k) plan, an
employee must have attained age 18. A participant may contribute up to 25% of
his or her total annual compensation to the 401(k) plan, or up to a statutorily
prescribed annual limit, if less. The annual limit for 1999 is $10,000. Each
participant is fully vested in his or her deferred salary contributions.
Participant contributions are held and invested by the 401(k) plan's trustee.
We may make discretionary contributions as a percentage of participant
contributions, subject to established limits. To date, we have not made any
contributions to the 401(k) plan on behalf of the participants. The 401(k) plan
is intended to qualify under Section 401 of the Internal Revenue Code, so that
contributions by us or our employees to the 401(k) plan, and income earned on
the 401(k) plan contributions, are not taxable to employees until withdrawn
from the 401(k) plan, and so that our contributions, if any, will be deductible
by us when made.
Limitation of Liability and Indemnification Matters
Our amended and restated certificate of incorporation limits the liability
of directors to the maximum extent permitted by Delaware law. Delaware law
provides that a director of a corporation will not be personally liable for
monetary damages for breach of the fiduciary duties as a director except for
liability
. for any breach of the director's duty of loyalty to us or to our
stockholders,
. for acts or omissions not in good faith or that involve intentional
misconduct or a knowing violation of law,
. for unlawful payments of dividends or unlawful stock repurchases or
redemptions as provided in Section 174 of the Delaware General
Corporation Law or
. for any transaction from which the director derives an improper personal
benefit.
Our bylaws provide that we shall indemnify our directors and executive
officers and may indemnify our officers, employees and other agents to the full
extent permitted by law. We believe that indemnification under our bylaws
covers at least negligence and gross negligence on the part of an indemnified
party. Our bylaws also require us to advance expenses incurred by directors and
executive officers in connection with the defense of any action or proceeding,
subject to several exceptions, arising out of the status or service as one of
our directors or executive officers upon an undertaking by that party to repay
these advances if it is ultimately determined that the party is not entitled to
indemnification. Furthermore, our bylaws authorize us to enter into
indemnification agreements with our directors, officers, employees and agents
and we intend to enter into these
54
<PAGE>
agreements. A copy of the form of the indemnity agreement has been filed as an
exhibit to the registration statement. We also maintain directors' and
officers' liability insurance.
At present we are not aware of any pending litigation or proceeding
involving any of our directors, officers, employees or agents where
indemnification will be required or permitted. Furthermore, we are not aware of
any threatened litigation or proceeding that may result in a claim for such
indemnification.
We are aware that the Securities and Exchange Commission considers
indemnification for liabilities arising under the Securities Act to be against
public policy. Even if our indemnification of our directors, officers and
controlling persons is permitted under indemnification agreements, it would be
unenforceable as a matter of public policy.
55
<PAGE>
CERTAIN TRANSACTIONS
On March 25, 1997 and June 10, 1997, we sold an aggregate of 3,220,000
shares of Series B preferred stock at a per share price of $1.00, in a private
placement equity financing with several unaffiliated investors and one of our
directors, including:
. an aggregate of 900,000 shares purchased by entities affiliated with WK
Technology Fund, a principal stockholder, of which Mr. Ko, one of our
directors, is Chairman; and
. 900,000 shares purchased by Mr. Ko.
On June 6, 1997, we entered into an employment agreement with Mr. McIlvane,
our Vice President, Worldwide Sales.
On June 3, 1997, we entered into an Advisory Services Agreement with WK
Technology Fund under which WK Technology Fund agreed that it would provide us
with business advisory services and finder services to identify, evaluate and
recommend outside director candidates. As compensation for these services, we
agreed to issue WK Technology Fund a warrant to purchase 1,400,000 shares of
common stock that vests monthly or immediately 30 days prior to the closing of
this offering at an exercise price of $0.05 per share and a warrant to purchase
360,000 shares of common stock that was exercisable on the date of issuance at
an exercise price of $0.05. As of March 31, 1999, WK Technology Fund had
exercised the warrants with respect to 768,328 shares of common stock. The
warrant covering the remaining 991,672 shares of common stock expires, will be
exercised upon the completion of this offering. The term of Advisory Services
Agreement with respect to the business advisory service is four years and the
term with respect to the finder services is one year.
On August 1, 1998, we entered into an employment agreement with Mr. Heaps,
our Chief Operating Officer Chief Financial Officer, General Counsel and
Secretary.
On December 7, 1998, we entered into an agreement with Intel Corporation
under which we agreed to collaborate on certain technical, public relations and
marketing activities. We agreed to allow Intel to purchase our products at the
same prices as the best price that we offer to any customer for similar
products and pursuant to similar terms and conditions at the time of Intel's
order. Intel can terminate the agreement at its convenience after September 30,
1999, without cause and both parties can terminate the agreement for cause upon
giving a 30-day notice and allowing for a 60-day cure period. Intel is one of
our principal stockholders.
We intend to enter into indemnification agreements with our directors and
executive officers for the indemnification of and advancement of expenses to
such persons to the full extent permitted by law. We also intend to execute
such agreements with our future directors and executive officers.
We believe that the foregoing transactions were in our best interest. As a
matter of policy the transactions were, and all future transactions between us
and any of our officers, directors or principal stockholders will be, approved
by a majority of the independent and disinterested members of the board of
directors, will be on terms no less favorable to us than could be obtained from
unaffiliated third parties and will be in connection with bona fide business
purposes.
56
<PAGE>
PRINCIPAL STOCKHOLDERS
The following table sets forth certain information regarding the beneficial
ownership of our common stock as of March 31, 1999, and as adjusted to reflect
the sale of our common stock offered by this prospectus:
. each stockholder who is known by us to own beneficially more than 5% of
our common stock;
. each of our named executive officers;
. each of our directors; and
. all of our directors and executive officers as a group.
Unless otherwise indicated, to our knowledge, all persons listed below have
sole voting and investment power with respect to their shares of our common
stock, except to the extent authority is shared by spouses under applicable
law. Beneficial ownership is determined in accordance with the rules of the
Securities and Exchange Commission. Applicable percentage ownership is based on
22,302,944 shares of common stock outstanding as of March 31, 1999, including
1,084,806 shares issuable upon exercise of warrants, together with options for
that stockholder that are currently exercisable or exercisable within 60 days
of March 31, 1999. In computing the number and percentage of shares
beneficially owned by a person, shares of common stock subject to options
currently exercisable, or exercisable within 60 days of March 31, 1999 are
counted as outstanding, while these shares are not counted as outstanding for
computing the percentage ownership of any other person. The percentage of
shares outstanding after the offering is calculated after giving effect to the
issuance of 4,000,000 shares of common stock offered by this prospectus,
assuming no exercise of the underwriters' over-allotment option.
<TABLE>
<CAPTION>
Shares Issuable Number of Shares Percentage of Shares
pursuant to Beneficially Owned Outstanding
Options Exercisable (Including the Number --------------------
within 60 days of Shares Shown in Before the After the
Name of Beneficial Owner of March 31, 1999 the First Column) Offering Offering
- ------------------------ ------------------- --------------------- ---------- ---------
<S> <C> <C> <C> <C>
WK Technology Funds(1)
c/o Ms. Leslie Kuo
10th floor, No. 115
Sec. 3 Ming Sheng East
Road
Taipei, Taiwan......... 0 5,055,270 22.67% 19.22%
1998 Wang/Chang Family
Revocable Trust(2)
c/o Clarent Corporation
700 Chesapeake Drive
Redwood City,
California 94063....... 0 2,667,708 11.96 10.14
1998 Vargo Family Trust
c/o Clarent Corporation
700 Chesapeake Drive
Redwood City,
California 94063....... 0 2,580,000 11.57 9.81
The Goldman Sachs Group,
Inc.(3 )
85 Broad Street
New York, New York
10004 ................. 0 2,127,658 9.54 8.09
Intel Corporation
2200 Mission Boulevard
Santa Clara, California
95052 ................. 0 1,519,756 6.81 5.78
Jerry Shaw-Yau
Chang(4)............... 0 2,667,708 11.96 10.14
Richard J. Heaps........ 0 0 * *
Michael F. Vargo(5)..... 0 2,580,000 11.57 9.81
Mark E. McIlvane........ 345,360 345,360 1.52 1.30
Heidi H. Bersin(6)...... 112,500 506,250 2.26 1.92
Mong Hong (Mahan) Wu.... 70,002 491,666 2.20 1.86
Wen Chang Ko(7)......... 0 6,855,270 30.74 26.06
Syaru Shirley Lin(8).... 0 2,127,658 9.54 8.09
All officers and
directors as a group
(8 persons)(9)......... 527,862 15,573,912 68.21 58.04
</TABLE>
- --------
* Represents beneficial ownership of less than one percent of the common
stock.
57
<PAGE>
(1) Consists of 556,028 shares held by and 14,838 shares issuable pursuant to a
warrant held by WK Global Fund Ltd., 747,520 shares held by and
1,003,946 shares issuable pursuant to warrants held by WK Technology Fund,
684,374 shares held by and 11,126 shares issuable pursuant to a warrant
held by WK Technology Fund II, 817,618 held by shares and 17,806 shares
issuable pursuant to a warrant held by WK Technology Fund III,
587,176 shares held by and 14,838 shares issuable pursuant to a warrant
held by WK Technology Fund IV and 600,000 shares held by WK Technology Fund
V. If not previously exercised, the warrants will expire upon the closing
of the offering. Mr. Ko is the chairman and a beneficial owner of each of
the above entities and exercises sole voting and dispositive powers with
respect to the shares held of record by the WK Technology Funds.
(2) Consists of 2,664,000 shares held by the 1998 Wang/Chang Family Revocable
Trust and 3,708 shares issuable pursuant to a warrant held by Alice Wang,
one of the trustees of the 1998 Wang/Chang Family Revocable Trust. If not
previously exercised, the warrant will expire upon the closing of the
offering.
(3) Consists of 1,519,756 shares held by The Goldman Sachs Group, Inc., 140,930
shares held by Bridge Street Fund 1998, L.P. and 466,972 shares held by
Stone Street Fund 1998, L.P. Bridge Street Fund 1998, L.P. and Stone Street
Fund 1998, L.P. are affiliates of The Goldman Sachs Group, Inc. The Goldman
Sachs Group, Inc. is the general partner or managing general partner of
each of these investment partnerships. The Goldman Sachs Group, Inc.
disclaims beneficial ownership of the shares owned by these investment
partnerships to the extent attributable to partnership interests therein
held by persons other than The Goldman Sachs Group, Inc. and its
affiliates. Each of these investment partnerships shares voting and
investment power with some of its respective affiliates.
(4) Consists of 2,664,000 shares held by the 1998 Wang/Chang Family Revocable
Trust, of which Mr. Chang is a trustee, and 3,708 shares issuable pursuant
to a warrant held by Alice Wang, Mr. Chang's spouse. If not previously
exercised, the warrant will expire upon the closing of the offering.
(5) Consists of 2,580,000 shares held by the 1998 Vargo Family Trust, of which
Mr. Vargo is a trustee.
(6) Consists of 393,750 shares held by the Bersin Family Trust, of which Ms.
Bersin is a trustee.
(7) Includes 3,992,716 shares held by and 1,062,554 shares issuable pursuant to
warrants held by the WK Technology Funds. Mr. Ko is the chairman of the WK
Technology Funds. Mr. Ko disclaims beneficial ownership of these shares
except to the extent of his proportional partnership interest therein.
(8) Consists of 2,127,658 shares held by The Goldman Sachs Group, Inc. and its
affiliated entities. Ms. Lin is an executive director in the Principal
Investment Area of Goldman Sachs (Asia) Limited. Ms. Lin disclaims
beneficial ownership of these shares.
(9) Includes an aggregate of 3,992,716 shares held by the WK Technology Funds,
2,664,000 shares held by the 1998 Wang/Chang Family Revocable Trust,
2,580,000 shares held by the 1998 Vargo Family Trust, 393,750 shares held
by the Bersin Family Trust, 2,127,658 shares held by The Goldman Sachs
Group, Inc. and its affiliated entities, 1,062,554 shares issuable pursuant
to warrants held by the WK Technology Funds and 3,708 shares issuable
pursuant to a warrant held by Alice Wang.
58
<PAGE>
DESCRIPTION OF CAPITAL STOCK
Following the closing of the sale of the shares offered by this prospectus,
our authorized capital stock will consist of 50,000,000 shares of common stock,
$0.001 par value, and 5,000,000 shares of preferred stock, $0.001 par value.
Common Stock
As of March 31, 1999, there were 22,302,944 shares of common stock
outstanding held of record by approximately 107 stockholders after giving
effect to the net exercise of outstanding warrants for shares of common stock,
on an as-converted basis. There will be 26,302,944 shares of common stock
outstanding after giving effect to the sale of the shares of common stock
offered by this prospectus. This number assumes no exercise of the
underwriters' over-allotment option and no exercise or conversion of
outstanding convertible securities after March 31, 1999.
The holders of common stock are entitled to one vote for each share held of
record on all matters submitted to a vote of the stockholders. Subject to
preferences that may be applicable to any outstanding shares of preferred
stock, the holders of common stock are entitled to receive ratably such
dividends as may be declared by the board of directors out of funds legally
available therefor. In the event of our liquidation, dissolution or winding up,
holders of the common stock are entitled to share ratably in all assets
remaining after payment of liabilities and the liquidation preferences of any
outstanding shares of preferred stock. Holders of common stock have no
preemptive rights or conversion rights or other subscription rights. There are
no redemption or sinking fund provisions applicable to the common stock. All
outstanding shares of common stock are, and all shares of common stock to be
outstanding upon completion of this offering will be, fully-paid and
nonassessable.
Preferred Stock
Effective upon the closing of this offering, we will be authorized to issue
5,000,000 shares of undesignated preferred stock. Our board of directors will
have the authority to issue the undesignated preferred stock in one or more
series and to determine the powers, preferences and rights and the
qualifications, limitations or restrictions granted to or imposed upon any
wholly unissued series of undesignated preferred stock and to fix the number of
shares constituting any series and the designation of these series, without any
further vote or action by the stockholders. The issuance of preferred stock may
have the effect of delaying, deferring or preventing any change in control
without further action by the stockholders and may adversely affect the voting
and other rights of holders of common stock, and the likelihood that the
holders will receive dividend payments and payments upon liquidation and could
have the effect of delaying, deferring or preventing a change in control. At
present, we have no plans to issue any shares of preferred stock.
Registration Rights of Certain Holders
The holders of 20,825,616 shares of common stock, including 1,084,806 shares
issuable upon exercise of warrants, or their transferees are entitled to some
rights with respect to the registration of these shares under the Securities
Act. These rights are provided under the terms of an agreement between us and
the holders of registrable securities. Subject to some limitations in this
agreement, the holders of the registrable securities may require, on two
occasions at any time after one year from the effective date of this offering,
that we use our best efforts to register the registrable securities, except for
the 5,244,000 shares held by the founders, for public resale, provided that the
proposed aggregate offering price exceeds $10,000,000. If we register any of
our common stock either for our own account or for the account of other
security holders, the holders of registrable securities are entitled to include
their shares of common stock in the registration. A holder's right to include
shares in an underwritten registration is subject to the ability of the
underwriters to limit the number of shares included in this offering. All fees,
costs and expenses of such registrations must be borne by us and all selling
expenses, including underwriting discounts, selling commissions and stock
transfer taxes, relating to registrable securities must be borne by the holders
of the securities being registered.
59
<PAGE>
Delaware Law and Some Charter Provisions
We are subject to the provisions of Section 203 of the Delaware Law. In
general, the statute 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 that the person became an interested
stockholder unless, with some exceptions, the business combination or the
transaction in which the person became an interested stockholder is approved
in a prescribed manner. Generally, a "business combination" includes a merger,
asset or stock sale or other transaction resulting in a financial benefit to
the stockholder, and an "interested stockholder" is a person who, together
with affiliates and associates, owns (or within three years prior, did own)
15% or more of the corporation's outstanding voting stock. This provision may
have the effect of delaying, deferring or preventing a change in control
without further action by the stockholders. In addition, upon completion of
this offering, some provisions of our charter documents, including a provision
eliminating the ability of stockholders to take actions by written consent,
may have the effect of delaying or preventing changes in control or
management, which could harm the market price of our common stock. Our stock
option and purchase plans generally provide for assumption of such plans or
substitution of an equivalent option of a successor corporation or,
alternatively, acceleration of vesting of shares issued pursuant to stock
grants, upon a change of control or similar event. The board of directors has
authority to issue up to 5,000,000 shares of preferred stock and to fix the
rights, preferences, privileges and restrictions, including voting rights, of
these shares without any further vote or action by the stockholders. The
rights of the holders of the common stock will be subject to, and may be
harmed by, the rights of the holders of any preferred stock that may be issued
in the future. The issuance of preferred stock, while providing desirable
flexibility in connection with possible acquisitions and other corporate
purposes, could have the effect of making it more difficult for a third party
to acquire a majority of our outstanding voting stock, thereby delaying,
deferring or preventing a change in control. Furthermore, this preferred stock
may have other rights, including economic rights senior to the common stock,
and, as a result, the issuance of this preferred stock could harm the market
value of the common stock. We have no present plan to issue shares of
preferred stock.
California Foreign Corporation Law
Pursuant to section 2115 of the California Corporations Code, under some
circumstances several provisions of the California Corporations Code may be
applied to foreign corporations qualified to do business in California
notwithstanding the law of the jurisdiction where the corporation is
incorporated. These corporations are referred to in this prospectus as "quasi-
California" corporations. Section 2115 applies to foreign corporations which
have more than half of their voting stock held by stockholders residing in
California and more than half of their business deriving from California,
measured on or after the 135th day of the corporation's fiscal year. If we
were determined to be a quasi-California corporation, we would have to comply
with California law with respect to, among other things, elections of
directors and distributions to stockholders. Under the California Corporations
Code, a corporation is prohibited from paying dividends unless:
(1) the retained earnings of the corporation immediately prior to the
distribution equals or exceeds the amount of the proposed distribution;
or
(2) (a) the assets of the corporation, exclusive of specific non-tangible
assets, equal or exceed 1 /1/4/ times its liabilities, exclusive of
specific liabilities; and
(b) the current assets of the corporation at least equal its current
liabilities. If the average pre-tax net earnings of the corporation
before interest expense for the two years preceding the distribution was
less than the average interest expense of the corporation for those
years, however, the current assets of the corporation must exceed 1 1/4
times its current liabilities.
Following this offering, we will be exempt from the application of Section
2115 until January 1, 2000, and thereafter in the event that more than half of
our voting stock is held by stockholders with residences outside of California
or is held by more than 800 persons.
Transfer Agent and Registrar
Norwest Bank Minnesota, N.A. has been appointed as the transfer agent and
registrar for our common stock.
60
<PAGE>
SHARES ELIGIBLE FOR FUTURE SALE
Prior to this offering, there has been no public market for the common
stock. We cannot provide any assurances that a significant public market for
the common stock will develop or be sustained after this offering. Future sales
of substantial amounts of common stock in the public market, or the possibility
of such sales occurring, could adversely affect prevailing market prices for
the common stock or our future ability to raise capital through an offering of
equity securities.
After this offering, we will have outstanding 26,302,944 shares of common
stock. Of these shares, the 4,000,000 shares to be sold in this offering or
4,600,000 shares if the underwriters' over-allotment option is exercised in
full, will be freely tradable in the public market without restriction under
the Securities Act, unless such shares are held by "affiliates" of Clarent, as
that term is defined in Rule 144 under the Securities Act.
The remaining 22,302,944 shares outstanding upon completion of this offering
will be "restricted securities" as that term is defined under Rule 144. 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 Rule 701 under the Securities
Act, as summarized below.
Pursuant to the "lock-up" agreements between our stockholders and either
Clarent or the underwriters, all of the holders of the restricted shares have
agreed not to offer, sell, pledge or otherwise dispose of, directly or
indirectly, or announce their intention to do the same, any common stock of
Clarent or security convertible into, or exchangeable or exercisable for any
security of Clarent for a period of 180 days from the date of this offering.
However, if the holder of the restricted shares is an individual, he or she may
transfer any such securities either during his or her lifetime or on death by
will or intestacy to his or her immediate family or to a trust the
beneficiaries of which are exclusively the holder of the securities and/or a
member of his or her immediate family. We also have entered into an agreement
with the underwriters that we will not offer, sell or otherwise dispose of
common stock for a period of 180 days from the date of this offering. On the
date of the expiration of the lock-up agreements, all of the restricted shares
will be eligible for immediate sale, of which 18,301,030 shares will be subject
to some volume, manner of sale and other limitations under Rule 144.
Following the expiration of the lock-up periods, some shares issued upon
exercise of options we granted prior to the date of this offering will also be
available for sale in the public market pursuant to Rule 701 under the
Securities Act. Additionally, 2,163,852 shares subject to vested options as of
the date 180 days after the completion of this offering will be available for
sale subject to compliance with Rule 701 and upon the expiration of the lock-up
periods. Rule 701 permits resales of such shares in reliance upon Rule 144
under the Securities Act but without compliance with the restrictions,
including the holding-period requirement, imposed under Rule 144. In general,
under Rule 144 as in effect at the closing of this offering, beginning 90 days
after the date of this prospectus, a person, or persons whose shares are
aggregated, who has beneficially owned restricted shares for at least one year,
including the holding period of any prior owner who is not an affiliate, would
be entitled to sell, within any three-month period, a number of shares that
does not exceed the greater of
. 1% of the then-outstanding shares of common stock or
. 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 some manner of sale and notice
requirements and to the availability of current public information about us.
Under Rule 144(k), a person who is not deemed to have been an affiliate at any
time during the 90 days preceding a sale and who has beneficially owned the
shares proposed to be sold for at least two years, including the holding period
of any prior owner who is not an affiliate, is entitled to sell these shares
without complying with the manner of sale, public information, volume
limitation or notice provisions of Rule 144.
61
<PAGE>
We intend to file, after the effective date of this offering, a registration
statement on Form S-8 to register approximately 10,831,842 shares of common
stock reserved for issuance under the 1999 amended and restated equity
incentive plan, the 1999 non-employee directors' stock option plan and the 1999
employee stock purchase plan. The registration statement will become effective
automatically upon filing. Shares issued under the foregoing plans, after the
filing of a registration statement on Form S-8, may be sold in the open market,
except for some holders, to the Rule 144 limitations applicable to affiliates,
the above-referenced lock-up agreements and vesting restrictions imposed by us.
In addition, following this offering, the holders of 20,825,616 shares of
common stock, including 1,084,806 shares issuable upon exercise of warrants,
will, under some circumstances, have rights to require us to register their
shares for future sale.
62
<PAGE>
UNDERWRITING
Under the terms and subject to the conditions contained in an underwriting
agreement dated , 1999, we have agreed to sell to the underwriters named
below, for whom Credit Suisse First Boston Corporation, BancBoston Robertson
Stephens Inc., Thomas Weisel Partners LLC and U.S. Bancorp Piper Jaffray Inc.
are acting as representatives, the following respective numbers of shares of
common stock:
<TABLE>
<CAPTION>
Number of
Underwriter Shares
----------- ---------
<S> <C>
Credit Suisse First Boston Corporation............................. 1,597,500
BancBoston Robertson Stephens Inc.................................. 958,500
Thomas Weisel Partners LLC......................................... 585,750
U.S. Bancorp Piper Jaffray Inc..................................... 408,250
Deutsche Bank Securities Inc....................................... 75,000
Hambrecht & Quist LLC.............................................. 75,000
Invemed Associates, Inc............................................ 75,000
Schroder & Co. Inc................................................. 75,000
Charles Schwab & Co., Inc.......................................... 75,000
Warburg Dillon Read LLC............................................ 75,000
---------
Total............................................................ 4,000,000
=========
</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.
We have granted to the underwriters a 30-day option to purchase on a pro
rata basis up to 600,000 additional shares at the initial public offering price
less the underwriting discounts and commissions. The option may be exercised
only to cover 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 $0.63 per share. The
underwriters and selling group members may allow a discount of $0.10 per share
on sales to other broker/dealers. After the initial public offering, the public
offering price and concession and discount to dealers may be changed by the
representatives.
The following table summarizes the compensation and estimated expenses we
will pay:
<TABLE>
<CAPTION>
Total
-----------------------------
Without With
Per Share Over-Allotment Over-Allotment
--------- -------------- --------------
<S> <C> <C> <C>
Underwriting discounts and
commissions payable by us........ $1.05 $4,200,000 $4,830,000
Expenses payable by us............ $0.28 $1,100,000 $1,100,000
</TABLE>
The underwriters have informed us that they do not expect discretionary
sales to exceed 5% of the shares of common stock being offered.
We and our officers and directors and other stockholders and option holders
have agreed not to offer, sell, contract to sell, announce our intention 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 common stock or securities
convertible into or exchangeable or exercisable for any shares of
63
<PAGE>
our common stock without the prior written consent of Credit Suisse First
Boston Corporation for a period of 180 days after the date of this prospectus.
The underwriters have reserved for sale, at the initial public offering
price up to 200,000 shares of the common stock for employees, directors and
other persons associated with us who have expressed an interest in purchasing
common stock in the offering. The number of shares available for sale to the
general public in the offering will be reduced to the extent such persons
purchase reserved shares. Any reserved shares not so purchased will be offered
by the underwriters to the general public on the same terms as the other
shares.
We have agreed to indemnify the underwriters against liabilities, under the
Securities Act, or to contribute to payments which the underwriters may be
required to make in that respect.
We have applied to list the shares of common stock on The Nasdaq National
Market.
Prior to this offering, there has been no public market for the common
stock. The initial public offering price will be determined by negotiation
between us and the representatives. The principal factors to be considered in
determining the public offering price include:
. the information set forth in this prospectus and otherwise available to
the representatives;
. the history and the prospects for the industry in which we will compete;
. the ability of our management;
. our prospects for future earnings;
. the present state of our development and our current financial condition;
. the general condition of the securities markets at the time of this
offering; and
. the recent market prices of, and the demand for, publicly traded common
stock of generally comparable companies.
Thomas Weisel Partners LLC, one of the representatives of the underwriters,
was organized and registered as a broker-dealer in December 1998. Since
December 1998, Thomas Weisel Partners has co-managed eighteen public offerings
of equity securities and has acted as an underwriter in an additional seven
public offerings of equity securities. Thomas Weisel Partners does not have any
material relationship with us or any of our officers, directors or other
controlling persons, except with respect to its contractual relationship with
us under the underwriting agreement entered into in connection with this
offering.
The representatives, on behalf of the underwriters, may engage in over-
allotment, stabilizing transactions, syndicate covering transactions and
penalty bids in accordance with Regulation M under the Securities Exchange Act
of 1934. 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 securities originally sold by the syndicate member are purchased in a
syndicate covering transaction to cover syndicate short positions. 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 in
the absence of these transactions. These transactions may be effected on The
Nasdaq National Market or otherwise and, if commenced, may be discontinued at
any time.
64
<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 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
pursuant to a discretionary exemption granted by the applicable Canadian
securities regulatory authority. Purchasers are advised to seek legal advice
prior to 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 and the dealer from whom the
purchase confirmation is received that:
. the purchaser is entitled under applicable provincial securities laws to
purchase the common stock without the benefit of a prospectus qualified
under the securities laws,
. where required by law, that the purchaser is purchasing as principal and
not as agent and
. 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 names
herein may be located outside of Canada and, as a result, it may not be
possible for Canadian purchasers to effect service of process within Canada
upon the issuer or these persons. All or a substantial portion of the assets of
the issuer and these persons may be located outside of Canada and, as a result,
it may not be possible to satisfy a judgment against the issuer or these
persons in Canada or to enforce a judgment obtained in Canadian courts against
the issuer or these persons outside of Canada.
Notice to British Columbia Residents
A purchaser of common stock to whom the Securities Act (British Columbia)
applies is advised that the purchaser is required to file with the British
Columbia Securities Commission a report within ten days of the sale of any
common stock acquired by the 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 in respect of 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 and 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.
65
<PAGE>
LEGAL MATTERS
The validity of the issuance of the common stock offered hereby will be
passed upon for us by Cooley Godward LLP, Palo Alto, California. The legal
matters in connection with the offering will be passed upon for the
underwriters by Wilson Sonsini Goodrich & Rosati, Professional Corporation.
EXPERTS
Ernst & Young LLP, independent auditors, have audited our consolidated
financial statements as of December 31, 1997 and 1998 and the period from July
2, 1996 (inception) to December 31, 1996 and the years ended December 31, 1997
and 1998, as set forth in their report, included in this prospectus and
registration statement. Our consolidated financial statements are included in
this prospectus and registration statement in reliance on their report, given
on their authority as experts in accounting and auditing.
WHERE YOU CAN FIND MORE INFORMATION
A registration statement on Form S-1, including amendments thereto, relating
to the common stock offered by this prospectus has been filed by us with the
Securities and Exchange Commission. This prospectus, which constitutes a part
of the Registration Statement, does not contain all of the information set
forth in the Registration Statement and the exhibits and schedules thereto. For
further information with respect to us and the common stock offered by this
prospectus, reference is made to the registration statement, exhibits and
schedules. A copy of the registration statement may be inspected by anyone
without charge at the public reference facilities maintained by the Securities
and Exchange Commission at 450 Fifth Street, NW, Judiciary Plaza, Washington,
D.C. 20549, and copies of all or any part thereof maybe obtained from the
Securities and Exchange Commission upon payment of certain fees prescribed by
the Securities and Exchange Commission. The Securities and Exchange Commission
maintains a World Wide Web site that contains reports, proxy and information
statements and other information filed electronically with the Securities and
Exchange Commission. The address of the site is http://www.sec.gov.
66
<PAGE>
CLARENT CORPORATION
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<S> <C>
Report of Ernst & Young LLP, Independent Auditors........................... F-2
Consolidated Balance Sheets................................................. F-3
Consolidated Statements of Operations....................................... F-4
Consolidated Statement of Stockholders' Equity.............................. F-5
Consolidated Statements of Cash Flows....................................... F-7
Notes to Consolidated Financial Statements.................................. F-9
</TABLE>
F-1
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Clarent Corporation
We have audited the accompanying consolidated balance sheets of Clarent
Corporation as of December 31, 1997 and 1998, and the related consolidated
statements of operations, stockholders' equity, and cash flows for the period
from July 2, 1996 (inception) to December 31, 1996 and for the years ended
December 31, 1997 and 1998. These financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant
estimates made by management, as well as evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the consolidated financial position
of Clarent Corporation at December 31, 1997 and 1998, and the results of its
operations and its cash flows for the period from July 2, 1996 (inception) to
December 31, 1996 and for the years ended December 31, 1997 and 1998, in
conformity with generally accepted accounting principles.
Ernst & Young LLP
Palo Alto, California
February 12, 1999,
except for the second paragraph of Note 4 and
Note 13, as to which the date is April 8, 1999
F-2
<PAGE>
CLARENT CORPORATION
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
<TABLE>
<CAPTION>
Pro forma
stockholders'
December 31, equity at
---------------- March 31, March 31,
1997 1998 1999 1999
------- ------- ----------- -------------
(unaudited) (unaudited)
<S> <C> <C> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents........ $ 474 $11,903 $ 7,267
Accounts receivable, net of
allowance for doubtful accounts
of $38, $807, and $1,204 at
December 31, 1997, December 31,
1998, and March 31, 1999,
respectively.................... 777 6,943 11,008
Inventories...................... 889 3,620 5,593
Prepaid expenses and other
current assets.................. 125 478 658
------- ------- --------
Total current assets........... 2,265 22,944 24,526
Property and equipment, net........ 543 2,233 4,078
Other assets....................... 10 -- 23
------- ------- --------
$ 2,818 $25,177 $ 28,627
======= ======= ========
LIABILITIES AND STOCKHOLDERS' EQ-
UITY
Current liabilities:
Accounts payable................. $ 506 $ 2,905 $ 5,600
Line of credit................... -- 2,500 2,800
Settlement expense accrual....... 570 -- --
Deferred revenue................. 155 4,414 6,752
Other accrued liabilities........ 253 1,594 1,908
Long term debt, current portion.. -- -- 470
------- ------- --------
Total current liabilities...... 1,484 11,413 17,530
Long term debt..................... -- -- 784
Commitments
Stockholders' equity:
Convertible preferred stock,
$0.001 par value, issuable in
series (aggregate liquidation
preference of $21,119):
Authorized shares--8,000,000 at
December 31, 1997, 1998 and
March 31, 1999 and pro form
Issued and outstanding shares--
4,220,000 in 1997, 6,864,241 in
1998 and March 31, 1999 and none
pro forma....................... 3,685 21,024 21,024 $ --
Common stock: $0.001 par value:
Authorized shares--50,000,000 at
December 31, 1997, 1998 and
March 31, 1999 and pro forma
Issued and outstanding shares--
5,401,000 in 1997, 7,129,076 in
1998, 7,489,656 as of March 31,
1999 and 21,218,138 pro forma... 27 2,746 14,795 35,819
Deferred compensation............. -- (1,771) (11,818) (11,818)
Notes receivable from
stockholders..................... (9) -- -- --
Accumulated other comprehensive
loss............................. (34) (68) (42) (42)
Accumulated deficit............... (2,335) (8,167) (13,646) (13,646)
------- ------- -------- --------
Total stockholders' equity..... 1,334 13,764 10,313 $ 10,313
------- ------- -------- ========
$ 2,818 $25,177 $ 28,627
======= ======= ========
</TABLE>
See accompanying notes.
F-3
<PAGE>
CLARENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Period from
July 2, 1996 Year ended Three Months Ended
(inception) to December 31, March 31,
December 31, ---------------- -----------------------
1996 1997 1998 1998 1999
-------------- ------- ------- ----------- -----------
(unaudited) (unaudited)
<S> <C> <C> <C> <C> <C>
Net revenue............. $ -- $ 3,359 $14,647 $2,396 $ 6,714
Cost of revenue......... -- 1,189 6,653 780 3,281
----- ------- ------- ------ -------
Gross profit........ -- 2,170 7,994 1,616 3,433
Operating expenses:
Research and
development.......... 136 1,044 3,356 540 1,566
Sales and marketing... -- 2,046 7,099 1,182 4,025
General and
administrative....... 140 639 2,484 176 1,357
Amortization of
compensation......... -- -- 879 2 1,980
Settlement expense.... -- 570 -- -- --
----- ------- ------- ------ -------
Total operating
expenses........... 276 4,299 13,818 1,900 8,928
----- ------- ------- ------ -------
Loss from operations.... (276) (2,129) (5,824) (284) (5,495)
Other income (expense):
Interest and other
income............... -- 70 204 11 61
Interest expense...... -- -- (172) (51) (45)
----- ------- ------- ------ -------
Total other income
(expense).......... -- 70 32 (40) 16
----- ------- ------- ------ -------
Loss before income tax-
es..................... (276) (2,059) (5,792) (324) (5,479)
Provision for income
taxes.................. -- -- (40) -- --
----- ------- ------- ------ -------
Net loss................ $(276) $(2,059) $(5,832) $ (324) $(5,479)
===== ======= ======= ====== =======
Historical basic and
diluted net loss per
share.................. N/A $ (2.14) $ (1.65) $(0.14) $ (1.00)
===== ======= ======= ====== =======
Shares used to compute
historical basic and
diluted net loss per
share.................. -- 962 3,544 2,326 5,481
===== ======= ======= ====== =======
Pro forma basic and di-
luted net loss per
share.................. $ (0.42) $(0.03) $ (0.29)
======= ====== =======
Shares used to compute
pro forma basic and di-
luted net loss per
share.................. 14,048 10,768 19,210
======= ====== =======
</TABLE>
See accompanying notes.
F-4
<PAGE>
CLARENT CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(in thousands, except share amounts)
<TABLE>
<CAPTION>
Convertible Notes Accumulated
Preferred Stock Common Stock Receivable Other
----------------- ------------------- Deferred from Comprehensive Comprehensive Accumulated
Shares Amount Shares Amount Compensation Stockholders Loss Loss Deficit
--------- ------- ---------- ------- ------------ ------------ ------------- ------------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Issuance of
restricted common
stock to founders
in exchange for
cash, technology,
debt forgiveness
and stockholder
receivables...... -- $ -- 7,400,000 $ 37 $ -- $(11) $ -- $ -- $ --
Issuance of
Series A
convertible
preferred stock,
net of issuance
costs of $8...... 1,000,000 492 -- -- -- -- -- -- --
Net loss......... -- -- -- -- -- -- -- -- (276)
--------- ------- ---------- ------- -------- ---- ------- ---- --------
Balances as of
December 31,
1996............. 1,000,000 492 7,400,000 37 -- (11) -- -- (276)
Issuance of
Series B
convertible
preferred stock,
net of issuance
costs of $27..... 3,220,000 3,193 -- -- -- -- -- -- --
Exercise of
common stock
options.......... -- -- 1,000 -- -- -- -- -- --
Repurchase of
common stock..... -- -- (2,000,000) (10) -- 2 -- -- --
Comprehensive
income:
Net loss........ -- -- -- -- -- -- $(2,059) -- (2,059)
Foreign currency
translation
adjustment...... -- -- -- -- -- -- (34) (34) --
-------
Comprehensive
loss............. -- -- -- -- -- -- $(2,093) -- --
--------- ------- ---------- ------- -------- ---- ======= ---- --------
Balances as of
December 31, 1997
(carried
forward)......... 4,220,000 3,685 5,401,000 27 -- (9) (34) (2,335)
<CAPTION>
Total
Stockholders'
Equity
-------------
<S> <C>
Issuance of
restricted common
stock to founders
in exchange for
cash, technology,
debt forgiveness
and stockholder
receivables...... $ 26
Issuance of
Series A
convertible
preferred stock,
net of issuance
costs of $8...... 492
Net loss......... (276)
-------------
Balances as of
December 31,
1996............. 242
Issuance of
Series B
convertible
preferred stock,
net of issuance
costs of $27..... 3,193
Exercise of
common stock
options.......... --
Repurchase of
common stock..... (8)
Comprehensive
income:
Net loss........ (2,059)
Foreign currency
translation
adjustment...... (34)
Comprehensive
loss............. --
-------------
Balances as of
December 31, 1997
(carried
forward)......... 1,334
</TABLE>
See accompanying notes.
F-5
<PAGE>
CLARENT CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (Continued)
(in thousands, except share amounts)
<TABLE>
<CAPTION>
Convertible Notes Accumulated
Preferred Stock Common Stock Receivable Other
----------------- ------------------ Deferred from Comprehensive Comprehensive Accumulated
Shares Amount Shares Amount Compensation Stockholders Loss Loss Deficit
--------- ------- --------- ------- ------------ ------------ ------------- ------------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balances as of
December 31, 1997
(brought
forward)......... 4,220,000 $ 3,685 5,401,000 $ 27 $ -- $ (9) $(34) $ (2,335)
Issuance of
Series C
convertible
preferred stock,
net of issuance
costs of $159.... 2,278,650 14,834 -- -- -- -- $ -- -- --
Issuance of
Series C
preferred stock
for settlement
expense.......... 45,592 300 -- -- -- -- -- -- --
Conversion of
Series C bridge
notes and related
accrued interest
of $56 to Series
C preferred
stock, net of
issuance costs of
$129............. 319,999 1,977 -- -- -- -- -- -- --
Issuance of
warrants in
conjunction with
Series C bridge
financing........ -- 228 -- -- -- -- -- -- --
Exercise of
common stock
options.......... -- -- 1,064,748 36 -- -- -- -- --
Exercise of
common stock
warrants......... -- -- 768,328 38 -- -- -- -- --
Repurchase of
common stock..... -- -- (105,000) (5) -- -- -- -- --
Forgiveness of
stockholder notes
receivable....... -- -- -- -- -- 9 -- -- --
Deferred
compensation
related to grant
of stock
options.......... -- -- -- 2,293 (2,293) -- -- -- --
Compensation
related to
issuance of
warrants for
services......... -- -- -- 357 -- -- -- -- --
Amortization of
deferred
compensation..... -- -- -- -- 522 -- -- -- --
Comprehensive
loss:
Net loss........ -- -- -- -- -- -- $(5,832) -- (5,832)
Foreign currency
translation
adjustment...... -- -- -- -- -- -- (34) (34) --
-------
Comprehensive
loss............. -- -- -- -- -- -- $(5,866) -- --
--------- ------- --------- ------- -------- ---- ======= ---- --------
Balances as of
December 31,
1998............. 6,864,241 21,024 7,129,076 2,746 (1,771) -- (68) (8,167)
Exercise of
common stock
options
(unaudited)...... -- -- 360,580 22 -- -- -- -- --
Deferred
compensation
related to grant
of stock options
(unaudited)...... -- -- -- 11,318 (11,318) -- -- -- --
Compensation
related to
issuance of
warrants for
services
(unaudited)...... -- -- -- 709 -- -- -- -- --
Amortization of
deferred
compensation
(unaudited)...... -- -- -- -- 1,271 -- -- -- --
Comprehensive
loss:
Net loss
(unaudited)..... -- -- -- -- -- -- (5,479) -- (5,479)
Foreign currency
translation
adjustment
(unaudited)..... -- -- -- -- -- -- 26 26 --
-------
Comprehensive
loss
(unaudited)...... -- -- -- -- -- -- $(5,453) -- --
--------- ------- --------- ------- -------- ---- ======= ---- --------
Balance as of
March 31, 1999
(unaudited)...... 6,864,241 $21,024 7,489,656 $14,795 $(11,818) $ -- $(42) $(13,646)
========= ======= ========= ======= ======== ==== ==== ========
<CAPTION>
Total
Stockholders'
Equity
-------------
<S> <C>
Balances as of
December 31, 1997
(brought
forward)......... $ 1,334
Issuance of
Series C
convertible
preferred stock,
net of issuance
costs of $159.... 14,834
Issuance of
Series C
preferred stock
for settlement
expense.......... 300
Conversion of
Series C bridge
notes and related
accrued interest
of $56 to Series
C preferred
stock, net of
issuance costs of
$129............. 1,977
Issuance of
warrants in
conjunction with
Series C bridge
financing........ 228
Exercise of
common stock
options.......... 36
Exercise of
common stock
warrants......... 38
Repurchase of
common stock..... (5)
Forgiveness of
stockholder notes
receivable....... 9
Deferred
compensation
related to grant
of stock
options.......... --
Compensation
related to
issuance of
warrants for
services......... 357
Amortization of
deferred
compensation..... 522
Comprehensive
loss:
Net loss........ (5,832)
Foreign currency
translation
adjustment...... (34)
Comprehensive
loss............. --
-------------
Balances as of
December 31,
1998............. 13,764
Exercise of
common stock
options
(unaudited)...... 22
Deferred
compensation
related to grant
of stock options
(unaudited)...... --
Compensation
related to
issuance of
warrants for
services
(unaudited)...... 709
Amortization of
deferred
compensation
(unaudited)...... 1,271
Comprehensive
loss:
Net loss
(unaudited)..... (5,479)
Foreign currency
translation
adjustment
(unaudited)..... 26
Comprehensive
loss
(unaudited)...... --
-------------
Balance as of
March 31, 1999
(unaudited)...... $10,313
=============
</TABLE>
See accompanying notes.
F-6
<PAGE>
CLARENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Period from
July 2, 1996 Year ended Three Months Ended
(inception) to December 31, March 31,
December 31, ---------------- -----------------------
1996 1997 1998 1998 1999
-------------- ------- ------- ----------- -----------
(unaudited) (unaudited)
<S> <C> <C> <C> <C> <C>
Operating activities
Net loss................ $(276) $(2,059) $(5,832) $ (324) $(5,479)
Adjustments to reconcile
net loss to net cash
used in operating
activities:
Depreciation.......... 9 82 516 53 346
Amortization of
compensation......... -- -- 879 2 1,980
Interest expense from
warrant issued in
conjunction with
Series C bridge
notes................ -- -- 99 33 --
Preferred stock issued
for interest
payable.............. -- -- 56 -- --
Forgiveness of
stockholder notes
receivable........... -- -- 9 -- --
Changes in operating
assets and
liabilities:
Accounts
receivable......... -- (777) (6,166) (1,701) (4,065)
Inventories......... -- (889) (2,731) (710) (1,973)
Prepaid expenses and
other current
assets............. (1) (124) (353) (12) (180)
Other assets........ (10) 1 10 3 (20)
Accounts payable and
accrued
liabilities........ 2 1,324 3,440 538 3,019
Deferred revenue.... -- 155 4,259 583 2,338
----- ------- ------- ------- -------
Net cash used in operat-
ing activities......... (276) (2,287) (5,814) (1,535) (4,034)
Investing activities
Purchases of property
and equipment.......... (95) (555) (2,207) (103) (2,191)
Financing activities
Proceeds from line of
credit................. -- -- 2,500 -- 300
Proceeds from issuance
of long term debt...... -- -- -- -- 1,254
Proceeds from Series C
bridge notes........... -- -- 2,600 2,600 --
Principal payment on Se-
ries C bridge notes.... -- -- (550) -- --
Proceeds from issuance
of common stock........ 37 (8) 69 12 22
Net proceeds from issu-
ance of preferred
stock.................. 492 3,193 14,834 -- --
Issuance of stockholder
notes receivable....... (11) -- -- -- --
----- ------- ------- ------- -------
Net cash provided by fi-
nancing activities..... 518 3,185 19,453 2,612 1,576
----- ------- ------- ------- -------
Effect of exchange rate
changes on cash and
cash equivalents....... -- (16) (3) (6) 13
----- ------- ------- ------- -------
Net increase (decrease)
in cash and cash equiv-
alents................. 147 327 11,429 968 (4,636)
Cash and cash
equivalents at
beginning of period.... -- 147 474 474 11,903
----- ------- ------- ------- -------
Cash and cash equiva-
lents at end of peri-
od..................... $ 147 $ 474 $11,903 $ 1,442 $ 7,267
===== ======= ======= ======= =======
</TABLE>
See accompanying notes.
F-7
<PAGE>
CLARENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
(in thousands)
<TABLE>
<CAPTION>
Period from
July 2, 1996 Three Months
(inception) Year ended Ended
to December 31, March 31,
December 31, ------------- -----------------------
1996 1997 1998 1998 1999
------------ ------------- ----------- -----------
(unaudited) (unaudited)
<S> <C> <C> <C> <C> <C>
Supplemental disclosure of
cash flow information
Cash paid for interest...... $ $ $ 28 $ $45
=== ==== ======= === ===
Supplemental disclosure of
noncash financing
activities
Issuance of common stock for
technology................. $37 $ $ $ $
=== ==== ======= === ===
Issuance of common stock for
note receivable............ $11 $ $ $ $
=== ==== ======= === ===
Repurchase of common stock
in exchange for forgiveness
of note receivable......... $ $ 2 $ $ $
=== ==== ======= === ===
Conversion of bridge notes
to Series C preferred
stock, less unamortized
cost of related preferred
stock warrant.............. $ $ $ 1,921 $ $
=== ==== ======= === ===
Issuance of preferred stock
for settlement expense..... $ $ $ 300 $ $
=== ==== ======= === ===
</TABLE>
See accompanying notes.
F-8
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
1. The Company and Summary of Significant Accounting Policies
The Company
Clarent Corporation was incorporated in the state of California on July 2,
1996. The Company is a provider of Internet protocol based technology for the
delivery of telecommunication services over public and private networks.
The Company has incurred operating losses to date, including a net loss of
approximately $5,832,000 for the year ended December 31, 1998.
The Company anticipates additional equity funding will be needed in order to
finance its expected operations for the year ending December 31, 1999, as well
as to fund its existing obligations. If additional equity funding is not
available, management believes, based on anticipated obligations, that
available resources will be sufficient to enable the Company to meet its
obligations through at least December 31, 1999. If anticipated operations are
not achieved, management has the intent and believes it has the ability to
delay or reduce expenditures so as not to require additional financial
resources if such resources were not available.
Basis of Presentation
The consolidated financial statements include the accounts of the Company
and its subsidiaries. The Company has export sales from the United States and
has operations in Taiwan and the United Kingdom. All significant intercompany
transactions and balances have been eliminated.
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.
Revenue Recognition
Revenue is recognized at the time of shipment of the products and when no
significant contractual obligations or acceptance terms, if any, remain
outstanding and collection of the resulting receivable is deemed probable.
Shipment of evaluation products are not recognized as revenue until acceptance
by the customer. Revenue from services is recognized when the services are
performed. Amounts billed or received in advance of satisfying revenue
recognition criteria are classified as deferred revenue in the accompanying
balance sheets.
Concentrations of Credit Risk and Credit Evaluations
Financial instruments which subject the Company to concentrations of credit
risk primarily consist of cash and trade accounts receivable. The Company
maintains its cash and cash equivalents principally in domestic financial
institutions of high-credit standing. The Company's receivables are derived
primarily from sales of software and hardware products and services to
companies primarily in the domestic and international telecommunications arena.
The Company performs ongoing credit evaluations of its customers and generally
does not require collateral. Reserves are maintained for potential credit
losses and such losses to date have been within management's expectations.
A limited number of customers have historically accounted for a substantial
portion of the Company's revenue. Two customers accounted for 44% and 35% of
the Company's revenue for the year ended December 31, 1997. Two customers
accounted for 36% and 12% of net revenue for the year ended December 31, 1998.
F-9
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
Sales of the Company's products and contracts for its technology will vary as a
result of fluctuations in market demand for such products and technology.
Further, the markets in which the Company competes are characterized by rapid
technological change and increasing competition.
Cash Equivalents
Cash equivalents consist of money market funds. For purposes of the
accompanying statements of cash flows, the Company considers all such liquid
instruments with an original maturity date of three months or less to be cash
equivalents. The fair value, based on quoted market prices of the cash
equivalents, is substantially equal to their carrying value at December 31,
1997 and 1998 and March 31, 1999.
Inventories
Inventories are stated at the lower of cost or market on a first-in, first-
out basis. Inventories consist of the following:
<TABLE>
<CAPTION>
December
31,
----------- March 31,
1997 1998 1999
---- ------ ---------
(in thousands)
<S> <C> <C> <C>
Raw materials...................................... $392 $2,529 $4,018
Finished goods..................................... 497 1,091 1,575
---- ------ ------
$889 $3,620 $5,593
==== ====== ======
</TABLE>
Property and Equipment
The Company records computer equipment and furniture at cost and calculates
depreciation using the straight-line method over the estimated useful lives of
the assets, generally three to five years.
Software Development Costs
Statement of Financial Accounting Standards No. 86, "Accounting for the
Costs of Computer Software to Be Sold, Leased or Otherwise Marketed," requires
capitalization of certain software development costs subsequent to the
establishment of technological feasibility. Costs incurred by the Company
between the establishment of technological feasibility and the point at which
the product is ready for general release have been insignificant. Accordingly,
the Company has charged all such costs to research and development expenses in
the accompanying statements of operations.
Stock-Based Compensation
The Company accounts for stock-based awards to employees under the intrinsic
value method in accordance with Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees" (APB 25), and has adopted the
disclosure-only alternative of Statement of Financial Accounting Standards
No. 123, "Accounting for Stock-Based Compensation" (FAS 123).
Advertising Expenses
The Company expenses advertising costs in the period in which they are
incurred. Advertising expenses for 1996, 1997, 1998, and the three months ended
March 31, 1998 and 1999 were approximately $0, $319,000, $706,000, $127,000,
and $472,000, respectively.
F-10
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
Foreign Currency Translation
Assets and liabilities of the Company's wholly owned foreign subsidiaries
are translated from their respective functional currencies at exchange rates in
effect at the balance sheet date, and revenues and expenses are translated at
average exchange rates prevailing during the year. Resulting translation
adjustments are reflected as a separate component of stockholders' equity.
Foreign currency transaction gains and losses, which have been immaterial, are
included in results of operations.
Comprehensive Income (Loss)
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income" (FAS 130). FAS
130 establishes new rules for the reporting and display of comprehensive income
and its components, requiring foreign currency translation adjustments, which
currently are reported in stockholders' equity, to be included in other
comprehensive income/loss. Prior year financial statements have been
reclassified to conform to the requirements of Statement 130. At December 31,
1997 and 1998, and March 31, 1999, the Company's accumulated other
comprehensive loss consisted entirely of cumulative translation adjustments.
Interim Financial Information
The interim financial information at March 31, 1999 and for the three months
ended March 31, 1998 and 1999 is unaudited but, in the opinion of management,
includes all adjustments, consisting only of normal recurring accruals, which
the Company considers necessary for a fair presentation of the financial
position and results of operations for the interim periods. The results of
operations for the three months ended March 31, 1999 are not necessarily
indicative of the results to be expected for the full fiscal year.
Recent Accounting Pronouncements
In March 1998, the Accounting Standards Executive Committee of the American
Institute of Certified Public Accountants (AICPA) issued Statement of Position
98-1, "Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use" (SOP 98-1). SOP 98-1 requires companies to capitalize certain
qualifying computer software costs which are incurred during the application
development stage and amortize them over the software's estimated useful life.
The Company adopted SOP 98-1 effective January 1, 1999. Adoption of SOP 98-1
did not have a material effect on the Company's consolidated financial position
or results of operations.
In December 1998, the AICPA issued Statement of Position 98-9, "Modification
of SOP 97-2, Software Revenue Recognition, With Respect to Certain
Transactions" ("SOP 98-9"). SOP 98-9 requires use of the "residual method" for
recognition of revenue when vendor-specific objective evidence (VSOE) exists
for undelivered elements but does not exist for delivered elements of a
software arrangement. The Company will be required to comply with the
provisions of SOP 98-9 for transactions entered into beginning January 1, 2000.
2. Related Party Transactions
In June 1997, the Company entered into an agreement for advisory services
with WK Technology Fund, a Taiwanese corporation, one of whose principals is a
member of the Company's board of directors. The advisory services primarily
relate to business strategy for the Company and are to be performed over a
four-year term. As consideration for the advisory services, the Company granted
to WK Technology Fund a warrant
F-11
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
to purchase up to 1,400,000 shares of the Company's common stock at an exercise
price of $0.05 per share. On the 6-month anniversary of the warrant effective
date, 175,000 of the warrants vested with the remaining warrants vesting
ratably over the subsequent 42 months or immediately 30 days prior to the
closing of the Company's public offering. The warrant has a life of five years.
The Company has valued the warrant using the guidance in the Financial
Accounting Standards Board's Emerging Issues Task Force Issue 96-18. The value
of the warrant was determined using the Black-Scholes valuation method. The
inputs used included the exercise price of the warrant of $0.05, the value of
the Company's common stock at each vesting date, expected dividend yield of 0%,
risk free interest rate of 6.0%, expected volatility of 0.3 and the contractual
life of the warrant of five years. The Company has recorded compensation
charges totaling $0 (amount was $3,000), $357,000 and $709,000 for the years
ended December 31, 1997, 1998 and the three months ended March 31, 1999,
respectively. These amounts are included in amortization of compensation
charges in the consolidated statement of operations. The Board of Directors
terminated the advisory services arrangement in June 1999 and elected to have
the unvested portion of the warrants to become fully vested. In connection with
this termination, the Company will record a compensation charge totaling
approximately $11.6 million in the quarter ending June 30, 1999. During 1998,
WK Technology Fund purchased 408,328 shares of the Company's common stock under
this warrant.
Also in June 1997, the Company entered into another agreement for certain
services with WK Technology Fund. These services were to assist the Company in
identifying, evaluating, and recommending an outside director for the Company.
Under the terms of this agreement, the Company is to grant to WK Technology
Fund a fully vested warrant to purchase up to 360,000 shares of the Company's
common stock at $0.05 per share upon the successful identification, evaluation,
and recommendation of an outside director of the Company. In February 1998, WK
Technology Fund was successful in obtaining an outside director for the
Company, and was granted the aforementioned warrant. The fair market value of
the Company's common stock on the date of this grant was $0.05 per share.
During 1998, WK Technology Fund exercised the option to purchase 360,000 shares
of the Company's common stock under this warrant.
In December 1998, the Company issued a warrant to purchase up to 101,000
shares of the Company's Series C preferred stock to both WK Technology Fund and
another Series C investor. These warrants are only exercisable upon the early
conversion of Series C preferred stock into common stock by certain other
Series C preferred stock investors. Upon such an event, one warrant for 101,000
shares will become exercisable and the other warrant for 101,000 shares will be
canceled. The warrants have an exercise price of $6.58 per share, and have a
contractual life of five years. As of December 31, 1998 and March 31, 1999, no
value was ascribed to these warrants as they are only exercisable based on
future events which are not currently deemed probable. These warrants will
expire unexercised upon the closing of the Company's Initial Public Offering.
3. Property and Equipment
Property and equipment consist of the following:
<TABLE>
<CAPTION>
December 31,
-------------- March 31,
1997 1998 1999
------ ------- ---------
(in thousands)
<S> <C> <C> <C>
Computer hardware and software........................ $ 473 $ 1,415 $2,130
Office equipment, furniture, and fixtures............. 108 1,204 2,072
Leasehold improvements................................ 53 221 829
----- ------- ------
634 2,840 5,031
Less accumulated depreciation and amortization........ (91) (607) (953)
----- ------- ------
$ 543 $ 2,233 $4,078
===== ======= ======
</TABLE>
F-12
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
4. Short-Term Borrowings
In February 1998, the Company obtained $2,600,000 in bridge financing from
certain investors and other parties. The financing was obtained via promissory
notes convertible into shares of the Company's Series C preferred stock issued
by the Company at a conversion price of $6.58 per share, at the option of the
note holders. In conjunction with this bridge financing, the Company issued to
the bridge financing investors warrants to purchase 59,266 shares of the
Company's Series C preferred stock at an exercise price of $5.593 per share
(including a discount of 15%). The warrants have a contractual life of 10
years. As of the date of this grant, the value ascribed to the warrants (using
the Black-Scholes valuation method with the following assumptions; expected
life of 10 years, exercise price of $5.593, stock price on date of grant of
$6.58, expected dividend yield of 0%, risk-free interest rate of 6%, and
expected volatility of .3) was approximately $228,000, of which approximately
$99,000 was recorded by the Company as additional interest expense over the
period the debt was outstanding. The remaining $129,000 was recorded as
issuance costs upon the conversion to Series C preferred stock. The effective
interest rate of the bridge promissory notes, as adjusted for the ascribed
value of the bridge financing warrants, was approximately 24.3%. In June 1998,
$2,050,000 of the bridge financing and approximately $56,000 of related accrued
interest was converted into 319,999 shares of the Company's Series C preferred
stock. The Company repaid the remaining $550,000 of the bridge financing and
all related accrued interest in June 1998.
In May 1998, the Company established a $5,000,000 line of credit with a
financial institution. The interest rate on this credit facility is variable
and is equal to one-half of one percentage point above the prime rate (8.5% in
total at December 31, 1998). Under the terms of this arrangement, the Company
is to pay an additional, pro-rated fee of 0.4% of all advances drawn in excess
of $3,000,000. In addition, borrowings under this arrangement are limited to
the Company's eligible receivable base. The terms of the line-of-credit
agreement establish certain affirmative and negative covenants, under which the
Company must maintain certain financial ratios and corporate reporting
practices, respectively. The Company failed to meet certain financial ratios
required to be maintained under the line of credit agreement as of December 31,
1998. The financial institution waived these events of default. On February 16,
1999, the financial institution increased the line of credit, to $7,000,000 and
revised the ratios. At March 31, 1999, the Company failed to meet certain
financial ratio covenants. The financial institution waived these events of
default and renegotiated new covenants. Borrowings under the line of credit are
secured by substantially all assets of the Company. At December 31, 1998 and
March 31, 1999, $2,500,000 and $2,800,000 was outstanding under this line of
credit, respectively. The line of credit agreement expires February 16, 2000.
5. Long-Term Debt
In February 1999, the Company entered into a $3,000,000 equipment term loan
facility. The loan bears interest at the bank's prime rate plus .75%. Under the
terms of the agreement, the Company grants a security interest in certain
assets of the Company and must maintain financial covenants (see Note 4) with
which the Company was not in compliance as of March 31, 1999. The financial
institution waived these events of default and renegotiated new covenants.
Borrowings and interest are repayable in installments over 24-27 months. As of
March 31, 1999, there was approximately $1,254,000 outstanding against the term
loan facility.
Maturities under these agreements are as follows:
<TABLE>
<CAPTION>
As of March 31, 1999
--------------------
(In thousands)
<S> <C>
1999 (nine months)...... $ 366
2000.................... 627
2001.................... 261
------
$1,254
======
</TABLE>
F-13
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
6. Settlement Expense
In November 1997, Wherever Computer Technology Co., Ltd. ("Wherever") filed
a complaint against the Company seeking to enforce a distributorship agreement
between Wherever and the Company or, in the alternative, for damages claimed in
connection with the breach of the distributorship agreement. On February 13,
1998, the Company's board of directors approved a settlement agreement with
Wherever. Under the terms of the agreement, the Company made an initial cash
payment to Wherever of $50,000, a cash payment to Wherever of $200,000 in
September 1998 and granted Wherever a 5% increase in the existing discount
Wherever receives applicable to a specific quantity of purchases of the
Company's products. In addition, under the terms of the settlement agreement,
the Company issued 45,592 shares of Series C preferred stock to Wherever at
$6.58 per share on August 12, 1998.
7. Income Taxes
The provision for income taxes of approximately $40,000 for 1998 consists
entirely of foreign income taxes provided on the profits attributable to the
Company's foreign operations. Pretax income (loss) from foreign operations was
$0 for the period from July 2, 1996 (inception) to December 31, 1996 and
approximately ($6,000) and $81,000 for 1997 and 1998, respectively. Due to
operating losses and the Company's inability to recognize an income tax benefit
from these losses, there is no provision for income taxes for 1997 or 1996.
The difference between the provision for income taxes and the amount
computed by applying the Federal statutory income tax rate (34%) to income
before taxes is explained below:
<TABLE>
<CAPTION>
Period from
July 2, 1996
(inception) Year ended
to December 31,
December 31, --------------
1996 1997 1998
------------ ----- -------
(in thousands)
<S> <C> <C> <C>
Tax (benefit) at Federal statutory rate.......... $(94) $(700) $(1,969)
Loss for which no tax benefit is currently
recognizable.................................... 94 700 1,969
Foreign tax...................................... -- -- 40
---- ----- -------
Total provision.................................. $ -- $ -- $ 40
==== ===== =======
</TABLE>
Significant components of the Company's deferred tax assets are as follows:
<TABLE>
<CAPTION>
December 31,
--------------
1997 1998
----- -------
(in
thousands)
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards............................... $ 524 $ 798
Tax credit carryforwards....................................... -- 200
Deferred revenue............................................... -- 1,061
Accruals and reserves not currently deductible................. 376 1,092
----- -------
Total deferred tax assets....................................... 900 3,151
Valuation allowance............................................. (900) (3,151)
----- -------
Net deferred tax assets......................................... $ -- $ --
===== =======
</TABLE>
F-14
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
Financial Accounting Standards Board Statement No. 109 provides for the
recognition of deferred tax assets if realization of such assets is more likely
than not. Based upon the weight of available evidence, which includes the
Company's historical operating performance and the reported cumulative net
losses in all prior years, the Company has provided a full valuation allowance
against its net deferred tax assets.
The valuation allowance increased by $800,000 and $2,251,000 during the
years ended December 31, 1997, and 1998, respectively.
As of December 31, 1998, the Company had federal and state net operating
loss carryforwards of approximately $2,000,000 and $1,400,000, respectively. As
of December 31, 1998, the Company also had research and development tax credit
carryforwards of approximately $200,000. The net operating loss and tax credit
carryforwards will expire at various dates beginning in 2004 through 2018, if
not utilized.
Utilization of the pre 1998 net operating loss and tax credit carryforwards
is subject to substantial annual limitations due to the ownership change
limitations provided by the Internal Revenue Code and similar state provisions.
The annual limitation results in the expiration of an immaterial amount of 1996
net operating loss carryforwards before utilization. Future ownership changes
may also subject the post 1997 net operating loss and tax credit carryforwards
to an annual limitation on utilization.
8. Employee Benefit Plan
The Company has a pretax savings plan that qualifies under Section 401(k) of
the Internal Revenue Code. Under the plan, participating employees may defer up
to 25% of their pretax salary but not more than statutory limits. The Company
may elect to make matching contributions to the plan. For the period from July
2, 1996 (inception) to December 31, 1996, and for the years ended December 31,
1997 and 1998, and the three months ended March 31, 1999, the Company made no
matching contributions and incurred immaterial expenses related to the plan.
9. Commitments
Leases
The Company leases its principal office under a noncancelable operating
lease agreement that expires in 2003. As of December 31, 1998, minimum lease
payments under all noncancelable lease agreements with initial terms in excess
of one year were as follows (in thousands):
<TABLE>
<CAPTION>
Operating
Year ended December 31, Leases
----------------------- ---------
<S> <C>
1999........................................................... $1,298
2000........................................................... 848
2001........................................................... 821
2002........................................................... 836
2003........................................................... 857
------
Total minimum lease payments.................................... $4,660
======
</TABLE>
Rent expense was approximately $24,000 for the period from July 2, 1996
(inception) to December 31, 1996, $81,000 and $492,000 for the years ended
December 31, 1997 and 1998, and $27,000 and $356,000 for
F-15
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
the three months ended March 31, 1998 and 1999, respectively. At December 31,
1998, the Company's aggregate future minimum rentals to be received under
noncancelable subleases is approximately $350,000.
10. Stockholders' Equity
Convertible Preferred Stock
Convertible Preferred Stock is as follows:
<TABLE>
<CAPTION>
Shares Issued and Outstanding
-----------------------------
December 31,
Authorized ------------------- March 31,
Series Shares 1997 1998 1999
- ------ ---------- --------- --------- ---------
<S> <C> <C> <C> <C>
A..................................... 1,000,000 1,000,000 1,000,000 1,000,000
B..................................... 3,220,000 3,220,000 3,220,000 3,220,000
C..................................... 2,750,000 -- 2,644,241 2,644,241
Undesignated.......................... 1,030,000 -- -- --
--------- --------- --------- ---------
Total Preferred Stock.................. 8,000,000 4,220,000 6,864,241 6,864,241
========= ========= ========= =========
</TABLE>
Each share of Series A, B, and C preferred stock is convertible into common
stock at the exchange rate in effect at the time of conversion, currently two-
for-one, and is subject to adjustment for common stock splits, stock dividends,
and similar transactions. Conversion is automatic upon the closing of an
initial public offering of common stock in which the aggregate gross proceeds
to the Company are at least $20,000,000 with a minimum offering price of $10.00
per share.
Each holder of Series A, B, and C preferred stock is entitled to the number
of votes equal to the number of shares of common stock into which such
preferred stock is convertible. For so long as at least 500,000 shares of
Series C preferred stock (subject to adjustment for any stock split, reverse
split, or other similar event affecting the Series C preferred stock) remain
outstanding, the vote or written consent of at least a majority of the Series C
preferred stock, voting as a separate series, shall be required to effect or
validate specified corporate actions. For so long as at least 250,000 and
500,000 shares of Series A and Series B preferred stock (as adjusted),
respectively, remain outstanding, the vote or written consent of the holders of
the majority of the Series A and Series B preferred stock shall be required to
effect or validate specified corporate actions. In certain instances, Series A
and Series B vote together as a single series.
Each holder of Series C preferred stock is entitled to receive, in
preference to the holders of any Series A and Series B preferred stock and
common stock, when and as declared by the board of directors, noncumulative
cash dividends at an annual rate of $0.53 per share of Series C preferred
stock. Thereafter, each holder of Series A and Series B preferred stock is
entitled to receive, in preference to any holder of common stock, when and as
declared by the board of directors, noncumulative cash dividends at an annual
rate of $0.04 and $0.08 per share, respectively, on a pari passu basis.
In the event of liquidation, before any distribution or payment is made to
holders of Series A and Series B preferred stock, the holders of Series C
preferred stock shall be entitled to a liquidation preference equal to $6.58
per share, plus all declared and unpaid dividends. Thereafter, before any
distribution or payment is made to holders of common stock, the holders of
Series A and Series B preferred stock shall be entitled to receive $0.50 and
$1.00, respectively, plus all declared and unpaid dividends. Any remaining
assets shall be distributed on a pro rata basis among the holders of common
stock.
F-16
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
Common Stock
In July 1996, 7,400,000 shares of common stock were issued to the Company's
three founders, one of whom subsequently left the Company, at $0.005 per share
in exchange for cash, software architecture technology ($10,000), debts owed by
the Company ($15,914) to the founders and stockholder notes receivable
($11,086). The notes accrue interest at a rate of 7% per year and are due and
payable on July 15, 2005, with interest payable annually. The outstanding
shares are subject to certain transfer restrictions through June 1999. These
shares are subject to repurchase at the issuance price upon the occurrence of
certain events, including termination of employment. The Company's right of
repurchase expires ratably over four years. In June 1997, 2,000,000 shares
issued to a founder who left the Company were repurchased. At December 31, 1998
and March 31, 1999, 5,400,000 shares issued to the two remaining founders
remain outstanding and 1,996,876 shares and 1,631,250 shares, respectively
remain subject to repurchase. The two remaining founders each hold 2,700,000
shares which have the same material terms.
Stock Option Plan
During 1996, the Company adopted the 1996 Stock Option Plan ("Option Plan").
Under the Option Plan, an aggregate of up to 10,503,000 shares of the Company's
common stock may be granted to directors, employees, and certain consultants.
During 1998, the board of directors approved the increase of options available
under the Option Plan by 3,303,000 shares. Under the Option Plan, options to
purchase common stock may be granted at no less than 85% of the fair value on
the date of the grant (110% of fair value in certain instances), as determined
by the board of directors. Options generally vest and become exercisable as to
25% of the shares one year from the date of grant and the balance in monthly
increments over the subsequent three years of service. Options have a maximum
term of 10 years. Certain stock options ("Performance Options") issued under
the Option Plan vest over a time period determined by the board of directors;
however, the vesting could be accelerated based on achievement of certain
performance criteria. As of December 31, 1998, the board of directors has
granted Performance Options to purchase 492,000 shares of common stock to
certain employees at an exercise price equal to the fair market value on the
date of grant. For the three months ended March 31, 1999, the Company granted
performance options to purchase 262,000 shares of common stock. These options
vest in seven years, but the vesting could be accelerated based on the
achievement of the performance criteria. The accelerated vesting schedule
provides that the grants will vest ratably over a 48 month term.
F-17
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
A summary of activity under the Option Plan is as follows:
<TABLE>
<CAPTION>
Options Outstanding
Shares ------------------------ Weighted-
Available Number of Price Average
for Grant Shares Per Share Exercise Price
---------- ---------- ------------ --------------
<S> <C> <C> <C> <C>
Authorized.............. 7,200,000 -- -- --
Granted................. (380,000) 380,000 $ 0.025 $ 0.025
---------- ----------
Balance at December 31,
1996..................... 6,820,000 380,000 $ 0.025 $ 0.025
Granted................. (5,040,000) 5,040,000 $0.025-$0.05 $ 0.032
Exercised............... -- (1,000) $ 0.25 $ 0.25
Canceled................ 400,000 (400,000) $0.025-$0.05 $ 0.038
---------- ----------
Balance at December 31,
1997..................... 2,180,000 5,019,000 $0.025-$0.05 $0.0285
Authorized.............. 3,303,000 -- -- --
Granted................. (3,030,896) 3,030,896 $ 0.05-$1.00 $ 0.62
Exercised............... -- (1,064,748) $0.025-$1.00 $ 0.035
Canceled................ 511,500 (511,500) $ 0.05-$0.35 $ 0.13
---------- ----------
Balance at December 31,
1998..................... 2,963,604 6,473,648 $0.025-$1.00 $ 0.305
Granted................. (1,522,900) 1,522,900 $3.00-$10.00 $ 5.30
Exercised............... -- (360,580) $ 0.05-$3.00 $ 0.12
Canceled................ 4,126 (4,126) $ 0.10 $ 0.10
---------- ----------
Balance at March 31,
1999..................... 1,444,830 7,631,842 $0.05-$10.00 $ 0.80
========== ==========
</TABLE>
The following table summarizes information concerning options outstanding
and exercisable at December 31, 1998:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
------------------------------------ ------------------------
Weighted-
Average
Weighted- Remaining Weighted-
Number of Average Contractual Number of Average
Exercise Price Shares Exercise Price Life Shares Exercise Price
- -------------- --------- -------------- ----------- --------- --------------
(in years)
<S> <C> <C> <C> <C> <C>
$0.025.......... 1,608,796 $0.025 8.22 324,206 $0.025
$0.05........... 2,491,252 $0.05 8.87 356,344 $0.05
$0.35........... 520,500 $0.35 9.55 61,166 $0.35
$0.75........... 929,100 $0.75 9.68 -- --
$1.00........... 924,000 $1.00 9.84 -- --
--------- -------
6,473,648 741,716
========= =======
</TABLE>
Deferred Compensation
The Company has recorded deferred compensation charges of approximately
$2,293,000 for the year ended December 31, 1998 and $11,318,000 for the three
months ended March 31, 1999, for the difference between the exercise price and
the deemed fair value of certain stock options granted by the Company. These
amounts are being amortized as charges to operations, using the graded method,
over the vesting periods of the individual stock options, generally four years.
Under the graded method, approximately 59%, 25%, 12% and
F-18
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
4% respectively of each options compensation expense is recognized in each of
the four years following the date of grant.
Pro Forma Disclosure of the Effect of Stock-Based Compensation
The Company has elected to follow APB 25 and related interpretations in
accounting for its employee stock options because, as discussed below, the
alternative fair value accounting provided for under FAS 123 requires use of
option valuation models that were not developed for use in valuing employee
stock options. Under APB 25, when the exercise price of the Company's employee
stock options equals the market price of the underlying stock on the date of
grant, no compensation expense is recognized.
In fiscal 1996, 1997 and 1998, the fair value of each option grant was
estimated on the date of grant using the minimum value method with the
following weighted average assumptions:
<TABLE>
<CAPTION>
December 31,
----------------
1996 1997 1998
---- ---- ----
<S> <C> <C> <C>
Risk-free interest rate.................................. 6.00% 6.00% 5.40%
Expected life of option in years......................... 4.00 4.00 4.21
Expected dividend yield.................................. -- -- --
</TABLE>
If compensation cost for the Company's stock-based compensation plan had
been determined based on the fair value at the grant dates for awards under
this plan consistent with the method provided for under FAS 123, then the
Company's net loss and loss per share would have been as indicated in the pro
forma amounts below:
<TABLE>
<CAPTION>
Years ended December
31,
-----------------------
1996 1997 1998
----- ------- -------
(in thousands, except
per share amounts)
<S> <C> <C> <C>
Net loss as reported............................. $(276) $(2,059) $(5,832)
Pro forma net loss............................... (276) $(2,064) $(5,869)
Net loss per shares as reported
Basic and diluted.............................. N/A $ (2.14) $ (1.65)
Pro forma net loss per share
Basic and diluted.............................. N/A $ (2.15) $ (1.66)
</TABLE>
The weighted average fair value of options granted to employees during the
years ended December 31, 1996, 1997 and 1998, were approximately $0.005, $0.005
and $0.125, respectively.
For purposes of pro forma disclosures, the minimum value of the stock grants
and stock options is deemed amortized over the grant vesting period. Because
FAS 123 is applicable only to options granted since inception its pro forma
effect will not be fully reflected until 2001.
F-19
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
Shares Reserved for Future Issuance
Common stock reserved for future issuance is as follows:
<TABLE>
<CAPTION>
December 31, March 31,
1998 1999
------------ ----------
<S> <C> <C>
Stock option plan................................. 9,437,252 9,076,672
Warrants.......................................... 1,312,204 1,312,204
Conversion of outstanding preferred stock......... 13,728,482 13,728,482
---------- ----------
Total common stock reserved for future issuance... 24,477,938 24,117,358
========== ==========
</TABLE>
11. Segments of an Enterprise and Related Information
The Company operates in one industry segment. The Company designs, develops
and sells IP telephony systems. The Chief Executive Officer has been identified
as the Chief Operating Decision Maker ("CODM") because he has final authority
over resource allocation decisions and performance assessment. The CODM does
not receive discrete financial information about individual components.
Net revenue for non-U.S. locations are substantially the result of export
sales from the U.S. Net revenue by geographic region based on customer location
were as follows:
<TABLE>
<CAPTION>
Three months
Year ended ended March
December 31, 31,
-------------- -------------
1997 1998 1998 1999
------ ------- ------ ------
(in thousands)
<S> <C> <C> <C> <C>
Net revenue:
United States................................ $ 213 $ 7,544 $1,391 $4,424
Other Americas............................... 2 99 -- 66
Europe....................................... 58 740 7 217
Asia......................................... 3,086 6,264 999 2,007
------ ------- ------ ------
Total......................................... $3,359 $14,647 $2,397 $6,714
====== ======= ====== ======
</TABLE>
12. Net Loss Per Share and Unaudited Pro Forma Stockholders' Equity
The Company follows the provisions of Statement of Financial Accounting
Standards No. 128, "Earnings Per Share." Basic and diluted net loss per share
is computed by dividing net loss by the weighted average number of common
shares outstanding during the period less outstanding nonvested shares.
Outstanding nonvested shares are not included in the computations of basic and
diluted net loss per share until the time-based vesting restrictions have
lapsed.
If the offering contemplated by this prospectus is consummated, all of the
convertible preferred stock outstanding as of the closing date will
automatically be converted into 13,728,482 shares of common stock based on the
shares of convertible preferred stock outstanding at March 31, 1999. The
unaudited pro forma stockholders' equity reflects this conversion.
F-20
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
The following table sets forth the computation of basic and diluted earnings
per share:
<TABLE>
<CAPTION>
Period from Year ended Three months
July 2, 1996 December 31, ended March 31,
(inception) to ---------------- ----------------
December 31, 1996 1997 1998 1998 1999
----------------- ------- ------- ------- -------
(in thousands, except per share amounts)
<S> <C> <C> <C> <C> <C>
Net loss (numerator).... $ (276) $(2,059) $(5,832) $ (324) $(5,479)
======= ======= ======= ======= =======
Shares used in computing
historical basic and
diluted net loss per
share (denominator):
Weighted average common
shares outstanding.... 7,400 6,400 6,248 5,507 7,281
Less shares subject to
repurchase............ (7,400) (5,438) (2,704) (3,179) (1,800)
------- ------- ------- ------- -------
Denominator for
historical basic and
diluted net loss per
share.................. -- 962 3,544 2,328 5,481
======= =======
Conversion of preferred
stock (pro forma)...... 10,504 8,440 13,729
------- ------- -------
Denominator for pro
forma basic and diluted
net loss per share..... 14,048 10,768 19,210
======= ======= =======
Historical basic and
diluted net loss per
share.................. N/A $(2.14) $ (1.65) $ (0.14) $ (1.00)
======= ======= ======= ======= =======
Pro forma basic and
diluted net loss per
share.................. $ (0.42) $ (0.03) $ (0.29)
======= ======= =======
</TABLE>
Clarent has excluded all convertible preferred stock, warrants for
convertible preferred stock and common stock, outstanding stock options and
shares subject to repurchase from the calculation of diluted loss per common
share because all such securities are anti-dilutive for all periods presented.
The total numbers of shares excluded from the calculations of diluted net loss
per share was 9,780,000 for the period from July 2, 1996 (inception) to
December 31, 1996, 19,297,000 and 24,158,334 for the years ended December 31,
1997 and 1998 and 18,727,000 and 24,324,862 for the three months ended March
31, 1998 and 1999.
13. Subsequent Events
In April 1999, the Company's Board of Directors approved the 1999 Amended
and Restated Equity Incentive Plan ("Plan"), subject to stockholder approval.
The Plan increases the authorized shares under the Company's existing stock
option plan from 10,503,000 to 11,358,170.
In April 1999, the Board adopted the 1999 Non-Employee Directors' Equity
Incentive Plan ("Directors' Plan"), subject to stockholder approval, to provide
for the automatic grant of options to purchase shares of common stock to our
non-employee directors who are not any of the Company's affiliates' employees
or consultants ("Non-Employee Director"). The Directors' Plan is administered
by the Board, and may be delegated to a committee.
The aggregate number of shares of common stock that may be issued under the
Directors' Plan is 300,000 shares. Under the terms of the Directors' Plan, as
of the initial public offering, each Non-Employee Director, and each person who
is thereafter elected or appointed for the first time to be a Non-Employee
Director automatically shall, upon the date of his or her initial election or
appointment to be a Non-Employee Director by the Board or stockholders, be
granted an option to purchase 5,000 shares of common stock. In addition,
commencing with the third regular meeting subsequent to the date of each Non-
Employee Directors' initial
F-21
<PAGE>
CLARENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(Information as of March 31, 1999 and for the three months ended
March 31, 1998 and 1999 is unaudited)
grant under the Director's Plan, each person who is then serving as a Non-
Employee Director automatically shall be granted an option to purchase 2,000
shares of common stock. The exercise price of the options granted under the
Directors' Plan will be equal to the fair market value of the common stock on
the date of grant. Options granted under the Directors' Plan vest and become
exercisable immediately.
In April 1999, the Company's Board of Directors approved the 1999 Employee
Stock Purchase Plan ("Purchase Plan"), subject to stockholder approval,
covering an aggregate of 600,000 shares of common stock. Under the Purchase
Plan, the Board of Directors or a committee may authorize participation by
eligible employees, including officers, in periodic offerings following the
adoption of the Purchase Plan. The offering period for any offering will be no
more than 27 months. The price of common stock purchased under the Purchase
Plan will be equal to 85% of the lower of the fair market value of the common
stock on the commencement date of each offering period or the relevant purchase
date.
In the event of certain changes in control, the Board of Directors has
discretion to provide that each right to purchase common stock will be assumed
or an equivalent right will be substituted by the successor corporation, or
that such rights may continue in full force and effect, or that all sums
collected by payroll deductions be applied to purchase stock immediately prior
to the change in control. The Purchase Plan will terminate at the Board's
discretion or when all of the shares reserved for issuance under the Purchase
Plan have been issued.
In April 1999, the Company's Board of Directors approved a two-for-one split
of the Company's common stock. The stock split will become effective with the
approval of the Amended and Restated Certificate of Incorporation by the state
of Delaware in connection with the Company's reincorporation. In addition, each
share of the Company's preferred stock will be convertible into two shares of
common stock. All share and per share amounts in the accompanying consolidated
financial statements have been adjusted retroactively.
On April 8, 1999, the Company's board of directors, subject to approval of
the Amended and Restated Certificate of Incorporation by the state of Delaware,
authorized the reincorporation of the Company in Delaware. The par value of the
preferred and common stock is $0.001 per share. The Company's Certificate of
Incorporation will be amended to authorize 5,000,000 shares of preferred stock
and 50,000,000 shares of Common Stock. The board of directors has the authority
to fix or alter the designations, powers, preferences, and rights of the shares
of each such series. The Company's reincorporation has been reflected in the
consolidated financial statements for all periods presented.
F-22
<PAGE>
[Graphic featuring a world map with stars indicating general geographic
locations of our deployed products]
The Clarent system has been installed in approximately 50 countries worldwide.
<PAGE>
[CLARENT LOGO APPEARS HERE]
